A quote by Karl Marx was doing the rounds on Wall Street in January, when many had already realized that the emperors of finance had no clothes. “Owners of capital will stimulate the working class to buy more and more expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism,” it read.
That seemed a pretty good approximation of what had happened in the Western financial system in the preceding months. There was rich irony here: major and minor members of the Wall Street plutocracy taking Marx’s prophecies with deadly seriousness, perhaps even contemplating the road to communism. But it was a big hoax.
Blogger Megan McArdle was quick to point holes in the story. She pointed out that workers in 19th century Europe did not get bank credit; perhaps the landlord or the butcher offered them a few shillings worth of goods on credit. She pointed out that Marx had written a lot on the inadequacy of worker housing rather than about the proletariat buying expensive houses. Most importantly, she pointed out that this did not remotely sound like Marx: “His core thesis was that falling wages would immiserate the working class, not that they would be done in by their overdrafts”. Bingo!
However, this little anecdote tells us a lot about where the roots of instability in modern economies lay: in finance rather than in production. Marx said that capitalism is unstable because of what happened in the real economy of output, consumption and jobs. John Maynard Keynes, too, thought that crises began in the real economy because of a drop in what he called the marginal efficiency of capital and the lack of effective demand. In other words, economies ran into trouble because of what firms and consumers did—and not because of what bankers did.
But it was not shocks in the real economy that brought the world to its knees during and after those harrowing days of September 2008.
One of Keynes’s contemporaries and one of his ardent followers offered better clues about what went wrong, since both brought financial variables into their analysis. Irving Fisher believed that falling asset values create a malign downward spiral of distress sales, contracting money supply, business closures and debilitating pessimism. Hyman Minsky showed how periods of financial calm lead to mountains of debt and excessive risk taking, culminating in a final stage of Ponzi finance before the inevitable bust.
It is too early to say for sure what was the root cause of the first financial crisis of the 21st century, but Fisher and Minsky offer the most interesting clues on how the problems built up, while Keynes offers the clearest road out of the wreckage (in short: governments should spend till consumers and firms have the confidence to do so). So, what happened? There are many suspects: global imbalances that saw a flood of Chinese savings move into the US economy, poor regulation of the financial system, a bonus culture that encouraged traders to take huge risks, rock bottom interest rates that encouraged a borrowing binge, irrational exuberance that led to pathological mispricing of risk—there were several factors at play. But they all came together in September 2008 to create a perfect storm that ripped through the heart of the global financial system.
The convulsions of the past 12 months were unusual in their ferocity. But economists Carmen Reinhart and Kenneth Rogoff have showed in recent research that financial crises are a recurring theme in human history, though each period before the final blow-up is almost inevitably accompanied by the belief that “this time it is different”. They have also showed that financial crises are equal opportunity menaces, threatening emerging markets and rich nations with equal vigour. In short, no country is safe: even a well-managed economy with low inflation, strong public finances and good institutions can take a knock or two.
Economists and policymakers have developed a fairly robust set of tools to deal with the garden-variety recession. Central banks can fine-tune economic activity: raising interest rates to cool down inflation and cutting rates to push growth. And governments can increase spending or cut taxes to boost flagging demand.
Extreme versions of these policies seem to have worked even in the current crisis, though this has meant zero interest rates and huge fiscal deficits in many countries, measures that will feed inflation if they are not reversed in the next year.
But if one assumes that the problems erupted because of what happened in the financial sector rather than the real economy—in Wall Street rather than Main Street, in the world of Minsky rather than of Marx—then the debate necessarily has to embrace touchy issues about how the financial sector is regulated, how bankers are paid and what role finance should play in a modern economy. These are questions that are now as important as the more traditional questions economists ask about public finances, trade openness, technology etc.
The policy choices will be difficult. Finance lubricates an economy. The task is to sometimes throw a fistful of sand in the machine to slow it down rather than hurl boulders to shatter it. In other words, the debates have to be about how to get the regulatory balance just right. Do too little, and recent history will repeat itself; do too much, and economies will slow down. So, how does one get the right balance? For now, nobody knows for sure.
Meanwhile, bankers are bound to push back, especially now that the world economy and financial markets are limping back to normal. In a sharp attack on the US financial industry published in The Atlantic in May, former International Monetary Fund economist Simon Johnson wrote about what he described as a “quiet coup”: the capture of the US government by a financial oligarchy that ensured that rules were written to favour it. If Johnson is right, then reforming the financial sector is not going to happen without a political fistfight.
Niranjan Rajadhyaksha is managing editor, Mint. Comments are welcome at email@example.com