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Crises today and the future of capitalism

The world is going into the worst economic crisis since the Great Depression. Credit is contracting, output is falling, unemployment is increasing, and most asset values are falling. It is likely not only to be a long downturn, but also a deep one.

The crisis was predictable, and predicted. But unfortunately, mainstream economists, politicians, and policymakers ignored the warnings. We have much to learn from these failures, as well as those of the economy itself.

Finally, the world is awakening to the need to do something. We are all Keynesians now. Not long ago, Keynesian economics was derided as old fashioned. Keynesianism, it was claimed, underestimated the ability of markets to be self-adjusting and self-correcting.

But there is more than one version of Keynesian economics. The standard version, popularised by Hicks, focused on wage and price rigidities. But another strand, linked more closely to Irving Fisher, and more recently to Minsky, Greenwald and Stiglitz, emphasised the role of dysfunctional and imperfect financial sectors. And indeed, this crisis has been precipitated by a failure of America’s financial sector, both to manage risk and allocate capital. This time we have a massive set of micro-failures giving rise to a massive macro-failure. Not only had the financial sector made bad loans, they had engaged in multi-billion dollar gambles with each other through derivatives, credit default swaps, and a host of new instruments, with such opacity and complexity that the banks couldn’t even ascertain their own balance sheets, let alone that of any other bank to whom they might lend. Credit markets froze.

It was natural, given that the source of the problem was a dysfunctional financial sector, to focus assistance on that sector. But as money was pouring in, they were pouring out money, to pay bonuses and dividends. No changes were made in either the perverse incentive structures that had led to bad lending, to the regulations that had allowed it, or to the flawed corporate governance that had led to the perverse incentive structures. Meanwhile, the shrinking economy and increasing uncertainty meant that even after recapitalization, banks had little incentive to lend.

In the U.S., the Fed became not just a lender of last resort, but a lender of first resort, as it took on lending to all major corporations — but with no effective mechanism of risk assessment — and its balance sheet swelled to over 2.3 trillion dollars. The Fed did not want to be blamed for this recession, in the way that it was blamed for the Great Depression, though to be sure, its policies of loose monetary policy and lax regulation had set the stage for the collapse, its failure to act in a timely way helped ensure that the downturn would be the longest in the post war era, and the recklessness of its bail-outs, as it and Treasury veered from one strategy to another, not only undermined market confidence and created huge market uncertainty, but set the stage for future problems. What happens when some of the loans go bad? Will the Fed be able to retrench in an orderly way as the economy eventually recovers?

We were giving a mass blood transfusion to the financial sector; but our patient was haemorrhaging from internal bleeding — the epidemic of foreclosures — and nothing was being done about it. Treasury and Fed pretended it was just a matter of confidence: announce a $700 billion programme and prices will be stabilised, foreclosures will be stopped. It was nonsense: we had had a housing bubble, and there is still more air to be let out.

Bush’s economic policies were rightly rejected in the November elections; and he seems to have gone into a total state of denial. No further extension of unemployment, no stimulus. Meanwhile, the economy plunges further down. Fortunately, Obama is putting together a massive stimulus, consistent with America’s long run needs — infrastructure, green technology, schools. But its effects will not be felt immediately, so unemployment is likely to increase and the recession to continue. Indeed, his promise to create 2.5 million new jobs in the next two years will not be enough; to bring us back to full employment, three times that number would have to be created.

There will be battles ahead: as the national debt soars, some of those in the financial markets will return to their fiscal religion — especially after they have gotten their bail-out, and the public will have decided no more for them. They may urge more limited increases in expenditures. They will argue against restructuring the financial sector’s bail-out, in ways to make it more effective and to ensure that the government recovers more of what it has given them. They will argue against tough regulation, claiming that one has to be careful not to suppress innovation. But much of the innovation of recent years was little more than accounting, regulatory, and tax arbitrage; it did not lead to better resource allocations or improved risk management — nothing was done, for instance, to help homeowners manage the simple risk of being able to stay in their homes in the face of interest rate volatility. Better regulation would help ensure that private rewards are commensurate with social returns, and would help direct innovation in ways which are more socially productive.

For 25 years there has been a battle over alternative economic philosophies. Market fundamentalism prevailed within the international economic institutions, in the form of the Washington consensus policies; in many circles, rational expectations models prevailed within academia. Advances in economic and other social sciences, meanwhile, had shown that markets often fail — the reason that Adam Smith’s invisible hand often seems invisible is that it’s not there — especially when there is imperfect and asymmetric information (as there always is); and they also showed that individuals are often irrational. These advances undermined the intellectual foundations of the Washington consensus. The fact that those countries that followed the Washington consensus did poorer than those that did not could be seen as an empirical verification of these ideas, and current episode provides further empirical support to them.

But we have not yet fully absorbed the full import of these events. Many central banks are, for instance, still focusing on inflation, as if maintaining price stability was necessary and almost sufficient to ensure economic prosperity. It was this single minded focus that contributed to the macro economic mistakes that underlay this recession.

This is the first global recession of the new era of globalisation. It will require a global response. But we have to realise how distorted the global financial system has become. Even though this crisis has a “made in U.S.A.” label, funds are flowing from developing countries back to the U.S. This is partly because developing countries are often forced to engage in pro-cyclical monetary and fiscal policies, while developed countries pursue countercyclical policies. The developing world is always buffeted by these storms worse than the developed — even when the problems originate in the developed world.

There is a recognition of the importance of a coordinated global fiscal and monetary response. But the required reforms go deeper, and include creating a new global reserve system and a new global financial regulatory authority. Only with such reforms is there a hope that, as the world emerges from this crisis, there will be robust and stable growth with shared prosperity for all countries.

(The writer is eminent economist, Nobel Laureate and Professor of Columbia University. This article is excerpted from the Tenth D. T. Lakdawala Memorial Lecture delivered by him on December 20 under the aegis of the Institute of Social Sciences, New Delhi.)

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