The Globalization of Boom and Gloom: The U.S. Financial Crisis and its Impact on Europe, Japan and Asia

Martin Schulz
Research Fellow

October 10, 2008 (Friday)

When the financial crisis in the U.S. unfolded with the collapse of Lehman Brothers and the demise of Wall Street, Japan and Europe basically did nothing beyond hoping that the storm would simply pass. The initial European reaction was to blame U.S. “turbo capitalism” vs. a more balanced approach of universal banking and tighter financial control in Europe. Japan, on the other hand, did not even get scared enough to blame anybody. After its own experience with a finance/real estate driven bubble and crisis, policymakers and companies felt comparatively comfortable in the knowledge that Japan’s finance had already taken the medicine the U.S. is now about to swallow, and that Japan’s painful decade-long internal restructuring might have insulated her companies from external trouble.

Both reactions were likely wrong and failure to act will turn out to be costly. The main mistake was to underestimate the extent of global integration not only in finance, but also in production and consumption that has emerged during the last decade. In the old days, during the U.S. S&L crisis or Japan’s financial crisis of the 90s, the direct impact of a financial crisis would have been more or less contained to the originating country, with some staged spillovers into the economies of partner countries, including related rescues of financial institutions. On basis of this experience, the European Central Bank’s early reaction to provide ample liquidity when things started to look shaky last year, as well as the UK’s early move to nationalize a troubled bank, looked prudent. Japan, again, seemed well protected; knowing that the BOJ would probably be the best prepared and most professional when it comes to flooding her market with liquidity when need arises (after all, zero-interest-rate and quantitative-easing policy had just ended a few years ago). Many Japanese companies, including major banks, even saw the bursting of the current financial bubble as a welcome chance to turn into vultures and press ahead with their plans of (strategic) overseas expansion.

But now, it turns out that nobody is immune and minor action turns out as insufficient - we are in this together. The balance sheets of European “universal” banks still look better than that of their American investment bank peers because they can fall back on a cushion of retail banking deposits. But European banks are heavily involved in the U.S. financial sector, and in quite a few vulnerable European markets as well. European banks are also exposed to a liquidity crisis, even if the ECB is able to provide ample Euro liquidity and closely cooperates with the Fed on Dollar assets. The main problem for European banks, however, is the same as in the U.S.: a crisis of confidence that imperils banks’ solvency when they do not lend to each other anymore. After all, even “universal” banks depend on the ability to “borrow short and lend long.” HSBC in the UK, for example needs to roll over four times their normal credit volume by next spring, with only limited ideas about how to raise the funds in the current situation. Already today, European banks are therefore lining up for public support and recapitalization; from cash-strapped (often small country) governments who are not even sure to whom these cross-border banks really belong.

Such financial globalization is only one side of the coin, however. The crisis now strikes at the other end of the market, the “real economy” with surprising speed as well. Expecting lower trade and exports, industrial production had already been cut quite a bit, but the huge “domestic” European market was thought to be safe. This was a wrong assumption, as it turns out - European consumers are balking at the cashier and are not buying anymore. They were already hit by high consumer prices that evolved with the steep increases of oil and producer prices during the build up of the U.S.-fueled global liquidity and production bubble. Now, as the financial crisis adds to insecurity, these households are reacting immediately and bringing Europe’s economy to a halt; long before a trade-related spillover of the U.S. crisis would have hit.

Similarly, in Japan corporations are facing a fast and severe deterioration of their business environment. It is not only exports to the U.S. that are faltering. With Europe heading towards recession and a looming financial crisis almost simultaneously with the U.S., overseas demand takes a big hit, which is bad enough in an economy that has been flat or shrinking on the domestic side for almost a decade. The real danger now looms in Japan’s (in the meantime) most important East Asian markets. Fast growing, developing countries and corporations depend on healthy export markets and on cheap, readily available credit and finance. And both are simultaneously under threat now.

So far sentiment in East Asia has been holding up pretty well, despite terrible experiences during the Asian crisis ten years ago and obviously negative consequences of a shortfall in exports. Optimism has been based on high growth and the fact that most Asian countries have overhauled their financial systems, which have become much stronger and less leveraged today. Banking balances on their liability side often look particularly strong because Asian high-growth, high-savings countries boast enormous (low interest) deposits. Optimism was also based on hopes that a “decoupling” of high-growth Asia from its mature exports markets has already been happening. Consumer demand in China, for example, is thought to have enormous potential because Chinese households have so far been saving almost 40% of their income. Similarly, Southeast Asia is thought to be able to significantly increase domestic investment, which has not yet recovered to pre-Asian crisis levels.

But such a benign scenario looks increasingly unlikely. Instead of a “decoupling” of the world’s regions and business cycles, the opposite has happened. Financial and “real” economic integration has increased, and now even the bubbles and their bursts travel the globe in sync. Even if Asian governments are able to push domestic demand by increasing spending, the new demand would have limited impact because it would not be for the same products that are piling up at the exporters backyards. There will certainly a time lag of effectiveness while the global crisis strikes already. Even public demand for infrastructure and construction is unlikely to be very effective (as Japan showed during the decade after the burst of its bubble) because the shortfall of demand from export industries and their middle-class workers can’t be covered. But government action will likely be much more limited to start with. Inflation in Asia is already high, which hurts low-income workers and farmers. Furthermore, Asia remains vulnerable to a financial crisis, which will occupy governments’ full attention at first, at least. High-growth (export) companies get hurt in a global recession and turn into “bad credit” when they default. At the same time, high-growth companies become even more vulnerable when banks become cautious and do not roll over their credit lines.

To make things worse, banks and companies are hurting in “Dollarized” economies when the Dollar devalues, as it has done over the last years. While high Dollar inflows first drive growth and production, the capital inflows tend to hurt banking profitability when governments try to “mop up” excessive liquidity and sterilize Dollar inflows in exchange for low-yielding government bonds. China’s banks, for example, are already getting a raw deal on their Dollar assets because the government forces them to accept low-yielding, negative real interest government bonds in exchange. When recession strikes, these banks will become even more unwilling to provide credit to their ailing (export industry) customers. Unfortunately, even if the Dollar gets stronger, as is often the case during a global crisis, falling domestic currencies might easily deepen a looming crisis of confidence - as they did during the Asian crisis.

It is important to recognize that the seeds of the current financial crisis had already been planted when extraordinarily lax monetary conditions and supervision standards in the U.S. were blowing the current bubble worldwide. The signs have been on the wall for sometime. The booming housing market in the U.S., which resonated in quite a few follow-up bubbles throughout the world, raised warnings basically anywhere outside the U.S. But the boom also fanned China’s extraordinary production run, which was reflected in steep oil and material prices. Certainly, the shift of a large part of the world’s manufacturing capacity from developed countries to one of the world’s least efficient ones couldn’t happen without an amazing waste of material. Similarly, the boom resulted in the longest period of expansion in Japan, which developed against the odds of a domestically flat or shrinking economy. Less obviously, the boom also resulted in an extraordinarily strong Euro that gained on concerns about U.S. stability. Investors favored the Euro despite strong concerns about its intrinsic vulnerability that is rooted in the lack of unified or integrated financial policy (and a possible response to a crisis).

From this perspective, it becomes quite a bit less surprising that the crisis hit the world in an instant - when consumers in Europe stopped buying even before the crisis had spread to the U.S. “real economy”. To consumers, the latter part of the bubble was already the first part of the crisis because sentiment already got hurt by the explosion of production and consumer prices. Asia, on the other hand, remained optimistic until very recently, despite falling stock exchanges, which clearly seemed overvalued, and an implosion of Vietnam’s dollarized financial system, which seemed vulnerable even before. In most parts of Asia, investors and governments felt sufficiently insured by extreme currency reserves, saving rates, and more cautious investment after the Asian crisis. But Asia had also been riding the global boom and had subscribed to funding and supplying U.S. consumption (Dollar reserves and exports) for years. So Asia now firmly sits in a much larger boat of global boom and gloom that is certainly hard to steer but nevertheless requires fast and significant local action. Now that a huge wave of nationalizations is now under way, many pundits are therefore asking for new global institutions and better worldwide supervision. But instead of hunting for lofty goals after a lofty bubble, it seems to be the much better response to learn from globalized companies, who started to follow a strategy of “thinking global and acting local” long ago.