Global financial crysis

From time to time in human history there occur events of a truly seismic significance, events that mark a turning point between one epoch and the next, when one orthodoxy is overthrown and another takes its place. The significance of these events is rarely apparent as they unfold: it becomes clear only in retrospect, when observed from the commanding heights of history. By such time it is often too late to act to shape the course of such events and their effects on the day-to-day working lives of men and women and the families they support.

There is a sense that we are now living through just such a time: barely a decade into the new millennium, barely 20 years since the end of the Cold War and barely 30 years since the triumph of neo-liberalism - that particular brand of free-market fundamentalism, extreme capitalism and excessive greed which became the economic orthodoxy of our time.

The agent for this change is what we now call the global financial crisis. In the space of just 18 months, this crisis has become one of the greatest assaults on global economic stability to have occurred in three-quarters of a century. As others have written, it "reflects the greatest regulatory failure in modern history". It is not simply a crisis facing the world's largest private financial institutions - systemically serious as that is in its own right. It is more than a crisis in credit markets, debt markets, derivatives markets, property markets and equity markets - notwithstanding the importance of each of these.

This is a crisis spreading across a broad front: it is a financial crisis which has become a general economic crisis; which is becoming an employment crisis; and which has in many countries produced a social crisis and in turn a political crisis. Indeed, accounts are already beginning to emerge of the long-term geo-political implications of the implosion on Wall Street - its impact on the future strategic leverage of the West in general and the United States in particular.

The global financial crisis has demonstrated already that it is no respecter of persons, nor of particular industries, nor of national boundaries. It is a crisis which is simultaneously individual, national and global. It is a crisis of both the developed and the developing world. It is a crisis which is at once institutional, intellectual and ideological. It has called into question the prevailing neo-liberal economic orthodoxy of the past 30 years - the orthodoxy that has underpinned the national and global regulatory frameworks that have so spectacularly failed to prevent the economic mayhem which has now been visited upon us.

Not for the first time in history, the international challenge for social democrats is to save capitalism from itself: to recognise the great strengths of open, competitive markets while rejecting the extreme capitalism and unrestrained greed that have perverted so much of the global financial system in recent times. It fell to Franklin Delano Roosevelt to rebuild American capitalism after the Depression. It fell also to the American Democrats, strongly influenced by John Maynard Keynes, to rebuild postwar domestic demand, to engineer the Marshall Plan to rebuild Europe and to set in place the Bretton Woods system to govern international economic engagement. And so it now falls to President Obama's administration - and to those who will provide international support for his leadership - to support a global financial system that properly balances private incentive with public responsibility in response to the grave challenges presented by the current crisis. The common thread uniting all three of these episodes is a reliance on the agency of the state to reconstitute properly regulated markets and to rebuild domestic and global demand.

As the global financial crisis unfolds and the hard impact on jobs is felt by families across the world, the pressure will be great to retreat to some model of an all-providing state and to abandon altogether the cause of open, competitive markets both at home and abroad. Protectionism has already begun to make itself felt, albeit in softer and more subtle forms than the crudity of the Smoot-Hawley Tariff Act of 1930. Soft or hard, protectionism is a sure-fire way of turning recession into depression, as it exacerbates the collapse in global demand. The intellectual challenge for social democrats is not just to repudiate the neo-liberal extremism that has landed us in this mess, but to advance the case that the social-democratic state offers the best guarantee of preserving the productive capacity of properly regulated competitive markets, while ensuring that government is the regulator, that government is the funder or provider of public goods and that government offsets the inevitable inequalities of the market with a commitment to fairness for all. Social democracy's continuing philosophical claim to political legitimacy is its capacity to balance the private and the public, profit and wages, the market and the state. That philosophy once again speaks with clarity and cogency to the challenges of our time.

Social-democratic governments across the world must rise to the further challenge of developing a practical policy response to the crisis that rebuilds shattered economic growth, while also devising a new regulatory regime for the financial markets of the future. This is our immediate challenge. But if we fail, there is a grave danger that new political voices of the extreme Left and the nationalist Right will begin to achieve a legitimacy hitherto denied them. Again, history is replete with the most disturbing of precedents.

We therefore need a frank analysis of the central role of neo-liberalism in the underlying causes of the current economic crisis. We also need a robust analysis of the social-democratic approach to properly regulated markets and the proper role of the state, in a new contract for the future that eschews the extremism of both the Left and the Right. And we must integrate this analysis with the unprecedented imperative for global co-operation if governments are to prevail in their task.

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Around the world today, there is understandable public bewilderment at the speed, severity and scope of the unfolding crisis. While the causes of the global financial crisis are complex, a small number of simple metrics are capable of conveying its magnitude and the havoc it has wrought in financial markets, the real economy and government finances.

Financial markets have suffered the greatest dislocation in our lifetime. Global equity markets have lost approximately US$32 trillion in value since their peak, which is equivalent to the combined GDP of the G7 countries in 2008. Credit markets have all but dried up, with credit growth at its lowest level since World War II. And, at the core of the crisis, house prices are plummeting in many countries, with American prices falling at their fastest rate since modern records began.

The real economy is facing one of its toughest periods on record, with the IMF predicting that advanced economies will contract for the first time in 60 years, causing the number of unemployed to rise by 8 million across the OECD. In developing countries, the International Labour Organization predicts that the financial and economic crisis could push more than 100 million people into poverty.

Furthermore, the crisis is producing unprecedented costs and debts for governments which will be felt for decades to come. It is estimated that the 2009 deficit in the United States will be as high as 12.5% of GDP. And estimates of the combined (actual and contingent) liabilities from the array of bank bailouts and guarantees run to more than $13 trillion - more than the cost of all the major wars the United States has ever fought. What this means for future American international borrowing is equally unprecedented.

Bewilderment, however, rapidly turns to anger when the economic crisis touches the lives of families through rising unemployment, reduced wage growth and collapsing asset values - while executive remuneration in the financial sector continues to go through the roof, apparently disconnected from the reality of recent events. In 2007, S&P 500 CEOs averaged $10.5 million (some 344 times the pay of typical American workers). The top 50 hedge-fund and private-equity fund managers averaged $588 million each (19,000 times the pay of typical workers). In 2007, the biggest Wall Street firms paid bonuses of a staggering $39 billion - huge payments to the executives whose investment banks have since been bailed out by American taxpayers.

These are epic numbers, generated by a greed of epic proportions. For a bewildered and increasingly enraged public, they raise the following questions: How was this allowed to happen? What ideology, what policy, what abuses made this possible? Were there any warnings? And if so, why were they ignored?

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George Soros has said that "the salient feature of the current financial crisis is that it was not caused by some external shock ... the crisis was generated by the system itself". Soros is right. The current crisis is the culmination of a 30-year domination of economic policy by a free-market ideology that has been variously called neo-liberalism, economic liberalism, economic fundamentalism, Thatcherism or the Washington Consensus. The central thrust of this ideology has been that government activity should be constrained, and ultimately replaced, by market forces.

In the past year, we have seen how unchecked market forces have brought capitalism to the precipice. The banking systems of the Western world have come close to collapse. Almost overnight, policymakers and economists have torn up the neo-liberal playbook and governments have made unprecedented and extraordinary interventions to stop the panic and bring the global financial system back from the brink.

Even the great neo-liberal ideological standard-bearer, the long-serving chairman of the US Federal Reserve Alan Greenspan, recently conceded in testimony before Congress that his ideological viewpoint was flawed, and that the "whole intellectual edifice" of modern risk management had collapsed. Henry Waxman, the chairman of the Congressional Committee on Oversight and Government Reform, questioned Greenspan further: "In other words, you found that your view of the world, your ideology, was not right; it was not working?" Greenspan replied, "Absolutely, precisely." This mea culpa by the man once called ‘the Maestro' has reverberated around the world.

To understand the failure of neo-liberalism, it is necessary to consider its central elements. The ideology of the unrestrained free market, discredited by the Great Depression, re-emerged in the 1970s amid a widespread belief that the prevailing economic woes of high inflation and low growth were exclusively the result of excessive government intervention in the market. In the '80s, the Reagan and Thatcher governments gave political voice to this neo-liberal movement of anti-tax, anti-regulation, anti-government conservatives.

Neo-liberal policy prescriptions flow from the core theoretical belief in the superiority of unregulated markets - particularly unregulated financial markets. These claims ultimately rest on the "efficient-markets hypothesis", which, in its strongest form, claims that financial-market prices, like stock-market prices, incorporate all available information, and therefore represent the best possible estimate of asset prices. It follows, therefore, that if markets are fully efficient and prices fully informed, there is no reason to believe that asset-price bubbles are probable; and if these do occur, markets will self-correct; and that there is therefore no justification for government intervention to stop them occurring. Indeed, in the neo-liberal view, deviations from market efficiency must be attributable to external causes. Bubbles and other disruptions are caused by governments and other "imperfections", not by markets themselves. This theory justifies the belief that individual self-interest should be given free rein and that the income distribution generated by markets should be regarded as natural and inherently just. In the neo-liberal view, markets are spontaneous and self-regulating products of civil society, while governments are alien and coercive intruders.

Neo-liberal economic philosophy has its roots in the theories of Hayek and von Mises, who believed that society should be characterised by the "spontaneous order" which emerges when individuals pursue their own ends within a framework set by law and tradition. Ideally, the role of governments is simply to enforce contracts and protect the allocation of property rights. All other economic functions should be left to what Reagan called "the magic of the market". Hayek himself referred to the market as "a game" - specifically the game of "catallaxy", taken from the Greek word "to barter", which according to Hayek is "a contest played according to the rules and decided by superior skill, strength or good fortune". In Hayek's order, "the game" is the only proper determinant of the allocation of resources, in contrast to any "atavistic" concept of social justice alive in the social-democratic project.

The advocates of neo-liberalism have sought, wherever possible, to dismantle all aspects of the social-democratic state. The idea of social solidarity, reflected in the collective provision of social goods, is dismissed as statist nonsense. In the face of vigorous resistance to cuts in public services, the neo-liberal political project has followed a strategy of "starving the beast", cutting taxes in order to strangle the capacity of the government to invest in education, health and economic infrastructure. The end point: to provide maximal space in the economy for private markets.

Neo-liberalism progressively became the economic orthodoxy. It was reflected in wave after wave of tax cuts. Governments bragged about their success in reducing measured levels of debt, while refusing to acknowledge the long-term economic cost of non-investment in education, skills and training (which increase productivity), and repudiating an appropriate role for public debt in financing investment in the infrastructure that underpins long-term economic growth. Neo-liberals have also exhibited a passionate commitment to the total deregulation of the labour market. Labour is routinely regarded by neo-liberals as no different from any other economic commodity. In the ideal neo-liberal system, labour-market protections should be restricted to physical safety rather than appropriate remuneration or minimum negotiation standards. Again, contract law, rather than any wider concept of a social contract, should prevail. Neo-liberals in government also become notoriously reluctant to identify and respond to instances of market failure. Climate change is a potent example. What Sir Nicholas Stern legitimately describes as the greatest market failure in human history is dismissed by neo-liberals as a prescription for wanton interference in market forces.

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The neo-liberal deregulation mantra has been even more evident in the management of financial markets. In the United States, the pursuit of financial deregulation crossed the Rubicon with the repeal of the Glass-Steagall Act, which had been established in the wake of the Great Depression. In the heady bubble years of the 1920s, American commercial banks, whose traditional function was simply to take deposits and make loans, plunged into the roaring bull market, trading on their own account, underwriting new stock issues and participating in reckless speculation. When the stock-market bubble burst in 1929, it took commercial banks with it, causing a devastating chain reaction which affected the entire economy for a decade. President Roosevelt implemented Glass-Steagall in 1933 to prevent Main Street commercial banks from being exposed to the vagaries of Wall Street in the future. As Keynes, himself a successful speculator, observed: "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

After a $300-million lobbying effort by the financial-services industry, Glass-Steagall was effectively repealed in 1999, removing the prohibition on commercial banks owning investment banks. The door was now open for the creation of huge financial-services conglomerates. One of the first to take advantage of the new regime was Citigroup, formed from the regular bank Citicorp and Travelers Group, which had previously incorporated the investment bank Salomon Smith Barney. The problem was that such combined entities became too systemically important to fail, yet their investment-banking arms were allowed to engage in speculation on a massive scale - so great as to imperil the finances of any government that had to bail them out. Citigroup was in fact to become the recipient of a taxpayer-funded rescue package worth an estimated $249 billion. It is ironic and - given the anti-government orthodoxy of neo-liberals - grossly hypocritical that the massive exposure to risk of these private financial conglomerates has resulted in a parallel exposure of the government, given the scale of possible government intervention in the event of bank failure. During the bubble, however, no account was taken of this, as massive profits were privatised and prospective losses socialised through the operation of implicit banking guarantees.

At the international level, bank risk is regulated by the Basel Accord. Yet the Basel II guidelines, published in June 2004, have now been demonstrated to be inadequate because they left the determination of risk to flawed credit-ratings processes and the banks' own "self-regulated" internal assessment models. Even then, the Basel rules were easily circumvented using innovative financial structures: structured investment vehicles were deliberately employed to shift risk off bank balance sheets. As Joseph Stiglitz has argued, "many of America's big banks moved out of the ‘lending' business and into the ‘moving' business," focusing on originating loans, repackaging them and selling them on, with little emphasis on their traditional role of assessing risk and screening credit worthiness.

Instead, the crucial risk-assessment function was passed, in large part, to the ratings agencies. Dependent as they were on the banks for their revenue, the agencies were hopelessly conflicted by the lure of big profits in return for easy ratings. Jerome Fons, former managing director for credit quality at Moody's, admitted in October 2008 that "the focus of Moody's shifted from protecting investors to being a marketing-driven organization ... management's focus increasingly turned to maximizing revenues." Ultimately, this focus on the bottom line contributed to an atmosphere in which a number of private ratings agencies became too inclined to take a favourable view of the risks inherent in their clients' investments.

Financial liberalisation also gave rise to a plethora of new, unregulated financial institutions in what is now broadly defined as the bank-intermediation market: hedge funds, private-equity funds, mortgage brokers. Investment banks with debt-to-equity ratios of 30:1 were also propped up by weak and defective accounting standards, which encouraged listed companies to "mark to market" their assets: that is, to effectively revalue their assets at market prices as they soared during booms.

A series of major national and international financial crises over the past decade should have begun to give pause for reflection, intervention and action. The Asian financial crisis of 1997 caused large-scale economic and social devastation and led to a flurry of calls for a "new international financial architecture". But these calls were always smugly discounted by the advanced economies as being primarily for the benefit of the Asian and other developing economies that had been caught up in the crisis. It was easier to blame "crony capitalism" than to look at the fundamentals of the neo-liberal orthodoxy (including unrestrained hedge-fund assaults on national currencies) that continued to govern global financial markets. Further warning signs came, including the bailout of the hedge fund Long-Term Capital Management (LTCM) in 1998 and the spectacular dotcom bubble and bust of 2000-01.

Each time a crisis arose, the US Federal Reserve came to the rescue by significantly lowering the federal funds rate, in order to pump liquidity back into the market and avert any further deterioration. After the 1987 stock-market crash, the Gulf War, the 1994 Mexican crisis, the 1997-98 Asian financial crisis, the LTCM debacle of 1998 and the 2000-01 bursting of the internet bubble, the response was always the same.

Investors increasingly came to believe that when things went bad, they would be protected by monetary policy in what came to be known as the "Greenspan put" - low interest rates, high liquidity and the protection of asset prices. Easy monetary policy was seen as an elixir that could cure any market instability that arose. In fact, it added yet more fuel to the fire, in the form of cheap money available for lending.

Low interest rates brought forth a new class of borrowers in the US who were encouraged by mortgage brokers to buy their own home. As a result, a huge amount of capital rushed into the sub-prime mortgage market, where it was directed towards borrowers with weak credit histories. At the same time, the prevailing anti-regulation culture in financial markets fostered a new banking model - the so-called originate-and-distribute model. Mortgage brokers originated loans that were then sold on to others, including hedge funds and structured investment vehicles, thereby severing the link between the assessor of credit worthiness and the ultimate holder of the loan. This is where the two worlds met: the world of easy credit as the defining characteristic of Greenspan's neo-liberal financial order, and the other neo-liberal world of unregulated financial institutions with its new banking model that effectively atomised risk. The combination was toxic: it produced an asset bubble of unprecedented proportions and, most critically, with unprecedented reach across the global financial system through the bank-intermediation market. Were the bubble to burst, the links to the mainstream commercial-banking system, with its implicit government guarantees, meant that the state (not the market) would be left carrying the can. This is the essence of the neo-liberal legacy now left to taxpayers - both today and into the future.