The World Still Lacks an Idea of What Tomorrow’s Financial System Will Look Like

Clearly, the depth and dynamics of the crisis are much more serious than previously estimated. Therefore, much more vigorous and painful cuts will be needed to bring it under control, especially to mitigate the negative effects on the real sector. However, these effects cannot be avoided, and the consequences of the crisis will be severe.

Written by: Dr. Žarko Primorac

The global economy is undergoing the most severe financial crisis in the last 80 years. The crisis initially affected a significant segment of the American financial system – real estate lending – and gradually spread to the banking system, insurance, funds, and stock exchanges. From American finance, the crisis spread to European finance, banking, and stock exchanges. The crisis began to reflect on the real sector as well. The growth rate of global GDP is seriously slowing down, real estate prices are falling, and some industrial sectors are beginning to suffer significant losses. Numerous warning signs indicate that the global economy is heading towards a serious recession. In an attempt to prevent the spread of the crisis, the governments and central banks of major countries have taken vigorous measures by injecting fresh capital into the banking sector. Additionally, several major banking names in the U.S. and the U.K. no longer exist. Furthermore, the U.S. government is practically taking over some banks, and the same scenario is being followed by some EU countries.

There is a widely held public opinion that the financial crisis was caused by bad (subprime) mortgage loans in the United States. A large bubble formed in the U.S. real estate market, which began to deflate, triggering a crisis scenario. But this is not the primary cause of the crisis.

We are witnessing, above all, a systemic, we would say, structural crisis of the global financial system. In this respect, it is more severe and different from previous crises. The foundations of the current financial system were laid at Bretton Woods in the mid-20th century. The American dollar was established as the cornerstone of the system, to which major currencies were fixed, and it was tied to gold. This constructed anchor functioned until the suspension of the dollar’s convertibility at the beginning of the 1970s. With the suspension of convertibility, the symbolic link between the real and financial economy was broken.
From there, the economy of symbols, or the financial sector, began to grow uncontrollably. Traditional conservative banking transformed, new institutions emerged, and new financial products, so-called financial innovations, options, derivatives, futures, and others were created. Thanks to all this, the financial sector developed independently and incomparably faster than the real economy.

The prevailing market doctrine that the financial market is a self-regulating mechanism and cannot go to extremes certainly contributed to the flourishing of finance. The growth of the financial sector and its globalization were enabled by dynamic deregulation, the development of ‘hard’ technologies – information technology and telecommunications, as well as the development of ‘soft’ technologies – an increasing number of financial innovations. The financial market became global, and gigantic financial entities, banks, and others developed, which became ‘too big to fail.’ Alongside the growth of the financial market, systems of oversight and regulation developed, but they largely remained national in character. Many innovative financial products, especially in the investment banking sector, operated outside the oversight system.

The dominant monetary medium for the development of the financial sector was the American dollar. Thanks to its position as the world’s reserve currency, the dollar allowed the U.S. to receive rather than give, to lend rather than forgo. Using the dollar’s dominant position, the U.S. financed its expansion, including wars. The U.S. budget deficit reached gigantic proportions after the Reagan and Bush administrations. Additionally, the U.S. Federal Reserve maintained a policy of low-interest rates. By manipulating the primary interest rate, an apparent balance was maintained, and crises that developed in the 1990s were avoided. The American prime rate was lowered from 6.5% to 3.5% within just a few months after 2000, and after the attacks on the towers in New York, to just 1% annually. In the following 33 months, the Fed maintained a negative real interest rate. On these foundations, lending expanded. Money was cheap and available.

The consequences of the expansion accumulated in the real estate market. In that segment, the bubble developed the fastest, but it also began to burst. The mechanism for the creation of the financial bubble was very simple: banks massively approved loans without solid risk assessment and without appropriate collateral. Often, it was sufficient to estimate that real estate prices would continue to rise. Home loans were granted to individuals without employment, as well as those who were genuinely unable to repay the installments. Human greed played a significant role in the expansion of lending. Banks earned huge profits, and their management received high bonuses. The population simply accessed loans, and the business community was satisfied with the rise in bank stock prices and contributions to funds. The financial market swung in an exhilarating rhythm, similar to drunkenness, for which the old saying holds true: A man feels better and better, while the body deteriorates.

The cheerful music played until the first visible signs of the crisis: on August 6, 2007, American Home Mortgage went bankrupt as the first victim of the American real estate market; on August 9, BNP Paribas suspended its three investment funds worth two billion euros because their market had ‘disappeared’; the European Central Bank injected the first 95 billion euros into the banking system, and similar actions were taken by the Fed and the Bank of Japan. The negative sequence continued: August 10, August 13, August 16… and so on until Bear Stearns, Lehman Brothers, AIG, and other collapses. From there, it was not far to the spread of the crisis to Europe and the entire world.

The primary financial instrument through which the financial market grew uncontrollably was financial derivatives. By using these innovative products, American banks ‘repackaged’ bad mortgage loans, secured top credit ratings, and resold them to investors in Europe. The derivatives market is the main segment of the global financial bubble. According to BIS estimates, the value of outstanding contracts in this area at the end of 2007 amounted to $600 trillion, which is 11 times the value of global production. A decade ago, the value of this financial segment was ‘only’ $75 trillion. The fastest-growing financial derivative, known as CDS (Credit Default Swaps), which enabled the insurance of mortgage credit products, grew to $55 trillion, which is more than the value of the entire American housing stock.

We have partially explained the roots and mechanisms of the financial crisis above. It also exhibits other characteristics that were not typical of previous occurrences. The current crisis is much more complex, not only due to its depth and spread but also because of the complexity of international economic relations, especially the positions of China and India as emerging global economic giants.

The current crisis is accompanied by another specificity, which is the determination of the governments and central banks of the affected countries to control negative processes. Although the reactions of governments in the early stages of the crisis were rather lukewarm, they have recently shown high determination. Liquidity in the banking sector is being secured, some banks are being taken over, and regulation is being tightened. Initially, the stock markets reacted positively to these measures, but great uncertainty still prevails. It is evident that the depth and dynamics of the crisis are much more serious than previously estimated. Therefore, much more vigorous and painful cuts will be needed to bring it under control, especially to mitigate the negative effects on the real sector. However, these effects cannot be avoided, and the consequences of the crisis will be severe.

As stated in the introduction, this is a crisis of the system. Regardless of how it ends, it will leave deep consequences on the structure of the global financial system. Much will change in finance, the organization of financial institutions, their roles and functioning, financial products, methods of regulation, and oversight. Few people have an idea of what tomorrow’s financial system will look like. However, one thing is certain: after the crisis, we are entering a period when the economic role of the state will be much more pronounced. The era of market fundamentalism, as the dominant principle in the last twenty years, will be pushed aside. Whether this will mean the end of the dollar monetary standard and the formation of a completely new financial paradigm remains to be seen.