Sneezing Giants

| March 29, 2009

Borders offer little to no protection in an economic crisis, we need a global risk management strategy.

There are several reasons why China may be the next locus of a financial crisis that will affect us all.

First, there are strong wealth imbalances developing in China; the economy, after a relatively brief slowdown, is likely to soon resume its feverish pace; the country's political and regulatory structures are immature and highly prone to cronyism on a large scale, as evidenced by the melamine in milk scandal and its aftermath; the media in China are not independent; and civil society is very weak.

These are conditions that are likely to lead to an investment bubble. The bubble is not likely to arise while China focuses on building infrastructure and on boosting exports, but when the economy starts to shift towards domestic consumer-driven expenditure, there will be huge sums of money sloshing about. The process may be accelerated if, at some point, China decides to repatriate the funds its institutions have invested in the USA.

If you forgive me moving to a different metaphor, using fire risk terminology, if China's economy were a forest, we would say that it will soon be ready to burn – and catastrophically so.

Given the amount of capital now vested in Chinese hands and especially given the dependence of the USA on Chinese investors, any bubble bursting in Beijing would have disastrous consequences for the world's economy. More disturbing still, it is quite likely that an economic crisis in China would usher in political trouble, because of the gap between rich and poor, between country and city and between the east and the west of that vast nation. Nations in economic and political trouble tend to become warlike or, at best, highly unpredictable.

We should start building our new global risk management engine right now, I suggest, so that we are ready for the next wildfire and, preferably, so that we can start to reduce the risk of fire, right now. Of course, even without a global approach, it is possible for countries or businesses to reduce the impact of a bubble burst. For example, Australia has been left relatively unaffected by the subprime crisis, because its internal regulation of the financial system has made it impossible for any Australian financial institution to become too enmeshed in the business practices that trapped other companies, in other jurisdictions-notably, the USA.

However, in the long run financial or economic crises in significant economies cannot be contained by national borders. Even a relatively minor crisis in one continent can, given the right circumstances, quickly become a global crisis, spreading as if by contagion, as if it were influenza or AIDS (Paul Krugman, in The Return of Depression Economics and the Crisis of 2008, provides some good examples of this).

Any new regulatory arrangements should not be structured along traditional regulatory lines, largely borne out of US and European perspectives of the 1940s. We need new ways to regulate global markets, more in tune with the demands of this century. In my next post, I will make a modest proposal along those lines.

Patrick Callioni is a former senior public servant, with the Queensland and Australian Governments, and is now the Managing Director of consulting company, Enterprise Intelligence Pty Ltd, which specialises in helping business to do business with government and vice-versa. www.enterpriseintelligence.net.au His book Compliance Regulation and Financial Services is available at Amazon

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