Apr 03, 2013 04:30 PM

The BRICS Countries Take Their Turn at Bat


The rolling crises of the past six years may be a permanent feature of the global economy. The main cause is lack of a sound global regulatory structure to oversee the globalization of financial capital. The solution is either reversing financial globalization or setting up a global super regulator. As neither is likely in the foreseeable future, the world will continue to suffer crisis one after another.
The bursting of the BRICS bubble is the main source of instability in 2013. Because interest rates are low everywhere, this bursting is happening in slow motion, confusing financial markets. As the months pass, the picture will become clear. The global economy is likely to be dragged into recession again.
The Cyprus Effect
The impact of the crisis in Cyprus is almost like a butterfly effect. It is so tiny that one cannot imagine it having a global impact. Yet, its crisis has dented global markets to the tune of trillions of dollars, hundreds of times the direct cost of the crisis. This demonstrates the inherent instability of the global financial system. A small change in perception can lead to big price moves on financial markets.
The troika solution to the Cyprus problem breaks two taboos regarding financial bailouts of the past five years. It wipes clean the rescued banks' senior creditors and gives large depositors a serious haircut. If creditors and depositors adjust their risk assessment, weak banks around the world could go under, taking down the global economy. Even if the chance of this is small, the consequent price adjustment in the global financial markets is significant.
The global financial system is holding major central banks and governments hostage. The Cyrus bailout addresses one serious flaw in today's financial system – the under pricing of risk due to implicit government guarantees. When a weak bank offers high interest rates to attract creditors and depositors, that latter are enticed because they assume government bailouts will prevent them from suffering losses. Hence, weak banks can survive by raising interest rates. They are incentivized to gamble in a high-risk investment. If they are lucky, they survive. If not, they fail, as they would anyway. Such a vicious cycle deepens the cost of a final bailout. Hence, the Cyrus solution puts creditors and depositors on notice. It should be a very healthy development.
The impact of the financial crisis in tiny Cyprus reminds us that governments and central banks are beholden to the global financial system. When they try to remove a flaw in the system, the resulting market reaction can bring down the whole house. Imagine that Italians were withdrawing all their deposits, would the European Central Bank be forced into guaranteeing all deposits? The expectation for that is preventing people from taking their money out. Hence, the bailout expectation is the key to stability.
The global financial system is so flawed that its stability depends on implicit government guarantees. Unfortunately, such guarantees ensure that such weaknesses persist. The vicious cycle keeps the global financial system permanently unstable.
The Triple Flaws
Three fundamental flaws in the global financial system reinforce each other and keep the global financial system on a knife's edge. First, central banks believe that, in addition to price stability, monetary policy is a tool for promoting growth and underwriting financial stability. The triple targets lead to exaggerated volatility in monetary policy, which creates opportunities for speculation. The proliferation of speculators amplifies the impact of monetary policy on financial markets. The central banks and speculators have developed an unhealthy mutual dependence. It works in the short term and leads to crisis over time.
For example, the top Fed officials openly speak of the stimulus effect of its monetary policy through asset inflation. This is essentially boosting demand by creating asset bubbles. Central bankers would have kept such thoughts hidden a decade ago. Now they have gone mainstream. Have Alan Greenspan's bubble economics won?

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