The Message from Economics to Politics: the Discussion on the New Economic Era from World Economic Forum 2009

This year's World Economic Forum attracts more attention as people are expecting the world's most influential political and business leaders will convey some important messages to the pale global economy. The WEF can take this responsibility since its spirit seems to lie in bringing people opportunities to communicate and listen to different opinions. The discussion session of the New Economic Era today pointed out key channels to deliver such a message.

The discussion was started from the perspective of economics. Panel experts talked about the important drive of world economy in the following several years and the possible methods of dealing with the severe financial crisis. Discussions were sparkled on the role and importance of fiscal policies in saving the national economy and as extend the global economy. In spite of the certain recognition of the fiscal policies, Heizo Takenaka, the Japanese economist, laid more emphasis on monetary policies; and some follow-up opinions by audience questioned the effectiveness of fiscal policies in the closed global economy viewed as a whole. The GDP growth rate can be sustained due to the fiscal stimulus but there may not be corresponding balance in the real economy. What's more, the fiscal policies adopted by one country or a few are certainly not helping too much. Yifu Lin urged the coordinated approach to deal with the crisis under which structure the developed countries should take up the responsibility to transfer some funds to the developing countries to help the development of the latter’s economy. This opinion displayed the picture of a multilateral plan which was not successful during the past experiences due to the unwillingness from countries to bear the responsibility. The IMF is not considered to be successful in conducting the multilateral support to world economy in the past. How about G20 which gathered the leaders from the most important nations in the world? People's view began to shift from a pure economic perspective to a political one. As many people might already realize, the message that could be delivered is not a pure economic one but with strong participation from the political world as a reconfirm of the repeated theme of history. However, to search for the path for multilateral cooperation means a greater involvement in the globalization, a trend that becomes more and more important and invertible whether people like it or not.

The WEF 2009 starts today and will continue to discuss a wide range of topics including global climate changes and regional relations. People expect the forum to give the world hope for dealing with the financial crisis. Obviously, the message that WEF can convey at best is to call for the understanding and cooperation between the world political leaders and business elites.

A Brief Review on the Current Financial Crisis (I)

Many people like to compare the current financial crisis and the Great Depression in 1930s. However, what we are facing is a much different version from many aspects. In this severe crisis, what is definitely of great value is our deeper understanding on our past wrong conceptions.
A brief review on the current crisis can be traced to the Greenspan’s age. After the fast development in the 1990s, financial institutions began to pursue higher profits by bearing higher risks. The risky desire located itself on the strategy to encourage people with imperfect credit history to purchase houses by taking mortgages with higher interests. As years of practice, with the help of the securitization, financial institutions discovered that it seemed quite safe to securitize those mortgages into Mortgages Backed Securities (MBS). Through this practice, financial institutions could get sufficient funds from MBS to support their loans towards the mortgage takers while using the cash flow from the interests of the mortgages to pay back the return for the MBS. However, the obvious mismatch between the asset and liability didn’t raise enough attention. The mortgages are long-term investment for financial institutions, while the MBS are usually short-term. If default rate of the mortgages becomes very high, financial institutions won’t be able to pay back the returns and principals of the MBS investors. Nonetheless, the seemingly prosperous world economy didn’t allow the elite to give the potential risk a second thought. This was even blessed by the deregulation of the financial sector under the reign of Alan Greenspan.
The up-and-down cycle finally turned to its dark side. When the house owners discovered that they were not able to clear the mortgages they had taken and more and more defaults occurred, the nightmare started. The drying up of the cash flow made the payment for the MBS difficult. What’s more, the financial institutions discovered that they had made another mistake, issuing credit default swaps. The credit default swaps are designed to insure the case when the third party’s (mortgage takers) default. For those MBS investors, buying credit default swaps may be a good idea in case that the mortgage takers defaulted. For financial institutions, they might take the long position of the swaps as a kind of insurance as well. Nonetheless, betting on the positive economic development and pursuing a higher profit, they took the short position; i.e. they are going to pay the investors if those mortgage takers default. Now stories became complex. The sudden turn of the housing market led doubled losses. Financial institutions had to pay the investors not only for the MBS but also for the swaps out of limited income streams. That was the end of the pride of those elite. They began to face the real trouble.
When the trouble spread from the housing market to the financial market, it could not be controlled easily any more. The financial markets nowadays are so interdependent that any fault in the chain may cause the dysfunction of the whole. Obviously the securitization was overused in the financial industry worldwide and the problem starting from the housing issue of the US became a global concern. Stock markets became so trembling that the confidence in the market was lost. This was the time for the test of hypothesis of “perfect arbitrage”. The perfect arbitrage is believed to be the base of modern financial markets, a hypothesis different pricing methods of financial instruments established. One example can show the profound influence of this hypothesis; Robert Merton, the 1997 Nobel Prize laureate, was awarded for his paper on “option pricing” which is deeply based on the perfect arbitrage assumption. According to the perfect arbitrage assumption, whenever the asset price seriously deviated from the true price, the arbitrageurs will fully take advantage of the opportunities to gain the arbitrage profit and correct the mispricing resulting from their arbitrage behavior. If it was true under no conditions, we would not see the Asian Financial Crisis in 1998 and would not see the messy financial markets today. In The Limits of Arbitrage, Andrei Shleifer pointed out the weakness of the perfect arbitrage assumption. The long-term capital management was the case to prove this point. When the market is full of panic atmosphere, arbitrage may not happen leaving the free fall of the asset price. That is what we are talking now; when everyone loses confidence in the market, who dares to put money into the market again?