The Global Financial Crisis: Challenges, Lessons, and Opportunities
Ben Lodewijks analyses the changes brought about by the global financial crisis.
The first images associated with a financial crisis are often those of balding, middle aged stockbrokers yelling frantically at each other as they helplessly watch their stocks tumble from the exchange floor. However, such images belie the true impact of a crisis. Those hardest hit by a financial crisis are inevitably low-skilled factory workers who, having never owned a stock in their life, suddenly find that their economic livelihood has been pulled right out from under them.
Protecting citizens’ economic and social wellbeing in the face of such a crisis poses an enormous challenge to governments around the world. However, the events and circumstances surrounding a financial crisis can also lead to a fundamental re-evaluation, not just of economic theory and the structure of financial regulations, but of the very nature of the relationship between a state and its citizens. The challenge for policy makers will be to build upon the lessons of past crises in responding to the present crisis. In so doing, states are also presented with an exciting opportunity to enhance long-run economic growth and international economic co-operation. In the light of the recent failure of the World Trade Organisation’s Doha round of trade negotiations, the importance of the latter can scarcely be underestimated.
Rethinking Economic Theory
Whilst cycles of booms and busts have been a persistent feature of economic life since the outbreak of Dutch Tulip mania in the seventeenth century, it was the Great Depression that brought about the most fundamental change in how the economic system was viewed. The previous, classical tradition had emphasised that excess unemployment would promptly disappear as wages fell to equate supply with demand. Keynes shook all this up by arguing that wages were not as downward flexible as previously imagined and that governments had an active role to play in creating jobs. He also disabused policy makers of their traditional aversion to budget deficits, arguing that increased government spending was essential to increasing aggregate demand.
“The events and circumstances surrounding a financial crisis can lead to a fundamental re-evaluation of the very nature of the relationship between a state and its citizens.”
Whilst Keynesian policies had a monumental impact on post-war economic policy, it took another crisis, the oil crisis of the seventies, to reveal the limitations of Keynesian policies. To deal with high inflation and unemployment from a supply shock, other mechanisms, such as strict inflation targeting, were needed. It was also acknowledged that Keynesian policies were, at best, a short-term remedy. If governments run deficits for too long, consumers realise that they will eventually have to pay it back and curtail their spending accordingly.
Whilst many economists argue that this makes Keynesian policies completely ineffective, this assertion relies on consumers having both rational expectations and being able to perfectly smooth their consumption. Such assumptions are somewhat problematic outside the rarefied world of academic journals. Notwithstanding these academic debates, the Keynesian policies that emerged in response to the Great Depression have significantly influenced both our understanding of economic dynamics and the response of policy makers to the present crisis.
The present crisis should also lead economists to rethink the recent movement towards using real business cycle models. Like earlier, classical models, these models also posit that there should be no involuntary unemployment in the economy, an assumption that may be readily challenged by the present crisis. Real business cycle models also rely heavily on individuals having rational expectations. However, recent research on behavioural economics has emphasised that consumers are not completely rational and that factors like financial contagion, herding, and peer pressure can play a vital role in economic decisions.
Along these lines, a number of economists, such as Jeffrey Sachs and Joseph Stiglitz, have argued that the Asian Financial Crisis had more to do with over-investment in property markets and subsequent herding in currency markets than any problems in the real economy. These observations suggest that more attention should be given to integrating the results of behavioural economics into existing models.
Yet the most salient lesson to emerge from the present crisis is that free markets should not be unregulated markets. Whilst the creation of complicated financial securities from sub-prime mortgages given to borrowers with poor credit histories is regarded as the catalyst for the present crisis, the roots of the regulation problem go much deeper.
One of the most fundamental financial regulations to emerge from the Great Depression was the Glass-Steagall Act. It prevented commercial banks from speculating and underwriting new stock issues as they had during the 1920s. After intense lobbying by the banks, the Act was effectively repealed in 1999. Commercial banks such as Citibank then went about merging with investment banks and insurers to create massive financial conglomerates.
“The crucial lesson of the present crisis is that policymakers need to regard financial regulations not as an economic burden on the market, but as an investment in reducing future government bailout obligations.”
Knowing that they were simply too big for the government not to bail them out, they gave their investment banking arms free rein to engage in significant speculation. When the crash hit, the U.S. Treasury was left with no option but to provide a US$50 billion bailout for Citibank and a total of US$700 billion to the banks to purchase distressed assets. The Great Depression had taught us that the banks were simply too economically important to fail, but financial deregulation led us to remove the very legislation designed to stop them failing in the first place. The crucial lesson of the present crisis is that policymakers need to regard financial regulations not as an economic burden on the market, but as an investment in reducing future government bailout obligations.
The Road to Growth
The consequences for those who lose their jobs as a result of a financial crisis can be devastating. Yet it has long been recognised that financial crises are an inevitable part of the cycle of booms and busts that characterise the capitalist system. It is during a recession that inefficient, old technology firms are replaced by newer and more efficient firms, shifting capital and labour to where they are most highly valued, and ultimately creating the preconditions for long-term economic growth.
The decline of the ‘big three’ auto-manufacturers in the U.S. is an obvious manifestation of this trend. Their comparative advantage had been eroded in recent years by high labour costs, extensive product lines and inefficient technology. The recent fall in consumer demand and rising oil prices only hastened their decline, as Chrysler and General Motors scrambled for emergency loans from the government.
Whilst there is an inevitable temptation to rescue the autoworkers with bailouts, re-training them in more efficient, knowledge-based industries, in which the U.S. still has a comparative advantage, will be more conducive to long-run growth. Similarly, since the boom on Wall Street attracted some of the world’s brightest minds, the collapse of the finance industry means that these talented individuals will begin to use their talents and energy in more productive industries.
Finally, the need for increased government spending to combat the crisis also provides governments with an unparalleled opportunity to invest in long-term growth. Under Roosevelt’s New Deal programs, physical investments in roads, dams and electrification played a crucial role in the post-war boom. In addition to physical investments, the present crisis also offers governments a unique opportunity to invest in research and development initiatives, and education and training programs for their citizens.
New Directions for Government Policy
The economic and social disruption caused by a financial crisis can also lead to a radical reconsideration of the social contract between a state and its citizens. Whilst providing for the poor was traditionally seen as a private or local government obligation, the enormous unemployment created by the Great Depression meant that federal governments were the only agencies with sufficient power to prevent large segments of their societies from falling into poverty. This led developed countries around the world to implement groundbreaking public work and social security programs.
The UK, Canada and New Zealand developed large-scale unemployment benefit programs for the first time, and the present U.S. Social Security system owes its origins to the Great Depression. This was the first fundamental acknowledgement that governments had an obligation to protect the economic rights of their citizens. Whilst the modern welfare system is now quite well-developed, the present crisis is likely to redefine a state’s relationship with its citizens in an entirely different manner.
Developed countries like the U.S., which have long spouted the benefits of globalisation, will suddenly find that as consumers become price-conscious, manufacturing job losses will extend well beyond the automotive industry. This shifting comparative advantage places a new burden on governments to identify and train workers in areas where they do have a comparative advantage.
In particular, governments will have to create incentives for workers to move to regions or industries less affected by the downturn. In regions where depressed house prices make moving unviable, governments should create financial incentives for new industries to move there, in order to provide jobs for local citizens.
Uncertain economic times also make temporary employment contracts more attractive to employers. In Spain, the number of workers on temporary contracts has risen to a third of the workforce. Governments will thus have an enhanced role, not only in supporting the reallocation of workers to newer, more efficient industries, but also in protecting existing workers’ rights.
A New Regime for International Economic Co-operation
Recent technological advances and globalisation mean that international economies are more interconnected than ever before. Greater freedom of trade and financial investment played a crucial role in post-war development, but at a significant cost. The speed with which domestic financial disturbances spread internationally is faster than ever before.
Countries with relatively sound banking systems and regulatory practices, like Australia, suddenly find themselves facing a shortage of credit because of unsustainable lending practices on the other side of the world. Profitable factories owned by foreign multinationals close down because of disruptions in their home markets, or are forced to search for even cheaper labour elsewhere.
The unprecedented speed with which the current financial crisis flowed on from the U.S. to Europe and Asia may, however, have the potential to forge much closer links between the world’s major economic powers. In pledging an extra US$5 trillion in fiscal measures by 2011, the G20 conference in April implicitly acknowledged that for any fiscal response to the crisis to be effective, it must be co-ordinated multilaterally. If only a few states stimulate their economies, there will be little effective demand for their exports, which will ultimately make such efforts self-defeating.
The G20’s creation of the new Financial Stability Board will play an important role in both identifying macroeconomic risks and preventing them from spreading. The Board’s powers to uncover tax havens will address a significant distortion in international financial markets that has long been ignored. The trebling of resources to the IMF will also play a critical role in helping to bail out countries that experience currency crises in the future.
“Financial crises provide us with an opportunity to reflect on the society we want to build. As Gordon Brown put it: ‘Sometimes it’s a crisis that forces change.’”
The effect of the present crisis on international co-ordination will, however, play out more clearly in the arena of international trade. The Smoot-Hawley tariffs of 1930, introduced by the U.S. in response to the Great Depression, led to a series of retaliatory tariffs from other nations and a severe contraction in international trade and global demand. The commitment of the G20 not to resort to such tactics, and their extension of trade finance to the developing world, demonstrates an awareness of both history and the critical role of trade flows in increasingly interconnected global economies.
Finally, while official commitments to the IMF and the World Bank by the G20 nations have risen in response to the crisis, the reality for developing countries is that private aid levels may shrink as the crisis develops. This presents the developing world with an enormous challenge in ensuring that millions more do not fall into poverty. At the same time, the extension of $250 billion in trade finance by the G20 to the Millennium Development Banks also offers developing countries an invaluable opportunity to access international trading markets: an opportunity that will critically depend on the willingness of developing countries not to resort to protectionist measures in response to the crisis.
Challenges, Lessons and Opportunities
The increased interconnectedness of the global economy means that financial crises pose greater challenges than ever before. Financial crises will disrupt the lives of individuals in industries and nations far removed from the initial disturbances. Yet to a large extent these disturbances are an inevitable product of the economic adjustment inherent in the capitalist system.
In Keynes’ words, the “animal spirits” of investors will never be wholly consistent with economic stability. Asset prices inflated by reckless speculators will inevitably return to their fundamental values. However, this process of correction also creates opportunities for new growth, as inefficient, old economy firms are replaced by more efficient, new firms, and labour and capital is reallocated to where it is most highly valued.
Financial crises also teach us invaluable lessons about economic management. Despite countries being more economically interconnected than ever before, the present financial crisis is unlikely to be as severe as the Great Depression because we have learnt some crucial policy lessons from it (though forgotten others). Contemporary ideas about the need for government spending, social safety nets, supporting banks at all costs, and free trade are very different from those prevailing in 1929. Moreover, if policy makers learn their lessons from the present crisis, the way we approach financial regulation will be very different in the future.
Perhaps most importantly, however, financial crises provide us with an opportunity to reflect on the society we want to build. As Gordon Brown put it: “Sometimes it’s a crisis that forces change.” Whilst the present crisis may prompt fundamental changes to economic regulation and skills development at the national level, an increasingly globalised world means that national solutions are sometimes no longer enough. By requiring international co-operation on macroeconomic policies, trade and financial regulations, the present financial crisis may more importantly provide an opportunity for states to take the first step towards the consensus required to address far deeper global problems.
