How the global economy is emerging from the crisis

Financial stability has become a top priority for all but it is essential that the growth of the financial market is not jeopardised, Vito Spada cautioned in his perspective on how the global economy is emerging from the crisis.

Prof. Spada, professor of banking and finance at Italy’s Universita del Salento in Lecce, outlined how two decades of positive growth before 2008 had translated into a constant reduction of inflation and increased productivity, among other factors.

The environment of progressive globalisation of financial markets favoured financial innovation. But global imbalances between the US, Europe and emerging markets, fuelled by the wealth effect from property prices and opposite trends in savings rates, were accompanied by an under-evaluation of risk taken, excessive optimism, excessive financial leverage, exploitation of loopholes in the financial system, and lack of transparency.

The effects of Lehman Brothers’ collapse on the financial markets and the ensuing contagion caused the global economy to be “severely hit by the devastating destruction of systemic risk, a notion discussed in text books but never realised on such a big scale”. It was the first time the world had experienced a crisis that had not stemmed from the real economy to the financial sector but the other way round. Regulators had all been caught by surprise.

In November 2008, the world stock exchanges lost $30,000 billion, more than the sum of the GDP of Europe, the US and Japan. The situation was completely incomparable with the Great Depression as the markets at the time did not have financial globalisation or the same correlation and capital mobility.

Prof. Spada mentioned how Citigroup’s capitalisation shrank from $255 billion to $19 billion, Royal Bank of Scotland’s from $120 billion to $4.6 billion, HSBC’s from $215 billion to $97 billion, Barclays from $91 billion to $7.4 billion, and UBS’s from $116 billion to $35 billion.

But, he continued, in the words of Axel Weber, former president of the Bundesbank, “the crisis does not mark the end of the world as we know it”.

“The point learned in this crisis is that a financial sector that goes beyond a breaking point can lead to excessive risk-taking, over-leverage and can produce a moral hazard problem for society as a whole,” Prof. Spada said. Attention has shifted to credit growth and leverage as critical factors to assess the state of the economy, he added.

The problem was economists did not have a precise level of the breaking point which should guide them in assessing the expansion of the financial sector.

While research on the right breaking point is under way, it was understandable that financial stability has become a top priority, he said. The ultimate aim of the new macro approach was that of identifying and assessing the possible systemic vulnerability to ensure that the financial system can withstand its effects, minimising the spill-overs to the real economy.

Prof. Spada pointed out that the economic situation in the world had largely recovered from the lows of 2009. IMF projections showed that world global production grew by five per cent last year. This year, the IMF expected an increase of 4.4 per cent. In the last five years, 75 per cent of global growth has been generated in emerging countries.

The crisis had demonstrated how huge the unintended consequences of a complex financial system can be, and had posed new challenges to monetary policies and central banks are now subject to more public scrutiny.

A strong, sustainable and balanced growth is going to be the necessary winning strategy for our economies, Prof. Spada concluded. The new regulation on banks will have an impact on the role and cost of capital, for the liquidity management of banks, and for their activities in general.

While bankers had cautioned that financial crises will never be completely preventable, there was opportunity to design regulations and frameworks that would at least make them rarer.

“Let us not forget however, that the future is always open and it is for us alone to forge it,” Prof. Spada stressed. “Working for a better tomorrow and a better future is not only a hope, it is first, our duty.”