Because financial institutions have too little capital relative to their debt, they have not been able or willing to provide the credit the economy needs. U.S. and European banks have been raising capital of about $400 billion from oil-producing countries and China, but the gap remains large as banks continue to write down bad loans. Financial institutions have been trying to pay down their debt by selling assets (including those mortgage-backed securities), but this action drives asset prices down and makes the institutions’ financial positions even worse. This vicious circle is what some call the “paradox of deleveraging.” The U.S. financial system is being crippled by inadequate capital, which will continue unless the federal government hugely overpays for the assets it buys, giving financial firms—and their stockholders and executives—a giant windfall at taxpayers’ expense. Regulators in some cases facilitated and in other cases failed to respond to the buildup in imbalances. The current economic crisis had many other culprits. A long period of abundant liquidity, rising asset prices, and low interest rates—in the context of international financial integration and innovation—led to the buildup of global macroeconomic imbalances as well as to a global “search-for-yield” and general underpricing of risk by investors. Complex, nontransparent instruments were mispriced and misunderstood. By early 2007, sovereign wealth funds managed over $3 trillion, in addition to foreign exchange reserves in emerging markets of $7 trillion. The uncertainty surrounding the losses to financial firms led to a flight to quality, as reflected by widening spreads between the London interbank offered rate and U.S. Treasury bill yields as well as among other financial instruments. At about the same time as the financial crisis was engulfing the United States, the excess asset demand that produced the crisis did not collapse. The financial instruments were deemed not as sound by capital investors (who were primarily from emerging markets) and by oil producers (who were in search of investment opportunities). Managing booms and busts is still the main economic policy challenge for developed and developing countries. The global oil price, which doubled between February 2007 and July 2008, is one such bubble that coincided with an endogenous response of a world economy that was trying to increase the global supply of financial assets (see figure 7.1). It is not the increased demand for oil from fast-growing China and India but the search for higher yields that is driving the commodity and financial bubbles.
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Frontiers in Development Policy