TCS Daily


When Is a Crisis Not a Crisis?

By Christopher Lingle - July 28, 2004 12:00 AM

FINANCIAL AND ECONOMIC TURMOIL SELDOM LEAD TO REAL "CRISES"

Here's a tough one. Let's banish the use of the term "crisis" from all discussion relating to unhappy economic or financial conditions. Granted, it will be hard to do. In the first place, more cumbersome words will have to be crafted to replace a single word. And, by some standards, it seems a perfectly good reference to a set of circumstances that involve bad economic news. In all events, it has gained certain credibility by government officials and organizations like the IMF that use the term with great alacrity.

Use of this word is confusing because it excites a sense of an impending or a recent brush with disaster, even a catastrophic collapse. Upon simple reflection, it is in most instances a wild exaggeration that is widely overused. As a shorthand expression to describe economic turmoil, it is applied when conditions are not so severe or even particularly widespread. Newspaper headlines scream out tales of financial crises, currency crises, debt crises, and economic crises.

Despite its emotionally charged nature of the term "crisis", even academic economists who are meant to be familiar with how markets use the term with little introspection. Indeed, few professional economists used the term until the late-1990s. Prior to that time, a survey of the academic literature would yield very few references to "crises", even when referring to the Great Depression. This is not surprising since the origin of the term is found in the critique of markets offered by Marxist economists.

Sure, there have been some bad times. However, in most instances, there were not heavy negative effects upon all or even most of the citizens of the countries where "crises" have supposedly occurred.

How did this term come to such heavy misuse? One reason is that politicians and bureaucrats invoke the image of doom as a way to justify their interference in economic matters and validate their discretionary use of more public resources.

And consider the record of the International Monetary Fund (IMF). It states that over two-thirds of its 182 member countries have experienced financial shocks over the last 20 years.

By citing such data, the IMF offers "proof" of its necessity and of its army of international bureaucrats with their six-figure salaries and their quasi-diplomatic status. But these highly-paid bureaucrats seem incapable of insuring that such unhappy events do not occur because they seldom see them coming.

For example, within a month or so after praising Turkey's macroeconomic stability that was developing under IMF tutelage, events unfolded that was deemed by the IMF to be a "crisis". When Russia defaulted on its international debt in 1998, it was under IMF care. Despite evidence of such relentless malfeasance, it seems that no one is punished or held accountable.

So let's get over it. Since true crises are rare, we should not use the term to describe every instance of economic or financial turmoil.

Given that there will be financial turmoil, understanding the process will make it easier to see the path forward. Presumably the goal is to reduce volatility that creates turmoil while promoting growth.

According to a study a few years back from the Milken Institute, economies with bank-dominated financial sectors tend to have more volatility and lower rates of economic growth. It turns out that size, composition, ownership arrangements, levels of concentration, and range of activities can affect the performance the financial system. As seen in 1997-98, otherwise robust economies in East Asia collapsed due to the weak foundations of their financial systems.

Using global financial data, the Milken study indicates that countries with financial sectors that are large relative to the overall economy and have a high degree of private ownership tend to have faster economic growth and higher per capita GDP. Alternatively, extensive restrictions on banking activity and concentration in the banking sector as well as in equity markets have a negative impact on GDP. Similarly, it was observed that if there is greater reliance on banks instead of capital markets that crises tend to be costlier.

Several policy recommendations are offered that encourage prudent and diversified financial systems. It turns out that positive correlation exists between the size of a financial system (i.e., the total of commercial bank assets, equity market capitalization, and bonds out-standing) and economic development as measured by GNP per capita.

A common thread found in most of the proposals offered here is the depoliticization of the financial sector. An appropriate role for governments is the provision of an appropriate legal, regulatory, enforcement and accounting environment for development and efficient functioning of domestic capital markets. Yet heavy restrictions on banks' activity should be avoided since they often interfere with customer service and tend to thwart innovation.

Steps should be taken to privatize state banks and limit concentration in bank ownership in private hands. This is because both arrangements introduce additional political and commercial risk into the financial sector that undermines economic development. However, privatization of state banks should occur only after there can be effective competition among private banks, including allowing the entry of foreign banks.

When a few banks dominate the financial system, it tends to suffer from government policies that treat unhealthy banks as being too-big-to-fail. And dominant banks face few pressures to develop a good system of commercial risk analysis.

Many emerging market economies have underdeveloped domestic capital markets. This makes them both dependent upon foreign capital and vulnerable to quick reversals of the flow of funds. As capital markets develop, individual banks or other corporate interests are less able to dominate the intermediation process.

Diversification of financial systems provides checks and balances in the process of allocating funds from savers towards worthy investors. For example, the growth of securities relative to loans in the US provided an important external source of funds for technology-oriented firms. Since such firms are heavily dependent upon human capital, they lack the tangible assets normally used as collateral for bank loans. And during their startup phase, sufficient funds are seldom generated internally. Since many startup companies in emerging market economies will display similar characteristics, domestic capital markets may better serve their funding needs.

So, while eliminating many "crises" is as simple as not using an inappropriate term, minimizing the cost of adjustments to financial turmoil is a bit more complicated. It involves the development of robust and well-supervised financial systems with well-capitalized financial institutions to reduce the vulnerability of emerging market economies to external shocks.

Christopher Lingle is Global Strategist for eConoLytics and is currently an Adjunct Professor of Economics with Georgetown University.


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