What Should the U.S. Show the World?

Over the past month, the U.S. and the world have watched unfold the biggest crisis since the Great Depression–a crisis that could change the landscape of the U.S. financial and economic system. The housing bubble burst, the stock market tumbled, and a swath of banks went bankrupt and were merged into others. The government bailed out Fannie Mae and Freddie Mac, the two mortgage giants; AIG, the nation’s biggest insurer; and some banks. The rescue plan struggled and was initially rejected in the Congress before it was finally passed. Still the market slump continues, financial markets are frozen, the credit crunch has begun to hurt the real economy, pessimistic predictions about the future prevail, and panic spreads over the whole society. Moreover, the crisis has spilled over to the EU, Asia, and around the world. Naturally, pundits are looking for culprits to blame for the shambles of the U.S. financial markets.

This crisis looks familiar and calls to mind the unhappy precedent that took place 10 years ago in Asia. With the collapse of the Thai baht market, the shock quickly spread into neighboring Southeast Asian countries, to South Korea, and to Russia and Latin America. A huge portion of financial institutions imploded or merged into others, stock markets lost up to 70 percent of their value in a short period, and economies plunged into recession. The panic spread quickly into society and the following political turmoil led to changes of government in some Asian countries. At that time, the U.S. and international organizations blamed the crisis on intrinsic problems of Asian countries and claimed that the crisis was punishment for Asian sins. The problems cited by those critics included: too much indebtedness of firms and financial institutions, crony capitalism, moral hazard,[1] opaque accounting, irrational exuberance, lack of appropriate regulation and supervision, illicit connections between the government and business sectors, and so on.

These external critics suggested solutions and imposed them arrogantly and with an excess of confidence. Besides the usual remedies of stringent fiscal and monetary policy and introducing flexible exchange rate systems, the IMF and the U.S. Treasury (supported by Wall Street) enforced many policies to eradicate the perceived Asian sins. They demanded that insolvent financial institutions must be closed or absorbed by stronger institutions right away, that governance must be improved, and that transparency and accountability must be strengthened. The demands didn’t stop there. They, in particular Wall Street, strongly opposed the governments’ rescue plans to inject public money into faltering financial institutions to stop the crisis from spreading. It was argued that governments should not intervene in the markets, and that sick institutions must be allowed to die according to market principles, because saving them would only encourage moral hazard. If public money were injected, these foreign observers stressed, the governments should let all investors take the loss, and all CEOs of failed companies should be replaced and stripped of any compensation and even take penal responsibility for their failure. (These attitudes, which were completely opposite to what these same actors are prescribing for the current crisis, gave rise to a conspiracy theory.)

Now, back to the current crisis in the U.S. Who should be blamed for this shameful demise and what should be done? The causes are multifaceted and very complicated, and it is very hard to pinpoint one. Accordingly, various efforts are underway to hunt for culprits of this financial fiasco. The blame ranges from a simple claim by President Bush that too many houses were built, to greed on Wall Street, and to many others including Alan Greenspan, China, President Clinton, and Prime Minister Thatcher. But the housing bubble is the most common target. Underlying causes of the bubble are greedy bankers, a flood of liquidity, excess leverage, lax regulation, moral hazard, and a toxic relationship between Washington and Wall Street – exactly the “Asian sins” that were decried a decade ago! But the US has an additional sin to Asian sins. The US has been in chronic deficit and huge indebtedness but kept affluent spending thank to financing from abroad: The US has got drunk on deficit spending.

The financial crisis and the resulting blame game is causing major damage to the U.S.’s image as the stable anchor of the world economy, and American leadership as the dominant financial superpower with free and innovative markets is in question. A hasty pundit has even claimed, “The balance of power in the world is being altered irrevocably.”[2] It is of course possible that U.S. leadership will be in serious peril due to this crisis. But the the extent to which the image of the United States is altered will depend on what it shows to the world to overcome the crisis.

Here, the U.S. should be very careful. At the onset of the crisis, most foreigners pointed fingers at the U.S., arguing that the current crisis was triggered by excessive greed on Wall Street, that the United States alone was to blame, and that the crisis was born in the U.S. Even though such arguments are rarely made publicly at the moment, many still believe that the U.S. is the root of the problem. Therefore, to minimize the damage to its global standing, the U.S. should show the necessary leadership, by taking responsibility and providing effective solutions to normalize the economy.

Casting blame is easy, but devising solutions is very hard. As the crisis reminds us of the Asian crisis and as a pattern emerges, the U.S. may be able to draw some clues from that precedent. A scholar suggests that the U.S. needs to “listen to experts in developing countries that have survived the very sort of crises that the U.S. is now facing.”[3] Such suggestions are music to Asians ears, and could be helpful in reestablishing their once impaired reputations. But it may be too much to hope for the U.S., with the pride of being number one, to learn from others. In truth, the U.S. doesn’t need to learn from Asians; neither does it have to listen to what the IMF and other organizations teach, because they have kept silent this time. The U.S. only has to do what it taught Asians during the Asian crisis such as sorting out insolvent financial institutions for closure or absorption; improving governance; strengthening transparency and accountability; and optimal regulation and supervision. Also, the U.S. needs to do itself what it stressed before: that failed CEOs must not be compensated at all. To most foreign countries, it looks ridiculous that CEOs still demanded compensation for their performance even after their companies failed and received public money – this definitely hurts American leadership. If the U.S. only teaches others but shows a different behavior in following what it says, it will be perceived as hypocritical, as in the aphorism, “my love affair is a romance, but yours an immorality.”

Two teachings were not helpful for Asians a decade ago and will not help the United States today. One is to let faltering financial institutions die according to market principles. In retrospect, some argue, if the Treasury had let Bear Stearns go bankrupt as well as Lehman Brothers, the crisis might not have been this serious. Of course, the government’s lukewarm and faltering approaches to crises normally result in the worst-case scenario, and laissez-faire may be better than such an inconsistent attitude. But experiences of past crises show that taking drastic measures to rescue financial institutions is much more effective than counting only on the market to ease credit crunches and prevent panic, given the immensity of the financial crisis. The other maxim that was incorrect is that a belt-tightening policy must be enacted during a crisis. Experiences also show that tight economic policies such as high interest rates and contractionary fiscal policy should not be implemented when the crisis is going on. Such policies will only aggravate the situation as we witnessed when they were forced on Asian countries during the Asian crisis. Fortunately, recent U.S. policy seems to have these two exceptions in mind and to be on the right track.

But ultimately, the problem would not be resolved unless the U.S. cures itself of its chronic indebtedness. After it emerges from the immediate crisis, the U.S. will need to reverse its prolonged expansionary fiscal and monetary policies by increasing interest rates and reducing budget deficits. Over the past several years, experts had warned that U.S. domestic and external imbalances were not sustainable and would lead to a debacle unless corrected swiftly; such warnings proved right. It might sound unfair to Americans to mostly blame the U.S. for the imbalances, and they may argue that the main cause was Asia’s savings glut rather than American profligacy. However, under the current ongoing crisis, it would not be wise for the U.S. to point fingers at others. Instead, the U.S. needs to acknowledge its part of responsibility for the worsening indebtedness and the resulting global imbalances, and adopt a harsh belt-tightening policy after the crisis. It will be difficult, but if the U.S. pays the price and plays its necessary role in the recovery, it would be much easier to put pressure on other countries to reduce their savings gluts.

Whatever solutions the U.S. adopts, it should not lean toward protectionism. Countries in crisis often tend to exhibit protectionist trends. During the current election campaign, presidential candidates have occasionally given in to the temptation to make protectionist remarks. If belt-tightening policies to resolve the chronic problem of U.S. indebtedness lead to pains of recession and job loss, such protectionist trends will likely increase. One of the most important lessons learned from the Great Depression is that a beggar-thy-neighbor policy and protectionism, as demonstrated by the Smoot-Hawley Act, only devastate all of us. Historians say that this law was a critical reason that the depression expanded over the world. If the U.S. shows even a hint of such movement, it would only have a boomerang effect and the world’s distrust of the U.S. would increase, further eroding American leadership.

[1] Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. For example, financial bail-outs of lending institutions by governments, central banks, or other institutions can increase moral hazard by encouraging risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.

[2] John Gray, “A shattering moment in America’s fall from power,” The Observer, September 28, 2008, http://www.guardian.co.uk/commentisfree/2008/sep/28/usforeignpolicy.useconomicgrowth, [accessed October 22, 2008].

[3] Kenneth Rogoff, “America Goes from Teacher to Student,” Project Syndicate, February 2008, http://www.project-syndicate.org/commentary/rogoff39, [accessed October 22, 2008].