Two CEOS stand in an office examining a chart showing plunging world GDP. One turns to the other, and says, “We can only hope that it turns around before there’s time to learn any lessons”.
It seems this wish, expressed in an April cartoon, might now be coming true. It has been over a year since a financial maelstrom growing between Wall Street and London suddenly sucked the world economy down with it, submerging production and drowning off the planet’s less fortunate elements. Despite much discussion of the necessity of reform, it is unclear how much politicians have actually changed, and one begins to wonder if the political momentum for reform has been lost now that small signs of recovery are appearing.
Deep Problems, Shallow Attention
Averting another similar financial disaster, of course, requires some agreement on what caused this one. This has been slow coming, but broadly speaking there are three levels where problems of instability contributed to the meltdown.
At the individual level, bankers, spurred on by large pay packages that encouraged short-term profit maximisation, took excessively risky positions and dispersed that risk system-wide through complex and opaque financial instruments. This was made easier and more dangerous by the fact that American consumers, who have tended to see their real wages fall over the past 30 years, had been convinced they could live the good life by taking on more and more debt, often against rising asset prices that turned out to be bubbles, easily burst.
At the national level, regulators failed to do their job. Keynes and Minsky showed us long ago that financiers will always hang themselves if given enough rope. Those in charge of overseeing financial markets let risk become increasingly large and opaque, allowed banks to become too big to fail and chose to ignore a massive housing bubble. This behaviour was bolstered by the belief, held by those at the top, that markets “worked” and would sort themselves out in the end.
At the global level, huge trade imbalances and massive flows of speculative capital moving at light-speed have led to an increasingly unstable world economy for years, and have contributed to the problems at the individual and national level. A globalised economy and global finances have not been matched by any real global governance, and the international regulations which kept the immediate post-war period relatively stable have been gradually removed since the early 1980s, in line with the same beliefs that drove deregulation at the national level.
What meaningful progress has been made in discussions of tackling these problems at these different levels? There has been some unconvincing discussion of reforming banker pay schemes, and there has been extensive talk of rearranging regulatory duties. Rearranging regulatory duties, however, is not the same as actually regulating. It was always someone’s job to oversee the system. It is not who does it, but if it is actually done, that matters.
Progress has been made on the requirement that banks hold higher amounts of capital to balance the money they have invested. But this is not much comfort even to such a mainstream commentator as Martin Wolf, author of Why Globalisation Works.
In the Financial Times, he writes, “higher capital requirements would again trigger an explosive expansion of an unregulated shadow banking system. In short, higher capital requirements will only work if they come with a huge increase in regulatory will and effectiveness. I am not holding my breath.” And as for the critical issues at the global level, there has been basically no progress whatsoever.
A Question of True Intentions
In a discussion for this article at the Financial Times offices in London, one journalist joked, “The steps needed to avert another global crisis? Good luck”. But in a sense, everyone knows what would avert another financial crisis. If stability was the main goal, politicians could easily take a set of aggressive steps to reform the system.
Governments could create a stringent regulatory structure at the national level in all the major economies, which would need to approve all new financial products. They could break up banks that are too big to fail, and use anti-trust law to prohibit banks from becoming too large in the future. Authorities could strictly separate different kinds of banking activities, and therefore erect walls between different types of risk, cutting short the risk of toxic contagion.
At the global level, governments could cooperate on reducing global trade imbalances, create multilateral institutions to oversee global risk, and re-legitimise the use of capital controls to offset the effects of fast-moving, speculative “hot money” which has brought down so many developing countries in the past 30 years.
Of course, if governments were committed, they could go even further. They could socialize financial markets. They could take greater control of them and attempt to run them in the public interest.
All economies, capitalist or not, need credit institutions to allocate resources and smooth exchanges and debt payments. “They are a vital public service, like a health service,” pointed out economist Peter Gowan before passing on earlier this year. At their best, financial markets efficiently allocate capital within the economy. At their worst, they suck money and talent out of the real economy and into risky activities that ultimately require bail-outs when they fail.
Democratic societies could decide the functions currently performed by financial markets are too important and risky to be entrusted to profit-maximising private actors, and should serve a public good rather than increasingly driving the economy and the state. This is another radical idea that has found its way into the mainstream as a result of the shock of 2008. Willem Buiter, professor at the London School of Economics and former member of the Bank of England’s Monetary Policy Committee, wrote on his blog for the Financial Times
“There is a long-standing argument that there is no real case for private ownership of deposit-taking banking institutions, because these cannot exist safely without a deposit guarantee and/or lender of last resort facilities, that are ultimately underwritten by the taxpayer. No doubt the socialisation of most financial intermediation would be costly as regards dynamism and innovation, but if the risk of instability is too great and the cost of instability too high, then that may be a cost worth paying…From financialisation of the economy to the socialisation of finance. A small step for the lawyers, a huge step for mankind.”
The fact that these aggressive approaches to averting another crisis would work does not change that they are extremely unlikely in the near future. They would quickly come up against large and powerful domestic political interest groups in the most important economies. And this is made even more difficult by the widespread belief that slowing down free-wheeling financial capitalism would slow down economic growth itself.
It is unclear that this is true. The world economy grew faster in the period from 1945 to 1980 than it has since. In that period, countries reserved the right to employ capital controls on cross-border transactions, exchange rates were largely fixed and negotiated rather than subject to real-time market movements, and finance was much less central to the economy. Financial crises have become an extremely common occurrence since 1980, usually in the poorer countries. Granted, it would be difficult to return to such a managed international capitalism and the growth rate then may have been attributable to a rebound after WWII. But even today, countries with more managed and defensive financial systems, from Brazil, China, to Saudi Arabia, have been better able to weather the current economic storm than more open counterparts such as Mexico, Japan, or Dubai.
But as developing countries know well, no amount of prudence can protect them from the vicissitudes of the international marketplace. No oil-exporting country, for example, can be reasonably expected to comfortably manage a swing in the price of oil up to $150/barrel and down to $30. It’s clear a large part of that swing was fueled by financial speculation. Some have argued credibly that the brief explosion in the price of oil was the result of an asset bubble blown by Anglo-American financial actors fleeing to oil from US housing markets before that bubble itself burst.
National Political Realities
So, then, it is not that one needs luck to come up with a way to avoid crises. It’s that no one knows exactly which approach can provide meaningful stability while realistically dealing with opposed interest groups
Since WWII, there have been two major transformations in the nature of capitalism, and they have both come after a crisis. 1945 saw world capitalism reconstructed after the chaos of the war along more cooperative and regulated lines. John Maynard Keynes was instrumental here, convinced, like most others at the time, that unrestrained international finance had helped cause the Great Depression.
From 1980, Reagan and Thatcher’s push for global deregulation, the elevation of international finance and a return to more liberal, unrestrained capitalism came after a decade of economic crisis in the rich countries in the 70s, when Keynesian policies seemed to be hitting a wall. Crises often provide fertile ground for a restructuring of society. “Never let a serious crisis go to waste,” as White House chief of staff Rahm Immanuel said.
The crisis of 2008-2009 could provide the necessary shock to reform the world’s financial system along more stable lines. But there is a big difference between 2009 and past transformations. In 1945 and 1980, there were no massively powerful groups with interests invested in the status quo. In 1945 there was no status quo whatsoever; the world economy was in ruins. In 1980, the only major powerful opponents to the neoliberal reforms were unions, influential to some extent in the US and Europe and less so in the developing world. But even this relatively weak coalition of forces proved a very tough nut to crack. Governments, especially in the developed world, had to stage bitter and protracted fights with labour movements.
The financial sector in the US and Europe now is much more powerful than unions were then. It is extremely unlikely Obama or anyone else is about to enter a long war with finance. Clawing back massive bonus packages for bankers is good insofar as it makes them less likely to privilege short-term risk, but in a sense it misses the point. Banks are only able to pay these huge bonuses because they are making huge profits, likewise because their activities have taken up such a large part of economic activity. In 2006, 40% of American corporate profits accrued to the financial sector of the British and US economies—quite a bit for a sector whose only job is to allocate credit. A real restructuring of the economy along more stable lines would reduce the size of the often “socially useless” sector, as Lord Turner, head of the British Financial Services Authority recently suggested—something the powerful lobbies of the finance industry simply won’t put up with.
What makes this even more difficult is that huge sections of the middle and lower classes in the rich countries have been financialised themselves. As their real wages fell during reforms of the 80s and 90s, they began living more and more on borrowed money. US household debt as percentage of GDP doubled from 50% to 100% from 1980 to 2007. In the financial sector, this jumped fivefold from 21% to 116%. Hard-working middle and lower-class households with large debt burdens and who have seen their pension schemes moved to the stock market found out how much they were tied to finance when they saw around 30% of their life savings disappear in October last year.
Finger Pointing Politics
At the crucial international level, these problems are compounded by a lack of credible global institutions to tackle global risk. Globalised finance has not been matched with global governance, and returning to a world of more stable and nationally managed finance is taboo, not least because doing so would hurt the same powerful interests listed above. The US still controls the two institutions with real power, the IMF and the World Banks. And getting weak multipolar bodies like the G20 to negotiate on such huge and prickly problems is like, as the phrase goes, “playing chess with 20 sides.”
Though the important issues of a new “international financial architecture” (rules, regulations, global cooperation, etc) remains undiscussed, global trade imbalances finally received some attention at the last G20 conference in Pittsburg, The logic behind the role of these imbalances on the crisis is fairly simple. Because of the role of the dollar as international currency, the US has been able to borrow cheaply internationally to fund its massive trade and fiscal deficits. In 2006, the US consumed more than it produced by an amount larger than the entire economy of India.
China, one of the largest surplus countries, re-invests a large portion of this money into the US to keep the dollar high enough to continue buying its exports. This massive inflow of money looking for places to invest contributes to asset bubbles and overwhelms weak regulatory structures in the US.
The US has told China and other exporter countries they need to consume more to reduce these imbalances. But this neglects the other side of the coin—that the US would have to consume less and deal with a drop in the value of the dollar. To consider the political toxicity of such a proposal, think of a US president running on the slogan “Let’s consume less”.
Blaming China and other export countries for these imbalances is a bit disingenuous. It implies that the US actually wants to export more and China wants to avoid consuming, instead of the other way around. Considering that US deficits have been a structural feature of the world economy since before China integrated into it, it’s a bit cynical to accuse China of perpetuating a system, when in actuality it had to find a way to adjust to it.
Future Horizons
On the other hand, blaming the US for the weaknesses of the current international economic order is a bit pointless, because due to its level of involvement the country is equally responsible for what have also been its many successes for fifty years. As always, things could have been better, but they could have been worse. What is more important is how the current situation can lead to an improvement given the current conflicting forces.
The question of the dollar has been made more critical as the US fiscal deficit balloons as a result of the US fiscal stimulus package. Acting quickly to inject money into the economy was important and likely saved the world from serious depression. But it indeed propped up the existing problematic system. The US spending trillions of dollars of money it doesn’t have surely does little to help global deleveraging.
Unfortunately, no action is likely to be taken on imbalances in the short term, nor on reducing the instability of global finance. And the regulatory reshuffling that will take place in the rich countries, it seems, will be far from ideal, if even minimally sufficient.
But there is a growing awareness, in the rich countries and worldwide, that the ideology which supports the structure that led to this crisis is sorely lacking. At the last G20 conference, China stepped forward for the first time, with Russia, to criticize the role of the dollar as international reserve currency. China has quietly begun diversifying investments away from dollars to assets in Africa and Latin America. Developing countries with socially regulated financial systems have been praised for prudence, when just yesterday they were scorned for backwardness and stupidity.
These changes may yet make 2009 a year that marks the beginning of a slow transformative process. Those with real power, including to block necessary reforms, may find the legitimacy they previously relied upon is being undercut by the patent failure of some of their approaches.
This will become especially relevant if we run into another market failure, something that remains all too possible if the reforms currently planned currently don’t get much tougher. If they don’t, we may find that another crisis comes around to teach us some real lessons.
Vincent Bevins – London-based journalist and political economist. A frequent contributor for New Statesman magazine and most recently for the Financial Times.
