Global crisis: The end of an era

Whereas the crises of 1975, 1982, 1991 and 2001 have been blamed on rigid labour markets, inflationary pressures, companies unfit for the world market, or government constrained financial markets, political and economic leaders are approaching the blame game much more cautiously this time. The crisis in fact started in a place where everything should have been at its best: in the liberalised, deregulated, globalised and highly profitable US financial market.

Disastrous financial market liberalisations

Since 1980, Western governments have removed national financial market restrictions and liberalised cross-border capital flows. They subsequently pressed developing countries to do likewise. Deregulation and liberalisation were expected to lead to more efficient capital allocation, a balance between North and South and greater welfare for all. Instead, the unexpected side effect of that medicine in the 1990s was a plethora of financial crises in developing countries. Western governments and their court economists blamed them on crony capitalism and the inadequacy of oversight bodies in developing countries. Yet the crises were regarded as growing pains that developing countries could overcome by emulating the exemplary financial market model of the industrialised countries, as well as our matured capitalism free of corruption.

The current financial crisis, the biggest since 1929, did not break out in Argentina but in the USA, «the most exemplary financial market of all time». Court economists did not see it coming. In their view, financial markets that had been freed from political interference and manipulation should have tended towards equilibrium rather than self-destruction.

Free financial markets were also regarded as guarantors of efficient capital allocation. Instead they wiped out thousands of billions of dollars in a few short months and produced what is historically the greatest misallocation of capital, and one that needs not eschew comparison with the Soviet Union's centrally planned economy.

Shaken self-confidence

It is this clash between unexpected reality and «scientifically» founded ideology that has shaken the self-confidence of officialdom in the Western world and makes this crisis different. One indicator of this is that governments – to their surprise as well as ours – reacted to last autumn's collapse with a kind of «spontaneous» vulgar Keynesianism, which contrasted starkly with all the economic policy tenets they have been preaching since the 1980s. The election of Barack Obama underlined the change of mood. Since then, the emphasis has been mainly on re-stabilising the banks, slowing the economic downturn and preserving some level of demand. The detailed discussions of what will have to change are only just beginning, however.

Towards «boring banking»

The banking sector is where the brunt of the restructuring is needed. For months now, US economist and Nobel laureate Paul Krugman has been advocating a reduction of the role of the financial sector in the economy. That sector had expanded twofold since the 1960s, and at its peak it was earning over 40 per cent of profits in the economy. «There is no reason to believe that anything productive happened as a result of all of that. These extremely highly compensated bankers were essentially just finding new ways to offload risks on to other people». Krugman advocates a return to the «boring banking» of the 1960s and an economy in which physicists and engineers work in industry rather than on deceptive mathematical models for «hedging» transactions in a system of casino capitalism.

The new financial market regulations now under discussion in the G20 and the UN are leaning towards «boring banking»: 1. Higher capital cover requirements and a much lower leverage ratio. 2. The inclusion of all credit transactions in the balance sheet and the prohibition of all off-balance sheet special purpose entities. 3. Making all financial companies and instruments subject to the regulatory authorities, and instituting procedures for the approval and banning of new types of financial companies and «innovative» financial products. 4. New remuneration systems free of fraudulent incentives. 5. Discontinuation of overly hasty financial market liberalisations, and the reintroduction of smart capital controls in developing countries.

The finance industry can be expected to offer resistance. Since November for example, Wall Street's nine biggest derivatives traders have been fighting stricter disclosure regulations regarding the new derivatives involved in the crisis, such as credit default swaps. Here in Switzerland it is being said indirectly: re-regulation should not hamper «innovations». What innovations? Do subprime securities, the securitisation of subprime securities, securitisation of insurances on securitised subprime securities and the like constitute economically useful «innovations» or «financial weapons of mass destruction», as the new derivatives have been described by Warren Buffett, quite an expert on the subject?

Financial bubbles instead of higher wages

Deregulation may well account for the absurd instruments that were used to build up untenable credit pyramids. And the liberalisation of capital markets accounts for the spread of a crisis from within the US mortgage market to the rest of the world. But these factors do not explain the proliferation of financial bubbles.

Over the past 30 years, the share of capital in national income has risen in most of the old industrialised countries whilst that of wages has fallen. Besides, only wages in the uppermost income brackets have risen, those of the «lower-middle-class» have stagnated, whilst those of the lowest income brackets have fallen.

This gave rise to an excess of capital in pursuit of gains, in the face of stagnating consumer demand. The «golden age» following the Second World War brought strong growth in real wages, and the world economy tended to over-consume, with inflationary repercussions. Contrastingly, the neo-liberal era since 1980 has been dominated by over-production and over-investment and deflationary trends, in the face of constant pressure on wages. At the same time, returns on equity of 15-20 per cent have become the order of the day. But because the economy is growing by a mere two to three per cent, such generous returns on equity mean siphoning off profits from other weaker economic sectors, compressing wages and payrolls, and building up credit pyramids even further.

In recent years, core countries such as the USA and the UK that embody the best – in other words the most liberal capitalism – have financed expanded consumer demand only from financial bubbles, from returns on assets that have grown thanks to speculation. They compensated for stagnating wage income. Without financial bubbles, the USA and UK would have recorded no economic growth since the end of the 1990s.

Speculation supported from the South

The speculative boom received a helping hand from unexpected quarters. Many developing countries drew their own lessons from the financial crises of the 1990s. Foreign capital inflows had proved a doubled-edged sword for them: during financial crises, foreign capital flowed out again as quickly as it had come in, leaving behind a trail of bankrupt companies and concrete skeletons. The emergency assistance extended to them by industrialised countries through the International Monetary Fund (IMF) was tied to policy conditions that exacerbated the crisis. The social and economic costs of the medicine were commensurately high.

This was what prompted them in the wake of the 1997/98 Asian crisis – China first and foremost – to build up massive foreign currency reserves, which to a great extent helped finance the USA's growing foreign trade and budget deficit. In so doing they helped fuel the speculative boom, while at the same time securing an export market for their products. Other «world export champions» such as Japan, China, Germany (and Switzerland) also benefited from the US double deficit and the role of the USA as global consumer of last resort.

The task in the years ahead will be to eliminate this economic imbalance by «soft» means without triggering the next financial crisis. There are no magic bullets. Banks, companies and private individuals in the USA will be paying down debts for years to come, and this will put pressure on the economy. US imports as well as its balance-of-payments deficit will contract, and the world will lose its consumer of last resort.

Opportunities for a new power dispensation

With their huge internal markets, China and India have the opportunity to promote their internal growth and become less export-dependent. As one of the biggest in the world, China's stimulus package points in this direction. South-South trade could be stepped up, and special development financing and currency cooperation instruments such as the Banco del Sur in Latin America or the Chiang Mai mechanism in East Asia further developed.

A new power dispensation or sharing of responsibility between industrialised and developing countries is on the agenda for the years ahead. Gone are the days when the G7 directed world economic affairs from around a fireplace. Today, Asia's capital exporters as well as the major emerging countries in Latin America and Africa must be taken on board. It is significant that in the crisis-ridden autumn of 2008, what the USA convened was not a G7 meeting but a G20 crisis summit. Asia's capital exporting countries are clearly not about to play any substantial role in the IMF (although this would be highly desirable at present) unless the voting majority of the industrialised countries in that body is broken up. Yet this is still facing strong resistance chiefly from Europe, including from Switzerland. Lastly, the outcome of endeavours to give the UN an enhanced economic policy role – for which NGOs have long been pressing and what a UN commission headed by economist and Nobel laureate Joseph Stiglitz has recently recommended – remains to be seen.

Pending environmental issues

In parallel, environmental issues are coming powerfully to the fore. Gone is the age of cheap and ever more abundant fossil fuels, which constituted the backbone of industrial production methods as we know them. At the same time, global warming is threatening to spiral out of control between 2010 and 2020 unless we begin seriously to move away from fossil fuels in the immediate future.

Unfortunately, we do have the impression that our Heads of State and economic leaders, buffeted as they are by crisis, would prefer to leave the matter to their successors rather than tackle it themselves. The crisis programmes could be a good possibility to invest in renewable energies and less energy-intensive infrastructure. Yet most of the stimulus programmes are still disappointing in this regard. For commendable exceptions we have to look to countries like South Korea with a strong tradition of industrial policies.

Contact: Peter Niggli