Global financial crysis

The rest, of course, is history. The annual volume of US sub-prime and other securitised mortgages rose from approximately $160 billion in 2001 to over $600 billion in 2006. Low interest rates and high demand for housing caused house prices to soar. In comparison to the 1.4% average annual appreciation of American home values during the 30 years leading up to 2000, the values of homes increased at 7.6% annually from 2000 to 2006, with massive growth in the sub-prime market. Indications of financial instability slowly became apparent to all who cared to look. Business leader Warren Buffett had recognised the emerging risks of financial innovation, easy money and weak regulation in 2003 when he noted that many of the new financial instruments were akin to "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".

The Bank for International Settlements, always more sceptical than most, was the first official institution to sound the alarm. In its 2007 annual report, the BIS warned that "years of loose monetary policy have fuelled a giant global credit bubble, leaving us vulnerable to another 1930s-style slump." Despite this, no systemic action was taken.

Despite three crises in a decade, despite the clear warnings that came with them and after them, the neo-liberals were so convinced of the ideological righteousness of their cause, and so blinded by their unquestioning belief that markets were inherently self-correcting, that they refused even to recognise the severity of the problems that emerged. The problems did not fit the model, so the evidence was simply discarded. Hardline neo-liberals were not interested, because they knew in their hearts they were right.

The time has come, off the back of the current crisis, to proclaim that the great neo-liberal experiment of the past 30 years has failed, that the emperor has no clothes. Neo-liberalism, and the free-market fundamentalism it has produced, has been revealed as little more than personal greed dressed up as an economic philosophy. And, ironically, it now falls to social democracy to prevent liberal capitalism from cannibalising itself.

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With the demise of neo-liberalism, the role of the state has once more been recognised as fundamental. The state has been the primary actor in responding to three clear areas of the current crisis: in rescuing the private financial system from collapse; in providing direct stimulus to the real economy because of the collapse in private demand; and in the design of a national and global regulatory regime in which government has ultimate responsibility to determine and enforce the rules of the system.

The challenge for social democrats today is to recast the role of the state and its associated political economy of social democracy as a comprehensive philosophical framework for the future - tempered both for times of crisis and for times of prosperity. In doing so, social democrats will draw in part on a long-standing Keynesian tradition. Social democrats will also need to reach beyond Keynes, given some of the new realities we face some 70 years after the publication of Keynes's General Theory.

Long before the term ‘Third Way' was popularised in the policy literature of the 1990s, social democrats viewed themselves as presenting a political economy of the middle way, which rejected both state socialism and free-market fundamentalism. Instead, social democrats maintain robust support for the market economy but posit that markets can only work in a mixed economy, with a role for the state as regulator and as a funder and provider of public goods. Transparency and competitive neutrality, ensured by a regime of competition and consumer-protection law, are essential.

Social justice is also viewed as an essential component of the social-democratic project. The social-democratic pursuit of social justice is founded on a belief in the self-evident value of equality, rather than, for example, an exclusively utilitarian argument that a particular investment in education is justified because it yields increases in productivity growth (although, happily, from the point of view of modern social democrats, both things happen to be true). Expressed more broadly, the pursuit of social justice is founded on the argument that all human beings have an intrinsic right to human dignity, equality of opportunity and the ability to lead a fulfilling life. In a similar vein, Amartya Sen writes of freedom as the means to achieve economic stability and growth, but also as an end in itself. Accordingly, government has a clear role in the provision of such public goods as universal education, health, unemployment insurance, disabilities insurance and retirement income. This contrasts with the Hayekian view that a person's worth should primarily, and unsentimentally, be determined by the market.

Social-democratic governments face the continuing challenge of harnessing the power of the market to increase innovation, investment and productivity growth - while combining this with an effective regulatory framework which manages risk, corrects market failures, funds and provides public goods, and pursues social equity. Examples of such a government are the Australian Labor governments of Bob Hawke and Paul Keating during the 1980s and early '90s. Hawke and Keating pursued an ambitious and unapologetic program of economic modernisation. Their reforms internationalised the Australian economy, removed protectionist barriers and opened it up to greater competition. They were able dramatically to improve the productivity of the Australian private economy, while simultaneously expanding the role of the state in the provision of equity-enhancing public services in health and education.

In the current crisis, social democrats therefore have the great advantage of a consistent position on the central role of the state - in contrast to neo-liberals, who now find themselves tied in ideological knots, in being forced to rely on the state they fundamentally despise to save financial markets from collapse. This enables social-democratic governments to undertake such current practical tasks as credit-market regulation, intervention, and demand-side stimulus in the economy. The uncomfortable truth for neo-liberals is that they have not been able to turn to non-state actors or non-state mechanisms to defray risk and restore confidence, rebuild balance sheets and unlock global capital flows. This is only possible through the agency of the state.

In the early stages of the global financial collapse, the centrality of the state was reaffirmed by governments of both the classical Left and Right as they acted to guarantee the integrity of the banking system. Die-hard neo-liberals invoked "moral hazard" - akin to arguing about who should pay for the fire brigade while the house itself is burning down. The alternative to government intervention, as the global banking fraternity knows all too well, was systemic collapse. The first step towards preserving confidence and restoring liquidity in late 2008 was the provision of an explicit guarantee of deposits placed in mainstream financial institutions. The willingness of the public, as expressed through their respective governments, to accept the associated contingent liabilities reveals a widely held perception that the stability of banking systems is itself a public good. As Robert Skidelsky, Keynes's biographer, observed: "when the crunch came, we discovered that national taxpayers still stand behind banks, and national insolvency regimes matter."

Subsequently, governments have also demonstrated a willingness to undertake unprecedented interventions in private credit markets. Specifically, governments have involved themselves in the capitalisation of banks, the direct purchase of bank and corporate securities, the establishment of joint-purpose vehicles to share risk with private financial institutions, and in sovereign guarantees to underpin inter-bank lending. In the United States, the rescue of Citigroup and the Bank of America amounts to a de facto nationalisation. This followed the placing into conservatorship of Fannie Mae and Freddie Mac, and the effective nationalisation of AIG, the world's largest insurance company. Once again, the social-democratic state, not the unfettered forces of the market, was called to the rescue.

These measures have not been implemented on the basis of socialist ideology, nor are they a return to state ownership and control. When the financial system stabilises and the global recession eases, we can expect to see governments pulling back from direct involvement in the ownership and operation of the banking sector. The object of the current intervention is to secure private credit markets so that they can serve the needs of private businesses and consumers. But clearly the days of effective non-regulation and unconstrained financial innovation are gone, and must not be allowed to return. The consequences for the economy are too great.

Stabilising the financial system is a necessary first step towards preventing systemic collapse. But the collapse of the speculative bubble and the subsequent credit squeeze have already brought about a slowdown in economic growth, rising unemployment, and the possibility of a lengthy global recession. Neo-liberals such as Alan Moran, of the Australian Institute of Public Affairs, argue that the cost of the recession should be borne by employees, through wage cuts and retrenchment - exactly the position of US Treasury Secretary Andrew Mellon at the outset of the Great Depression. Social democrats, by contrast, stress the central role of the state in maintaining aggregate demand, both for consumption and investment spending, at a time of faltering growth. That is, the state must involve itself in direct demand-side stimulus to offset the large-scale contraction in private demand. The IMF revised its growth forecast for 2009 down four times, by a total of 3% of global GDP. This "growth gap" indicates the dimensions of the fiscal-stimulus task that now lies ahead for governments if the demand-side gap is to be met and massive unemployment avoided. This is classic Keynesianism, pure and simple.

Keynes argued that, in Stiglitz's words, "in a severe downturn, monetary policy was likely to be ineffective. Fiscal policy was required." He believed that in times of dramatically slowed economic growth, monetary authorities would find themselves in a liquidity trap, unable to "induce an increase in the supply of credit in order to raise the level of economic activity". Or, as others have described it, monetary policy becomes ineffective because it is just "pushing on a string". Indeed, as Paul Krugman suggests, "the failure of monetary policy in the current crisis shows that Keynes had it right the first time." The truth is, fiscal policy must reinforce monetary policy in aggregate demand. Neither by itself is sufficient.

Reasoning that the costs of failing to provide fiscal stimulus will outweigh the negative effect on budgets, Tony Blair implores current leaders to "do whatever it takes ... to get the blood pumping back round the financial system again". The challenge for new Keynesians is also to ensure that this stimulus is targeted, timely and temporary. As private consumption and business investment recover, fiscal stimulus should be reduced commensurately, so as not to push up inflation during the period of economic recovery.

In proposing active measures to stimulate demand, it is therefore important to emphasise the central tenet of Keynesian economic management: the need to balance budgets over the course of the economic cycle. Failure to do so, along with excessive tolerance for inflation, was a major contributor to the breakdown of Keynesian economic management in the early 1970s. Increases in public investment and direct transfers to households will stimulate the economy, but they will have to be paid for in the future, when strong economic growth has resumed.

Social democrats have always emphasised the potential for systemic shocks arising from speculative bubbles and busts driven by what Keynes referred to as the unpredictable "animal spirits" of investors. Financial regulation must allow banks and other financial institutions to be intermediaries between household savings and business investment, without themselves becoming a source of systemic instability. This requires prudential regulation beyond simply ensuring that individual institutions adhere to standards designed to guard against their insolvency under normal economic conditions. The sector as a whole should be constrained from actions that promote systemic risk, such as excessive expansion of derivatives markets. Equally important in light of the recent crisis is that a social-democratic framework recognises the effect of incentive structures within firms on the level of risk-taking by individuals. For social democrats, systemic stability and integrity represent public goods in their own right - public goods which will always take precedence over individual opportunities for profit maximisation.

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A further challenge for social democrats in dealing with the current crisis is its almost unprecedented global dimensions. This has two aspects: the integration and interdependence of financial markets, which has brought about a rapid spread of the contagion; and the consequences for the real economy as collapsing demand in one country affects exports from another.

Instead of distributing risk throughout the world, the global financial system has intensified it. Neo-liberal orthodoxy held that global financial markets would ultimately self-correct - the invisible hand of unfettered market forces finding their own equilibrium. But as Stiglitz has caustically observed: "the reason that the invisible hand often seems invisible is that it is not there." Financial markets have not self-corrected. Global financial innovation has compounded the problem of asset bubbles, not reduced it. Neo-liberalism's anti-regulation agenda rapidly converted a problem in American mortgage markets into a full-blown global financial and economic crisis that now threatens the future of open global markets - yet another example of capitalism cannibalising itself, but this time on a frightening, global scale.

Three cardinal principles emerge: first, national financial markets require effective national regulation; second, global financial markets require effective global regulation, if for no other reason than that the quantum of global financial transactions is now capable of overwhelming most single national economies standing alone; and third, the means for achieving effective regulation in both can only be delivered by national governments operating together. There has been no private financial-market solution on offer to deal with the scale and complexity of global systemic instability we now face.

That is why the world has turned to co-ordinated governmental action through the G20: to help provide immediate liquidity to the global financial system; to co-ordinate sufficient fiscal stimulus to respond to the growth gap arising from the global recession; to redesign global regulatory rules for the future, including a new Basel III; to reform the existing global public institutions - especially the IMF - to provide them with the powers and resources necessary for the demands of the twenty-first century. The tragedy is that after decades of neo-liberal ascendancy, the IMF, Keynes's child from Bretton Woods, for a time became the agency through which neo-liberal doctrines were spread around the world - to the detriment of the fund's long-term standing and with a real impact on its capacity to act effectively in the current crisis with the various national economies it has treated poorly in the past.

Governments must craft consistent global financial regulations to prevent a race to the bottom, where capital leaks out to the areas of the global economy with the weakest regulation. We must establish stronger global disclosure standards for systemically important financial institutions. We must also build stronger supervisory frameworks to provide incentives for more responsible corporate conduct, including executive remuneration.

Further, the IMF's authority to undertake prudential analysis must be expanded and its early-warning system for institutional vulnerabilities enhanced. And its governance arrangements must be reformed. It makes no sense for the governance structure of the global financial system today to reflect the balance of power in 1944. It is only reasonable that if we expect fast-growing developing economies like China to make a greater contribution to multilateral institutions such as the IMF, they should also gain a stronger decision-making voice in these forums.

The longer-term challenge for governments is to address the imbalances that have helped to destabilise the global economy in the past decade: in particular, the imbalances between large surplus economies such as China, Japan and the oil-exporting nations, and large debtor nations such as America. In the short term, these imbalances are likely to increase as America's budget deficit balloons. In the medium term, overcoming these imbalances and working towards a more stable global macroeconomic framework will demand new levels of global economic co-operation and co-ordination. Any sudden change in managing these global imbalances - for example, if China sharply reduced the purchase of US government bonds - would send tremors through foreign-exchange markets, with dire consequences both for the US dollar and for the prospects of global economic recovery. Again, this looms as a challenge for statecraft; we cannot simply hope that individual market participants somehow magically do the right thing.

There is one further dimension to the role of social democrats in dealing with the current global crisis. The impact of the crisis on poverty and political stability in the developing world has not fully registered in the global debate about policy responses to the crisis so far. World Bank intervention, bilateral official development assistance and the continued implementation of the Millennium Development Goals become essential elements in managing the effects of a crisis that will otherwise throw much of the developing world back into poverty. Social democrats, both by instinct and by tradition, are predisposed to engage in this, but it will become harder and harder as developed countries' budgets come under ever more stress from the unprecedented domestic demands now placed upon them by the crisis.

Neo-liberals, like neo-conservatives (their ideological bedfellows in the foreign-policy sphere), are intrinsically suspicious of all forms of multilateral governance. In fact, there is a parallel between neo-liberals' hostility to national governments intervening in national markets and their hostility to international governmental institutions intervening in global markets. Again, the contrast with social democrats is instructive, given social democrats' long tradition of internationalism - itself an accommodating attribute given the complexities of global market governance, co-operation and co-ordination we all now confront. The truth is that there are no credible unilateral solutions on offer, given the increasing dispersal of global economic power.

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The political home of neo-liberalism in Australia is, of course, the Liberal Party itself. Over the past decade, the Howard government reduced investment in key public goods, including education and health. It also refused to invest in national economic infrastructure, notwithstanding multiple warnings from the Reserve Bank of the impact of long-standing capacity constraints on economic growth. The Liberals in government also set about the comprehensive deregulation of the labour market - based on the argument that human labour was no different to any other commodity. Driven by a philosophy of minimal government intervention in the markets, the Liberals ignored both the 2003 Dawson Review and multiple reports from the ACCC calling for the criminalisation of cartel conduct. They refused to act to prevent the accumulation of market power through creeping acquisitions. They refused to effectively regulate consumer credit or credit-rating agencies. And they ignored calls - from the Financial Stability Forum in 2000, the Australian Prudential Regulatory Authority submission to the HIH Royal Commission in 2002, and the 2006 IMF Financial Sector Assessment Program - to implement a deposit-insurance scheme that would bring our deposit protection in line with almost all other OECD nations. Most critically, the Howard government oversaw an unprecedented increase in household and national debt. The average ratio of household debt to annual gross disposable income more than doubled to 114.5%, up from 49.8% under the Hawke-Keating governments; household net savings to net disposable income fell to an average of 1.1%, down from an average of 7.9% under the Hawke-Keating governments; and the level of Australia's net foreign debt increased to 55.5% of GDP, up from 37.9% of GDP under the Hawke-Keating governments.

The contrast between the competing political traditions within Australia on the role of governments and the market is clear. Labor, in the international tradition of social democracy, consistently argues for a central role for government in the regulation of markets and the provision of public goods.

Consistent with this tradition, the Labor government has acted decisively through state action to maintain the stability of the Australian financial systems in the face of the economic crisis. The government acted in October to guarantee all deposits. To support intra-bank lending by the Australian majors, it intervened to provide a facility for guaranteeing wholesale funding of financial institutions. To encourage liquidity, the government legislated to increase by $25 billion the maximum value of government bonds that can be issued at any one time. It also initiated a program to purchase residential mortgage-backed securities. To protect financial institutions from predatory speculators, a temporary ban on short selling was introduced. Labor has also acted to help the real economy, to stimulate economic activity by investing in targeted job creation; in the reform of services in health, education, disabilities and homelessness; and in roads, rail, ports and other critical infrastructure. All through decisive state action.

The Liberals, embracing the neo-liberal tradition of anti-regulation, seek to reduce the agency of the state in private markets as much as possible. The distinction is reflected in the previous prime minister's statements that "competitive capitalism within free markets remains the most effective economic paradigm, both domestically and internationally"; that "the right responses will be grounded in free-market orthodoxies"; and that "we should avoid the resort to re-regulation." This ideology has not served Australia well in preparing for the current crisis.