For a return to common sense
The malady of infinite aspiration?
More articles on the financial crisis.
As I write, a deepening financial crisis is ricocheting worldwide, its tremors causing anguish as the economic downturn spreads. It is not long ago since the European Parliament passed a report that I drafted together with the Dutch MEP Ieke van de Burg, in which we argue for an overhaul of the regulatory and supervisory framework of financial markets in the EU.1 I should underline that the paradigmatic underpinnings of our report did not dawn upon us during the current financial mess engulfing western economies; for a long period of time both of us, though belonging to different political groups in the European Parliament,2 have harboured similar views about what is wrong with the dynamics of world finance.
Economic freedom and entrepreneurship, which lie at the root of innovation and economic advance, rely and feed on free markets; this is indisputable and explains why communist economies collapsed, eventually, during the last century. In this regard, Ludwig von Mises, Friedrich von Hayek, Joseph Schumpeter and the Austrian School were quite right. But it is misleading to argue that free markets are synonymous with non-regulated markets, with the practical extinction of public sectors and public policies. Modern economies and societies need regulations and public policies so that goods are in adequate supply and harmful external factors are prevented or restricted. This implies that public sectors function alongside free allocation of resources (at market prices) and vibrant economic competition. It goes without saying that one needs to streamline and make public sectors run efficiently so that public resources are not wasted. It is also obvious that without moral compass, everything else gets bogged down, sooner or later.
When I was chief economist at the Romanian Central Bank, I was asked by the representatives of the IMF whether I would support Romania’s opening of a capital account; that dialogue took place in 1996, about one year before the eruption of the Asian financial crisis. I replied that such a move would be highly risky, a dangerous course of action that I would not recommend to my country’s political leaders. Fortunately, they did the right thing: nowadays many accept that the Asian crisis was primarily caused by the fact that economies in the region prematurely opened capital accounts with the IMF. I have always felt that the rush to privatize public utilities is not warranted. As Joseph Stiglitz3 and others have highlighted, institutional contexts are essential if privatized companies are to perform well. In addition, some public utilities should stay in public hands. It should be added that institutional change is time-consuming and that time cannot be compressed at will.
The oversimplification of “good practices” in governance and the hypocrisy with which, in more than a few cases, they have been propounded by major industrialized countries around the world is today more than obvious.4 The deep financial crisis, the failed Doha Development Round (with the controversy over the difference between free and fair trade), and the lack of results wherever development policies have been simplistically encapsulated in the ideological mantra of neoliberalism, are telling. Having said that, I do not overlook corruption, lack of clarity in property rights, misallocation of resources and, in many poor countries, waste and embezzlement of public resources — all of which impede economic growth.5 But such structural weaknesses do not constitute a convincing argument for accepting, without qualification, policy remedies that are too general and often divorced from concrete local conditions.
While market-based reforms freed up entrepreneurship and stimulated economic growth in China after 1978 and in India in the last decade, they were implemented in a pragmatic way. Close attention was paid to social issues and rural development problems, while financial markets were not liberalized recklessly. In these two very complex cases, while big policy trade-offs and dilemmas remain, economic progress has been extraordinary. Dani Rodrik,6 Paul Krugman7 and other clairvoyant economists have constantly asked for open-mindedness when examining the major problems afflicting poor countries; they have rejected oversimplifications and advocated policies that vary according to local circumstances. Although their intellectual credentials are exceptional, their voices were not sufficiently attended.
I lived for a substantial part of my life under communism and I value economic and political freedom in ways that those fortunate to have lived in liberal democracies may not fully understand. But I am not blind to the downsides of market economies, especially those that are not adequately regulated. I consider myself an economist of a liberal persuasion, though I am not a libertarian. I espouse a type of liberalism that owes much to Karl Popper’s concept of an “open society”.8 For me, individual liberties coexist with social solidarity, social equity,9 public good and moral values (trust, honesty, trustworthiness, accountability, etc.). The German notion of the “social market economy” (soziale Marktwirtschaft) well sums up my approach.10
I mention moral values because, frequently, I hear people (in the European Parliament, too) who claim that morality is meaningless in business. I would argue that this is so only for those for whom society is quite meaningless. I also think that ruthless competition in the global economy strains European societies and their social model. Measures that focus on boosting competitiveness while ignoring social cohesion and the social contract between state and citizens can be equally damaging to society. The experience of Scandinavian countries in undertaking reforms that enhance competitiveness without disregarding the social fabric of society could be instructive for the European Union.
The crisis that has struck the core of world finance is, in my opinion, a clear refutation of the paradigm that glorifies total deregulation, regardless whether economies are rich or poor.11 The repeal in 1999 of the Glass-Steagall Act, which limited ownership of financial companies operating in other market segments, and the decision in 2004 to exempt the brokerage operations of Wall Street investment banks from debt limits, have proved to be historic blunders.12 The root cause of this crisis is an under-regulated financial system. The waves of deregulation in the financial industry brought to the market a plethora of fancy products whose risks were poorly understood. Mortgages are not toxic per se; badly constructed securities based on them are toxic. Toxic is the packaging and repackaging of financial products, making their valuations increasingly unclear and reducing their tradability. Reward schemes that shape the decisions of managers and agents in markets and that make their behaviour irresponsible — that is toxic. Misleading quantitative models are toxic. The trigger for this financial crisis may have been the mortgage market, but the mortgage market is not the structural cause of the crisis.
What this crisis should make plain to everyone is that not all financial innovation is benign. It is baffling to hear the argument that fresh regulation is bad because it would stifle financial innovation. Fresh regulation is necessary because it has been a lack of proper regulation and supervision. The enormous mistakes that have been made by allowing finance to develop its own, highly risky raisons d’être must be undone. But are we capable of learning that lesson? Why is it that we fail to learn from previous crises? Alexandre Lamfalussy issued warnings almost a decade ago; the financier Warren Buffett and the former Federal Reserve chairman Paul Volcker are among the other important figures to have fired off warnings. Nouriel Roubini did the same, including at Davos Forum meetings. Why were their predictions of a crisis not heeded?
As traffic needs rules and lights in order to protect lives, so market economies need regulations to limit collateral damage and enhance the production of public goods. A lax monetary policy can lead to higher inflation and, ultimately, to a recession; it cannot, by itself, cause the meltdown of a financial system. This is the crux of the matter: the features of the financial system that have brought the threat of collapse are those of the “new” financial system, including the breakdown of due diligence.
Vested interests can have a long arm and try to influence regulation and supervision. But they must be strongly resisted, using all available means. Regulators and supervisors should know that financial markets are volatile and prone to instability, and that the efficient-markets hypothesis — that prices reflect all known information — is a fantasy.
The huge bailouts underway in the financial sectors will introduce, or reinforce, elements of state capitalism in numerous countries, including the US. The impact on national budgets will be burdensome for years to come. In order to mitigate the pain and reduce dependency on foreign credit, saving ratios will have to go up in all economies in which banks have been recapitalized. A legitimate question then arises: can rich societies all of a sudden become more economizing and forward-looking? This hinges very much on social cohesion (solidarity) and the capacity of politicians to lead in times of distress. If one adds here the implications of climate change, aging and strained welfare states, as well as the challenges posed by emerging global economies in terms of competitiveness, the contours of a very complex public policy agenda in the decades to come are not hard to delineate.
The effects of the current financial crisis have hit the western world at a time when tectonic shifts in the global economy have been taking place for over a decade. The rise of China, India, and Brazil, along with the resuscitation of a capitalist Russia (that benefits from huge natural resources), is ushering in an increasingly multi-polar world, the economic and geopolitical reverberations of which are growing. The struggle for the control of exhaustible resources (oil and gas in particular) epitomizes this phenomenon. The financial crisis has given more salience to criticisms of policies that are not pragmatic and that succumb to fundamentalist tenets.
The fall of communism, which was equated by some with the “end of history”,13 has favoured immensely the advance of neoliberal ideas. In the western world this advance has fuelled the ascendancy of so-called Anglo-Saxon capitalism — and its “Third Way”14 reflex on the Left of the political spectrum. Needless to say, the overwhelming superiority of the US on all fronts (economic, military, technological) offered a sort of a Pax Americana and created the prerequisites for an “international regime”. The latter was supposed to order the world by providing international public goods and by resolving or preventing possibly major conflicts. Neoliberalism (market fundamentalism) has revealed its serious flaws over time and, for the time being, has been shelved for the sake of salvaging the market economies. What is happening now is not a rejection of market forces as an essential mechanism for the allocation of resources and the stimulation of business, but the invalidation of a gross misinterpretation of what it takes for a modern economy to perform economically and socially over the long run.
Fragments of state capitalism are being put in place and we will see what will remain out of them over time. Probably, substantial chunks of the new state sector will be re-privatized at some point in time. Monetary policies are now geared towards achieving financial stability and have acquired the sort of flexibility that is reminiscent of John Maynard Keynes’ injunctions regarding ways of avoiding “bad equilibria”. The very concern of governments and central banks with radically overhauling the regulation and supervision of financial markets, so that “Minsky moments” — moments at which, according to late economist Hyman Minsky, financiers lay waste to the economy15 — are averted, is a strong vindication of Keynes’ intellectual legacy and of his sense of realism in understanding the functioning of markets in general.
The crux of the matter is that the reshaped, mixed economies have to function in such a way that extravagant policies are avoided for the benefit of democracy and the welfare of most citizens. Cycles cannot be eliminated and crises will erupt again. But a financial meltdown, with its dire effects on the real economy, can be prevented by proper policies and regulations.
The EU and US will come out of this crisis with reshaped economies (with larger public sectors) and will very likely continue to be, fundamentally, liberal democracies. But the financial crisis has weakened them, whereas the ascendancy of the new global powers is hard to stop, despite the worldwide impact of the economic slowdown. I see the future as being driven by competition between liberal and authoritarian forms of capitalism — the latter represented principally by China and Russia.
Liberal democracies will have to come to grips with their weakened standing in the world economy and, for their own sake, shed their hubris in dealing with the rest of the world.16 This applies to the reform of the international financial institutions and a new architecture for tackling global governance issues, which will have to involve the emerging global powers. As some say, a new Bretton Woods Agreement is needed.
The years to come will mark the prominent return of Keynes and the idea of government intervention. We need common sense and pragmatism in economic policy-making, not fundamentalism. As some have aptly observed, “History proves the importance of policies for preserving the social fabric”.17
- Ieke van den Burg and Daniel Daianu, "Report with recommendations to the Commission on Lamfalussy follow up: future structure of supervision" , Rule 39 of the Rules of Procedures, European Parliament, 2008.
- Daianu belongs to the Alliance of Liberals and Democrats for Europe, van de Burg to the Socialist Group -- ed.
- Joseph Stiglitz, Making Globalization Work, Allen Lane: New York 2006. See also Narcis Serra and Joseph Stiglitz (ed.), The Washington Consensus Reconsidered, Oxford University Press: New York 2008.
- The World Bank has been concerned with "good practices" (good governance) for a long time and regularly disseminates information on this topic around the world. But why has this institution not also paid attention to malpractice in the financial industry in the older, wealthy economies?
- See for instance William Easterly, The Elusive Quest for Growth, MIT press: Cambridge 2001.
- Dani Rodrik, One Economy, Many Recipes, Princeton, Princeton University Press, 2007. See also his The New Global Economy and Developing Economies. Making Openness Work, Washington DC, Overseas Development Council, 1998.
- Paul Krugman won the Nobel Prize in 2008 for having shown the effects of an economy's scale on trade patterns and the location of economic activity. He was prescient in foreseeing the pitfalls of the new financial system; see The Return of Depression Economics, Norton: New York 1999.
- Karl Popper, The Open Society and Its Enemies, Routledge: London 1945.
- See John Rawls, A Theory of Justice, Harvard University Press: Cambridge 1971.
- A leading theorist of the social market economy was Wilhelm Roepke; a leading practitioner Ludwig Erhard.
- In a letter published by Le Monde, 22 May 2008, one can read: "Some are tempted to see the ongoing financial crisis as a recurrent accident, albeit more severe, which has been occurring regularly worldwide as a result of cheap credit. But a careful reading would go at its structural roots. Globalization of markets and financial engineering, with precarious and, frequently, absent regulations, highly skewed incentive schemes, and numerous conflicts of interest, have created the milieu for the current crisis". The letter was signed by Helmut Schmidt, Otto Graf Lambsdorff, Lionel Jospin, Jacques Delors, Michel Rocard, Romano Prodi, Jacques Santer, Göran Persson, Pär Nuder, Massimo D¹Alema, Hans Eichel, Poul Nyrup Rasmussen, Daniel Daianu, Paavo Lipponen, Ruairi Quinn, Laurent Fabius, and Anneli Jaatteenmaki.
- Alan Greenspan, the long-serving president of the Fed, is quoted by the International Herald Tribune to have acknowledged that something has been wrong with the free market theory he has upheld (Brian Knowltoon and Michael Greenbaum, "Greenspan makes rare admission of fallibility", 24 October 2008). Greenspan is well known for having been a staunch opponent of regulating the "new banking sector".
- Francis Fukuyama, The End of History, Free Press: New York 1990.
- Anthony Giddens, The Third Way, Polity Press: Cambridge 1998.
- Hyman Minsky, Stabilizing an Unstable Economy (1st edn., 1986), Mc Graw Hill: New York 2008.
- To see how "others" view the US and the EU in the twenty-first century, read Kishore Mahbubani, The New Asian Hemisphere, Public Affairs: New York 2008.
- Robert Shiller, The Subprime Solution, University Press: Princeton 2008, 2.