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: A recession that has caused untold misery to millions across the world through loss of employment, lifetime savings, and denial of welfare support from budget constrained states. It has also undermined the theoretical edifice of mainstream economics. We are on the threshold of a new economics that would form the basis of a new public policy quite different from the one that was followed within the Neo-classical paradigm that has held sway over the last six decades. In this article I will examine briefly, the origins and nature of the latest crisis in the world capitalist economy and its implications for economic theory.
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 multinational corporations that emerged in this period not only sold goods and services on a global scale but were able to achieve internationalization in their production processes such that different components of a particular good could be manufactured in their facilities in different countries to take advantage of country specific resource endowments. This laid the basis of an unprecedented growth in productivity, and profits. Given the problem of investing these profits within the sphere of production, due to demand constraints, profits from the sphere of production began to flow into the financial sphere.
The second structural change that emanated from the first, was that the flow of profits from the sphere of production into the sphere of finance became so large that the relative weight of the financial sphere in the world economy became greater than the sphere of production, in contrast to the preceding two centuries when the production sphere had far outweighed the financial sphere. Evidence that I have compiled for a forthcoming paper shows that in 1964, international banking was only 20 billion USD while international trade in goods and services was 9 times greater at USD 188 billion. Over the next two decades the financial sphere grew at an explosive pace so that by 1985, international banking had become greater at USD 2,598 billion compared to international trade in goods and services at USD 2,190 billion.
The emergence of finance as the dominant sphere imparted to the global economy a new fragility which was based on three factors. First, financial markets which in the pre-globalization period had been segmented regionally became integrated across space after globalization. This meant that any shock in a particular location would be quickly transmitted across the world economy. Second, the US, the largest economy of the world at the time, withdrew regulatory constraints that forbade retail banks from engaging in high risk investment activities (such as securitization). This occurred when the Glass-Steagall Act of 1933 was repealed by the Clinton administration in 1999, because of the reigning Neo-classical belief that markets are self correcting. This set the stage for the mortgage based housing bubble which subsequently burst and unleashed the global economic crisis. As Skidelsky (2009) has argued the housing bubble was based on securitization through which the highly risky sub-prime mortgages entered the banking system. Securitization means creating bundles of individual mortgages with different attached risks and sold in the global market by the initiating bank. This resulted in a situation where one-third of the sub-prime mortgages were loaned to borrowers whose average loan size was six times their average annual earnings. Such housing booms spread across the Western world. Most policymakers as well as banks imagined that the housing boom would continue and so long as house prices continued to rise the risk remained hidden. Warren Buffet (an American businessman and philanthropist) in a prescient observation in 2002 noted, that if the housing market failed, the paper securities would become “financial weapons of mass destruction”.
In an environment of inadequate regulatory mechanisms, the desire to make quick money resulted in banks and finance companies producing a wide range of derivatives and the financial sphere continued to expand rapidly. So did the gap between the risk which the individual thought he was taking and the actual risk. There were two reasons for this: first, the asymmetry of information about the financial product risk between the buyer and the seller. There was a consequent tendency for individuals and organizations to undertake overly risky investments without being aware of it. Second, financial derivatives 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. As Michael Spence, the Nobel Prize winning economist has pointed out, in a situation where individual risks were positively correlated, the measurement of systematic risk was inherently difficult, let alone the incapacity of the markets to provide a positive feedback to the investor.
Spiraling production and sale of derivatives, with multiplying systemic risks that were unknown to the individual investors created a time bomb that threatened the global financial system and thereby the real economy. When it exploded in September 2008, most of the 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.
The Great Depression of the 1930s had been overcome through government intervention on the basis of the Keynesian paradigm which postulated that the market mechanism does not necessarily ensure full employment. However, within a few decades the old Classical dogma that markets produce efficient outcomes whereby individual greed transmutes into public welfare, returned in the form of Neo-classical economics. Within this paradigm, the belief was not only that the market system constituted the most efficient framework for the production of goods and their distribution but also that markets are self correcting. Crises within this framework are supposed to be rare events. Yet John Eatwell of Cambridge and later Joseph Stiglitz of Columbia University pointed to evidence that a crisis occurs somewhere in the capitalist system every ten years. Greenwald and Stiglitz, on the basis of their work on the theory of imperfect information demonstrated that the market mechanism does not even have a tendency towards an efficient equilibrium – thereby overthrowing the Neo-classical doctrine of a minimalist role of the state. Indeed during the post war period, in the most successful Third World countries such as China and East Asia, the government had an active role to play.
The central lesson of the latest world economic crisis, as indeed in the case of the Great Depression of the 1930s, is that markets are not self regulating. The environmental crisis that threatens not only the stability of the economy but life itself has also shown that markets are unable to adequately incorporate externalities into the calculus of private profitability. A carefully crafted national and global regulatory framework is therefore needed if the trauma of recurrent economic crises is to be avoided and the life support systems of the planet are to be sustained.