Explaining the Financial Crisis and How It Could Work for Africa

I was in Uganda when the global financial crisis hit, and a lot of people asked me to explain what had happened, because they didn't have a clear idea about it, nor how it might affect them. The lessons from the financial crises of the 1990s in Asia, Latin America and Russia are instructive, and since I know the Asian crisis best, I'll use that as a case (and the lessons are directly relevant to the current one).

To explain, we have to look at how the financial system works. I'll offer a very crude analogy but it'll help to explain the picture. Money is sort of like a tray filled with water and ice. But imagine ice, once frozen sinks to the bottom and stays there. Every country has some barriers to money flows (tariffs, physical barriers in moving fixed capital) which you could imagine are partitions in the tray. This protects them in some ways from events elsewhere in the tray, but also, if too high a barrier, from getting more water into its share of the tray.

Now inflation is a bit like pouring more water into the tray and nothing actually productive comes of it, but some people feel richer (and can make money out of it, that is, get more water) because it's unevenly distributed. The tray's water level isn't even either - it's very choppy.

Market liberalisation is a bit like melting that ice, and at the same time, lowering the partitions of the tray. There's very good reasons why companies and banks want those barriers lowered and the ice melted - they want to be able to move their capital more efficiently to where growth areas are. In the 1990s, one of these growth areas were the emerging markets in Asia.

But unfortunately, there's a couple problems - once melted, the ice is very difficult to freeze up again. And secondly, what if everyone thinks there's a growth area where there really isn't? Or what happens when a supposed growth area suddenly collapses under its own weight, possibly because of inflated bubbles in the financial markets? What if there's a terrible leak in one of the partitions?

Immediately, the rational choice for the individual is to get out of that area, and move their money (water) to somewhere safe. So water starts draining out of the bad areas, and hopefully somewhere "safe". The problem is, when there's not enough ice left in that area, the economy can take a much harder hit that drags otherwise viable companies down, even if its fundamentals are doing quite well. That's because all companies need cash flow (liquidity) to operate their business.

This was what happened with the Thai property market in 1997 and the first to pull out were those with the most liquidity. Worse still, it began to spread around the region. When the IMF decided that Indonesia should let its banks fail to learn the hard way according to free market principles, it caused even more panic and even more outflows. This pattern of bank runs was well analysed by Jeffrey Sachs, and he demonstrated how rational choices on an individual level led to what appeared to be all out panic at the macroeconomic level.

Asia learned that lesson the hard way. It needed more ice in its trays. So it increased reserve ratios, some like Malaysia flat out banned currency outflows (a panic-move but fortunately was an emergency measure that they soon relaxed), publicly backed their main banks, instituted deposit insurance schemes, and so on.

The danger with the globalised economy and money moving so freely, is that it can lead to large destabilisation at regional levels - all of the crises of the 1990s repeated this pattern. The US, after a year of toxic assets in the subprime markets, managed only to delay the panic that was to come. When banks as large as Lehman Brothers or Merrill Lynch couldn't hold up from the slow drain (people moving their money out of the US part of the tray, into more promising ones like Asia, and in some opinions, oil futures), all hell broke loose. Regardless of the fundamentals, people were shocked that something as large as the US could be brought to its knees with a liquidity crunch. For all the flak McCain received for stating the fundamentals of the economy were strong, he would have been right if he'd said it a month earlier. The US economy was merely facing a liquidity crunch but it desperately needed to be halted before it brought down other industries (unfortunately, panic does travel astoundingly fast, thanks to the rational decisions of individuals on a global scale).

The question now is: what level of ice and water should there be? And what about the partitions in the tray? It would be foolish to erect them back to 1960s or even 1980s eras. After all, despite the financial crises of the 1990s, most of the emerging markets (East Asia, Brazil, Argentina) were all back on track as early as 2001-2 because it was fundamentally a cash flow crisis, even if it did destroy some companies, industries and banks later on. It was not a problem with their fundamentals.

Now the US has to deal with this question, and there's been a lot of solutions proposed. The bailout has been criticised rightly for throwing money away too eagerly and carelessly, but the idea of the bailout is sound - massive inflows were needed. The question now is how to regulate money flows effectively on the world markets such that it isn't susceptible to these sorts of tidal waves, the likes of which we will not see the end of in the 21st century.

So inflation played a part but really isn't the whole picture. More importantly, a global financial regulatory system needs to be set up that ensures money can still flow, but with a view of preventing uncertainty, making sure people have better ideas of what are real growth areas and what are bubbles (i.e. much more transparent financial systems). Lots of important suggestions have been made.

One is the total reform of mark-to-market accounting that judges assets and prospects based on fickle market values. Another is the increase in reserve ratios. A third is to have some banks that will be able to maintain consumer confidence regardless of the magnitude of the crisis - if the markets can't achieve that, can governments? A fourth is to control hedge funds (the kind of ultra-liquid money that deregulation in the 1980s and 1990s allowed to boom into such profitable yet potentially destructive forces).

But this has to be balanced because some liquidity is needed, and you don't want to introduce too many "sunk costs" for prospective investors and companies that might want to set up shop in your neighbourhood.

Tariffs on money flows? Bad idea. Protectionist moves? Bad idea. Nationalisation of every industry that fails (unfortunately massive job-losses are bad for politicians so these get far more importance than they deserve)? Not a great idea, but if you have to do it, do it right - set timelines of how soon you're going to get it running profitably again. Transparent accounting with very tough standards? Good idea. Dollar stability? Good idea. Increased deposit insurance protection? Good idea. Global currency? I just don't think we're ready for it.

African economies were largely insulated from the crisis, because they haven't been so closely integrated in the global economy. How can this be turned into an opportunity for Africa? Many African economies are growing at rates, despite the crisis, well in line with emerging markets. There's a hunt at the moment for relatively safe places to invest, and if African governments can make their business environments more conducive for risk-taking by demonstrating the stability of their economies and prospects for growth, then there are plenty of opportunities to be found in Africa. In the wake of the Asian financial crisis, China and India seized the moment to rouse from their slumber. Could it be Africa's turn?