Paulson's Post-Mortem on the Credit Crisis

Outgoing Treasury Secretary Hank Paulson recently told The Financial Times that the worldwide credit crisis was partly the result of a collective failure to come to terms with the way the rise of emerging markets was reshaping the global financial system. These imbalances, which arise from differences in savings rates among various nations, are reflected in large current account deficits (or surpluses) around the world. Secretary Paulson said that in the years leading up to the crisis, high savings from fast-growing emerging nations such as China and the oil exporters, at a time of low inflation and booming trade and capital flows, put downward pressure on yields.

These years of low yields and high risk spreads laid the seeds of a global credit bubble, he said, referring to the more than $50 trillion market for credit default swaps that extended far beyond the U.S. sub-prime mortgage market and has subsequently burst with devastating consequences worldwide. Paulson’s argument, which has been advanced by a number of other economists – and is largely endorsed by Fed Chairman Ben Bernanke – suggests that the roots of the credit crisis do not lie in failures within the U.S. financial system alone. After all, the market for credit default swaps is global, and it is actually larger that the entire world’s annual GDP output.

Secretary Paulson made it clear that avoiding another credit crisis will require global cooperation as well as better financial regulation and risk management. Translated, this means that allowing banks to hide excessive risk offshore, like Citigroup’s vast exposure to Structured Investment Vehicles and being leveraged to the hilt in offshore vehicles will simply no longer be acceptable.

Treasury Secretary Paulson also made it clear to the Financial Times that the U.S. government did not have all the tools it needed to deal with the recent financial crisis effectively. Paulson said “we’ve done all this without the authorities that a major nation like the U.S. needs,” adding that “we are dealing with something that is really historic and we haven’t had a playbook.”

He ticked off the reasons for his difficulties: “First of all, these excesses have been building up for many, many years. Secondly, we had a hopelessly outdated global architecture and regulatory authorities” in the U.S. He said the $700 billion Trouble Asset Relief Program (TARP) did not have adequate tools, such as special bankruptcy capacity for non-bank financial firms. Despite these comments, Paulson was surprisingly upbeat about the progress that has been made since TARP was passed, despite the fact that banks are not lending enough yet. He stressed that “there would be much less lending if the actions were not taken to increase confidence in the banks.”

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