Even in normal economic times, the poor as a group do not affect public policy. Why then would it be different during a financial crisis, when saving the elites and saving the ‘financial world’ is of paramount importance?

The financial crisis originated in the USA and Western Europe and spilled over to the relatively poorer countries in Emerging Europe, Asia and Africa and to a lesser extent the Latin American countries. The middle and low-income countries were better prepared in 2009 to address the social fallout of the financial and economic crisis than in 1997, but available information from household and labor surveys still find that the people below the poverty line in developing countries have been disproportionately impacted due to the crisis.

To wit, this crisis initially led to credit crunch, lowered export and output growth and increased unemployment and poverty, lowered flow of remittances, reduced fiscal space as revenues fell sharply (due to lower business profits, fall in stock prices, lower commodity prices, lower output) while ‘bailout’ spending increased dramatically (support to industries, fiscal stimulus). The crisis of 2008-09 could be dubbed the ‘Great Reversal’ for when it is ultimately over, it will undoubtedly show that decades of poverty reduction has been eroded. The World Bank estimates that 53 million new poor may have been added to about 2 million already poor in the world.

Within countries, there is uncertainty about which groups will be impoverished during this crisis. Not only have the poor and vulnerable been adversely affected, but also those in middle class, working in export manufacturing and services. As such more people in urban industrial areas may have been affected than rural folks.

Joe Stiglitz, Nobel Laureate and former World Bank Chief Economist, is out again making headlines. This time because of his new book Freefall - America, Free Markets and the Sinking of the World Economy (W.W. Norton & Company, New York, 2010).   I had the pleasure of hosting his presentation at the World Bank’s Infoshop a few days ago – see video conference here -, and there were several things that struck me from what he said. Freefall might be mainly about the US economy but we can draw some very important lessons relevant for our development work.

Let’s see. Stiglitz provides considerable evidence that the US and others got into trouble by ignoring standard economic and financial guidelines that we recommend to developing countries, and which –by and large—the latter have been following in recent years. Mainly, rich countries overindulged in weak financial sector regulation, the housing bubble, and ended up giving out financial sector bailout packages that are almost textbook examples of what not to do.

"As chief economist of the World Bank, I had seen gambits of this kind," writes Stiglitz. "If this had happened in a Third World banana republic, we would know what was about to happen - a massive redistribution from the taxpayers to the banks and their friends. The World Bank would have threatened cutting off all assistance. We could not condone public money being used in this way, without the normal checks and balances."  (p. 122). 

by Otaviano Canuto

As my World Bank colleague Milan Brahmbhatt and I observed in a recent note, primary commodity exports remain crucial for most developing countries. When one takes a simple average across developing countries (i.e. attributing each country an equal weight) for 2003-07, commodities still show up as accounting for over 60 percent of merchandise exports, with half of the group featuring a commodity export dependence of over 70 percent. Chart 1 shows different degrees of primary commodity dependence across regions.

Source: Brahmbhatt & Canuto (2010)

This global crisis in not only about financial market failures but also government failures in several countries as reflected in failure to contain the housing bubbles and credit booms, bad regulations, and lack of supervision and enforcement). Both in advanced and developing countries, there are second thoughts on open markets, private ownership of nationally ‘strategic’ industries (autos, banks), and movement of transnational financial and industrial firms, and migrant labor. Trade and financial protection is on the increase as countries that have been less reliant on exports and foreign capital are weathering the storm better. In this semi-open global environment, would export-led growth strategy be combined with industrial policies to protect domestic industries, and/or emphasize resource-dependent growth, where possible?
Before we respond to these questions, it will be useful to focus on what went wrong in economics in 2007-08. Some economists are re-inventing economics to respond to such a query.

By early-2007, it became clear as housing prices began to decline, losses on sub-primate mortgages that originated in 2003-2006 were rising more rapidly than the assumptions used and risk-model predictions. The deterioration in borrowing quality and other shortcomings mentioned above gave little comfort to investors. The losses were hard to estimate, especially in an environment of house-price busts, and given that the sub-prime mortgage-backed security (MBS) had been re-packaged into complex collateralized debt obligation (CDOs) and CDO-conduits were financed by commercial paper and various notes.

The bursting of the housing bubbles in the United States, as reflected in a surge in defaults and foreclosures since mid-2006 in the US, resulted in a plunge in the prices of MBSs — assets whose value ultimately comes from mortgage payments. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt (US financial firms lost over $1 trillion by Dec. 2008). This problem is especially severe because households, corporations, and government took on so much debt during the bubble years (that debt cumulated to over 400% of US GDP and about 450% of UK GDP).

Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs. (US and European banks have been raising capital of about $400 billion from oil-producing countries and China but there is still a large gap as banks continue to write-down bad loans).

The collapse of the dot.com bubble in early-2001 and the 9/11 attacks was followed by an easing of monetary policy in the US and Euro Area as a response to avert an economic slow-down. Around the same time, coming out of the Asian crisis, emerging BRICs and Gulf countries started building up huge foreign exchange reserves, primarily denominated in US dollars and safest financial securities, such as US Treasury bills. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels (see Bernanke (2005). The supply of safe financial assets did not meet the demand. Western banks and investors began to scout around for alternative, higher-yielding financial investment opportunities. China, India, Brazil, Vietnam and other labor-rich but capital-scarce countries raised the return to physical capital formation everywhere. The unsustainable current account deficit of the US was made to appear sustainable through the willingness of China and many other emerging markets to accumulate large stocks of US dollars, both as official foreign exchange reserves and for portfolio investment purposes.

The excess liquidity in the world went primarily into credit growth and resulted in speculative bubbles in housing, stocks, and commodities (and not into consumer price inflation). The exact time when the home mortgage problems surfaced can now be pin-pointed as mid-2006 even though the housing problem was not fully acknowledged by the government and market players until almost summer of 2007. By mid-2006, there was now enough evidence that housing prices began to decrease significantly and default rates increased in some states such as California, Arizona etc.

 What? Senior Policy Seminar on
“Managing Capital Flows and Growth
in the Aftermath of the Global Crisis”
When? April 27-30, 2010
Where? Paris, France

Tentative Agenda

Since 1998, the World Bank Institute’s Growth and Crisis Program has organized a "Senior Policy Seminar on Capital Flows" in Paris, France. This event was launched right after the 1997 Asian crisis, and has been delivered continuously since then. It is a fee-based event planned and jointly delivered with the Federal Reserve Bank of San Francisco, the Bank of England, the Center for Pacific Basin Monetary and Economic Studies and Banque de France. Every year, this annual event brings together senior policymakers from countries around the world to reflect on global financial and economic issues, and review policy options.

This year’s delivery is scheduled for April 27-30, 2010. It will focus on “Managing Capital Flows and Growth in the Aftermath of the Global Crisis” and specific topics covered include: global challenges to growth and capital flows after the crisis, micro—and macro-prudential regulations, policy responses and impact by regions, and global outlook and policy options available to countries.

To apply for this fee-based event or for more information, please contact the course coordinator Hippolyte Fofack.