China Offers Lessons

Wharton China expert Marshall Meyer said that for those grappling with the American banking implosion, China's current economic situation is more relevant than its financial sector's experiences during the 1990s Asian financial crisis. With a stock market that recently fell 70%, a sharp rise in inflation, and billions of dollars in undeclared U.S. currency in the market, China's current woes are in the "real economy" rather than just the financial sector. With a trade and especially export-oriented economy, China faces a serious threat when recession curbs the appetites of American or other foreign spenders. "Don't bank on China to drive the global economy," Meyer said. "Ultimately, I think the Chinese economy must and will turn inward."

Penn political scientist Heiner Schulz, an expert on bank liberalization in emerging markets who also spent time as a visiting scholar at the Bank of Korea, said the aftermath of Mexico's 1994 financial panic left him unhappily certain that America's current woes would be more expensive that predicted, longer-lasting than predicted -- and would likely take a real bite out of the real economy.

Schulz, who worked as a management consultant to firms doing business in the country at the time, said the possible collapse of the Mexican banking sector had prompted a full-fledged government response, complete with a takeover of bad loans, recapitalization of banks and direct intervention into failing institutions. Legal changes also allowed foreigners, and their capital, into the industry -- which they came to dominate in the ensuing decade. The crisis did little to hurt economic growth, which trucked along for much of the decade.

Why will the United States be different? Just as the costs to the Mexican treasury grew beyond initial forecasts, Schulz said he believes costs here will be far higher than advertised. At present, predictions about bailout costs for the current crisis amount to 6%-7% of GDP. But the $300 billion savings and loan rescue was initially forecast to be just $50 billion to $60 billion, Schulz said. And in Mexico, where the banking sector was unsophisticated and smaller than that of the U.S., the 1994 rescue wound up costing 15% of GDP. It also took 10 years to clear up the bad debt, which at its peak amounted to just under 19% of loans. But those were simple, basic loans. Schulz believes that America's debt problem, which is centered around complex financial instruments, will be much harder to even calculate. "It takes a lot of work to deal with a bad debt problem," he said. "This is tough even for simple loans." According to Schulz, Mexico's nonfinancial sectors escaped much damage because the economy was far less tied to the banking industry. By contrast, he said, the U.S. has a degree of "financialization" that is 10 times higher.

Schulz fears that the possible effects of the American crisis may include a backlash against financial innovation, something he sees as disastrous since complex mortgage-backed securities, especially in emerging economies, help lower-income people buy property. He also fears a broader backlash against Western models of development by countries wary of being lectured by Washington during their own economic troubles. "They might turn to other models" -- such as China -- "after watching what they have been told is the gold standard turn out to be not so strong," Schulz said.

Schulz did, however, offer a grain of salt to anyone who would extrapolate too much from the recent financial crises the Wharton panelists had studied: Parallels between past and present are always tricky, especially between emerging and developed economies. "Like the generals who are always trying to fight the last way, the regulators are always trying to fight the last crisis," he said.

Schulz's own prescription for preventing a recurrence of the 2008 meltdown would focus on improving America's balkanized financial regulatory system and on reducing moral hazard and information asymmetry. The latter is especially tough since an age of innovation necessarily means bankers may be inventing things faster than regulators can figure them out. "This is, in my view, another of those rare opportunities in the U.S. to change the regulatory system that's in place," Schulz said.

"In order to be a cat, you have to have been a mouse," Meyer added. "Maybe our MBAs should have to be regulators before they are bankers."