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The financial crisis and the digital revolution

“Crashed: How a Decade of Financial Crises Changed the World”, by Adam Tooze, reviewed.



This week marks the tenth anniversary of the collapse of Lehman Brothers, symbol of the global financial crisis that had been playing out since the year prior. What is the link between the crisis of 2008, and where finance is today – in particular, its digitization?

For perspective, the best place to begin is Crashed by Adam Tooze, published earlier this year, which connects the dots from the crisis to today’s troubled politics.

Tooze explains: “What the Europeans, the Americans, the Russians and the South Koreans were experiencing in 2008 and the Europeans would experience again after 2010 was an implosion in interbank credit.”

He argues that the eurozone crisis was the second act in the same crisis because of the transatlantic system of dollar-based funding. The US was connected to the U.K. and Western Europe through financial flows of securitized mortgages and the collateral required to fund it, such as asset-backed commercial paper.

The response to both the MBS crisis in the US and the eurozone was technical and incomplete, and although the Fed and the Treasury stabilized the system – and the centrality of the dollar – it came at the cost of ordinary people.

In both America and Europe, while bailed-out banks continued handing out bonuses, millions of people lost their jobs, saw their savings devastated, and were further priced out of their neighborhoods. This gave rise to populist politics, which the Right turbocharged with nativism and xenophobia.

The crisis and China
Most of Tooze’s book focuses on the U.S. and Europe where the crisis unfolded. But he also examines China’s response. Beijing found its massive buildup in dollar-denominated debt at risk, but aside from curtailing its positions in agency bonds, it learned it had no safe, liquid alternative to Treasurys. It was interdependent with the West, like it or not – a lesson the West learned, too, because for the first time in modern history, global growth depended on China, which responded to the crisis with a no-holds-barred fiscal stimulus, financed through state-owned banks.

China avoided the fate of Russia or South Korea in 2008 because its banks and corporations had limited need for dollar funding, and so the country was insulated from sharp swings in foreign-exchange rates or interest-rate differentials that drive investment flows. Its exposure to the world was mostly through trade, not finance, other than its dependence on the dollar for its vast trade-built reserves.

China seems to have only turned some of these lessons into policy. Its central bank has sought to create dollar alternatives, reflected in its drive to include the yuan in the IMF’s special-drawing-rights unit of account.

But the country has become only more connected to the dollarized system of finance. Tooze writes: “By the end of 2014, while China’s official reserves reached $4 trillion at their peak, cross-border claims against Chinese businesses had surged to $1.1 trillion, most of which was denominated in dollars and more than $800 billion of which was owed to large Western banks.”

This exposure became a problem in early 2015’s botched yuan liberalization, which led to a stock-market collapse in China and a panicky response by regulators. The internationalization of China’s economy, driven as much by capital flight as by corporate overseas borrowing, has made it more vulnerable to the dollar system – and the 2015 crisis shows Beijing’s regulators didn’t understand this.

Digital finance and the post-dollar system
In the West, surprisingly little has changed ten years on from the crisis. The nexus between Wall Street and Washington endures, as the Trump administration works with banks to dismantle Obama-era regulations requiring banks to hold more capital and to protect consumers from banks’ fraudulent activities.

Wall Street, distracted by first the crisis and then a tsunami of compliance requirements, belated woke up to the changes in society driven out of Silicon Valley. Fintech’s greatest promise has been to make customer satisfaction the keystone of growth, whereas financial services have primarily morphed into machines to extract fees. Technology is doing more than Elizabeth Warren ever could to bring competition to banking, but big financial firms, saved by the Obama administration, are well resourced and now ready to use digital tools to defend their turf.

My guess is that the true disruption will come from China, which will use technology to find a way to match its global ambitions without depending so much on the dollar. Belt and Road and the Asian Infrastructure Investment Bank are part of this, but so will be a digital yuan, which China may deploy as a means of payment for its international projects.

Chinese banks, flatfooted by the likes of Alibaba, are responding by looking at blockchain and A.I. to leapfrog Western banks and Western banking norms.

And fintechs everywhere are looking at things like tokenizing assets to create new forms of securitization. Real estate was at the heart of the 2008 crisis because it is both the largest form of wealth, and it is the most important form of collateral for borrowing. When real-estate prices in America plummeted, these assets couldn’t be used for collateral, which meant that funding dried up – a death knell for banks, especially in Europe.

Tokenizing real estate represents an exciting prospect for democratizing ownership, rising volumes in trading, and new ways to collateralize debt. This may well happen in Asia first, as part of a new financial infrastructure that doesn’t rely on the U.S. dollar.

But this also means sidelining the Federal Reserve. The Fed’s response to the crisis made it without question the world’s lender of last resort. Blockchain is meant to be decentralized – Satoshi Nakamoto had a bee in his bonnet about money-printing central banks – but if the 2008 crisis teaches us anything, it’s that when backs are against the wall, a lender of last resort will be required. Will the People’s Bank of China understand that responsibility, and be ready to assume it?

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