The financial crisis one year on: Has anything been learnt?

It was a year ago that the current economic crisis erupted in the US and spread to the rest of the world. Have policy makers learnt the important lessons from this crisis? No, says Jayati Ghosh and explains why.

EXACTLY one year ago, the Wall Street investment bank Lehman Brothers was allowed to go bust, in a move that is generally seen to have brought on the global financial crisis. Shockwaves hit the financial markets; stock markets collapsed in waves of contagion across the world; credit seized up in most developed and many developing economies; and for a while it really did seem as if global capitalism was facing direct threats to its very survival.

The collapse was not entirely unexpected. The implosion of the US housing market over the past year had already exposed the massive fragilities in the global financial system, with institutions interlocked in such opaque ways that the full extent of liability was not known even to the most experienced players. In consequence, the summer of 2008 had already witnessed the US Federal Reserve bailing out several major financial institutions, beginning with providing a dowry for the failing bank Bear Stearns in its shotgun marriage with JP Morgan, and then going on to protect and then effectively nationalise the mortgage holding agencies Freddie Mac and Fannie Mae. It was well known that many major investment banks and other financial institutions (such as the insurance giant AIG) were all extremely vulnerable, and short-selling by those betting against such institutions only hastened the likely denouement.

After the Lehman Brothers debacle, the US government, and indeed other governments in Europe and elsewhere, swung into action on an unprecedented scale to prevent what seemed like a possible financial and economic catastrophe of global dimensions. Monetary policy was loosened to the absolute limit and fiscal stimuli were introduced to maintain spending. Most of all, there were more bailouts: huge injections of liquidity that directly and indirectly benefited certain big financial players who were seen as integral to the functioning of the system.

One year on, it can be said that that particular crisis was averted. The world economy went into recession, but did not collapse altogether. Today there is talk of recovery everywhere, even in currently recessionary Europe and certainly in the US. So was the emergency response successful? And have policy makers learnt the important lessons from the crisis?

Unfortunately, this does not seem to be the case. The attempt seems to have been to patch up the broken bits somehow or other, and provide a combination of fiscal resources and loose central banking to avoid the worst possible outcome, and then to proceed with business as usual in global capitalism. The larger issue of global macroeconomic imbalances that were building up for several years before during the preceding boom has not been addressed. Nor has the issue of how to reorient growth to more sustainable and less ecologically damaging directions been seriously considered.

Most significantly in terms of the immediate prospects, hardly anything seems to have been learnt in terms of required regulation of finance, either nationally or globally. Despite overwhelming evidence to the contrary, there has been no moving away from the 'efficient markets' hypothesis that determined the hands-off approach of governments to the financial sector. Financial institutions have been bailed out at enormous public expense, but without changes in regulation that would discourage irresponsible behaviour. Banks that were 'too big to fail' have been allowed to get bigger. Flawed incentive structures continue to promote short-term profit-seeking rather than social good. So we have protected private profiteering and socialised its risks.

One of the worst consequences of this flawed manner of dealing with the crisis is that moral hazard is now more pronounced than ever. The Palgrave Dictionary of Economics defines moral hazard as 'actions of economic agents in maximising their own utility to the detriment of others, in situations where they do not bear the full consequences'. In financial markets, these problems are especially rife because such markets are anyway characterised by imperfect and asymmetric information among those participating in the markets.

The moral hazard associated with any financial bailout results from the fact that a bailout implicitly condones the earlier behaviour that led to the crisis of a particular institution. Typically, markets are supposed to reward 'good' behaviour and punish those participants who get it wrong. And presumably those who believe in 'free market principles' and in the unfettered operations of the markets should also believe in their disciplining powers.

But when the crisis hits, the shouts for bailout and immediate rescue by the state usually come loudest from precisely those who had earlier championed deregulation and freedom from all restriction for the markets. The arguments for bailout are related either to the domino effect - the possibility of the failure of a particular institution leading to a general crisis of confidence attacking the entire financial system and rendering it unviable - or to the perception that some institutions are too large and too deeply entrenched in the financial structure, such that too many innocent people, such as small depositors, pensioners and the like, would be adversely affected.

The problem is that this leads to both signals and actual incentives actually encouraging further irresponsible behaviour. Both financial markets and government policies have operated in such a way that those running the institutions that might or do collapse typically walk off from the debris of the crisis not only without paying any price, but after substantially enriching themselves further. Because those responsible for the crisis do not have to pay for it, they have no compunctions in once again creating the same conditions.

These features are not new to capitalism, but rather they should be especially familiar to us now because of the very recent history of how certain types of deregulation generate very large moral hazard, in the US and other major centres of capitalism as well as in emerging markets. A clear illustration is provided by the book The Best Way to Rob a Bank Is to Own One: How corporate executives and politicians looted the S&L industry by William R Black (University of Texas Press, 2005). This is a brilliant expos‚ of the Savings and Loan scandal in the US in the early 1980s, in which Black developed the concept of 'control fraud' - frauds in which the CEO of a firm uses the firm itself, and his/her ability to control it, as an instrument for private aggrandisement.

Such control fraud is greatly abetted by the incentives thrown up by modern executive compensation systems, which allow corporate managers to suborn internal controls. As a result, the organisation becomes the vehicle for perpetrating crime against itself.

This was the underlying reality in the Savings and Loan scandal of the early 1980s that Black used to illustrate the arguments in his book. But it has been equally true of subsequent financial scams that have rocked the US and Europe, from the scandal around the Bank of Commerce and Credit International (BCCI) in the UK in 1991, to the Enron, Adelphia, Tyco International, Global Crossing and other scandals in the early part of this decade, to the Parmalat Spa financial mess in Europe, to the recent revelations around accounting practices of banks and mortgage providers in the US in the current financial crisis.

The point is that such dubious practices, which amount to financial crime, flourish during booms, when everyone's guard is down and financial discrepancies can be more easily disguised. And this environment also creates pressures for CEOs and other corporate leaders to show, and then keep showing, good results so as to keep share prices high and rising. The need becomes to maximise accounting income, and so private 'market discipline' actually operates to increase the incentives to engage in accounting fraud. This intense pressure to emulate peers in a bull market, and deliver 'good' results even if they are fake, is a well-known feature of financial markets, which intensifies extant problems of adverse selection and moral hazard. According to Black, 'This environment creates a "Gresham's Law" dynamic in which perverse incentives drive good underwriting out of circulation.'

Black further argues that the tendency for such control fraud has greatly increased because of neoliberal policies that have reduced the capacity for effective regulation. According to him, this operates in four ways: 'First, the policies limit the number and quality of regulators. Second, the policies limit the power of regulators. It is common for the profits of control fraud to greatly exceed the maximum allowable penalties. Third, it is common to choose lead regulators that do not believe in regulation (Harvey Pitt as Chairman of the SEC [US Securities and Exchange Commission] and, more generally, President Reagan's assertion that "government is the problem"). Fourth, it is common to choose, or retain, corrupt regulatory leaders. Privatisation, for example, creates ample opportunities, resources, and incentive to corrupt regulators.

'Neo-classical economic policy further aggravates systems capacity problems by advising that the deregulation, desupervision and privatisation take place very rapidly and be radical. These recommendations guarantee that even honest, competent regulators will be overwhelmed. Overall, the invariable result is a self-fulfilling policy - regulation will fail. Discrediting regulation may be part of the plan, or the result may be perverse unintended consequences. Neo-classical policies also act perversely by easing neutralisation. Looting control frauds are guaranteed to produce large, fictional profits. Neo-classical proponents invariably cite these profits as proof that the "reforms" are working and praise the "entrepreneurs" that produced the profits. Simultaneously, there is a rise in Social Darwinism. The frauds claim that the profits prove their moral superiority and the necessity of not using public funds to keep inefficient workers employed. The frauds become the most famous and envied members of high society and use the company's funds to make political and charitable contributions (and conspicuous consumption) to make them dominant.

'In sum, in every way possible, neo-classical policies, when they are adopted wholesale, sow the seeds of their own destruction by bringing about a wave of control fraud. Control frauds are a disaster on many different levels. They produce enormous losses that society (already poor in many instances) must bear. They corrupt the government and discredit it. They inherently distort the market and make it less efficient. When they produce bubbles they drive the market into deep inefficiency and can produce economic stagnation once the bubble collapses. They eat away at trust.'

Wasted opportunity

The latest crisis provided many more examples of control fraud, and what is most alarming is that they have not only gone unpunished but have actually been rewarded by the system in the manner of response to the crisis by governments. This is why these enormous bailouts should have been accompanied by much more systematic and aggressive attempts at financial regulation, to ensure that the same patterns that led to this crisis are not repeated. Similarly, there must be regulation to prevent speculative behaviour in global commodity markets, which can otherwise still cause a repeat of the recent crazy volatility in world fuel and food prices that created so much havoc in the developing world.

This opportunity wasted by governments - reflecting the lack of basic change in the power equations governing capitalism - will prove to be expensive. We should brace ourselves for an even worse replay of the financial crisis in the foreseeable future. And the lopsided government response - benefiting those responsible for the crisis without adequate concern for the collateral damage on innocent citizens - may give public intervention a bad name, at a time when we desperately need such intervention for more democratic and sustainable economies.

We need democratic and creative public intervention for many reasons, especially in developing Asia. To begin with, of course, the need for genuine controls on finance is paramount. There is no alternative to systematic state regulation and control of finance. Since private players will inevitably attempt to circumvent regulation, the core of the financial system - banking - must be protected, and this is only possible through social ownership. Therefore, some degree of socialisation of banking (and not just socialisation of the risks inherent in finance) is also inevitable. In developing countries this is also important because it enables public control over the direction of credit, without which no country has industrialised.

But in addition, there are other reasons why new forms of public intervention must go beyond financial regulation to reconsider the economic growth paradigm itself. The obsessively export-oriented model that has dominated the growth strategy of the region for the past few decades needs to be reconsidered. This is not just a desirable shift - it has become a necessity given the obvious fact that the US can no longer continue to be the engine of world growth through increasing import demand in the near future. This means that developing countries in general, and particularly those in developing Asia that continue to rely on the US and Europe as their primary export markets, must seek to redirect their exports to other countries and, most of all, to redirect their economies towards more domestic demand. This requires a shift towards wage-led and domestic-demand-led growth particularly in the countries with economies large enough to sustain this shift. This can happen not only through direct redistributive strategies but also through public expenditure to provide more basic goods and services.

Third, this means that fiscal policy and public expenditure must be brought back to centrestage. Clearly, fiscal stimulation is now essential in both developed and developing countries, to cope with the adverse real-economy effects of the current crisis and prevent economic activity and employment from falling. Fiscal expenditure is also required to undertake and promote investment to manage the effects of climate change and promote greener technologies. And public spending is crucial to advance the development project in the South and fulfil the promise of achieving minimally acceptable standards of living for everyone in the developing world. Social policy - the public responsibility for meeting social and economic rights of citizens - is not only desirable but also contributes positively to development.

Fourth, there have to be conscious attempts to reduce economic inequalities, both between countries and within countries. We have clearly crossed the limits of what is 'acceptable' inequality in most societies, and future policies will have to reverse this trend. Globally and nationally, we have to recognise the need to reduce inequalities in income and wealth, and also most significantly in the consumption of natural resources.

This is even more complicated than might be imagined, because unsustainable patterns of production and consumption are now deeply entrenched in the richer countries and are aspired to in developing countries. But many millions of citizens of the developing world still have poor or inadequate access to the most basic conditions of decent life, such as minimum physical infrastructure including electricity and transport and communication links, sanitation, health, nutrition and education. Ensuring universal provision of this will inevitably require greater per capita use of natural resources and more carbon-emitting production. So both sustainability and equity require a reduction of the excessive resource use of the rich, especially in developed countries, but also among the elites in the developing world. This means that redistributive fiscal and other economic policies must be specially oriented towards reducing inequalities of resource consumption, globally and nationally. For example, within countries essential social and developmental expenditure can be financed by taxes that penalise resource-wasteful expenditure.

New consumption pattern

Fifth, this requires new patterns of both demand and production. This is why the present focus on developing new means of measuring genuine progress, well-being and quality of life is so important. Quantitative GDP growth targets, which still dominate the thinking of regional policy makers, are not simply distracting from these more important goals, but can even be counterproductive. For example, a chaotic, polluting and unpleasant system of privatised urban transport involving many private vehicles and over-congested roads actually generates more GDP than a safe, efficient and affordable system of public transport that reduces vehicular congestion and provides a pleasant living and working environment. So it is not enough to talk about 'cleaner, greener technologies' to produce goods that are based on the old and now discredited pattern of consumption. Instead, we must think creatively about such consumption itself, and work out which goods and services are more necessary and desirable for our societies.

Sixth, this cannot be left to market forces, since the international demonstration effect and the power of advertising will continue to create undesirable wants and unsustainable consumption and production. But public intervention in the market cannot be knee-jerk responses to constantly changing short-term conditions. Instead, planning - not in the sense of the detailed planning that destroyed the reputation of command regimes, but strategic thinking about the social requirements and goals for the future - is absolutely essential. Fiscal and monetary policies, as well as other forms of intervention, will have to be used to redirect consumption and production towards these social goals, to bring about such shifts in socially created aspirations and material wants, and to reorganise economic life to be less rapacious and more sustainable.

This is particularly important for quality of life in urban areas: the high rates of urbanisation in developing Asia mean that within two decades more than half our population will live in urban areas. Yet, because we still do not plan for the future to make our cities pleasant or even liveable for most residents, we tend to create urban monstrosities of congestion, inequality and insecurity.

Seventh, since state involvement in economic activity is now an imperative, we should be thinking of ways to make such involvement more democratic and accountable within our countries and internationally. Large amounts of public money will be used for financial bailouts and to provide fiscal stimuli, and how this is done will have huge implications for distribution, access to resources and living conditions of the ordinary people whose taxes will be paying for this. So it is essential that we design the global economic architecture to function more democratically. And it is even more important that states across the world and within developing Asia, when formulating and implementing economic policies, are more open and responsive to the needs of the majority of their citizens. 

Finally, we need an international economic framework that supports all this, which means more than just that capital flows must be controlled and regulated so that they do not destabilise any of these strategies. The global institutions that form the organising framework for international trade, investment and production decisions also need to change and become not just more democratic in structure but also more genuinely democratic and people-oriented in spirit, intent and functioning. Financing for development and conservation of global resources must become the top priorities of the global economic institutions, which means in turn that they cannot continue to base their approach on a completely discredited and unbalanced economic model. 

Jayati Ghosh is a Professor of Economics at Jawaharlal Nehru University in New Delhi.

*Third World Resurgence No. 228/229, August-September 2009, pp 6-9