Origins of the Great Recession
The collapse of Lehman Brothers five years ago exposed the rotten core of the west’s financial system, changing America, Ireland and the world
The defining event of our century thus far has been the failure of the West’s financial system. The consequences – budgetary, economic, political, social and geopolitical – continue to play out five years after that failure became fully apparent with the collapse of Lehman Brothers and the near implosion of the financial system. And they will continue to be felt for many years, if not decades to come.
The super-bubble that inflated in the developed world’s financial system and which burst half a decade ago was long in the making. By some measures, the financial services industry began to over-expand as long ago as the 1980s, after decades of being a relatively small and straightforward sector.
While Gordon Gecko types have always existed, the role played by aggressive speculators grew in the 1980s as investment banks moved away from providing big companies with financial advice and increasingly played the markets on their accounts.
Alongside the change in traditional Wall Street firms, a “shadow banking” system grew up in the 1990s which included new kinds of financial institutions, such as hedge funds. As memories of the financial collapse that led to the Great Depression of the 1930s faded, so too did the checks and balances imposed on the financial sector to protect the wider economy from out-of-control speculation. Many of the regulations of that era were repealed and the shadow banking system was left largely unrestrained.
The “financialisation” of western economies proceeded apace into the new century and, if anything, accelerated. As the rewards in finance rose over the decades relative to other professions, more and more of the brightest people in the world were drawn to it as a career.
Among other things, this allowed a belief to evolve that very sophisticated people, using very sophisticated financial models and selling very sophisticated products had removed, or greatly reduced, risk in the system.
The market for financial services, by this account, had become not only ultra-efficient, but very safe too.
The conventional wisdom turned out to be utterly wrong. The system the financiers had created was so complex that nobody fully understood it and, rather than being invulnerable to shocks, it had become ever more fragile.
As public and private debt levels underwent long-run increases in most western countries over decades, the entire system became increasingly vulnerable. That system, already teetering from the summer of 2007 when the first tremors had been felt, was hit by an earthquake exactly half a decade ago, when the largest default in world history took place. Lehman Brothers collapsed five years ago on Sunday. It owed $440 billion.
In the weeks that followed the Lehman collapse, the US and European financial systems slid towards meltdown, as the most intense financial panic since 1929 took hold. The tectonic plates of the rich world’s economy started shifting. So real and massive was the threat that governments began planning for the social disorder that would follow as even basic payments systems broke down (in developed economies banknotes and coins represent only around one per cent of the money supply, with the rest as mere entries on balance sheets).
By late October, the global financial system had begun to stabilise as a result of a series of unprecedented government interventions including bailouts, rescues, nationalisations and guarantees.
But it was too late to stop the shock spreading out to the real economy. And that happened with alarming rapidity. Consumer confidence collapsed and companies rushed to lay off workers in the hopes of surviving the upheaval.
Among the most immediate effects was a collapse in international trade on a scale and speed that had only one precedent – the Great Depression.
The parallel was brought home by a short academic paper that became one of the most-read scholarly essays in history. In April 2009, Irish economic historian Kevin O’Rourke and US co-author Barry Eichengreen published A Tale of Two Depressions. Within a week it had been read by 100,000 people.
The tsunami hits Europe
In the event, a repeat of the 1930s spiral was narrowly avoided. Most economies had pulled out of their nosedives by the middle of 2009. That said, the downturn was deep enough to be named the Great Recession. However, and as with other recessions caused by financial collapses, there was never going to be a quick recovery from the crash of 2008.
Double and triple dips have been the lot of many economies as they have struggled to recover. In the US, only recently has per capita GDP returned to 2008 levels and there are still almost 2.5 million fewer people at work than before the crash.
Some regions have suffered more than others. Many state governments, including the largest – California – are flirting with bankruptcy and have introduced swingeing austerity, including mass lay-offs of public sector workers.
If the crash had its origins and epicentre in the US, such is the interconnectedness of the financial system on either side of the Atlantic, the effects of Lehman’s collapse hit Europe like a tsunami.
For the continent as a single economy, it has been the worst five years since the first half of the 20th century. While some economies have fared better than others, more than a handful have experienced shocks of previously unthinkable proportions. Countries as diverse as Greece, Iceland, Ireland, Latvia, Portugal and Spain have suffered depressions, defined by economists as a contraction in output of 10 per cent or more.
Even now, signs of recovery are limited and not particularly strong, and economies where high levels of debt – private, public or both – are making the slowest progress.
The euro crisis
Among the most serious effects of the financial crisis was the revealing of the profound weaknesses of Europe’s single currency. European monetary union was created without a fiscal and banking union. Although these deficiencies were recognised when the edifice was being designed in the 1990s, the degree to which they weakened the entire structure was as underestimated as the fragilities of the west’s financial system.
When the latter failed and the tectonic plates of the global economy started shifting, the euro construct began to wobble. On many occasions since the euro crisis began, it has appeared as if single currency was on the brink of collapse.
Although there has now been a year of calm, the fundamental weaknesses remain and will have to be addressed. A form of banking union is currently being negotiated and more changes, including yet another change to the EU’s treaties, is very likely in order to make the single currency sustainable.
But questions remain over whether the political will exists to do whatever it takes to save the currency. It is still perfectly possible that a return of financial market panic could pull the euro apart.
The failure of the rich world’s financial system had inevitable knock-on effects for the rest of the world. The global collapse in international trade had the most immediate impact, causing a dip in exports from the developing world to Europe and the US.
Despite a rebound in trade from late 2009, the half-decade of weak growth in the euro-American economy has depressed exports from emerging markets, thereby making their rates of growth lower than they would otherwise have been.
A more insidious effect has been the impact of the experiments western central banks have conducted in the hope of restarting growth. The flood of cheap money has probably been the single most important factor in avoiding depression in the west, but it has created new bubbles in financial markets across the world, affecting everything from food and energy prices to currencies and government bonds.
The recent signalling by the US central bank that it would begin pulling back on its provision of cheap money has caused those bubbles to deflate, destabilising developing economies and causing fears of slump (or worse) in some of the big emerging markets.
Resentment towards the West, related to the spillover effects of unorthodox central bank actions, has further weakened its authority to take the lead on global economic management issues.
While Europe and the US together still account for half of the world economy, their dominance has been waning over decades, as developing countries have grown more rapidly. Over the past half-decade, the shift in economic power has accelerated as the West has stagnated and the rest collectively surged ahead.
The replacement since the collapse of Lehmans of the west-dominated G7 group of nations with the much broader G20 group is the most visible sign of shifting geopolitics. But it is not the only one. Europe’s integration project was once looked on a model for emulation elsewhere. How the rest of the world looks at it now, after the failures of the euro, has changed, probably forever.
Has the financial system been restructured and re-regulated sufficiently to ensure that a catastrophe of the magnitude suffered over the past half decade could never happen again?
The answer, very depressingly, is “No”. The always plain-speaking former chairman of America’s central bank, Paul Volker, put it bluntly about the US: “The regulatory landscape has been little changed”. He attributed this partly to the “ever-growing cadre of lobbyists equipped with the capacity to provide campaign financing”.
If the European law-making process is better insulated from lobbying by big finance, owing to much stricter rules on funding political parties and election campaigns, the industry retains massive and undue influence over the shaping of the regulatory framework and how rules are implemented.
But it is not only vested interests and inertia that have prevented a more profound restructuring and more aggressive reregulation of finance. Complexity has also worked against change. The truth is that nobody fully understands how the system works, making change more difficult.
Nothing quite illustrates how mainstream economics failed to understand the financial system than a 2005 public encounter between Raghuram Rajan, the man who has just become the governor of India’s central bank, and Larry Summers, the man who is in the running to take over at the helm of the US central bank.
Rajan was one of the few people in mainstream economics to raise questions about the stability of the financial system before the crash. At a meeting of central bankers in August 2005, he made points that would now be entirely uncontroversial. But Summers, reflecting the overwhelming consensus, dismissed Rajan’s concerns and called him a “Luddite”.
That Summers became a prominent member of the Obama administration and stands a good chance of becoming the most powerful central banker in the world is just one further indication that too little has changed in response to the crisis.
That said, the intellectual climate has altered considerably. Today, the notion that financial markets are self-correcting is held by only the most rigid ideologues. Market failure in finance is to be seen wherever one looks in the many nooks and crannies of the sector – from common or garden property bubbles, as Ireland has experienced, to complex derivitives products of the kind that almost brought down AIG, a giant US insurer, within days of the Lehman bankruptcy.
Given the huge size and enormous complexity of the sector, restructuring it and reregulating it will take time. Vested interests may ultimately prevail, leading eventually to an even bigger crash in the future. But the idea of perfectly efficient markets in finance is dead.
As the implications of that seep into the wider consciousness, how the industry evolves, and is allowed to evolve, may make it less dangerous for the wider economy. As John Maynard Keynes said, in the long run only ideas matter.