The current crisis is often seen as a match to the Great Depression of the 1930s.  Yet there is a hope that it would not evolve into a humanitarian disaster. The standard of living in the crisis-hit countries is much higher now than 80 years ago, and they are not facing the threat of all-out unemployment or poverty. The world’s GDP is not going to fall by one quarter within the next few years, and hungry people will not be marching to Washington or other capitals, while inhuman dance marathons, such as the one in Sydney Pollack’s movie  is likely to forever remain a screenplay.

The two crises are similar in that they both began in the United States, with financial upheavals quickly engulfing the manufacturing sector and a majority of regions of the world. The key common characteristic is the breakdown of market mechanisms. In the 1930s, it was caused by the first wave of globalization. Production technologies changed dramatically at the turn of the 20th century: there was a breakthrough in the development of transport and communications, and transnational oil companies were established and gained a firm footing. As a result, certain national and colonial economies were drawn into the world economic system. The collapse of the New York Stock Exchange on October 24, 1929 put an end to an erratic market. It turned out that market forces could not run the world economy without an active participation by the state.

The current restructuring of the market relations was triggered by the completion of the global economy formation. In the past two decades, we witnessed processes that have changed the world. The rapid development of information technologies, the breakup of the bipolar political system, the spreading of capitalism to all regions of the world, the liberalization of capital flows and the fast growth of financial markets have lent a new quality to the world economy. The interdependence of certain countries, regions, markets and processes has increased dramatically. The imbalances in trade and financial flows have grown to global proportions.

At present, the state – as in the times of the Great Depression – has to re-define its relations with the market: figuratively speaking, it has to tame the dragon first, and then dance with it, keeping time with the situation on the world market. The task would be difficult, because each country, region and group of countries will have to learn and perform a dance of their own.

ROCK’N’ROLL, STEP, AND BREAKDANCE

The events that have led to the ongoing crisis are surprisingly reminiscent of the situation in the 1920s. In 1925-1929, stock prices on the New York Exchange grew almost three-fold. Millions of Americans speculated on the exchange to gain more profit. In the first years of the 21st century, not only stock prices grew rapidly, but also real estate’s. The record-low interest rates stepped up competition among banks. To attract clients, the banks eased the requirements to borrowers. They took little interest in the borrowers’ real incomes in the hope that the prices of houses they had as collateral would keep growing and that loans would easily be redeemed with higher prices. In other words, banks and their clients were playing a big financial pyramid. As in 1929, there came a moment when it collapsed.

It is opportune to describe the present crisis as over-consumption, rather than overproduction. Excessive consumption, not justified by the real economic situation, became the last resort for the markets of the United States and a number of European countries to delay an impending system transformation. Mass consumption involved everybody: the population, companies, banks and the state. The average state debt of the U.S. and the 27 EU countries stood at around 60 percent of the GDP in the recent years. In 2006, the debt of U.S. and British families reached 150 percent of their real income, while in Germany and many other EU countries it made up 80 to 100 percent. Clearly, no family can live without buying food and medicines and paying for electricity for 18 months in a row. At present, U.S. families deduct 18 percent from their net income for debt payments, on the average. Thus, the 150-percent liability can be redeemed in eight or ten years. Until very recently, ordinary members of the consumer society would never think of tightening their belts for such a long period.

Many came to believe that the global economy was able to produce virtual money to buy real goods and services. Stock indices grew by leaps and bounds in the past few years. The rising stocks were a welcome security for credits. But this implied that one kind of obligation – shares and bonds – made the groundwork for other obligations, i.e. bank loans. The emission of virtual money by private companies and banks turned into a separate economic activity, quite profitable and practically unaccountable to anybody. New financial instruments played the key role in that process; the consequences of their use were not clear to the state and consumers, and even its originators were unable to fully realize the implications.

The long worldwide increase in the prices of real estate, gold, stocks and exchange commodities was, in fact, a warped form of world inflation. The bloated U.S. balance of payments deficit and the constant decrease in the dollar rate from 2002 against major currencies made investors turn to alternative assets. With the statistically low inflation in developed countries (2 to 3 percent a year), inflationary pressures began to affect the spheres which monetary authorities were unable to control – the commodity and stock floors. As a result, the hidden inflation, together with money supply, made a classic crisis tandem.

Information flows are another reason behind the malfunctions of market mechanisms, or, rather, their changed role in the production of material values. In the past 10 to 15 years, information has become as important a factor of production as labor, land and capital. But whereas labor, land and monetary relations are regulated by extensive legislation shaped over centuries, relations in the sphere of information are still at the puberty stage of wild capitalism. Newspapers and magazines, along with advertising and rating agencies, directly influence the demand, supply and prices of products on the market – from simple commodities to complex financial instruments. Yet none of them bears responsibility commensurate to the deviations of money flows they create.

Many have an impression that the era of monetarism, associated with the names of Ronald Reagan and Margaret Thatcher, is fading into the past, to be replaced by a modified version of Keynesian economics. Indeed, speeches by world leaders and declarations by international economic organizations are infused with Keynesian rhetoric.

The nationalization of debts, massive injections into the banking sector, increased controlling functions by the state – these are all Keynesian tools. At the same time, it would be incorrect to assert that Keynesian objectives – full employment and stimulation of domestic demand – have been made the cornerstone.

The new economic policy (regardless of the name it will be given in the future) should be able to resolve two key tasks: restore the normal functioning of market mechanisms and return to the state the niche it has lost in the economic system. At first glance, this mission has inherent contradictions, as it appears to be neo-classical and Keynesian at the same time. Yet it is based on common sense and the current situation.

That market mechanisms are imbalanced can be seen with the naked eye. Dramatic fluctuations in the prices of stocks, real estate, fuel and food show that the market has ceased to be the key measure to gauge the socially justified cost of this or that product. If that is so, the allocating function of the market (dealing with rational distribution of resources) is faulty as well: capital is invested in speculative transactions rather than in the manufacturing sector. This hampers the realization of yet another objective of the market – facilitating technological process and increasing labor productivity.

The breakdown of adequate supply-demand interaction is particularly noticeable on the money market, or the market of inter-bank loans. When U.S. banks cut the volume of current credits to European partner banks in September 2008, due to non-payments at home, a liquidity crisis hit Europe. There was an acute shortage of dollars for daily trade and conversion transactions. In this situation, each commercial bank decided to hold back its cash and stopped extending loans to other partner banks even at high interest rates. To save the market from collapsing and solvent banks from bankruptcy, European governments and the European Central Bank took unprecedented bailout measures.

The panic in the banking sector subsided, but the money market has not been re-launched since. Large commercial banks with sufficient supply of cash only give loans to privileged clients. An overwhelming majority of other European banks can only borrow from national central banks, which makes such transactions less convenient and more expensive. The most popular instrument – unsecured one-day loans – has been withdrawn from the market. Basic reference rates (LIBOR, EURIBOR, EONIA), a starting point in calculating the cost of credits, have become, in effect, a theory. Their use has decreased due to the drastic decrease in the volume of transactions.

The deformation of market mechanisms is fraught with yet another danger. If operators stop relaying signals to each other – and therefore do not contribute to market pricing, the state monetary-credit policy stops working. For example, in order to pull the economy from recession, central banks normally lower the refinancing rate. It is assumed that intermediaries, i.e. commercial banks, will also decrease their rates, at which they extend loans to each other and their clients. But in a situation where the market of inter-bank credits is idling (which is happening in Europe at present), cheaper credits may be unavailable for businesses and the population. For example, the European Central Bank (ECB) lowered the refinancing rate by 1 percent in October and November, but the cost of credits for the population and companies practically remained unchanged by December.

The peculiarity of the current crisis is that it started amidst low inflation and low interest rates. In the 4th quarter of 2008, the inflation rate slowed down considerably, with decreasing oil and food prices among the contributing factors, yet the demand for investments did not budge. According to prognoses, developed countries will post zero growth in 2009 at best, or a 1- or 2-percent fall at worst. This implies that the Western world risks getting into a trap of deflation (economic decline under low inflation) similar to the one the Japanese economy has been trying to overcome for more than a decade.

The evil of deflation is that it limits domestic investments and is conducive to capital flight. Monetary authorities lose the main lever that could be used to speed up economic growth – the opportunity to lower interest rates. Deflation is first and foremost dangerous to the euro zone. European business has become accustomed to an evolutionary and moderate monetary policy; the ECB rarely changes its rates, and the range of their fluctuations is quite narrow. Conversely, U.S. entrepreneurs have long got used to the aggressive and jerky interest rate policy by the Federal Reserve System, so the U.S. will be able to pull out of deflation. According to the January forecast by the European Commission, inflation in the euro zone will make up 1 percent in 2009, a two-fold decrease from the normal level. In Great Britain, the consumer price index is expected to fall to 0.1 percent.

SALSA, CZARDAS, AND HOPAK

In 2009, countries with developing markets will account for 100 percent of the growth of the world’s GDP, which is unlikely to exceed 2 percent. According to forecasts, their economies will grow 4 to 5 percent, whereas the GDP of developed countries will fall 1.5 to 2 percent. In 2004-2008, the average GDP growth rates in developing states reached 6 to 8 percent a year, exceeding the economic growth in developed states (pacing at 2 to 3 percent a year) by more than three times.

The crisis is quite painful for young market economies, despite positive dynamics there. In recent months, the IMF approved bailout loans for Hungary, Kyrgyzstan, Ukraine, Iceland, Belarus, Latvia and Serbia, worth a total of 40 billion dollars. IMF missions reported alarming conclusions after visiting Uzbekistan, Vietnam and Kazakhstan. The crisis is setting an almost impossible task before countries with developing markets – that of modernizing market mechanisms and strengthening the state’s position in the economy, although their economic system is deformed a priori, while international practices and standards ignore the fact of this deformation.

Whereas Western countries have to tame just one dragon – the markets, developing states have to deal with two “monsters” at once – the markets that got out of control and the inherent defects of a transitional economy. Some of these defects stem from the “catching-up” type of development – a relatively low standard of living of the population and high GDP growth rates. Consequently, almost all macroeconomic indicators fluctuate within a broader range, compared with countries with developed economies. Market situation changes, for example, in Mexico and Hungary, are much more pronounced than in the U.S. or Germany. This “roll” is a natural consequence of fast economic growth and insufficient stability of the economic system in general. As a result, any unfavorable changes on world markets (or external shocks) are more painful for developing markets than developed ones.

The fuel and food price hikes in the world pushed the inflation rate in Asian states with developing markets from 4 percent in 2007 to 8 percent in 2008. Compare: the average annual consumer price index in the euro zone increased to 3.3 percent from 2.1 percent. The reason behind the difference is high energy consumption of the GDP, and a large share of foodstuffs in family budgets of developing states. On the whole, inflation is a sore subject for these countries. It is generated by high economic growth rates and frequent pay rises, a characteristic and necessary measure (from the social point of view) for the “catching-up” type of development. In addition, budget deficit can push up the inflation, following huge spending by the state on modernizing production, technological development and welfare programs.

Low interest rates are not possible under high inflation, which itself creates inflationary expectations. A vicious circle is thus formed, which is hard to break.

According to a forecast published by The Economist, inflation in Russia, Turkey, Ukraine, Kazakhstan, Uzbekistan, Vietnam, Argentina and Bolivia will reach 10 to 15 percent in 2009. In Venezuela, it may increase from the current 30 percent to 40 percent. In Brazil, Mexico, India, Indonesia, Lithuania, Latvia, Estonia and Bulgaria, prices are expected to grow 6 to 7 percent.

The second part of the problem stems from the fact that globalization influences developing countries not in the way it influences the developed world. However, the global rules of the game are determined by the interests and practices of developed countries. Importantly, national market systems in the West matured in the conditions of more or less free trade and closed financial markets. States that embarked on the road of capitalism in the 1990s had no such margin of safety. With the possible exception of China, they quickly liberalized foreign trade, and found themselves de jure in equal, and de facto in subordinate relations to the main financial centers and currencies of the world.

Not surprisingly, many of their crucial economic inter-relations acquired quite a different shape compared with those of their Western partners. During the past decade, a majority of countries with developing markets had large inflows of foreign capital, especially short-term ones. This is understandable: high rates of growth transformed into high yields of stocks, which attracted investors from Western countries with slower development rates. Since the financial markets of young economies are not large, the increased external demand for their securities was vigorously pushing the rates of their currencies upwards. According to the Bank for International Settlements (BIS), the Russian ruble appreciated against the majority of currencies in the world by 90 percent in the period from 2000 to the middle of 2008 in real terms (which takes into account an adjustment for inflation); the Czech koruna appreciated by 70 percent; and the Hungarian forint by 60 percent. During the designated period, the currencies of Brazil, India and Poland appreciated by 40 percent each, on the average.

But since last autumn, when markets experienced shortages of liquidity, investors rushed to convert their funds from “exotic” currencies into dollars. The increasing inflation and the general worsening of the economic situation in countries with developing markets only speeded up the outflow of short money. As a result, the Brazilian real fell by 26 percent, the Mexican peso, the Indonesian rupiah, the South Korean won and the Polish zloty fell by 15 to 20 percent, and the Hungarian forint and the Czech koruna by 12 percent each over the last few months of 2008.

The currencies of the three Baltic States, pegged to the euro, are still within the designated corridor. But the margin of their strength is diminishing before our very eyes, as are the reserves of their central banks. The situation is particularly difficult in Latvia: the inflation rate in this country has reached 15 percent, and forecasts for 2009 show a 7-percent decrease in the GDP. If IMF and EU loans received by the country fail to save the Latvian lats from devaluation, the currencies of Estonia and Lithuania will come under pressure.

Another peculiarity of transitional economies is that the authorities have to fight for the stability of prices and stability of the exchange rate at the same time – the tasks the developed states never combine because they are mutually exclusive. For example, the European Central Bank has always underlined that its key and only objective is to keep prices stable, and that it does not handle the euro rate.

Things are different in countries with developing markets. The population there can easily slip away from the national currency to euros or dollars, so normal economic development is impossible without a stable exchange rate. A falling exchange rate provokes a rapid derangement of the national monetary system, and more stable foreign currencies begin to edge out the national currency from circulation, which pushes up inflation even more, cuts investments and devalues the local currency. Today, the world’s expert community does not deal with this issue in earnest, while international organizations do not issue recommendations to developing countries. Each of them resolves the problem at its own risk, as a rule in a “manual control” mode.

There is a tremendous difference between developed and developing states in terms of monetary and credit policy. The above loaning pattern (the central bank gives money to commercial banks and the latter extend loans to companies and the population) exists only theoretically in transitional economies. Indeed, the central bank fixes the refinancing rate, which is the reference point for rates on the inter-bank market and the final rates for clients. But commercial banks do not borrow from the central bank, so the borrowing pattern does not materialize. The reason is simple: interest rates in developing countries are always higher (due to inflation and fast growth) than in developed ones. In the conditions of globalization, there is no need for local commercial banks to borrow from the central bank at 10 percent interest per annum, if they can borrow from foreign banks at a half-price rate. That is, the disproportion in interest rates in developed and developing countries, paralyzes the refinancing mechanism in the latter. As a result, the state loses a crucial instrument of economic regulation.

Therefore, developing countries, often accused of excessive state regulation, have far less freedom in macroeconomic policy compared with developed states of the West. Using a truncated toolbox, they encounter tasks that their stronger partners have never faced, and that have no adequate solutions in modern economic practice.

TRAINING IN INTERNATIONAL CHOREOGRAPHY

Many think that the on-going crisis will stimulate unconventional, bold solutions and help overhaul the existing rules. According to Deutsche Bank CEO Joseph Ackermann, 2009 will go down in history as a year of complete reconfiguration of the world financial system. Director of the IMF European Department Marek Belka adds that “the crisis could generate political momentum in favor of deeper reforms that seem impossible in normal times.”

The crisis has showed that neither national nor international bodies failed to correctly assess the risks that had emerged on the financial markets in recent time.

The crisis was not predicted, so no measures were taken in time to ease its intensity and scale. Several oversights became obvious in methods for monitoring financial markets. At present, banking supervision systems operate on the national scale, whereas financial markets have become global. The share of foreign capital in the aggregate volume of funds attracted by banks keeps growing, as does the scope of their international operations.

It is easy now for investors to choose which securities are more attractive: national or foreign. The same applies to loans. Consequently, the interest rates on government bonds and stock markets of various countries become increasingly dependent on each other. Whereas economic slowdowns in the U.S. earlier triggered corresponding slowdowns in Europe only several months later, there was no time lag this time. The high dependence of developing countries on exports to the U.S. and other Western states, as well as on world fuel prices and the international movement of capital, did not let them protect themselves from the crisis.

Now the international community’s efforts are directed towards working out international rules that would help prevent the recurrence of such a crisis in the future. To this end, the leaders of the world’s 20 largest countries met in Washington on November 15, 2008. Their final declaration began with the phrase about the readiness to “work together to restore global growth and achieve needed reforms in the world’s financial system.”

The document noted the necessity of major improvement of the international regulation of financial markets, enhancing their transparency, strengthening the international regulation of trans-border flows of capital, and carrying out reforms at international financial institutions, while attracting to this task countries with developing markets, too.

Prior to the meeting, the IMF and the Financial Stability Forum (FSF), a body created after regional crises of 1997-1998), published a joint statement on the division of their spheres of responsibility. It was confirmed that the objective of the IMF was to monitor the international financial system as a whole, while the FSF should work out international standards of financial supervision and regulation. Together, these two institutions will be setting up early warning mechanisms. The IMF will assess macro-financial risks and systemic vulnerabilities, while the FSF will assess financial system vulnerabilities.

The crisis showed an obvious lack of knowledge about important economic processes and interaction. For example, complex methods to test banking systems have been developed in recent years, with the use of state-of-the-art econometric instruments. Stress-tests were run in 2005-2007 in a majority of EU countries. They all showed a high stability of banking systems – which the world crisis quickly disproved. It turned out that the tests did not take into account psychological factors and the system behavior of financial institutions. Furthermore, it has become obvious by now that market operators around the world were acting pro-cyclically before the crisis. During the boom stage, banks and investment companies were only pursuing maximum profit and did nothing to limit their future losses. In other words, they were making things worse.

The fact that the acute shortage of liquidity on financial markets occurred after years of intensive increase in money supply indicates little knowledge of the mechanism of monetary circulation in the conditions of globalization. Top officials of the Central European Bank acknowledge that both inflation and deflation processes at low interest rates have not been sufficiently analyzed. This has even more significance for the specifics of economic processes in countries with developing markets. There are all reasons to assume that the crisis will give a powerful impulse to the development of economic science and boost international cooperation in this field.

The development of regional financial cooperation is another measure. The EU has already publicly acknowledged the necessity to step up interaction between supervising bodies of various countries, and work out general principles of control over financial markets. Monetary authorities of a number of countries, especially, small and open ones, have insistently called for creating uniform supervision bodies for the EU. The crisis has made it clear that the European Union has to improve its legislation regulating trans-border banking.

For example, in Finland, where two of the main three banking networks belong to Swedes, apprehensions have been voiced starting late last year that anti-crisis programs, approved at headquarters, would be aimed at preserving parent businesses. Meanwhile, affiliated banks in Finland are of strategic significance, and their shutdown would deliver a blow to the whole national economy.

The crisis has seriously complicated the situation in small and open European economies which are not part of the euro zone. In Switzerland and Denmark, analysts say that if these countries were part of the monetary union, their financial markets and national currencies would not have come under such heavy external pressure. The difficult situation, in which the Baltic States’ economies have found themselves due to problems in the banking sector, has only strengthened their resolve to enter the euro zone as soon as possible. 

The necessity to boost regional integration is broadly discussed in Asia. From 1990 to 2007, the share of regional trade in the whole foreign trade of 15 countries in East Asia – ASEAN plus Three (China, Japan, and South Korea) – increased from 43 to 54 percent.

ASEAN states created free trade zones with China, Japan, Korea, India, Australia and New Zealand. In response to the financial crisis of 1997, the region set up a network of credit lines to fight speculative attacks on the currencies of the participating countries. In late November 2008, Bangkok hosted an international conference “The Future of Economic Integration in Asia.”  Governor of the Bank of Thailand Dr Tarisa Watanagase noted that “while we see significant adverse impacts of global integration, Asian economic integration, in fact, has a crucial role in helping a number of our regional economies withstand this enormous external destabilizing shock.”

On the agenda now are such issues as the liberalization of the market of financial services and the harmonization of the standards of financial activity, including accountability. But the main objective is to set up a deep, liquid and stable financial market in the region.

RUSSIAN DIVERTIMENTO

Russia needs to make the best use of opportunities, emerging during the acute phase of the crisis (presumably until the second half of 2009), to convert its international cooperation in the financial sphere into a new substantive quality.

First: It should raise, together with several CIS (Commonwealth of Independent States) and/or SCO (the Shanghai Cooperation Organization) partners, within the framework of a G-20 summit, scheduled for April, an issue of setting up an international center to study macroeconomic processes and policies in countries with developing markets. The functioning of such a center under the aegis a leading international financial institution will help to:

1) attract the attention of the international economic community to problems of transitional economies;

2) raise the level of knowledge about the patterns and principles of their economic processes;

3) work out better methods for carrying out monetary, currency and economic policies in this group of countries;

4) take into account the specifics of the fledging markets in working out international financial control standards. On the whole, the measure will contribute to the movement towards a multi-polar world within the scope of a global economic dialogue and G-20 meetings.

Second: It is expedient to put issues of anti-crisis settlement and crisis prevention in relations with the European Union on the agenda of the next Russia-EU summit in mid-2009. This subject is politically neutral and has an important practical content, which everybody acknowledges. The fact that a number of EU countries, including former Socialist states, have found themselves in a difficult economic situation, will contribute to the development of productive dialogue between Russia and the EU in this field. It should be taken into account that Sweden will take over the rotating EU presidency from July. This country has one of the world’s best economic schools with strong positions in issues of monetary circulation, finance and exchange rates.

Third: The crisis should be used as the starting point for a decisive breakthrough in financial integration within the CIS framework. Until now, there have been no tangible results in this sphere of cooperation, although the 1998 crisis in Russia quickly spread to other CIS states and now these countries are experiencing serious economic difficulties. Meanwhile, the region has all opportunities for active use of the ASEAN and EU experience in the stabilization of national currencies, integration of their national stock markets, harmonization of financial standards, and the development and unification of trans-border payment systems.

Resisting the crisis and developing international cooperation in this field should be made central issues on the agenda of the coming meetings of CIS governing bodies. They should adopt clear programs of actions that would meet the best international practices. In order to accomplish this, Russia (on its own, or together with active partners, such as Kazakhstan) should coordinate the issues of technical support for future projects with international groups of experts, for example, from the Central European Bank, which carries out such activities in some third countries.