Humpty is dead

2009-12-29 12:50


WE ARE at a moment when the range of uncertainties facing the

global economy is unusually wide. We have just passed through the worst

financial crisis since World War II.

The only relevant comparisons are with the Japanese real-estate

bubble, which burst in 1991 (and from which Japan has not yet recovered) and the

Great Depression of the 1930s – except that this crisis has been quantitatively

much larger and qualitatively different.

Unlike the Japanese experience, this crisis involved the entire

world, rather than being confined to a ­single country.

And, unlike the Great

Depression, this time the ­financial system was put on artificial life-support,

rather than being allowed to collapse.

In fact, the magnitude of the problem today is even greater than

that of the Great Depression.

In 1929, total credit outstanding in the US was 160% of gross

domestic product (GDP), and it rose to 250% by 1932. Last year, we started at

365% – and this calculation leaves out the pervasive use of derivatives, which

was absent in the 1930s.

Despite this, artificial life- ­support has worked. Barely a year

after the bankruptcy of Lehman Brothers, financial markets have stabilised,

stock markets have ­rebounded and the economy is showing signs of recovery.

People want to return to business as usual – and to think of the crash as a bad


Unfortunately, the recovery is ­liable to run out of steam and may

be followed by a second economic downturn, though I am not sure whether it will

occur next year or in 2011.

My views are far from unique, but they are at

variance with the prevailing mood. The longer the turnaround lasts, the more

people will believe that it will continue.

But in my judgment, this is

characteristic of far-from-equilibrium situations, when perceptions tend to lag

behind reality.

To complicate matters, the lag works in both directions. Most

­people have not yet realised this crisis is different from previous ones – that

we are at the end of an era. Others – including me – failed to ­anticipate the

extent of the rebound.

Overall, the global financial ­authorities have handled this crisis

the same way as they handled previous ones: they bailed out failing

­institutions and applied monetary and fiscal stimulus.

But this crisis was much

bigger, and the same techniques did not work. The failed ­rescue of Lehman

Brothers was a game-changing event: financial markets actually ceased to


This meant that governments had to effectively guarantee that no

other institution whose collapse could endanger the system would be ­allowed to


That is when the crisis spread to the periphery of the world economy,

because countries on the periphery could not provide equally credible


Eastern Europe was the worst hit. Countries at the centre used

their central banks’ strong balance sheets to pump money into the system and

guarantee the liabilities of commercial banks, while governments engaged in

deficit financing to stimulate the economy on an ­unprecedented scale.

But the growing belief that the ­global financial system has

escaped collapse, and that we are slowly ­returning to business as usual, is a

grave misinterpretation of the ­current situation. Humpty Dumpty cannot be put

together again.

The globalisation of financial markets that took place since the

1980s allowed financial capital to move freely around the world, ­making it

difficult to tax or regulate.

This put financial capital in a privileged position: governments

had to pay more attention to the ­requirements of international capital than to

the aspirations of their own people.

Individual countries found it difficult to

offer resistance.

But the global financial system that emerged was fundamentally

unstable, because it was built on the false premise that financial markets can

be safely left to their own ­devices.

That is why it broke down, and that is why

it cannot be put ­together again.

Global markets need global regulations, but the regulations

currently in force are rooted in the principle of national sovereignty.


are some international agreements, ­notably the Basel Accords on minimum capital

requirements; and there is also good cooperation among market regulators.

But the source of the authority is always the sovereign state. This

means it is not enough to ­restart a mechanism that has stalled; we need to

create a regulatory mechanism that has never ­existed.

As things stand, each country’s financial system is being sustained

and supported by its own government. But governments are primarily concerned

with their own economies.

This gives rise to what may be called financial

protectionism, which threatens to disrupt and perhaps destroy global financial


British regulators will never again rely on the Icelandic

authorities, and Eastern European countries will be reluctant to remain

­dependent on foreign-owned banks.

So regulations must become ­international in scope. Otherwise,

global financial markets will be ­destroyed by regulatory arbitrage.


will move to countries where the regulatory climate is the most benign, exposing

other countries to risks they cannot afford to run.

Globalisation was successful because it forced countries to remove

regulations; but the process does not work in reverse.

It will be difficult to

get countries to agree on uniform regulations. Different countries have

different interests which drive them towards different solutions.

This can be

seen in Europe, where the European Union’s member states cannot agree among

themselves on a uniform set of ­financial rules. How, then, can the rest of the


In the 1930s, trade protectionism made a bad situation worse. In

­today’s global economy, the rise of financial protectionism constitutes a

greater danger.

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