Exactly one year ago, the Wall Street investment bank
Lehmann Brothers was allowed to go bust, in a move that is generally seen to
have brought on the global financial crisis. Shock waves 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 that
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 Lehmann 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.
On 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 learned the
important lessons from the crisis?
Unfortunately, this does not seem to be the case. Most significantly, hardly anything
seems to have been learned in terms of required regulation of finance. 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 its
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.
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.
Jayati Ghosh is Professor of Economics and currently also Chairperson at the Centre for Economic Studies and Planning, School of Social Sciences, at the Jawaharlal Nehru University, in New Delhi, India. With C.P. Chandrasekhar, she co-authored Crisis as Conquest: Learning from East Asia. This article was first published by the International Development Economics Associates on 16 September 2009; it is reproduced here for educational purposes.