The last week has changed everything. A series of extraordinary events in the United States – from the collapse of Lehman Brothers to the forced sale of Merrill Lynch, from the state takeover of insurance giant AIG to the Federal Reserve’s emergency bailout plan – has transformed the crisis in the financial markets into an argument about the very foundations of the model of economic governance that rules the world.
For three decades the ship of global finance has been steered by the economics of globalisation – the flawed neo-liberal economics of the Chicago school. Their navigational charts for deregulation and liberalisation have led the global economy into a financial hurricane of unprecedented intensity. This crisis will prove immensely destructive – of the value of assets like property, of jobs, of pensions and investments, and of the hard-earned achievements of companies small and large, everywhere. Above all, the crisis will damage the lives and the futures of millions of blameless citizens, most of them poor.
Orthodox economists did not see the crisis coming, even as the financial hurricane hit land on what I have called “debtonation day“, 9 August 2007. They still do not understand it. They failed to warn their paymasters or the captains, crew and passengers of the finance-sector’s ships. Even now, their intellectual and policy maps offer no way forward.
This is because orthodox, neo-liberal economic theory pays little regard to the role of finance in the economy. Systemic insolvency is not permitted in the assumed world of orthodox economics. Very few members of the Chicago school have read Irving Fisher’s Booms and Depressions (1932); and if they have read John Maynard Keynes on the theory of money and interest, it was only to malign or marginalise his rationale for the regulation of finance. Instead, they lionised free-marketeer Milton Friedman, trenchant enemy of “big government”.
But in the single week of 14-20 September 2008, the public and even much of the media began to register the scale of the finance sector’s and governments’ intellectual and policy failure. No one – it seems – is fooled anymore. Free-marketers now embrace big government with a fervour that embarrasses socialists. Even more conservative voices in the establishment media have begun to challenge the flawed economics that they have for so long championed.
The world may be moving on its axis, but the change has not yet gone nearly far enough: for neo-liberal economists remain at the helm of the global economy, and continue to disseminate potent mis-diagnoses of what is happening. These economists include the world’s major central bankers and finance ministers. It is vital that their economics and their three principal delusions are challenged if the global economy is to be steered safely out of this all-consuming storm.
The first and most important of these delusions is the belief that banks and financial institutions are illiquid, when in fact they are insolvent. Systematic insolvency is, again, categorically excluded from world of orthodox economics. It was the failure of central-bank governors and finance ministers like Alistair Darling and Hank Paulson to acknowledge insolvency in the summer and autumn of 2007 that has prolonged and deepened the crisis. It is the failure to recognise insolvency now that lies behind the apparently endless, and ineffective flow of taxpayer-backed liquidity from central banks.
Second, central bankers are – thanks to their reverence for orthodox economic theory – allowing illusory inflationary pressures to justify keeping interest-rates high, and refusing to relax monetary policy. Despite a spike in oil and food prices, inflation is now falling. The deleveraging of asset prices (think of the fall in property prices) will force down a whole range of prices and if not checked, could lead to deflation. Deflation will be far more devastating to the population as a whole than mild inflation. The 1930s and Japan since 1990 are sobering precedents here. Central bankers must escape from the gridlock of orthodox economic theory and act now to check the downward, debt-deleveraging, deflationary spiral.
Third and most urgently, central bankers and finance ministers have to escape the constraints of orthodoxy – and think system-wide fixes not quick fixes. To ban a few short-selling speculators is but tinkering with a system that needs comprehensive overhaul.
What then should be done? Here are four steps.
First, a good place to start would be where Franklin D Roosevelt did in 1933 – by declaring a week-long bank holiday. The Federal Reserve, the Financial Services Authority (FSA) and the Bank of England could then take time and check the books of banks for well-hidden “toxic waste” – their massive undeclared liabilities, including more than $60 trillion of so-called “credit default swaps” (CDS). Only when regulators have a proper sense of the scale of the mess, can they take decisive and appropriate action. Right now they are sloshing buckets of our money about, unsure as to the whereabouts of the financial “weapons of mass destruction” that banks have concealed.
Second, there must be an end to “inflation targeting” – which is just a cover for keeping interest-rates high. High interest-rates are great for lenders/creditors, but a killer for debtors, and there are far more debtors in the economy than savers. If this financial crisis – and the planetary threat of climate change – are to be faced, there is a need for cheap (but not easy) money to help finance investment in energy security (for more on this theme, see the report I co-authored, A Green New Deal [new economics foundation, 2008]).
Third the Bank of England and the Fed should regain control over interest- rates – all rates. The interbank lending rate (the so-called Libor rate) should no longer be set by a closed committee of private bankers meeting daily at the British Bankers’ Association. Rates must be set by a committee accountable to society; and, when setting rates, it must consider the interests of all who make the economy work – labour and industry as well as finance.
Fourth, in order to again exercise control over all rates, the Bank of England will have to reintroduce capital controls. That might require a new international agreement, along the lines agreed at Bretton Woods in 1947.
All of this is doable as well as necessary. These are the initial system-wide fixes needed to deal with systemic threats; the public have every right to expect the guardians of the nation’s finances to implement them promptly.
If they are to do so, these guardians will need a new moral compass, new navigators and new helmsmen and women. But one thing that is not needed is a new navigation chart. That was provided by John Maynard Keynes in his The General Theory of Employment, Interest and Money (1936). Its ideas will today do just as well to restore the world to a period of stability as after the great depression of the 1930s. This was a period that Barry Eichengreen and Peter H Lindert (in The International Debt Crisis in Historical Perspective, MIT Press, 1991) described as “a golden era of tranquillity in international capital markets”.
To return to such a golden era, the money-lenders, speculators, and orthodox economists responsible for the gross failures exposed by the week that changed everything must stand aside – so that everything indeed can change, and for the better.