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The Economy's Safety Valve


Does a healthy global economy need periodic financial crises?

This may be a touchy question to ask, with Wall Street firms grimly toting up the cost of their bad subprime bets and the U.S. housing market nowhere near bottom. Still, we've seen five major financial disruptions over the past 20 years, starting with the October, 1987, stock market crash. Each event, when it happened, seemed potentially destructive. The 1990-92 credit crunch, for example, was called at the time the biggest banking crisis since the 1930s. And the 2000-02 tech bust was by some measures the worst bear market since the Great Depression.

Yet the damage in each case, while deep, was relatively limited in scope. Central banks and regulators responded vigorously, the financial markets did not collapse, and the world economy kept expanding.

Since 1987, global growth has averaged a 3.7% annual gain, with no down years. Over the same stretch, the U.S. has experienced two relatively mild and short recessions.

The latest financial crisis--and what likely will be the biggest nationwide home-price decline since the Great Depression--could cut U.S. growth to 2% or less, with some chance of a mild downturn. But the stock market hit new highs on Oct. 9, employment is still rising, and the subprime mess seems more like a bump than a disaster for the rest of the world. "If nothing worse happens, it shouldn't really have any substantial impact on world GDP," says Farid Abolfathi, an international economist at Global Insight Inc.

In fact, these financial disruptions, rather than being signs of instability, may serve as critical safety valves for the global economy. At least so far, the periodic bouts of volatility have scared investors and borrowers out of excess exuberance without causing any lasting major damage to growth. The implication: If the global markets are functioning well, we should expect a financial crisis every few years. Indeed, the bigger danger may be that the gap between crises gets too wide, so the excesses have a chance to build up.

Consider this: Global growth today is being driven, in part, by the free flow of capital. It's increasingly easy for people and companies around the world to raise money through any of a number of credit channels. The exact form is not important--the funds could come via private equity, or junk bonds, or subprime mortgages, or venture capital, or bank loans, or direct investments by corporations in emerging markets, or exotic derivatives.

Access to relatively cheap credit fuels spending and growth across the board--but it also opens up the possibility of dangerous lending and borrowing sprees. Central banks do what they can to keep a lid on excess. But in today's complex and globally integrated financial markets, it's almost impossible for regulators to plug every hole.

Instead, fear is what keeps borrowing from racing out of control. Lenders and borrowers have to be worried enough about losing their shirts that they exercise some caution.

In that way, a financial crisis every five or so years becomes part of the self-equilibrating mechanism of the global economy. One credit channel gets wiped out for a time and scares the heck out of market participants. But the rest of the financial system keeps functioning, especially if central banks react quickly enough and pump money into the markets. For example, when banks stopped lending to businesses from 1990 through 1993, the bond market took up the slack, providing corporations with plenty of funds. Today, banks are returning the favor, boosting commercial and industrial loans by $84 billion in August and September, the biggest two-month increase on record, as commercial paper markets froze.

This is not to minimize the real damage to individuals, many of them low-income, who are directly hit by a major financial disruption. Today, for example, many subprime borrowers could either lose their homes or find themselves stuck with staggering mortgage payments. Looking a decade back, the 1997-98 emerging market crisis sent countries such as South Korea and Russia into deep recessions. Unemployment in Korea, for example, skyrocketed from 2.1% in 1997 to a painful 8% by the end of 1998. Nevertheless, both of these countries have subsequently prospered, and now have a bigger share of the global economy than they did before the crisis.

There's also no guarantee that the next crisis won't spread and turn into the Big One, which undermines the whole financial system. That's the great fear of central bankers and economists. "The different components of the financial system are quite tightly linked to each other," says Barry Eichengreen, an international finance expert at University of California at Berkeley. "You don't really have a spare tire."

Raghuram G. Rajan, who served as chief economist of the International Monetary Fund from 2003 to 2006, worries that financial disruptions by themselves don't create enough deterrence for imprudent behavior. Because central banks are worried about recessions and spreading damage to the financial system, they step in before borrowers and lenders have been hit hard enough. "I think there's a limit of tolerance of collateral damage," says Rajan, who is now at the University of Chicago Graduate School of Business. As a result, "the market cannot punish enough."

Instead, Rajan argues that another round of regulation and self-regulation may be needed to restrain the excesses. "Finance goes through phases where innovation may exceed prudence for a little while," he says. "We figure out the kinds of places where things broke down, fix that, and move forward."

But to get rid of the financial crises completely would require far more regulation than is desirable or even possible. The occasional financial disruption, even a major one, is a good trade-off for open and easy access to credit and rapid global growth.

By Michael Mandel, with Peter Coy in New York


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