After all is said and done, this crisis had its genesis in US and European countries living beyond their means. This was reflected in large current account deficit which was financed by emerging economies of China, Russia, Brazil, Korea and others. This was in contrast to economic theory which tells us that advanced economies are supposed to generate savings and hence have current account surpluses while developing countries should be borrowing to finance their deficits (as they need foreign capital to finance their infrastructure and other needs).
The world is in the midst of extreme political risk – defined as not only wars and coups but governments rushing in with quantitative easing, banking bailouts, and large fiscal stimulus packages, embarking on industrial policies, and trying to re-regulate without fully understanding the unintended consequences of their actions. These expansive domestic policies have increased sovereign debt risk and raised stock prices in a large number of countries. Governments are trying to find domestic solutions to global problems of market volatility – volatility as reflected in descent of euro vis-à-vis the dollar, large movements in stock market indices, and swings in commodity prices. Markets in turn are looking at how governments are coping with big problems, such as the sovereign debt problems in Greece, Spain and other European countries. California could default on its debt obligations – what then for the global economy?
Easy policies are already showing up in a jump in inflation in India, China and other countries. How will US, UK, Japan and other vulnerable countries manage the inflationary expectations and rising deficits and debts. Markets are watching and the recent crisis has shown that there is no such thing as “too big to fail” economy and that both advanced and developing countries are prone to crisis. McDonald’s has better credit rating than the US government at this time of history.
Politicians remain oblivious and ignorant or at best obfuscate the problems. Yet in EU, US and Basel (uncoordinated) new rules and regulations are being proposed. Yet not one can say what this will entail in terms of taxes on banks and people, capital that need to be raised to deal with the reserve requirements, and how derivatives and hedge funds will be handled. Bailouts have only provided more incentives for the financial sector to misbehave once again knowing fully well that Governments and politicians will once again come to their rescue. In fact, post-crisis, there are fewer banks and financial institutions, more concentration and less transparency and unprecedented profits in 2009.
Another thing that could go wrong is the carry trade – where it is easy to borrow at near zero interest rates in US dollars and invest (recklessly) in high-yielding instruments and in both advanced and emerging countries. With US dollar depreciating this means that the interest rate is negative and all the more tempting to borrow and take exorbitant risks. What if the US dollar depreciates further? What if the Asian and Middle East surplus countries do not want to buy US dollars anymore?
Globalization if not well managed can be very disruptive. For example, India, China and other emerging markets have a population of over 4.5 billion people. This means that they have low-wage rates, and jobs will continue to move from advanced countries towards the labor-surplus countries in the form of outsourcing. More people are also on the move across countries. Many things can go awfully wrong.