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Wim Naudé: Instead of bailing out reckless banks, the west should re-assess the global financial system

Guardian Economics 2nd February 2009

Following the World Economic Forum's gathering this week in Davos in the icy grip of winter, expect to receive yet more descriptions of an apparently deepening economic crisis. Indeed, an avalanche of metaphors has already been used to describe the crisis. From "hurricane" to "perfect storm" to "global meltdown", the message is the same: the whole world stares an unprecedented crisis in the face, we should all fear for our jobs, incomes, assets, health, stability and security. In the world media the crisis has become a basso continuo, a refrain that has now been taken up by policy makers and others as a modern-day bogeyman.

Yes, there is a financial crisis in the USA and in parts of Europe. Yes, these countries will be in recession in 2009: but it will neither be their first nor last recession. And yes, the recession in many countries in the west and the world's largest economy will have a negative impact on other regions of the world. But no, there is no global recession or global "meltdown". No, most countries in the world, particularly in emerging and developing regions, are not in recession.

All expectations are that countries in Asia, Africa and Latin America will on average experience growth of at least 4% and upwards in 2009 and beyond. China, now the world's third largest economy, just posted a 6.8% growth for the last quarter of 2008. Shock and horror, many cried! But when last did any western economy grow that fast? And Germany, the world's fourth-largest economy, just indicated that it expects the recession there to have blown over by next year and to resume positive growth, albeit more modestly. So really, comparisons with the Great Depression are greatly exaggerated.

Having a bogeyman may however be convenient, as parents with unruly children understand. In the media it may just be good business, as humans have a tendency – hard-wired by evolution – to be biased towards bad news. The media like to simplify and package news and information, so "global recession" is a convenient explanation for a complicated phenomena. Western bias in the media also plays against explanations of what might be happening in developing economies.

But the danger is not the slowing down of growth over the short-term. No, the world has seen many upswings and downturns, and the mistake would be to believe that the business cycle is something of the past. Come boom, come bust: the IMF has documented 124 systemic financial crises since the 1970s. The world has survived them all. This will therefore not be the last financial crisis; and although the impact on poverty is a real cause for concern, we should perhaps be even more concerned about the underlying lasting danger posed by the crisis as bogeyman.

The lasting danger, to be feared, is talking up a global financial crisis that scares nations into believing that the only way out is through bailouts – basically throwing their hard-earned taxpayers' money at the problem. Or worse, giving it to those responsible for the crisis amidst even more expansionary monetary policies than those that contributed to the crisis. The real danger is Bailout Man, not the bogeyman of global meltdown.

There are at least five dangers inherent in the rich world bailing out firms. First, the moral hazard problem of rewarding bad behaviour. The crisis is largely the consequence of greed and reckless risk-taking, amid cheap and easy credit and inadequate regulation, by overpaid CEOs and asset managers. How will financial institutions behave in the future knowing that if they get risk assessment and capital management wrong, they have an automatic "get-out-of-jail-free" card? And shouldn't we be concerned that policy makers, wanting to avoid this obvious moral hazard, will not now over-regulate and control the financial system, thereby stifling future growth?

Second, a message is being sent out that not only are some firms too large and important to fail, but by rescuing them and consolidating some into even more concentrated sectors they will become even more important. How would financial institutions and other firms behave in the future knowing they have even more potential market power? Will consumers still pay the price of the bailouts in terms of higher prices and poorer service long after the crisis has passed?

Third, some would argue that bailing out banks at least would prevent systemic instability. But what about other firms such as car makers? Where should the line be drawn? And who decides?

Fourth, what if many more countries started to bail out their unsuccessful industries? What if this means carte blanche for populous countries such as China and India to openly increase subsidies to their car makers and other industries? What would this mean for international bodies (such as the World Trade Organization) based on reciprocity ? and what would it mean for the environment?

Fifth, the bailout-bogeyman may protest that these bailouts are ultimately in the interest of developing countries. Really? Affording the bailouts (which will probably exceed $2 trillion in the US and EU) will involve a substantial transfer of resources from developing countries, which now hold $6 trillion of the world's foreign reserves. As the United Nations said in its Global Outlook 2009, "Developing countries as a group are net creditors to the rest of the world, and their savings will quite likely provide, directly or indirectly, a major source of funding to cover the costs of the multi-trillion dollar bail-outs of financial institutions in the United States and Europe."

The poor are literally filling the purse of Bailout Man. And it is not that this is the first choice of investment for these countries: holding so many US dollars is a great cost and risk. It largely reflects the inadequacy of the global financial system, about which much has been written, but little done, especially since the Asian financial crisis a decade ago.

This crisis has now shown that the global financial system itself can be a cause of moral hazard by encouraging western countries to pursue reckless growth. Addressing the five dangers mentioned here within the context of reforming the system is thus not only in the interest of developing countries who have been clamouring for change, but also in the interest of sustained growth in the west, and most notably the US.

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