As a shell-shocked world tries to fathom how its economic collapse happened, commentators are busily outbidding each other with claims about the exceptional nature of this crisis. But the most astounding fact is how familiar its physiognomy and physiology look compared to past financial crashes.
No one can read the chronicles of those earlier crashes without sensing – with a chill – that history is repeating itself. The story of the modern capitalist economy is a rhythmic repetition of cycles, syncopated by eerily similar crises. These crises, while their details differ, are but variations on the same theme. Easy money, geared up by leverage, floods the financial system through innovative products. This simultaneously pumps up asset prices and obscures their speculative nature, with euphoria usurping the place of analysis. Until, one day, something triggers a loss of confidence in the continued rise of prices, and the whole leveraged edifice crumbles.
Today’s collapse has followed the same pattern – as outlined on Tuesday in the FT’s series on the future of capitalism. Easy money came from global macroeconomic imbalances that generated enormous capital inflows into deficit countries. Those flows helped drive interest rates down and increase access to credit, fuelling a leveraged asset bubble. Many leaders in the affected countries – in particular the US – knew this: Alan Greenspan himself spoke of “irrational exuberance”. And yet they did not understand how they had to act to prevent a replay of the past.
Today’s disastrous outcome is testimony to those leaders’ intellectual failure. Most fundamentally to blame is their unwillingness to see (or their wilful ignorance of) what markets need in order to produce good outcomes for society.
Every first-year economics student learns the conditions for an unregulated market, in theory, to function efficiently. The most important are full information, enforceable property rights and contracts, and the absence of “externalities” – effects of economic transactions on third parties. These conditions are never fulfilled, but many markets come close enough that participants’ self-interested actions achieve good outcomes for all.
When these conditions are absent, markets malfunction; the way they do so is one of the great topics of economic theory. It tells those who care to listen that when a market is too opaque, or when the effects of market transactions are too inter-dependent, the pursuit of self-interest can make everyone worse off, or unfairly land some with the losses caused by others, or – in extremis – make markets disappear altogether. Nowhere are these problems greater than in financial markets.
Finance expands our economic possibilities by enabling us to shift funds between the present and the future, and between different outcomes of risky ventures. For that reason, confidence in future values is everything for a financial product: if confidence is lost, the market collapses. But in a non-transparent financial sector, unwarranted valuations will often occur, which, when they fail, can destroy confidence throughout the financial system. And the more implicated the economy is in the financial sector, the wider are the repercussions of such dysfunctions – to the point where financial failures can threaten the economic system as a whole.
Economic policymakers could have limited these dangers, but they did not do so. Instead, they allowed the bubble to inflate and let financial transactions become increasingly opaque and ever more leveraged. As in previous bubbles, value came to rely on the perception of value itself: growth pulling itself up by its own leveraged bootstraps. Many assets were not even priced through market trading but valued by complex formulas – akin to peddling tulips with equations.
People were not unaware of the risks, but both regulation and private risk management were based on the faulty premise that if each entity looks after its own risk, no one needs to worry about systemic risk. The great mistake was to rely merely on self-interest in as imperfect and as important a market as the financial sector. The huge profits bankers reaped reinforced their collective blindness to the illusory value of the assets they traded.
Those who sound the death knell of market capitalism are therefore mistaken. This was not a failure of markets; it was a failure to create proper markets. What is to blame is a certain mindset, embodied not least by Mr Greenspan. It ignored a capitalist economy’s inherent instabilities – and therefore relieved policymakers who could manage those instabilities of their responsibility to do so. This is not the bankruptcy of a social system, but the intellectual and moral failure of those who were in charge of it: a failure for which there is no excuse.
Copyright The Financial Times Limited 2009
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