Is there some meaning – some lessons to be learned – for a developing country such as Pakistan of the financial meltdown in the United States? It is a fair question to ask, especially given the concerns it has raised and the damage it has already done in America and Europe.

The United States has seen the collapse of a number of investment banks and, with the demise of Washington Mutual Bank, it has also witnessed the largest bank failure in its history. Is the crisis likely to spread to the developing world, including Pakistan? This question has two answers.

The first is simple. Pakistan’s financial system is not sufficiently integrated with global finance to get engulfed by the spreading American crisis. As such the turmoil in the United States will not have any direct consequence for the country. The second answer needs a bit more explaining. This concerns the several lessons, the country’s central bank, the financial regulators, and the bank owners and executives must draw from the American story. I will explore some aspects of this subject.

What happened in the United States; how the financial crisis developed. It all started with a combination of what is called “the American dream” and some new economic thinking espoused by Alan Greenspan, the legendary chairman of the US Federal Reserve System, the “Fed”. The American dream relates to the desire of all households to own their own home. Houses are not bought with one’s own savings but in part with bank borrowing. When I purchased my first residence in America, the down payment was about 20 per cent. Then – some three and a half decades ago – with $20,000 of personal savings one could buy a house worth $100,000. In those days $100,000 purchased a reasonable detached family residence in a reasonably well located suburb of Washington. The remaining $80,000 was financed by a bank, mostly “savings and loan associations” whose primary function was to lend for housing.

A 30-year mortgage at five per cent a year meant a payment of about $1500 a month and if this was about a third of the household income, this was considered to be a viable option. This was the system that supported a gradual increase in home ownership until Alan Greenspan took office as Fed’s chairman.

Greenspan, as he explains at some length in his autobiography, brought some new thinking to economic management. Like all central banks, the Fed’s principal concern is to keep inflation in check. It does that by looking carefully at a number of economic trends including non-accelerating inflationary rate of unemployment (NAIRU). Rapid economic expansion would increase the demand for workers.

If the NAIRU dropped below a certain level, there was the fear that the tightening of the labour market would push up wages as the workers would be able to demand higher levels of compensation. This would cause inflation. The central bank’s response to check this development would be to raise short-term rates, the only major instrument of policy lever over which it has control. A rise in these rates normally increased the cost of doing business which in turn would reduce the demand for workers. The economy would return to a non-inflationary equilibrium.

When in the mid-1990s, the rate of economic growth picked up and the NAIRU fell below what was considered to be the acceptable level of 6.5 per cent of the labour force, Greenspan came up with the hypothesis that the United States had moved into a new economic situation. He called it the “new economy”. This was ushered in by the extensive application of information technology by the American enterprises to their processes. As a result, worker productivity had increased and the same amount of workforce could now sustain a higher rate of economic expansion.

If this was true, there was no reason to check the rate of economic expansion by increasing interest rates.

This thinking ushered in a period of easy money in the United States. Lower interest rates increased the demand for housing. The application of information technology to the sector of finance also helped the banks to develop new lines of products including mortgage-backed securities that aggregated the loans they had given into new financial products. These were made available to cash-rich institutions such as investment banks and pension and hedge funds. This development was hailed as a major advance in finance since it spread the risk banks had brought on to their books by bringing in non-commercial bank institutions into the housing market.

Intense competition among banks lowered their standards and many of them began to lend to the borrowers who could not afford to purchase mortgages. Loans were given with little or no down payment. Many borrowers were enticed into the housing market by new instruments, among them adjustable rate mortgages (ARM) that had initially low rates of interest. The ARM rates were increased later in the repayment cycle with adjustments made in line with the prevailing rates.

This kind of lending to households who were at the margin of creditworthiness came to be called “sub-prime lending”. When a couple of years ago, the Fed began to raise interest rates to cool down the economy, the terms for the home owners hardened and the amounts they needed to pay increased significantly. American households don’t have a cushion of savings to absorb these kinds of shocks and many of them began to default on their payments to the banks.

This led to hundreds of thousands of foreclosures and the properties the banks had taken over from the defaulting owners were dumped on the market. This led to sharp decline in the price of houses. The prices fell to such an extent that for many buyers the amounts they owed to banks were more than the value of the houses they owned. This situation of “negative equity” led to more defaults and a vicious cycle was in full operation.

This crisis could have been contained had financial engineering not spread the risks to so many institutions that were not directly involved in lending to the stressed home owners.

The institutions that had bought the complicated products sold to them by the original lenders found that they could not put a proper value on the assets they owned.

The share holders who held positions in these institutions became concerned and dumped their holdings on the market and the value of the shares of many financial enterprises collapsed. Several large institutions found that they could not obtain credit to stay afloat. Some of the big name institutions such as Bear Sterns, Lehman Brothers, Merrill Lynch and AIG either went out of business or were effectively taken over by the government. The crisis was raging full force by the beginning of September.

There are a number of lessons to be learned from this episode even for a relatively less developed financial and banking system such as Pakistan’s. The first is that once people begin to lose confidence in the system, it can very quickly unravel. This has already happened to the stock market in Pakistan, one part of the financial system. The second is that extreme care must be exercised by banks in making loans. At this time, the Pakistani banks have high exposure to consumer finance, including credit card debt. There are many people who are not fully creditworthy but have been given loans to purchase consumer durables that have only a fraction of the value once the sale is made. As the economy weakens, personal incomes decline and unemployment increases, these borrowers may come under extreme financial stress and begin to default on their obligations.

Third, the regulatory system must always be on its toes to detect when the institutions they are responsible for have crossed the limit of prudence.

Fourth, the government must always have a contingency plan in place for dealing with financial crises. Do these conditions exist in Pakistan? My reading of the financial system of Pakistan is that it is not robust enough to withstand the shocks that may be delivered as the country continues to wrestle with difficult economic problems. Islamabad needs to turn its attention also to ensuring the health of this vital part of the economy.