In order to draw some of the main consequences of the current financial crisis a deep rooted diagnosis of the origins and causes is needed. The origin of the current crisis in the financial markets can be traced back to the set of incentives that were introduced in the public policy stance to encourage a rapid expansion of credit and thus avoid deeper economic recessions in Western countries following the bursting of the dot.com bubble and the geo-political instability brought about by the 9-11 terrorist attacks. This goal was achieved by means of an expansive monetary policy, one that kept real interest rates negative over many years, penalizing savers and encouraging indebtedness globally. This policy was led by the US Federal Reserve, but was followed, with a greater or lesser degree of enthusiasm, by most of the central banks. The implementation of this policy without producing any immediate cost in terms of inflation, was made possible by the credibility of the central banks, combined with the strong deflationary pressures created by the globalization process. The Chinese role in the global economy as an enabler agent of this process must be stressed both as the major exporter of deflationary pressures and the provider of net savings in a world anxious of high consumption. In addition, in the US, the government tried to benefit from the cheap money environment by promoting public policies aimed at increasing the availability of credit to those experiencing difficulties in the access of home ownership. A complex institutional architecture centered around Fannie Mae and Freddie Mac was designed to promote access to mortgage credit through implicit state guarantees, especially for individuals with low incomes. The impact of these political measures, combined with individuals' proverbial capacity to respond to public incentives, led to a spectacular increase in private indebtedness across Western economies and to the creation of the “toxic assets” whose loss of value has served as a catalyst for the financial crisis. In this respect, the costs that are currently being perceived in terms of financial instability and economic recession are actually the hidden and deferred costs of a series of public policies whose benefits were being enjoyed up until 2007.
This boom period started to lose momentum as soon as inflation pressures arose as a consequence of the expected scarcity of various raw materials, if new production capacity had to be built to meet the expected global demand growth. Subsequently, central banks changed the direction of monetary policy to stop inflation increases. The interest rate rise impacted the default rate in the United States sub-prime mortgage market, highlighted the poor allocation of a considerable volume of financial resources during a time of abundant credit. This, in turn, led the whole real estate bubble in the United States to burst as soon as the crutch provided by an expansive monetary policy was removed. Since the burst, we have become aware of how high the level of risk banks were assuming in other segments of the market, such as hedge funds, leveraged corporate operations, etc., all spurred on by the abundance of cheap credit.
A banking crisis is almost the logical consequence of this process. However, financial innovation, the sophistication and bad implementation of risk management systems, the long duration of the period featuring negative real interest rates, the existence of truly global financial markets and the adoption of new accounting standards in the majority of the non-Anglo Saxon countries, are all factors that have made this crisis especially severe and widespread to world financial markets. It is now time to recognize that excesses were committed during the “good times” and payment is due. The complexity of the transmission mechanisms of the crisis led to a climate of unprecedented uncertainty regarding the total amount and the distribution of losses in toxic assets across financial institutions. As a result, at the end of September 2008, in view of the lack of information regarding the solvency position of various systemic financial institutions (a situation exacerbated by the discrediting of the rating agencies that were supposedly specialists in this field), lenders (including other financial institutions) decided not to grant any financing to any financial institution, thus worsening the liquidity problems faced by banks since August 2007. Over a period of more than a year, economic policy decision-makers around the world have been working under the premise of a liquidity crisis. This has meant that coordinated measures designed to mitigate the underlying solvency problem have not been implemented on time.
The geopolitical consequences of this drying up of the credit markets to all financial institutions will be profound and long lasting and will imply a change in the balance of power that was emerging during the last 15 years. Emerging economies heavily relying on the global market will suffer a great deal during the economic recession resulting from the financial crisis. Those countries, whose economic and political strength during the boom period was based on their capacity to export to the global market and on their capacity to pile up high amounts of international reserves, will face a dramatic change in the international landscape. Raw material prices, including oil and gas, have plummeted as soon as the markets have realized the longer term effects of the credit constrains on global demand growth.
The world has entered a new era of limited expectations and in this context it is apparent that it is no longer feasible to simultaneously finance the European welfare state, the American dream (which included home ownership and high consumption profiles) and the development plans of large emerging countries. All will suffer, but the limits on global growth will have the toughest consequences on those countries who have incurred accumulation of physical capital in their economies to become the global producers of certain items based on the expectation of a high increase in world trade. The run to safety already conducted by international investors has made the dollar and the yen strengthen, while the currencies of most high exporting countries have depreciated during the last year.

Consequences in China

Global trade is contracting, thus making much of the investment in new production capacity spare and unprofitable, provoking additional loses to those financing them. The damaging consequences will be especially painful in the Chinese economy, which has witnessed during the last three decades the highest saving and investment rates around the world. Contrary to the development programs of many Latin American economies, financing of Chinese growth has been primarily domestic (indeed China helped finance consumption and investment in many Western economies). This was made possible through compulsory funneled flows of funds in a heavily controlled national banking system. The Chinese have never had the possibility to invest their savings abroad. They were obliged to invest in the local banking sector at penalizing interest rates or face the full inflationary loss of purchasing power if kept in bank notes. For a long time, the Chinese banks were a mere instrument of regional, local and central governments in China. Thus, funds were used to finance public oriented growth strategies and poor or no risk controls were in place. As a natural consequence the Chinese banking sector has been experiencing bankruptcy problems of a scale much larger than that of many Western banking systems.
Social unrest was avoided in the past through subsequent recapitalization plans financed due to abundant credit and reserves generated by the high economic and exports growth rates. Despite recent developments to introduce sound lending criteria in the banking sector, 21 percent of total savings of the population are deposited in credit institutions not fulfilling Chinese solvency standards. Millions of Chinese are uncomfortable with this, as their only safety net for the future is provided by their own savings, as no meaningful healthcare or pension system is available for most Chinese workers or entrepreneurs. The slowdown in the economy makes less likely that the recapitalization process that is under way will succeed.
As also happens with the Chinese labor market, China needs growth rates to exceed 8 percent and a sustained internal inflation to sustain their financial system. The prospect of many Chinese seeing their future vanish could lead to political unrest and instability in the country.

Fernando Navarrete is Director of Economics and Public Policy at the FAES Foundation and editor of the "Estrategia Global” magazine. He spent most of his professional career at the Spanish Central Bank. These remarks are based on his December 2, 2008 lecture at the annual Wollinsky Symposium on "Global Challenges 2009" at Bar-Ilan University, co-sponsored by the BESA Center, FAES, and the Foreign Policy Research Institute of Philadelphia.