Crisis over? Time to look deeper

Last Monday, Nouriel Roubini, writing in the Financial Times, said there are now three open questions about the economic crisis: when will it end, what shape will it be, and are there risks of relapse? Clearly these are pertinent questions, but they reflect a general tendency for commentary to be framed in terms of a desired return to normal, a restoring of economic growth. The assumption that this is a ‘normal’ crisis, not much more than a really nasty lurch in business as usual, has meant that the reforms deployed so far have been relatively superficial, and possibly even counter-productive.

Obviously, an urgent response was necessary to rescue normal functioning. But now that this seems to have staved off the worst, this is the stage to be asking about neglected deeper aspects of the crisis. Particularly if they hint that this has been just a foreshock of something larger – meaning there are still things that must be mended to avoid a much worse crisis later.

The sense that deeper reforms might be needed also seems to have prompted Adair Turner, chairman of the UK’s FSA, to think out loud this week in Prospect magazine about the need for a Tobin tax. But as always it is tempting to reach for answers without spending enough time exploring what the question might be.

Is there more amiss with the global financial system than simply an excess of speculative activity, which a Tobin tax would aim to damp? Three deeper aspects come to mind:

First, where are the economic circuit-breakers? The 1933 Glass-Steagall Act in the US introduced the separation of investment and commercial banking. It was repealed in 1999, and since the onset of the financial crisis there have been many calls to revive it. But opponents argue that this would not be the simple panacea it might seem, and that the real problem lies in the hazy linkage between the banks and the shadow financial system where vast amounts of leverage can be created without regulatory oversight.

While the old definitional line may be obsolete, the principle still remains valid. If we fail to distinguish and separate the casino dimension of banking from critical social infrastructure such as the payment clearing system and the safety of deposits, we place the so-called ‘real economy’ – the everyday world of ordinary people – at unnecessary risk of cascading failures. Social well-being somehow needs to be insulated from the inherent oscillations of the market. It’s not that having a free speculative market is a bad idea, it’s just that the whole of society shouldn’t be hardwired to the outcome.

Second, is the playing field level? The current rules of the global financial system tolerate persistent trade imbalances. At the Bretton Woods Conference in 1944, J. M. Keynes, negotiating for the UK, attempted to persuade the US to accept a system that would penalize both creditor and debtor countries. He failed, and 65 years later the US is now the principal debtor, and the pernicious effects of international imbalances threaten the global economy. Do we now need a new Bretton Woods agreement, close to the one we might have had originally?

Put in simpler, and some might say more naïve terms, the underlying question here is about the overall fairness of the financial system. The US benefited for many decades from the post-Bretton Woods tilt of the international playing field, but this unfair advantage has blown back and inflicted a possibly fatal wound. As in all matters strategic, when a strength is overplayed it eventually turns into its own opposite.

This outcome is very similar to what is now recognized as the curse of oil, the counter-intuitive outcome that oil wealth leads to worse economic outcomes in the long term – unless specific protective institutions are put in place as in Norway. The wisdom we need is to realize that such unbalanced advantages cause moral erosion, and that if they endure at a global level, all societies will become less equal and ultimately worse off.

Thirdly, do we have the right money? Money is not something arbitrary and unchangeable. It is very much a human invention and several alternative designs are available. The money we have now, technically known as fiat money, is created by means of debt, which requires interest, which in turn demands economic growth. The expansion of debt creates bubbles and crises. The inevitability of interest drives inflation and undermines individual financial independence. The requirement for growth drives corporate excess and over-exploitation of the natural environment. If we really want to address these things at the root level, in the end we will need to change the design of our money system.

The solutions to these deeper issues are much harder than introducing a Tobin tax, which itself would meet stiff opposition. Changing the money system is virtually inconceivable as things stand. Yet as long as the financial basis of the world economy has deep design flaws the risk of catastrophic crisis remains.

We must not heave a sigh of relief too soon. The worst may appear to be over, but this may just be a breathing space. If so, now is the time to begin addressing the deeper issues to avoid something far worse next time.