:: Jayati Ghosh

Return of the Capitalist

Jayati Ghosh

Sept.15 : Exactly one year ago, the Wall Street investment bank Lehman 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 American International Group) were all extremely vulnerable, and short-selling by those betting against such institutions only hastened the likely denouement.

After the Lehman 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.

One 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 policymakers learned 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.