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UPDATED: November 24, 2010 Web Exclusive
The Financial Tsunami: Its Origins and Prevention
A financial crisis that originated in the U.S. in the latter half of 2008 has swept the world like a tsunami. What led to this crisis?


JOBLESS: Job seekers talk with representatives from an employment agency at a job fair in Los Angeles on September 20, 2010. The unemployment rate in the United States has hovered between 9 and 11 percent since the eruption of the global financial crisis in 2008 (AFP)

A financial crisis that originated in the U.S. in the latter half of 2008 has swept the world like a tsunami. What is the real reason for this crisis, and how can countries work together to avoid a similar catastrophe in the future? Zheng Xinli, Vice Chairman of the China Center for International Economic Exchanges (CCIEE), shared his views on the CCIEE's official website. An excerpt from his essay can be found below.

What led to the financial crisis of 2008? Was it an economic imbalance caused by international trade? Financial bubbles and over-use of leverage? A sovereign debt crisis?

The answer is none of the above. Rather, the real reason is that the U.S., as the major reserve currency issuer in the world, has been misusing its sovereign credit for a long time and implementing a twin deficit policy to maintain its domestic over-consumption and government over-spending, which paved the way for the financial tsunami.

Moreover, American credit rating agencies covered up credit risk and misguided international capital flow, which led to the fall of the last defensive wall against financial risk.

Market economy is based on credit, and economic globalization has made sovereign credit an important part of a nation's competitiveness and economic strength. Good sovereign credit provides significant impetus for economic growth by reducing the financing cost for governments and enterprises, and also by attracting more foreign capital.

On the contrary, misuse of sovereign credit, especially by the world's major reserve currency issuer, is doomed to incur a domestic and global economic catastrophe as such an action will always harm other countries' wealth and create financial risk.

With identification of the origin of the financial crisis, it is a responsibility shared by economists and governments from all over the world to explore fundamental approaches to prevent similar crises from happening again.

In the post-crisis period, most countries have concluded that regulations should be strengthened in various financial institutions including banks, equity markets, bond markets, insurance institutions, investment institutions and especially in financial derivatives.

Recently, U.S. President Barack Obama signed a new financial regulation bill; I believe this bill is a good move based on lessons learned from the crisis. In addition to bringing all non-banking financial institutions into regulation, the firewall between the banking system and the capital market should be rebuilt.

After the Great Depression of the 1930s, the U.S. learned lessons and passed a set of legislation that prohibited banks from holding corporate equities, which effectively prevented corporate bankruptcy from turning into bank failure and prevented further economic collapse. However, this legislation was regarded as a barrier to the pursuit of new liberalism and was repealed in the 1980s. In conclusion, historical and current experiences tell us that it is necessary to rebuild the firewall between the banking system and the capital market, which is vitally important for guarding banks' safe operation and the interest of resident savings.

Since the Bretton Woods system collapsed in the 1970s, currency issuance has been decoupled from gold reserves. As the world's major reserve currency, the U.S. dollar has found its base on U.S. sovereign credit. This has enabled the U.S. to shift its debt burden to other countries by way of dollar depreciation. Between 1971 and 2010, the dollar depreciated by about 97.2 percent against gold, causing huge losses for those countries holding dollars as their reserve currency. It did not take long to see the disappearance of dollar securities in the stock market during the crisis.

This phenomenon shows that the impact on financial security of the world's major reserve currency issuer can go beyond borders and spread to every single U.S. dollar asset holder including residents, enterprises and governments. Therefore, it is vitally necessary and reasonable to create international regulations on the financial operations of the world's major reserve currency issuer. It is fully feasible for international financial institutions to undertake such task.

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