Only a few years ago, the European common-currency arrangements were held up as a possible model for Asia.

With the euro under serious threat, we do not hear much about this now, but the current mess in Europe could well contain a number of lessons for Asia.

Lesson one might be surprising at first sight: membership of a currency block is still seen as valuable. Ireland, Portugal and Greece seem ready to undergo years of wrenching austerity in order to stay in. Greece understands that in leaving the euro, it would be swapping one set of problems for another. And countries such as Turkey are still very ready to join.

Lesson two is more obvious: it is hard to make common currencies work. Currency blocks work smoothly only if the member economies have a lot in common. There was always the promise — or hope — that membership would be the catalyst to make Greece more like Germany. But for Greece, there has been neither economic nor political convergence, and continuing membership may prove to be unworkable.

Lesson three is an old one: financial markets are prone to radical changes of risk assessment and lemming-like herding. The markets initially treated Greek debt as more or less on par with German debt. But when they belatedly perceived the reality, they pulled the plug.

Lesson four is that support mechanisms are needed when markets lose confidence. Even countries like Spain and Ireland — which are trying harder than Greece to be good euro citizens — need external support. The euro arrangements are providing this through loans and the support of the European Central Bank (ECB). There is a further sub-lesson here: when the crunch comes and confidence is lost, the supportive response is always tentative, inadequate and chaotic. It is always too little, too late.

So, what are the implications for East Asia’s emerging economies? Despite strong international advice after the Asian crisis to adopt freely floating exchange rates, these countries are yet to adopt a pure free float. They are managing their exchange rates, not only to smooth out volatility, but also to resist appreciation pressures that would diminish their international competitiveness. And as their production structures are becoming increasingly integrated through supply-chain frameworks, maintaining competitive parities with neighbours is becoming more important.

So far, this maintenance of competitive parity has been an informal affair, and it could be given more regional structure. If each country maintained stability (perhaps within a band) vis-à-vis a common basket of currencies — including a heavy weighting of Asian currencies — this would have some of the characteristics of the early stages of Europe’s move to the euro.

While this sort of structure creates tighter relativities, it sets up potential vulnerabilities. In Europe, the euro’s precursors — the ‘snake’ and the European Exchange Rate Mechanism — both broke down. So support arrangements like those offered by the ECB would be an essential part of any tighter currency arrangements. Emerging East Asian economies might receive help from the IMF, but many still carry bitter memories of the Fund’s failures in 1997. And while the Chiang Mai Initiative is exactly the sort of arrangement that might do the job, it proved unusable when it was needed in 2008, and in its present form provides only trivial support.

Asia might also heed the lesson that currency blocks should choose their participants carefully. One suggestion is that a smaller yuan-based grouping of ASEAN, China, Hong Kong and Taiwan might make more sense than a region-wide linkage.

All this leaves Asian exchange rates in an awkward policy space. The managed rates of the post-1997 period are working well enough, but continued reserve accumulation is not sustainable, and running chronic current account surpluses is not optimal. Capital should be flowing ‘downhill’ to these emerging countries, not in the reverse direction. Establishing a stable range of relativities among a sub-set of the region might be a start in the right direction.

Stephen Grenville is a Visiting Fellow at the Lowy Institute for International Policy and a former Deputy Governor at the Reserve Bank of Australia.

An earlier version of this article was first published here on the Lowy Institute for International Policy website.

1. Regional cooperation and national sovereignty: Asia and the euro crisis
2. The financial crisis and East Asia
3. India’s role in East Asia: lessons from cultural and historical linkages

Andrew Sheng’s recent book – From Asian to Global Financial Crisis, is a balanced judgment upon the relationship between the Asian and Global Financial Crises. Sheng’s analysis is important not only for its historical value – it also presents a basis for the creation of durable solutions to current structural problems in the global economy.

Sheng brings a diverse but relevant experience to this financial history: he has been central banker, corporate regulator, academic, and World Bank official. He has observed, first-hand and close up, the amazing development of East Asia’s financial sector in Malaysia, Hong Kong and China.

He was an active participant in the international discussions surrounding the 1997-8 Asian Crisis. Since then, he has been active in fostering better regulation and international cooperation. There would be few who could match his authority and insight about the events of the past dozen years.

Dealing first with the Asian Financial Crisis (‘AFC’), Sheng finds fault with all the main players – the affected countries, the IMF and also the developed countries that pontificated on the causes of the crisis. Japan’s pivotal role, with its boom-and-bust experience in the 1990s, low interest rates, volatile exchange rate, and strong home-bias in investments, is also highlighted. Sheng notes that before the crisis, the Japanese ‘flying geese’ model of industrial development, with government policy playing a key role in spreading and advancing technology throughout the region, was an important prelude to the 1997-8 crisis.

This point is particularly important for the current debate about the RMB valuation, because the complex supply chains that have built up throughout the region need to be factored into this debate. The role of the yen ‘carry-trade’ and associated capital flows in the AFC was understated at the time. Not only is it now better understood, it is also relevant again to current circumstances, as the global economy again faces the prospect of renewed disruptive international capital flows.

Sheng’s comparison between the AFC and the Global Financial Crisis (‘GFC’) of 2007-8 is also valuable. Importantly, he resists the glib point-scoring arguments that would occur to many who observed both crises, when the countries that had lectured East Asia about the deficiencies of crony capitalism exhibited some of the same symptoms themselves ten years later.

As Sheng states, these were different crises with different causes.

But, as Sheng points out, both crises raise questions about our core belief in the ‘magic of the market’. The common thread is that in both cases the market did a poor job of price discovery, identification of good investment opportunities, arbitrage, and the pricing and distribution of risk. These deficiencies must be the core concern of policy-makers responding to the GFC.

Sheng brings his story full circle by observing changing paradigms. The AFC reflected the breakdown of the ‘Tokyo Consensus’ (the Japanese view that industrial policy will generate growth and prosperity), and in the GFC the ‘Washington Consensus’ that replaced it ‘was put to the stress test and found wanting’.

What will replace it is less clear: a ‘Beijing Consensus’? Sheng looks forward to the era when ‘Asian economies emerge to become economic powers in their own right’. Whatever the commonality between 1997-8 and 2007-8, if another crisis occurs, ‘there will be no one else to blame…except ourselves’.

The list of GFC causes is long. Complex financial engineering often involving derivatives; ubiquitous and convoluted network effects creating intricate interconnectedness; excessive and non-transparent leverage; the serious assessment mistakes of credit rating agencies; the ‘illusion of liquidity’; central banks underwriting of financial stability; loose monetary policy; the Minsky problem that ‘stability is destabilising’; accounting deficiencies; moral hazard; ill-directed incentives; blinkered risk management and greed all contributed to the 2007-8 crisis. While some of these elements may have been present in 1997-8, the later experience was clearly different in nature, magnitude and impact. Regulators were left impotent by the power of vested interests and failed to respond to the challenge of macro-prudential stability (even though it had been extensively discussed in the decade leading up to the GFC).

What should be done?  Simplicity should replace complexity and counter-cyclical regulatory action should replace the existing pro-cyclical regime. Regulatory capture has to be addressed; political economy is at the heart of the required reform. As Sheng points out, ‘the crisis is ultimately political in nature’.

As the GFC unfolded, a senior Mexican official observed, ‘thank goodness it’s not our fault this time’. Andrew Sheng goes further, and explains how and why the two crises differed. This is a valuable contribution to a growing literature, having as its special attribute the Asian perspective which Sheng brings.

Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy and a former deputy governor at the Reserve Bank of Australia.

This piece is an edited version of a book review of From Asian to Global Financial Crisis from Andrew Sheng, Cambridge University Press.

1. Global financial crisis and Asian responsibilities
2. The sub-prime crisis and East Asian financial cooperation
3. International financial crises and the ASEAN economies

In his book ‘The Lexus and the Olive Tree,’ Thomas Friedman told us that globalisation would lead to a ‘Golden Straitjacket’, where countries would voluntarily adopt a fairly uniform set of global rules to facilitate their participation in international integration. When the Global Financial Crisis (GFC) demonstrated that substantial changes were needed in financial regulation, it was easy to put these changes in the context of the Golden Straitjacket. The G20 put supervision of financial sectors on its agenda, and any changes were to be implemented through the Financial Stability Board (FSB) and the Bank for International Settlements (BIS) in Basel.

But just how internationally uniform should these rules be?

Clearly, an internationally coordinated set of rules is needed to cover the large international banks whose complex financial transactions cross borders and jurisdictions in ways that preclude a single national authority from sorting out problems that might arise.

But these rules may not be appropriate for the majority of countries. One of the lessons of the GFC is that simplicity is a virtue in financial structure. Asian banks came through the GFC in good shape in part because they lacked the arcane structures of the larger international banks.

Further, countries should not all aspire to have their banks as major players in international markets. As Ireland and Iceland found (and as was seen less devastatingly in Belgium, Holland, Sweden, Austria and Switzerland), international banks ‘live abroad but come home to die’, at the expense of domestic taxpayers. Policy-makers should focus on building robust domestic banks, which can facilitate international transactions, but which orient their business to the home market. Such banks should not be subject to the same rules as huge international financial conglomerates.

Beyond this, are the uniform rules of the Golden Straitjacket even feasible?

It took a decade of strenuous negotiation to put in place the last set of revisions to the Basel Rules, which were quickly overtaken by the GFC. Now it is already clear that fundamental differences of view exist as to what reforms are needed. Complex conglomerated banks in Continental Europe would fall foul of the Volcker rule (that banks should not carry out proprietary trading on their own account), so, even at this broad level, uniformity seems unattainable.

Instead, it may be better to see the Basel international rules as developing a minimalist framework, with each country’s supervisors using them as a template for a set of rules appropriate to their individual needs. Adopting this approach would encourage individual countries to get on with the task of reform without having to wait for tortuous international negotiations to grind out the Basel II rules.

The danger here is that an individual ‘go it alone’ approach might be seen as ‘Basel Lite’ or ‘Basel for Beginners’. This misunderstanding could be avoided if the G20 persuaded the Basel rule-makers to explicitly embrace the idea that their rules are a minimalist framework upon which others will build. The validity of this approach could be further assured if it were to be endorsed in regional forums.

East Asia already has an embryonic framework that is well placed to offer such support.  This framework would link all the countries of the region into the overall international process. The six Asian countries that are members of both the East Asia Summit (EAS) and the G20 could form a regional FSB within the EAS framework, thus providing mutual sustenance for a ‘minimalist framework’ approach.

Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy and a former deputy governor at the Reserve Bank of Australia.

1. Is the love of finance the root of all evil?
2. Does the Global Financial Crisis need a Domestic or International Response?
3. Indonesia’s banking system under threat

This article is the second part of a digest of a public forum at the ANU.

Ross Garnaut’s book, ‘The Great Crash of 2008’, is an important contribution to the ongoing critical discussion of the global economic crisis.

However, it lacks in one respect: the book is written as if Australia went through basically the same experience as the US.

In the US it was an old fashioned financial crash, like 1907 when JP Morgan locked the bankers in his library and told them that he wouldn’t let them out until they had sorted out the mess. The financial sector caused the US downturn. The Australian experience, on the other hand, was our usual externally generated shock. This affected our financial sector, exacerbating other problems through knock-on effects. But our cycle wasn’t caused by the weakness of the financial sector.

Understanding what happened, and the state of the new world economy, is vital for good policy making. The question for Australian policy makers now is when to wind back the fiscal stimulus. The financial sector made it through the crash reasonably well, and there are no major issues.

If we take the rankings of banks in the world, there’s only one AAA bank and 8 AA banks left. Australia has 4 of those top 9 banks. Of course, isolated examples exist: Opes Prime, Allco, Babcock & Brown, and Storm Finance were all messy, but they caused no structural damage to the financial sector.

Asset price bubbles are still an unresolved policy problem, but the interest rate cannot be used by central banks to eliminate this issue. Central banks may be given some so called macro-prudential instruments, but at the moment those instruments lie with the prudential regulator.

You could imagine a world where, instead of the financial sector having a pro-cyclical effect on the cycle, capital ratios, liquidity ratios and maybe loan-to-valuation ratios would be altered over the course of the cycle.

Leaning against the asset price increases, or cleaning up after the event still seem to be the two choices available.

Even before the crisis some central banks, including the RBA, understood that sensible leaning against asset price increases would be a good idea.

Australian real estate agents fought the Reserve Bank in the early part of the 2000s, believing it to be pushing interest rates up too much.

I don’t think the Efficient Markets Hypothesis(EMH) was a central policy belief among the Australian authorities. The failure of HIH cleaned out any EMH proponents that might have been in policy circles. There wasn’t any light or ‘soft’ touch supervision in Australia. The four pillars probably helped by restraining the degree of competition between the big four.

I think of the guarantee that was given on banks’ overseas borrowings as similar to a lender-of-last-resort facility. We’ve always known that financial sectors were fragile and you needed some authority like a central bank that would stand ready to lend in extreme circumstances. If for some reason the banks had not been able to borrow in New York they would simply have come to the Central Bank and borrowed there, shifting the problem of funding the current account to someone else.

In the United States, they had a dispersed regulatory framework that encouraged regulatory shopping, and extraordinary mortgage contracts that allowed renegotiations if interest rates moved.

Australia had nothing equivalent to the NINJA borrower. There were non-complying loans in Australia, but they comprised some half a per cent of outstanding loans. There was no physical overbuilding here.

The very low interest rates that in America were a response to the 2001 tech-wreck weren’t present here. There was no shadow banking sector, with its high leverage and dependence on the money market. Most of the lending action in America was in the securitised sector of the market, relying on derivative credit wraps and credit rating endorsements – what one might call paid endorsements. Likewise, there was no Wall Street lobby.

If Australia is in a relatively good position, what about America? There are four areas that need fundamentally reform in the US.

Firstly ,regulation, including more stringent capital requirements. This is an important step to take, but it won’t solve the problem. Looking back on this crisis, it’s unclear what amount of capital would have actually saved us from this crisis. I don’t have much hope that a minor shift in capital is actually going to solve the problem.

Secondly, the structure of the financial sector requires a great deal more thought. What we see in recent years is the way it conglomerated and became inter-connected, losing those old (and valuable) separations achieved through the Glass-Steagall act. We need a financial sector in which the institutions are more specialised, and where the structure can be seen more clearly. If these are the core institutions that take in the money from widows and orphans and lend in simple ways, they need to be protected and supported. We also need the institutions which supply high-risk capital to fund innovation, but these institutions shouldn’t be protected and supported by the government. We need to make sure that casinos aren’t mixed with the utilities.

Thirdly, the most serious problem for America is the political economy of all of this; the way Congress was basically in the pocket of Wall Street. Money, jobs, the whole story of excessive influence.

Finally, macro policy. There is a macro mistake behind every crisis. In this case, it’s clear that low interest rates in America following the tech-wreck were a serious macro fault.

Australia and the US face very different tasks. The US has almost 10 per cent unemployment, a current account deficit nearly as big as Australia’s, a fiscal deficit running at 12 per cent of GDP, and an exchange rate which has fallen already and needs to fall further.

This is part of the process of fixing the imbalances. But this fall will create additional problems because they still need the Chinese to keep their money in US dollars. Their banks still contain large volumes of non-performing loans. On top of that, the shadow banking system – which Greenspan once described as the spare tyre, ready if anything went wrong with the banking system – has been doing the heavy lifting for some years. Securitisation of the kinds that we’ve seen over the last 5 years, with complex structured products, cannot return any time soon.

To function again, securitisation needs credit wraps, reduction in the complexity of slicing and dicing, and credible credit rating agencies. The credit wraps and the credit rating agencies are both discredited. AIG won’t be there to provide the credit wrap next time.

The role of markets and their interaction with governments and regulation still needs a lot of sorting out. Ross’ book takes us some way in addressing this challenging task.

Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy and a former deputy governor at the Reserve Bank of Australia

1. Garnaut on understanding the Great Crash of 2008
2. The role of macroeconomic management in the Great Crash
3. The Great Crash – Weekly editorial

There is no doubt that the current financial crisis is global. Any hope there might have been of ‘decoupling’ has long since gone. Even innocent bystanders in good shape (like Australia) have been swept into the maelstrom.

The G20 Leaders have met and urged action. Learned commentators have opined that there can be no solution without international concerted action. There are calls for a Global Prudential Regulator, and for a massive increase in the IMF’s international lender-of-last resort capabilities.

Curiously, however, just about all the action so far has been on the domestic policy front. Is this just the triage stage, with much more international cooperation to follow later? Or are most of the required responses to the Global Financial Crisis, in fact, domestic?

The immediate need is to shrink leverage, maintain a flow of new lending and keep the core financial sector afloat, while addressing sagging confidence with fiscal stimulus. This requires big cash infusions, lower interest rates and budget deficits – all purely domestic issues.

When this triage stage is over, there are two obvious candidates for international cooperation: the global prudential regulatory framework and external imbalances. But to see what might usefully be done in these two areas, we need to define the agenda more precisely.

Almost ten years was spent developing and implementing the detailed Basel II Rules – 300 pages of requirements for banks. Before this is properly in place, one of its three ‘pillars’ looks distinctly shaky, relying as it does on the conflicted assessments of the rating agencies, which played a central role in the current crisis. A second “pillar” – market discipline – has shown itself to be ineffectually lenient in good times and punishingly harsh when things turn bad.

Basel III may be another decade away, but there is no need to wait. Most of the problems can be corrected by determined domestic action. The biggest task by far is in the USA, where the dispersed, uncoordinated and under-resourced regulatory bureaucracy was over-ridden, by-passed or ignored by the entrenched forces of Wall Street and the powerful anti-regulation free-market ethos. The UK has already begun substantive reform, demonstrating that the opportunity and responsibilities lie squarely with the national authorities, who need no international oversight.

What about international policy coordination? Until 1971, the Bretton Woods system provided some discipline and international coordination, fixing exchange rates and tolerating restrictions in capital flows. When this system broke down, such was the belief in the magic of the market that it was widely believed that flexible exchange rates would allow stable capital flows to fund whatever external imbalances the “consenting adults” in each country desired.

Despite ample evidence since then that the market doesn’t work at all smoothly in price discovery or equilibration, the US has shown no enthusiasm at all for attempting international policy coordination – the Plaza Accord and Louvre Agreement were aberrations, more than twenty years ago. Where external imbalances have been identified as excessive, the response has usually been bilateral and, judged by the recent finger-pointing at China by the new US Treasury Secretary, poorly-founded and counter-productive. Multilateral agencies such as the IMF have been side-lined.

If we believe that the world ‘savings glut’ (Fed Chairman Bernanke’s phrase) forced world interest rates down and funded the sub-prime excesses, the case for international coordination is compelling. More compelling still, the world system is clearly out of equilibrium, and relying on the spooked financial markets to sort the mess out requires more faith in self-equilibrating forces than the historical evidence would justify. Policy responses taken by one country impinge on others, sometimes adversely.

Much needs to be resolved if China, Germany, Japan and the US are to shrink their imbalances smoothly. Trade-offs and quid-pro-quo deals may well be a useful part of the process. If the pace of adjustment in the different countries is out of sync, GDP and exchange rates may be sharply disrupted.

The time-scale of this adjustment seems particularly intricate. China can’t suddenly turn off its export machine without serious internal damage (and damage back along the international supply-chain). Nor is there, now, any concern that China’s external surplus is pushing down world interest rates: central banks everywhere are pushing them down as fast as possible. The necessary prospect of huge US budget deficits suggests that turning America’s under-saving around can’t (and shouldn’t) be an urgent priority.

The top priority is to maintain the flows of international finance which countries in a globalised world have come to rely on. The more that countries like Australia assure their own nation’s access to international capital markets through AAA government guarantees, the harder it is for second-tier countries (particularly the emerging countries) to maintain their foreign funding.

So the case for international coordination is strong. But for success, it requires both heightened motivation and a new forum.

Perhaps the new G20 Leaders meeting is this forum. The December 2008 communiqué set out a realistic agenda, waiting to be built on in April. International peer pressure can urge countries to act more strongly where there is beneficial international spill-over, such as expansionary fiscal policy. G20 can discourage countries from actions which threaten an international spiral of tit-for-tat policy – principally trade protection.

It can spotlight US regulatory inadequacies by urging members to undertake the IMF/World Bank assessments of their regulatory frameworks: the US is the only G20 country not to have begun this process. It could oversight the strengthening of the Financial Stability Forum and pressure belated governance reform on the IMF. And it could provide the setting for a serious discussion of the international external imbalances, directly involving all the countries which matter.

Has the enormity of the Global Financial Crisis created the motivation for international cooperation? How serious do things have to get before all opportunities – international included – are brought to bear?

Stephen Grenville is an Adjunct Professor with the Crawford School, a visiting fellow at the Lowy Institute for International Policy and a former deputy governor at the Reserve Bank of Australia. This article originally appeared in the February 7-8 edition of the Australian Financial Review.

1. An Asian response to international financial reforms
2. China’s response to the global financial crisis
3. Global financial crisis and Asian responsibilities

Just what is World Bank President Robert Zoellick up to? He attended the G20 meeting in Brazil over the weekend, only to argue that this is the wrong grouping and should be replaced by a more exclusive gathering. To say the least, this is an unhelpful intervention, not just for Australia (which would be excluded from the Zoellick group) but also for the urgent need to address the current world situation.

Zoellick’s attitude ignores the time-consuming negotiations of a decade ago which gathered a consensus around the G20 membership. A cynic might say that it just looks like a spoiling strategy to leave the anachronistic status quo in place, with G7 plus a few ad hoc new recruits who are allowed to sit in on the old club.

The problem with the Zoellick proposal is that it starts with the G7. The G7 is lopsided. It includes Italy, for example, thus giving gross over-representation to Europe. Zoellick’s proposed group also includes South Africa. This might seem a good idea because it gives geographic representation to Africa. But it adds nothing to the group’s ability to confront the financial crisis or future international macro coordination. And if geographical balance is the criterion, then it’s hard to see why all three North American countries have a place at the table.

A better starting point is to ask, ‘who is likely to make the best contribution to an informed and constructive discussion?’ You don’t need to hear the European viewpoint from four separate voices. You do need countries which can contribute to a wide-ranging debate on how to reform the current failed system. Countries with robust domestic economies, strong and sophisticated financial sectors and well-functioning regulatory experience would be a help around the table. A track record of fresh outward thinking, active participation in the international economic debate, and deep involvement in regional economies would also be a plus.

These are attributes Australia brings. We might even cast aside modesty and remind Zoellick that Australia demonstrated a better understanding of the 1997-8 Asian crisis than the G7 countries. And, if we wanted to be less polite, we might ask why he doesn’t ‘stick to his knitting’ and concentrate on the World Bank’s job? We might recall his role in promoting preferential bilateral trade pacts, to the detriment of the conceptually-superior multilateral system. And we might explore a governance issue: ‘On whose behalf is he talking?’

Cross posted from the Lowy Interpreter

1. The case for an East Asian Caucus on global governance: a Korean perspective
2. Managing the risk of inflation during economic recovery – the case of Vietnam
3. The Chinese legal system and the Stern Hu case

The US Treasury’s former attack-dog, Ted Truman, has now got his jaws around another Inconvenient Truth: that the world’s current financial problems not only have their epicenter in the US but can be largely sheeted home to US deficiencies.

Truman wants to argue that the blame is widely spread. One might almost conclude from his piece that the US was an innocent bystander, swept along by events beyond its control. He cites Japan as having had similarly loose monetary policy as the US, blames China’s exchange rate and reserve accumulation, says that housing problems were ‘essentially universal’ and that prudential regulators everywhere were ‘consenting adults’ in their misjudgments of the situation: ‘The finance ministers and central bank governors should not blame Washington, they should blame themselves’.

Truman, now at the Peterson Institute, has always been a forceful advocate, even when defending the indefensible. But the counter-argument is pretty compelling:

1. Other countries may have housing price asset bubbles, but no country has lent so much to so many borrowers who have so little capacity to service the loan. The US has a uniquely vulnerable lending model, whereby housing borrowers can refinance their loans if interest rates move against them, and can return the keys without further recourse if they decide they don’t want to repay the loan.
2. The US has its own version of ‘crony capitalism’, operating between their lending agencies (Fannie and Freddie) and Congress, ensuring that cheap housing loans with ‘teaser’ interest rates became a political vote-buyer.
3. Whereas other countries have consolidated their market regulators to improve coordination, US regulatory and prudential responsibilities were spread in a way that made coordination and proper oversight of systemic vulnerabilities impossible. Critical functions were in the hands of state-level or minor offices ill-equipped to identify problems, let alone do anything about them.
4. Ratings agencies (under US supervision, of sorts) were allowed to let commercial advantage influence ratings and provided AAA ratings to financial instruments which could not survive a systemic shock.
5. The US mono-line insurers were allowed to provide credit enhancements way beyond their capacity to back these up from their own capital.
6. Wall Street and the Institute for International Finance (the bankers’ lobby group) have been effective in ensuring that the international model for prudential supervision (the Basle rules) was ‘light-touch’ (some would say ‘soft-touch’).
7. The limits to financial engineering were pushed out through special investment vehicles (SIVs) and other off-balance-sheet methods of avoiding capital requirements, despite the Enron experience. These ‘innovations’ were condoned by the prudential authorities.
8. The ‘shadow banking sector’ (mainly investment banks) was allowed to expand without prudential regulation.
9. Securitisation was encouraged as a method of spreading risk, without proper assessment of who was holding the risk.
10. The LTCM crisis in 1998 was allowed to pass without reform of excessive leverage via derivatives. Hedge funds, derivatives and short-selling all allowed a degree of leverage which was unsustainable.
11. Chairman Greenspan’s famous ‘spare tyre’, whereby non-bank finance would stand ready to pick up the slack if the banks faltered, turned out to be subject to the same correlated errors.
12. US monetary policy was kept too loose for too long after the ‘tech-wreck’ in 2001. The Fed Chairman held a strong view that asset bubbles could not be identified ex ante and the only proper action was to attempt to clean up after the mess.
13. Unsustainable macro imbalances (large current account deficit, budget deficit, huge household dis-saving) remained unaddressed.
14. The delay in passing the $US700 billion Congressional package plus the failure to bail out Lehman Brothers ushered in a new and much more vertiginous phase of the crisis.

Sure, other countries went along with many of the institutional changes which exacerbated vulnerabilities, and some made their own policy mistakes. China’s reserve accumulation provided Americans with enough rope to hang themselves. But world leadership, and long years of vigorous advocacy for free markets and globalization, imposes special obligations to ensure that the interlinked financial system doesn’t have intrinsic fatal vulnerabilities. We are all entitled to feel let down by the US performance.

Cross posted from the Lowy Interpreter

1. Thailand: from financial crisis to financial resilience
2. The financial crisis – and loansharks in Japan and NZ
3. Financial crisis driving emissions up or down?