Global economic and financial news remain disappointing. There are no signs of economic recovery, and expectations of negative growth for the global economy this year have only risen. Meanwhile, an increasing number of observers expect further contraction of world equity markets. Amid mounting efforts to pump more liquidity into the financial system, governments are becoming increasingly vocal about the need to strengthen regulation of the financial sector, a quite understandable but nonetheless populist move. Debates mostly center on the need to change and strengthen the role of the International Monetary Fund or create a superior regulator. Such proposals are implicitly based on the assumption that an "ultimate regulator" with perfect knowledge of the system and sufficient authority can be established in principle. But little is said about the need to improve the quality of regulation.
I have expressed doubt about such ideas in the past. If international financial institutions, which are supposed to have all of the necessary information, money and authority at their disposal, have failed to predict a number of crises in the developed world — above all in the United States — then who can guarantee that a new regulatory entity will perform any better? The debate on the new financial architecture should instead shift from the need to create a perfect global regulator toward greater responsibility on the part of governments and international financial organizations in establishing more transparent and mutually acceptable rules of the game, such as guidelines for macroeconomic policy.
Ultimately, it was central banks and governments that created an environment where private financial institutions were "encouraged" to take excessive risks. After all, the roots of the crisis can be traced to the government's negative real interest rates and growing budget deficits that create the illusion of an abundance of money. Why can one be so sure that the same regulators will suddenly achieve perfection or at least become more efficient?
I believe that most serious macroeconomic problems usually originate from flawed macroeconomic policies rather than the activities of private financial institutions, for which it becomes not only tempting, but even reasonable in some sense, to take excessive risks and create complicated and risky financial products when money is easily available. The soaring growth in money substitutes such as institutional money funds helped to inflate balance sheets, particularly on the assets side. This, in turn, helped with obtaining increasingly more credit, thereby inflating the liabilities side. As a result, the system became overleveraged. Ratings agencies only aggravated the problem by rubber-stamping those money substitutes with high ratings.
Thus, central bankers in many developed countries — above all the United States — lost control over growth in the money supply in recent years, helping private financial institutions create money. Interest rate differentials stimulated borrowing in a low interest rate environment and transfers to countries with higher rates. Even though no virtual money was created in this fashion, excessive moves in exchange rates also generated potential sources of instability
Overall, there is a growing consensus that the "balance sheet recession" will last a long time. This term, first coined by the U.S. Federal Reserve in 1991 and popularized in Richard Koo's 2003 book "Balance Sheet Recession," describes a severe economic contraction caused by a sharp drop in assets prices that leads prudent companies to pay down debt at the expense of business expansion. In his book, Koo explains Japan's prolonged stagnation of the 1990s as a classic balance sheet recession. You can draw certain parallels between balance sheet recessions and the current global economic crisis in which banks keep absorbing cash aid from governments but continue to behave like "zombies" — that is, not lending until their balance sheets are restored. Given the size of the problem and the depth of the global financial system, this process may last for years, in which time global growth will remain poor.
Across countries, however, the situation may differ. Russia is among those countries that can overcome the current problems much faster. First of all, Russia is mostly a pipeline exporter, and the elasticity of pipeline exports is not as high as that of, say, automobiles. That said, on the exports side, Russia was mainly hit by falling prices and only to a lesser extent by decreased volumes. Adjusting the exchange rate, which has largely already occurred, should do much to stabilize the balance of payments and money markets. Hence, I believe that Russia's recession is not only externally influenced, but largely a homegrown phenomenon originating from the slow reaction of the authorities.
I also believe that Russia's response to the current problems should differ from the policies adopted by other governments. The Russian economy was already overstimulated by excessive budgetary spending and foreign borrowing, and these trends need to be moderated. Meanwhile, I think that the current exchange rate will help keep the current account in surplus while helping to address capital account problems, such as repaying foreign debt.
Russia is the only country among the Group of 20 with double-digit inflation, and this remains one of the country's most serious problems. Russia's key dilemma is how to contain inflation while allowing the Central Bank to cut its benchmark interest rates. Meanwhile, in an environment of soaring Central Bank lending in recent months, the relatively cheap and abundant supply of rubles was converted into foreign cash, thereby shrinking the money supply. This stands in contrast to what occurred in other countries, where many banks loaded up on toxic assets. This was never a problem in Russia.
Given that Russia's financial system is not as deep as those in other countries — the total ruble money supply fell to around $330 billion as of Feb. 1 — Russia's version of the balance sheet recession should last for a much shorter period of time.
Yevgeny Gavrilenkov is managing director and chief economist at Troika Dialog.
This article was first published in The Moscow Times
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