Let it snow, let it snow, let it snow.

Torrens Hume’s new year’s prediction for 2012: Somewhere it will snow, and somewhere there will be an avalanche.

International macro types take great pleasure in trying to predict the next international crisis. Not only is it fun but, if done well, can be a powerful way of winning friends and influencing people, especially if you actually get one right. There is also that inherent satisfaction to point out the flaws in someone else’s economies.
Predicting an economic crises is a bit like predicting an avalanche – you can often tell when the conditions for an avalanche are right, but predicting which snowflake will trigger the avalanche is a much more difficult task. It’s like that in Europe; the situation is risky, but it’s not exactly clear what the trigger would be. And it is possible that economic conditions could improve enough to avoid a crisis before the trigger is released.
It’s quite likely that there are other avalanches around the world waiting to be triggered as well. It’s just a matter of time. The question is where. One of the factors that make emerging markets more prone to crisis – more financially fragile – is that many lack good institutions that promote good governance and respect for the rule of law.
Here is one reason why a good institutional environment matters, suppose that you have an economy with a large banking system. Banks are inherently challenging because depositors never really know for sure what a bank plans to do with their money. Hopefully the bank has a sound lending policy that will enable depositors to get their money back. But you can never be sure.
When you have an asymmetric information problem like this you have what is referred to as a moral hazard problem – the bank may not be as careful with the depositors’ money as depositors’ would like them to be. The bank may get careless, or it may behave dishonestly (using some deposits for the personal interest of the bank owners).
One solution is to require banks to hold a large chunk of capital (i.e. bank owners own money) that can be lost before depositors are wiped out. This creates an incentive for bank owners to be careful with depositors’ funds, because the law will require that they bear losses before depositors do. Incidentally, this is exactly the solution that has been adopted in advanced economies in response to the global financial crisis. Banks have been required to raise capital requirements. The hope is that they won’t take the sorts of risks that they did with US sub-prime paper again.
But there is the rub: “the law will require … .” So what happens in an environment where corruption greases the wheels of commerce? What happens when regulators take bribes to turn a blind eye to shortfalls in required bank capital? Or when bankers are above the law and simply lie? Like the US experienced in 2008, these situations often leave a country’s banks susceptible to runs or sudden reductions in financing when market sentiment changes. But in emerging markets the problems caused by poor governance can be worse.
During the global financial crisis, many emerging markets experienced a surge in capital inflows. The question is whether their governance structures are sufficiently robust to cope with these inflows. Torrens has his doubts.
So here it is, his new year’s prediction is that 2012 will see an emerging market crisis (the euro crisis was his 2010 prediction – because of the vested interest of policy makers not to deal with their banking problems). Which snowflake will cause the avalanche is anyone’s guess, but THs avalanche conditions are weak governance, large banking systems and a current account that has a small surplus or a deficit.

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