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
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.