What began as a financial crisis in 2008, rapidly metastasized into a global economic crisis that pushed the world economy into the deepest recession since the Great Depression of the 1930s. The governments of the US and European countries undertook multi trillion dollar bailout packages for private sector banks and public sector stimulus packages to resuscitate their economies. However after a weak economic upturn earlier this year, the Western economies continue to stagnate. Understanding the origins and nature of this crisis may help illuminate the policy challenges that lie ahead.

In the process of its growth the world economy has undergone a structural change in the post war period in terms of two important features: First, the emergence of multinational corporations in the 20th century enabled the organization of knowledge, resources and production processes on a global scale and thereby laid the basis for an unprecedented growth in productivity and profits in the post war period. However given the problem of reinvesting these profits (due to demand constraints), profits from the sphere of production began to flow into the financial sphere.

Second, within two decades in the second half of the 20th century (1963 to 1985), the relative weight of the financial sphere in the world economy changed dramatically: For example in 1964, international banking was only about 10 percent of the value of the international trade in goods and services. As the financial sphere grew 10 times faster than the sphere of production, by 1985, international banking had become greater than the value of international trade in manufactured goods and services.

The emergence of finance as the dominant sphere, imparted to the global economy a new fragility. Banks and finance companies could rapidly devise a wide range of financial products and sell them in an integrated global market at a hitherto unimaginable speed.

Two factors induced in this finance dominated global economy, a tendency for crisis: (a) The failure of national governments to establish an adequate institutional framework at the international level for regulating global financial transactions. This was primarily due to the prevailing ideology that markets are self regulating. (b) In the science of economics, while individual risk can be easily calculated on the basis of probability theory, the mathematics for estimating systemic risk is yet to be developed. As the Nobel Prize winning Harvard economist, Michael Spence has pointed out, the estimation of risk at the level of the economic system as a whole is based on a particular probability distribution of individual risk. If, as in the case of the current crisis, the distribution of individual risk is changing, then it becomes extremely difficult to accurately model systemic risk.  

What made the global financial system fragile was that the new financial products were priced by financial experts on the basis of risk estimates whose methodology was not transparent to the buyers. This asymmetry of information between producers and buyers of financial products created a tendency for individuals and organizations to undertake overly risky investments without being aware of it. The fragility of the global financial edifice was made acute by the fact that many of the new financial products such as sub prime mortgages, debt bonds and risk insurance, while appearing individually distinct products, were actually interlinked and hence created escalating risk at the systemic level.

Spiraling production and sale of derivatives, with multiplying systemic risks that were unknown to the individual investors, created a time bomb that could threaten the global financial system and thereby the real economy. When it exploded some of the most important banks and finance companies suffered simultaneous and major damage which brought the financial and economic system of the world into the most serious crisis in a century.