Friday, February 20, 2009

Guest blog: A silver lining for the financial crisis?

Guest blogger: Alex Cobham, policy manager for Christian Aid

A silver lining for the financial crisis?

The TJN blog has already kindly highlighted the key points that Christian Aid’s report, The morning after the night before: The impact of the financial crisis on the developing world, made in regard to the Doha conference on Financing for Development. (We blogged on the negotiations and the outcome of the conference here.)

The report shows the damage that the crisis is already doing to people living in poverty in developing countries – people who are completely blameless for the crisis, yet are likely to suffer much more because of it over the coming years.

The report also contains our analysis of the causes of the crisis, and raises the possibility of a silver lining for development- a possible outcome which would represent a massive and fundamental step forward for the fight against poverty. We summarise this analysis here.

Background to financial crises

This global financial crisis is of a piece with the crises suffered by many developing countries in the last thirty years, as a direct result of the liberalisation of international financial flows (capital account liberalisation). In each case, rapid expansion of credit availability to the domestic economy was followed by an economic boom based on consumption and asset price bubbles.

At some point, investor sentiment turned and the sudden withdrawal of funds plunged stock markets, banks and other financial institutions into crisis – leading to bank runs and collapses, and an equally sharp withdrawal of funds from business and household credit. This in turn caused bankruptcies and widespread unemployment, leading to a collapse in consumption demand. The sum effect is a sharp contraction in economic activity, and the resultant social and economic dislocation.

John Williamson, who famously coined the term ‘Washington Consensus’, showed in a 1998 paper with Molly Mahar that every serious episode of capital account liberalisation had been followed by a bust. For a while, it was claimed – despite all evidence to the contrary – that the overall economic growth benefits were still positive. This position became untenable for all but the most ideologically driven. Most recently, former IMF chief economist Raghuram Rajan has shown that countries which rely more on foreign finance have exhibited systematically lower rates of growth.

Causes of the crisis

In the current case, there was no single act of liberalisation responsible. Instead, over a quarter of a decade or more, the richer economies engaged in competitive deregulation of financial markets. ‘Tax havens’ – secrecy jurisdictions – took this to an extreme, exploiting the gaps left by national regulation of global finance.

Regulation of banks and other financial institutions exists primarily to limit the risk that they are able to take on, recognising the huge social costs of their collapse – costs that the bank bailouts around the world now clearly illustrate.

In particular, regulation limits the amount of assets that banks and others can acquire, as a proportion of their own capital base, in order to protect depositors from undue risk. The Basle II capital accord allows assets of $1,250 for each $100 of capital. As Jim Stewart of Trinity College, Dublin has shown in Tax Justice Focus, the Irish holding company of now-collapsed US bank Bear Stearns held $11,900 of assets for each $100 of capital.

The crisis was driven by two key factors which allowed an unsustainable expansion of credit. One was the complexity of new financial instruments that confused investors and regulators as to the true ownership of assets and liabilities. The other was the opacity of the ‘shadow banking system’ – financial activities outside the traditional banking system, from hedge funds and private equity, to the structured investment vehicles and other conduits of investment banks and others, all taking advantage of ‘regulatory arbitrage’ to operate out of secrecy jurisdictions.

Obama’s incoming US Treasury Secretary, Timothy Geithner (then of the New York Federal Reserve Bank), has estimated just some of these activities as exceeding the total assets of the entire US banking system in size. As he explains, “Financial innovation made it easier for this money to flow around the constraints of regulation and to take advantage of more favorable tax and accounting treatment.”

Trigger point

As in developing country liberalisation episodes, the process continued until – almost arbitrarily – investor sentiment finally turned. In this case, the trigger was a growing realisation by investors that somebody, somewhere was holding assets whose value was based on the tanking US subprime mortgage market. As banks and others refused to reveal their true exposure – or were genuinely unable to do so, baffled like others as to their own position – investors moved rapidly out of the entire sector, seeking perceived safe havens like gold and US Treasury bills.

So began the unravelling that has yet to run its course, despite the vast amounts of public money injected to recapitalise the banks. The recession in the rich economies is likely to be long and deep, while the impacts in developing countries are already being felt in lost trade, investment and remittances – topped off only by questions over whether donor countries will honour their aid commitments.

The silver lining

There is growing consensus among international policymakers and opinion-formers about the above analysis – you only need to follow this blog to see that. Increasingly too, there is a demand for real action to prevent a repeat. This means true corporate transparency about their activities, assets and liabilities in each jurisdiction. It means preventing secrecy jurisdictions from exploiting the gaps between national regulation – and that means global agreement on the responsibilities that are implied by being allowed to participate in international financial markets, including automatic information exchange between jurisdictions to eliminate the key gaps.

As luck would have it, these measures could also eliminate the key international obstacles to effective taxation in developing countries – which as we have shown would go so far not only to increase much-needed revenues, but would also have a long-term dividend in strengthening democracy, improving standards of governance and reducing corruption. These are the reasons that Christian Aid are now campaigning, along with the our friends at ActionAid, for an international accounting standard for country-by-country reporting by multinational companies, and for automatic tax information exchange between all jurisdictions – that is, for tax transparency of the private sector and of secrecy jurisdictions.

This silver lining will not lift the cloud of the damage that the crisis is causing, and will cause in the next few years, to the poorest men and women in the world. It would, however, set a radically different context for the prospects for their countries’ future independent development – and this is why the ongoing discussions around global financial reform must include developing countries in a genuine and transparent way.

Alex Cobham


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