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Mainstream, Vol XLVII No 13, March 14, 2009

Review Article: Financial Crisis and How to Tackle It

Sunday 15 March 2009, by Devdatt P. Dubhashi

The Subprime Solution by Robert J. Shiller; Princeton University Press; 2008.

The Origin of Financial Crises by George Cooper; Random House; 2008.

The Credit Crunch by Graham Turner; Pluto Press; 2008.

The tsunami of the financial crisis that struck the world in 2008 caught most economists by total surprise, and has now generated a large outpou-ring of analysis of what went wrong. The books under review have three very different takes on it. Roughly speaking, one may characterise them respectively as a mainstream free market angle, a Keynesian angle and a Marxist angle (though the authors would very likely object to these labels, especially the last).

Robert Shiller’s book starts from a basic faith in the market tempered by an admission that it suffers from periods of irrational exuberance. Shiller’s earlier book by that name was hailed as a masterpiece. In the present book, he follows in the same vein and shows that the housing market was indeed a bubble fed by irrational exuberance that bore no relation to reality. Thus his diagnosis of the crisis is basically that it was a result of bad judgments and unjustified risks undertaken by people acting irrationally. While undoubtedly true, this seems a rather unsatisfactory and premature point to end the analysis.

George Cooper takes the analysis a step further in his book whose tounge-in-cheek style contrasts with the stately and measured prose of Shiller. Cooper’s starting point is the falsity of the Efficient Market Hypothesis (EMH) that is the bedrock of all mainstream economists including Shiller. This holds that markets are self-correcting mechanisms that left to themselves converge to the most efficient equilibrium. Cooper gives a number of examples to challenge this stance. Indeed, he asks: how do the economists who staff central banks square their faith in the EMH with their jobs?! Cooper subscribes to the Financial Instability Hypothesis (FIH) of Herman Minsky, the foremost devotee of John Maynard Keynes in the US. The FIH maintains that market economies are inherently unstable, generating crises internally even in the absence of external shocks. This is especially true of markets in assets such as land or finance. In periods of relative stability, economic agents are induced to take much larger risks than otherwise.

Far from leading to a stable equilibrium, this produces credit bubbles that burst and lead to a crisis. Thus, as Keynes insisted, governments have a crucial role in regulating markets to prevent major crises.The US Federal Reserve was created for just this purpose after the financial instabilities of the early twentieth century.

However, far from solving the problem, central banks have tended to exacerbate it, according to Cooper. He gives a breezy entertaining account of the history of money and banks, leading up to modern-day central banks and their current role. In times when asset prices are rising, the Central Bank is loath to interfere, regarding it as the natural progression of the market to a new equilibrium. However, when prices drop, then it interferes very aggressively to brake the movement, effects bailouts and thus generates moral hazards which sow the seeds for future crises. According to Cooper, this asymmetric reaction is one among the many ways in which the present-day central banks violate the basic spirit of the original proposal by Keynes.

Graham Turner’s book, dense with data and financial jargon compared to the other two, points the finger at the forces of globalisation and the role of multinational corporations.

In search of profits, multinational companies have scoured the world looking for cheap labour using the opportunities presented by globalisation. This has resulted in downward pressure and stagnation of wages in the developed Western countries. In order to keep the lid on the resulting political discontent at home, Western governments have deliberately allowed the creation of housing bubbles and credit schemes leading to an exponential growth of debt. Just that you don’t think this is a wild conspiracy theory, he gives very convincing data to demonstrate this debt explosion and the dependence of Western economies on it. This created an unsustainable situation which had to give in sooner or later. Indeed Turner was one of the few people (other than the by now famous Dr Doom, Nouriel Roubini) who predicted the crisis in advance.

Turner blames globalisation whereas his own analysis clearly suggests he means capitalist globalisation. Indeed when seen in this light, the housing bubble, the debt crisis and deregulation troubles are not a mistake but rather an essential feature of the system. Two features of the modern economic system stand out: the stagnation of wages and the increasing financialisation of capital in response to the decreasing rates of profit in traditional avenues for investment. This develop-ment to a monopoly-finance stage of capitalism meant that asset bubbles and spiralling debt was just a means of putting off the point at which the problems of the system would explode. Had there been tighter regulation and caps on debt, a crisis would have just occurred earlier! Turner’s scrupulous avoidance of the ‘C’ word, when his own data and analysis scream at it, is perhaps deliberately designed to boost sales by not scaring away readers.

What should be done about it? This is the question on everybody’s mind today as the situation seems to get grimmer by the day, despite the massive bailouts and stimulus plans announced by the US, the UK, Germany and even China, India and other countries around the world. Shiller’s answer has a short-term and a long-term component. In the short-term, he believes bailouts are essential, however unfair they may seem—punishing the prudent for the follies of the reckless. For, the overriding need of the hour is to save the faith and confidence of the people in the system and its institutions. In the longer term, Shiller believes a thoroughgoing reform of the financial architecture is needed. In this new architecture, he thinks, the new insights of financial engineering and the new tools of information technology will play a key role, leading to a democratisation of finance. In other words, let’s have more of exactly the things that got us into the mess in the first place! This sounds uncomfortably like the unalloyed belief of free market fundamentalists that Shiller himself rejects. Cooper too sees a need for radical changes in the economic system, though of a very different nature. In particular, he believes central banks will have to fundamentally change their approach to a more symmetric treatment of upturns and downturns. He draws an analogy to an analysis of mechanical governors due to the 19th century giant of physics, James Clerk Maxwell, who proposed a design that led to continually decreasing oscillations. Similarly, he believes that Central Bank Governors should pursue policies that, while not able to avoid the inevitable oscillations predicted by the FIH, would at least lead to successively dampened swings. A corollary of this approach is that sometimes the Central Bank must encourage small busts to clear out the inefficiencies in order to avoid really massive bottomings such as today’s. Cooper also believes new concepts and tools will be needed for risk management, but very unorthodox ones, compared to Shiller. For instance, he believes Mandelbroit’s fractal models with memory deserve at least a look, and he suggests that
- one should try to develop better models that
- take feedback as a central mechanism, some-
- what echoing the reflexivity paradigm of George Soros.

Finally, for Turner, the key is of course to address the problems caused by globalisation. In particular, he believes there should be a better balance between the power of corporations and that of labour, so that the dividends of profit are shared more equitably with the latter. Thereby the hope is to move way from debt based to more sustainable economies. Just how this is going to be achieved is left unsaid. Indeed, if one follows his own data and analysis a bit further, it is clear that the problems of the system will not be easily resolved by cosmetic changes, for example, better regulation. Nor are stimulus packages going to be a panacea. In fact, Obama’s much-touted ‘new deal’ already seems still-born. If, as argued briefly above, this financial crisis is a result of deep-seated problems within the heart of the capitalist system, then a radical restructuring of the economic and political system must be part of any answer in the long term.

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