World Bank chief economist warns of two lessons from current financial crisis

Backgrounder: U.S. Financial

Crisis

by Liu Hong

WASHINGTON, Oct. 7 (Chinese media) -- World Bank Chief

Economist Justin Yifu Lin said recently that the world should learn two lessons

from the current financial crisis, the most serious since the Great Depression

in the 1930s.

"One was that we cannot solve one problem at the

expense of creating another even bigger one and the other is that hidden trouble

of financial innovation cannot be let alone," he told Chinese media in an exclusive

interview.

DOT COM BUBBLE LEADS TO

REAL ESTATE BUBBLE

Dr Lin, 56, named as chief economist and senior vice

president for Development Economics at the World Bank in February after a global

search, said this financial crisis "has much to do with the way that the U.S.

government dealt with the Internet bubble in 2001."

"When the dot com bubble burst, the U.S. economy

should have slid into recession. However, that economic downturn trend was

halted swiftly and the negative economic growth only lasted for about one

quarter," he said.

Following the collapse of the dot com bubble and the

9/11 tragedy, the U.S. Federal Reserve slashed interest rates from 5.5 percent

to 1 percent and kept it there for as long as three years.

"By cutting the interest rate, the Federal Reserve

successfully stimulated the housing market, turning around the economic

slowdown," Dr Lin said.

"However, in the highly prosperous real estate market

also lies the seed of today's financial meltdown," said the Taiwan-born Chinese

economist. "The housing market bubble which is bigger than the Internet bubble

triggered a cascade of challenging problems after it burst."

With the burst of the housing bubble in early 2006,

the subprime mortgage crisis quickly followed and one year later developed into

a financial crisis with a worldwide impact.

HIDDEN TROUBLE OF

FINANCIAL INNOVATION

The second lesson the world should learn from this

financial crisis was the hidden trouble of financial innovation, Dr Lin said.

"The financial derivatives in the U.S. are becoming

more and more complex, but the rules and regulations lag far behind. Like adding

fuel to the fire, lack of supervision made the situation even worse," said the

chief economist.

He believes that financial innovation was both

necessary and unpreventable, "but people should be aware of the merits and

demerits of these innovative products."

"You cannot only focus on the merits while neglecting

the downside of these products," he said.

Dr Lin said that although the White House and the Fed

have adopted a huge bailout plan of unprecedented size, the prospects of the

U.S. economy remain unclear.

What can be expected includes a restructuring of U.S.

financial institutions, a decline of investment and consumer financing and as

lowdown of the U.S. economy, he said.

"But questions like to what extent the economy will

slow down and how serious this economic slowdown would be are unpredictable," he

said.

CHINA SHOULD INCREASE

DOMESTIC DEMAND TO COPE WITH CRISIS

Dr Lin, also the first chief economist of the World

Bank from a developing country, said the U.S. subprime mortgage products

purchased by Chinese financial institutions are very limited, so the current

financial crisis would have a relatively small direct impact on China.

But the slowdown in the economy will surely decrease

U.S. demand for imported products, thus having an indirect impact on China's

exports to the U.S., he said.

As for the question of how China should deal with the

grave financial situation, Dr Lin said China should increase domestic demand and

that this is one of the areas that China still has tremendous potential.

"China has a huge urban-rural gap, which means the

country can work on various projects to revive the construction of rural areas.

In addition, China's financial situation is relatively better so that it is

financially capable of stimulating domestic demand," he said.

As the financial crisis is worldwide, the U.S.

government has called for international cooperation to address the problem.

China's cooperation is also highly expected, but

according to Dr Lin, China's stable and fast economic development is itself a

contributor to the world economy.

"The stable and rapid economic development in China

not only boosts China's exports, but also provides a bigger market for the rest

of the world," he said.

Well known for his work on fiscal decentralization,

enterprise reform, urban and rural modernization and agricultural innovation and

reform, Dr Lin has taught at several eminent universities, including Peking

University, the Hong Kong University of Science and Technology, Duke University

and at UCLA.

He has twice been awarded the Sun Yefang award,

China's highest economic honor.