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Financial Sector

How to Prevent Future Credit Bubbles?

Raj Nallari's picture

Several institutions, such as the US Federal Reserve Bank, the Bank of England, the Bank for International Settlements, and the IMF among others as well as private consultancy firms (e.g. McKinsey) have opined on the above question. Here is what we know from their writings. There is now a broad consensus that advanced country monetary policy had focused almost exclusively on inflation-targeting or in the case of the US, a very narrow definition of price stability, and had neglected the speculative bubbles which were jeopardizing the financial stability.

Don’t Blame Mother Nature

Otaviano Canuto's picture

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)

Changing Development Paradigms

Raj Nallari's picture

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.

Transmission of Crisis from Home Mortgages to US Credit Freeze

Raj Nallari's picture

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 'Perfect Storm'

Raj Nallari's picture

The collapse of the 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.

Does Successful Development and Economic Transformation Require State Intervention in Industry and Technology?

Raj Nallari's picture

Proponents of state intervention argue that ‘market failures’ in information, coordination, credit and others necessitate ‘infant-industry protection’ and therefore an activist role for the government. For example, information about success or failure of new industries or technological adoption may be only available to investors and innovators and not shared with other entrepreneurs. Also, new industries and technologies require complementary human capital, and basic infrastructure among other things.