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.