When the Pyramid Collapsed

Dr. Mohammed Sabah AlSalem AlSabah's lecture entitled "October 2008: When the Pyramid Collapsed" at the first session of the Third International Conference of the College of Administrative Sciences at Kuwait University
December 16, 2008


When Dr. Rashid asked me to give a lecture at this important conference, I did not hesitate at all for several reasons.

First: Any invitation I receive to return to the warm embrace of Kuwait University is my pride and honor, because although I left the academic environment, this environment did not leave me, so allow me to take off my political robe and put on the academic robe and address you as one of you.  The ideas I will present today do not necessarily reflect the position of the Kuwaiti government, but rather represent my personal efforts.

Secondly: The theme of the conference at this time is very important because it talks about competitiveness in a changing world.
Competitiveness... This hypothesis is the backbone of the pyramid of neoclassical economic thought, and it is the hypothesis on which most modern economic models such as Computable General Equilibrium Models and Econometric or Stochastic models are currently used with almost absolute faith in their outputs by the Bretton Woods institutions: IMF, World Bank and World Trade Organization.

 Third: When the financial markets around the world collapsed two months ago, this collapse did not only represent a severe blow to traders and politicians, but also a severe shock to those who believed in the competitiveness and absolute efficiency of markets and believed in the rationality and rationality of those who deal in these free markets from consumers and producers and that all their decisions are based on rational expectations (Rational Expectations). The absolute belief in the intellectual system of the classical pyramid turned into a deep skepticism of the validity of its assumptions, especially the assumption of the primacy of free competitive markets, which led the most famous US central bank governor in the twentieth century, Alan Greenspan, to say:
I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders
This is where the stones of the pyramid began to fall.

What happened:

Any fair-minded observer would say that what is currently happening is the natural outcome of a financial bubble bursting, something that has happened repeatedly in recent economic history, and when anyone interested in the matter enters the term economic bubbles in Google, they will get about 15 million websites, and I think the best writer on the history of this phenomenon is MIT's economic historian Charles Kindleberger
Charles Kindleberger; Manias, Panics, and Crashes
A History of Financial Crises

He reviewed the economics of bubbles from Tulipmania in the Netherlands in 1636, speculating on tulip seeds, through the South sea bubble in England in 1720, to the bubbles of the 20th century (ironically, the discoverer of gravity, Isaac Newton, lost part of his fortune in South Sea stock speculation).

So what happened two months ago, and how did the competitive free market model fail to predict this bubble?

The story began with the failure of the subprime mortgage market in the United States, and in less than a year it turned into a global economic crisis unprecedented since the collapse of the New York Stock Exchange in October 1929.  The intensive and aggressive monetary policies of central banks in most developed countries did not avert this crisis, nor did the concentrated injection of liquidity into money markets and the rapid reduction in interest rates prevent the collapse of huge financial institutions in the United States, starting with the bankruptcy of the largest investment bank in the United States, Bear Stearns.

In September 2008, three months earlier, the contagion of the US financial crisis turned into a financial tsunami sweeping across the globe.  In a globalized world where not only the markets of goods and services but also emotions and concerns are intertwined and intertwined, the panic that hit the US market spread to all global markets, drying up the sources of financial lending and starting an immediate sell-off in all stock markets around the world, and huge financial castles of banks, investment companies, and insurance companies became reeling before this terrifying financial wave.  Countries such as Iceland, Hungary, Ukraine, Belarus, Serbia and Pakistan rushed to urgently ask the International Monetary Fund (IMF) to provide loans and liquidity to save their economies from catastrophe, and we began to see the rapid transition of this contagion from the financial economy to the real economy and from markets in general to the ability of countries to fulfill their obligations.

This crisis is expected to lead to a general reluctance to invest in emerging markets and developing countries in general, as the spread in the Emerging Markets Bond Index (EMBI) jumped from 250 basis points to 550 basis points in September alone, reflecting the degree of fear and caution among global financial institutions from lending and financing operations in emerging markets.

The year 2009 is expected to witness a sharp capital flight from developing countries to developed markets. The drop in the yield on US Treasury bonds to near zero may be an indication of the strong international demand for this financial asset.

Although developing countries were not involved in the subprime mortgage crisis in the United States of America, the collapse in primary commodities, the sharp increase in the cost of external borrowing and the flight of foreign capital from emerging markets portends a devastating economic phase for developing countries, especially the poor ones, and it is expected that the year 2009 will witness many economic collapses in developing countries, as the World Bank Vice President and Chief Economist Justin Lin recently predicted that many developing countries will enter the danger zone and the poor in those countries will suffer more than others from the global financial crisis.

Talk about the possibility of the US economy entering a "liquidity trap" as in Japan is evidence of the growing concern in economic circles. When consumers and investors lose confidence in the economy, banks refrain from financing and lending, and interest rate cuts become ineffective in stimulating economic activity, monetary policy loses its effectiveness and attention turns to other means.

We now see many countries, primarily the United States, abandoning their ideological bias against Keynesianism and starting to design expansionary fiscal policies (Stiglitz's Colombia professor Joseph called for allocating a trillion dollars to stimulate the US economy) Ignoring calls for caution about increasing the budget deficit and ignoring the warnings of Barro, Harvard Robert that government spending by increasing the deficit would be ineffective due to Ricardian Equivalence.

This approach to expansionary fiscal policy was not limited to the United States only, as most European Union countries adopted this policy, and even the chief economist of the International Monetary Fund, IMF Blanchard Olivier, called on all countries of the world to allocate at least 2% of their GDP to stimulate the economy in the short term in order to prevent the global economy from collapsing, so China allocated 15% and Korea 1% of GDP to be used to finance the expansion of the public spending program, and we started hearing about multiple rescue programs ranging from the automotive industry in the United States to the cheese industry in Italy.

But the question is whether these traditional means and tools are sufficient to get out of the crisis.

The events of last October proved that the philosophical structure of the neoclassical economic pyramid system failed to predict the economic crisis and also failed to minimize its repercussions, and the unprecedented overlap and entanglement in the financial, currency and commodity markets may be a primary reason for the weakness of traditional tools in influencing macro variables.

The UNCTAD report for 2008 indicates that most economically successful developing countries have used innovative means of a diversified mix of lower interest rates and a competitive exchange rate policy to stimulate domestic investment, thereby achieving higher rates of domestic investment than relying on foreign capital.
 Experience has also proven the failure of relying solely on classical approaches in determining the role of monetary policy in fighting inflation. Therefore, monetary policy must take its full role in directing economic development to the productive sectors and be responsible for establishing an early warning system that prevents the emergence of financial bubbles or at least minimizes their severity.

The financial crises in Asia and Latin America in the late 1990s are an example of the failure of the principle of free movement of capital to prevent dangerous and persistent deviations in exchange rates or to address accumulated current account deficits.

As for the current financial crisis, Columbia professor Jeffery Sachs announced the collapse of the global financial system and the fall of the Bretton Woods institutions, and former US central bank president Alan Greenspan attributed responsibility for the current crisis to his belief in the efficiency of competitive markets and the rationality of dealers, as the relaxation of the restrictions of the financial control system on investment institutions led to the deviation and recklessness of these institutions and their entry into unprecedented operations. Instead of playing their traditional and supposed role in risk management, these institutions entered strongly into the manufacture and production of risks by creating so-called financial derivatives or, as businessman Warren Buffet called them, financial weapons of mass destruction. In 2003, they amounted to 85 trillion dollars, while the total global trade did not exceed 50 trillion dollars, and answering a simple question like "What do I own?" became almost impossible.

Although the recent G-20 meeting in Washington, D.C.20 meeting held recently in Washington did not discuss the causes of the collapse of the Bretton Woods system, the need is now more urgent to rebuild the global economic system on new foundations, principles and creative ideas that address the effects of the collapse and prevent its recurrence in the future, and this undoubtedly requires a serious political will and desire by the developed countries to allow the developing countries to take their role in this reconstruction In a globalized world, it is not possible to face acute challenges except by finding multifaceted solutions, and to reform the global financial system, i.e. reforming the Bretton Woods system, it is first necessary to reform the institutions of this system, namely the International Monetary Fund (IMF), the World Bank and the World Trade Organization (WTO).

The IMF must abandon the rigid methodology and canned solutions in addressing the effects of the global financial crisis on developing countries and relax the requirements of the Washington Consensus. Joseph Stiglitz has called for the creation of a new organization to lend to developing countries as a result of the repeated failure of the IMF's policies with developing countries. He and other prominent economists have also called for the revitalization of British economist Keynes' 70-year-old idea to create a global reserve currency instead of relying entirely on the dollar in order to mitigate currency fluctuations and prevent worsening balance of payments imbalances.

In addition, the international financial system should be restructured, international financial monitoring and risk assessment institutions should be established, and serious consideration should be given to imposing a Tobin tax, the idea advocated by Tobin professor Yale James in 1978 to impose a tax on currency market transactions in order to curb harmful speculation and provide additional liquidity for the Bretton Woods institutions.
The World Bank should also urge rich countries to fulfill their commitments to meet the global development goals adopted in Monterrey, Mexico, six years ago, which called for allocating 0.It is unacceptable for the United States and Europe to provide $3 trillion to bail out their banking institutions while failing to provide one-thousandth of that amount to help poor countries fight hunger and disease.

Finally, the World Trade Organization must fight protectionism in the face of the current crisis by expediting the approval of the results of the Doha Round of negotiations, and encouraging incentives must be given to achieve a significant and sustainable increase in food production in developing countries by promoting investments, developing production in the agricultural sector, promoting rural development and intensifying agricultural research in this field.

In conclusion, let me, honored guests, review with you the measures and policies taken by the State of Kuwait to deal with this crisis and minimize its repercussions:

- Reflecting Kuwait's belief in the importance of stimulating economic growth and raising the standard of living to alleviate poverty, His Highness the Amir Sabah Al-Ahmad Al-Jaber AlSabah announced in April of this year an initiative to establish a decent life fund of $100 million to help countries affected by high food commodity prices and increase their capacity for agricultural production.

- Kuwait has also allocated 300 million dollars to fight poverty in the African continent through the Islamic Development Bank.

-In the field of development assistance to developing countries and least developed countries, Kuwait's share of such assistance has, over the past three decades, amounted to 2% of gross domestic product, which is nearly three times the internationally agreed rate of 0.7%. In this regard, I would like to refer to the development efforts undertaken by the Kuwait Fund for Economic Development since its establishment in 1961, which included more than 100 developing countries by providing soft loans and grants for infrastructure projects, whose number has so far reached 750 projects covering various sectors such as agriculture, transportation, communications, energy, water, health and education with a total value of 14.5 billion dollars.

- The State of Kuwait, based on its international and regional responsibilities in achieving development and working to promote it, has called for an Arab Economic Summit to be held in January of next year to study development issues in the Arab countries, in addition to discussing ways to face the new challenges arising from the current global financial crisis. The outcomes of the conference and the follow-up to their implementation will constitute a joint collective responsibility to ensure that the desired sustainable development is achieved.

Honorable attendees.

I hope that this modest contribution has helped to clarify the dimensions of the overall picture of the current financial crisis, please accept my sincere apologies for the prolongation.

Thank you and God bless you all.

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