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Global Financial Crisis

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  • by Anup Shah
  • This Page Last Updated Sunday, March 24, 2020
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The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.

On the one hand many people are concerned that those responsible for the financial problems are the ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns.

This article provides an overview of the crisis with links for further, more detailed, coverage at the end.

On this page:

A crisis so severe, the world financial system is affected

Following a period of economic boom, a financial bubble—global in scope—has now burst.

A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail.

The scale of the crisis: trillions in taxpayer bailouts

The extent of the problems has been so severe that some of the world’s largest financial institutions have collapsed. Others have been bought out by their competition at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions.

The effect of this, the United Nation’s Conference on Trade and Development says in its Trade and Development Report 2008 is, as summarized by the Third World Network , that

the global economy is teetering on the brink of recession. The downturn after four years of relatively fast growth is due to a number of factors: the global fallout from the financial crisis in the United States, the bursting of the housing bubbles in the US and in other large economies, soaring commodity prices, increasingly restrictive monetary policies in a number of countries, and stock market volatility.

… the fallout from the collapse of the US mortgage market and the reversal of the housing boom in various important countries has turned out to be more profound and persistent than expected in 2007 and beginning of 2008. As more and more evidence is gathered and as the lag effects are showing up, we are seeing more and more countries around the world being affected by this rather profound and persistent negative effects from the reversal of housing booms in various countries.

A crisis so severe, those responsible are bailed out

Some of the bail-outs have also been accompanied with charges of hypocrisy due to the appearance of socializing the costs while privatizing the profits. The bail-outs appear to help the financial institutions that got into trouble (many of whom pushed for the kind of lax policies that allowed this to happen in the first place).

Some governments have moved to make it harder to manipulate the markets by shorting during the financial crisis blaming them for worsening an already bad situation.

(It should be noted that during the debilitating Asian financial crisis in the late 1990s, Asian nations affected by short-selling complained, without success that currency speculators—operating through hedge funds or through the currency operations of commercial banks and other financial institutions—were attacking their currencies through short selling and in doing so, bringing the rates of the local currencies far below their real economic levels. However, when they complained to the Western governments and International Monetary Fund (IMF), they dismissed the claims of the Asian governments, blaming it on their own economic mismanagement instead.)

Other governments have moved to try and reassure investors and savers that their money is safe. In a number of European countries, for example, governments have tried to increase or fully guarantee depositors’ savings. In other cases, banks have been nationalized (socializing profits as well as costs, potentially.)

In the meanwhile, smaller businesses and poorer people rarely have such options for bail out and rescue when they find themselves in crisis.

There seems to be little sympathy—and even growing resentment—for workers in the financial sector, as they are seen as having gambled with other people’s money, and hence lives, while getting fat bonuses and pay rises for it in the past. Although in raw dollar terms the huge pay rises and bonuses are small compared to the magnitude of the problem, the encouragement such practices have given in the past, as well as the type of culture it creates, is what has angered so many people.

Side note on those taking on risky loans in the subprime market

In the case of subprime mortgages, it is also argued that those who took on the risky loans are to blame; they should not have borrowed so much money when they knew they would not have the means to repay. While there is truth to this, and our culture of expecting easy money, consuming beyond our means, etc is something that needs urgent attention, in the case of subprime mortgages, it seems easy to forget the predicament of people living in relative poverty. Financial advisors that irresponsibly pushed these loans (with no interest or care of the borrower in mind) were generally aggressive as they had a lot to gain from these loans.

For people living in poverty even in wealthy countries life can be desperate and miserable. Concerns will range from crime in the neighborhood, to good schooling, to getting by week by week on very little, and ensuring a job lasts. The hope of being able to escape it for a while was, in effect, exploited. When in poverty, long term thinking is not always going to enter the realm of immediate concern.

Furthermore, it is likely that those lower down the social strata are not going to be as financially savvy as those further up. Hence there is usually more trust placed in a bank or financial advisor. It is often forgotten these days that banks and financial institutions have changed in nature; there is less concern about the people they serve, but more about how they can sell products from which they can make profit.

To some extent risky borrowers bear some responsibility, but overall they have lost out; lenders are being bailed out, while those taking out risky loans either have lost their homes, or face a real threat of losing their home in the near future.

A crisis so severe, the rest suffer too

Because of the critical role banks play in the current market system, when the larger banks show signs of crisis, it is not just the wealthy that suffer, but potentially everyone. With a globalized system, a credit crunch can ripple through the entire (real) economy very quickly turning a global financial crisis into a global economic crisis.

For example, an entire banking system that lacks confidence in lending as it faces massive losses will try to shore up reserves and may reduce access to credit, or make it more difficult and expensive to obtain.

In the wider economy, this credit crunch and higher costs of borrowing will affect many sectors, leading to job cuts. People may find their mortgages harder to pay, or remortgaging could become expensive. For any recent home buyers, the value of their homes are likely to fall in value leaving them in negative equity. As people cut back on consumption to try and weather this economic storm, more businesses will struggle to survive leading to further further job losses.

As the above has played out, the situation has been bad enough that the International Labor Organization (ILO) has described this crisis as a global job crisis.

And so, many nations, whether wealthy and industrialized, or poor and developing, are sliding into recession if they are not already there.

The financial crisis and wealthy countries

Many blame the greed of Wall Street for causing the problem in the first place because it is in the US that the most influential banks, institutions and ideologues that pushed for the policies that caused the problems are found.

The crisis became so severe that after the failure and buyouts of major institutions, the Bush Administration offered a $700 billion bailout plan for the US financial system.

This bailout package was controversial because it was unpopular with the public, seen as a bailout for the culprits while the ordinary person would be left to pay for their folly. The US House of Representatives initial rejected the package as a result, sending shock waves around the world.

It took a second attempt to pass the plan, but with add-ons to the bill to get the additional congressmen and women to accept the plan.

However, as former Nobel prize winner for Economics, former Chief Economist of the World Bank and university professor at Columbia University, Joseph Stiglitz, argued, the plan remains a very bad bill:

I think it remains a very bad bill. It is a disappointment, but not a surprise, that the administration came up with a bill that is again based on trickle-down economics. You throw enough money at Wall Street, and some of it will trickle down to the rest of the economy. It’s like a patient suffering from giving a massive blood transfusion while there’s internal bleeding; it doesn’t do anything about the basic source of the hemorrhaging, the foreclosure problem. But that having been said, it is better than doing nothing, and hopefully after the election, we can repair the very many mistakes in it.

Writing in The Guardian , Stiglitz also added that,

Americans have lost faith not only in the [Bush] administration, but in its economic philosophy: a new corporate welfarism masquerading behind free-market ideology; another version of trickle-down economics, where the hundreds of billions to Wall Street that caused the problem were supposed to somehow trickle down to help ordinary Americans. Trickle-down hasn’t been working well in America over the past eight years.

The very assumption that the rescue plan has to help is suspect. After all, the IMF and US treasury bail-outs for Wall Street 10 years ago in Korea, Thailand, Indonesia, Brazil, Russia and Argentina didn’t work for those countries, although it did enable Wall Street to get back most of its money. The taxpayers in these other poor countries picked up the tab for the financial markets’ mistakes. This time, it is American taxpayers who are being asked to pick up the tab. And that’s the difference. For all the rhetoric about democracy and good governance, the citizens in those countries didn’t really get a chance to vote on the bail-outs.

In environmental economics, there is a basic concept called the polluter pays principle. It is a matter of fairness, but also of efficiency. Wall Street has polluted our economy with toxic mortgages. It should now pay for the cleanup.

A crisis signaling the decline of US’s superpower status?

Even before this global financial crisis took hold, some commentators were writing that the US was in decline, evidenced by its challenges in Iraq and Afghanistan, and its declining image in Europe, Asia and elsewhere.

The BBC also asked if the US’s superpower status was shaken by this financial crisis:

The financial crisis is likely to diminish the status of the United States as the world’s only superpower. On the practical level, the US is already stretched militarily, in Afghanistan and Iraq, and is now stretched financially. On the philosophical level, it will be harder for it to argue in favor of its free market ideas, if its own markets have collapsed.

… Some see this as a pivotal moment.

The political philosopher John Gray, who recently retired as a professor at the London School of Economics, wrote in the London paper The Observer: “Here is a historic geopolitical shift, in which the balance of power in the world is being altered irrevocably.

The era of American global leadership, reaching back to the Second World War, is over… The American free-market creed has self-destructed while countries that retained overall control of markets have been vindicated.

… How symbolic that Chinese astronauts take a spacewalk while the US Treasury Secretary is on his knees.

Yet, others argue that it may be too early to write of the US:

The director of a leading British think-tank Chatham House, Dr Robin Niblett … argues that we should wait a bit before coming to a judgment and that structurally the United States is still strong.

America is still immensely attractive to skilled immigrants and is still capable of producing a Microsoft or a Google, he went on. “Even its debt can be overcome. It has enormous resilience economically at a local and entrepreneurial level.

“And one must ask, decline relative to who? China is in a desperate race for growth to feed its population and avert unrest in 15 to 20 years. Russia is not exactly a paper tiger but it is stretching its own limits with a new strategy built on a flimsy base. India has huge internal contradictions. Europe has usually proved unable to jump out of the doldrums as dynamically as the US.

But the US must regain its financial footing and the extent to which it does so will also determine its military capacity. If it has less money, it will have fewer forces.

Europe and the financial crisis

In Europe, a number of major financial institutions failed. Others needed rescuing.

A number of European countries have attempted different measures (as they seemed to have failed to come up with a united response).

For example, some nations have stepped in to nationalize or in some way attempt to provide assurance for people. This may include guaranteeing 100% of people’s savings or helping broker deals between large banks to ensure there isn’t a failure.

Structural Adjustment for Industrialized Nations

The financial crisis and the developing world

For the developing world, the rise in food prices as well as the knock-on effects from the financial instability and uncertainty in industrialized nations are having a compounding effect. High fuel costs, soaring commodity prices together with fears of global recession are worrying many developing country analysts.

Summarizing a United Nations Conference on Trade and Development report, the Third World Network notes the impacts the crisis could have around the world, especially on developing countries that are dependent on commodities for import or export:

Uncertainty and instability in international financial, currency and commodity markets, coupled with doubts about the direction of monetary policy in some major developed countries, are contributing to a gloomy outlook for the world economy and could present considerable risks for the developing world, the UN Conference on Trade and Development (UNCTAD) said Thursday.

… Commodity-dependent economies are exposed to considerable external shocks stemming from price booms and busts in international commodity markets.

Market liberalization and privatization in the commodity sector have not resulted in greater stability of international commodity prices. There is widespread dissatisfaction with the outcomes of unregulated financial and commodity markets, which fail to transmit reliable price signals for commodity producers. In recent years, the global economic policy environment seems to have become more favorable to fresh thinking about the need for multilateral actions against the negative impacts of large commodity price fluctuations on development and macroeconomic stability in the world economy.

Asia and the financial crisis

Countries in Asia are increasingly worried about what is happening in the West. A number of nations urged the US to provide meaningful assurances and bailout packages for the US economy, as that would have a knock-on effect of reassuring foreign investors and helping ease concerns in other parts of the world.

Many believed Asia was sufficiently decoupled from the Western financial systems. Asia has not had a subprime mortgage crisis like many nations in the West have, for example. Many Asian nations have witnessed rapid growth and wealth creation in recent years. This lead to enormous investment in Western countries. In addition, there was increased foreign investment in Asia, mostly from the West.

However, this crisis has shown that in an increasingly inter-connected world means there are always knock-on effects and as a result, Asia has had more exposure to problems stemming from the West. Many Asian countries have seen their stock markets suffer and currency values going on a downward trend. Asian products and services are also global, and a slowdown in wealthy countries means increased chances of a slowdown in Asia and the risk of job losses and associated problems such as social unrest.

Africa and the financial crisis

Perhaps ironically, Africa’s generally weak integration with the rest of the global economy may mean that many African countries will not be affected from the crisis, at least not initially, as suggested by Reuters in September 2008.

The wealthier ones who do have some exposure to the rest of the world, however, may face some problems.

In recent years, there has been more interest in Africa from Asian countries such as China. As the financial crisis is hitting the Western nations the hardest, Africa may yet enjoy increased trade for a while.

In the long run, it can be expected that foreign investment in Africa will reduce as the credit squeeze takes hold. Furthermore, foreign aid, which is important for a number of African countries, is likely to diminish. (Effectiveness of aid is a separate issue which the previous link details.)

Latin America and the financial crisis

Much of Latin America depends on trade with the United States (which absorbs half of Latin America’s exports, alone, for example). As such Latin America will also feel the effect of the US financial crisis and slower growth in Latin America is expected.

Due to its proximity to the US and its close relationship via the NAFTA and other agreements, Mexico is expected to have one of the lowest growth rates for the region next year at 1.9%, compared to a downgraded forecast of 3% for the rest of the region.

A number of countries in the region have come together in the form of the Latin American Pacific Arc and are hoping to improve trade and investment with Asia. Diversifying in this way might be good for the region and help provide some stability against future crises. For the moment, the integration is going ahead, despite concerns about the financial crisis.

A crisis in context

While much mainstream media attention is on the details of the financial crisis, and some of its causes, it also needs to be put into context (though not diminishing its severity).

A crisis of poverty for much of humanity

Image: Deep Sea slum in Kenya. (© Amnesty International)

In poorer countries, poverty is not always the fault of the individual alone, but a combination of personal, regional, national, and—importantly—international influences. There is little in the way of bail out for these people, many of whom are not to blame for their own predicament, unlike with the financial crisis.

There are some grand strategies to try and address global poverty, such as the UN Millennium Development Goals, but these are not only lofty ideals and under threat from the effects of the financial crisis (which would reduce funds available for the goals), but they only aim to halve poverty and other problems. While this of course is better than nothing it signifies that many leading nations have not had the political will to go further and aim for more ambitious targets, but are willing to find far more to save their own banks, for example.

A global food crisis affecting the poorest the most

While the media’s attention is on the global financial crisis (which predominantly affects the wealthy and middle classes), the effects of the global food crisis (which predominantly affects the poorer and working classes) seems to have fallen off the radar.

The two are in fact inter-related issues, both have their causes rooted in the fundamental problems associated with a neoliberal, one-size-fits-all, economic agenda imposed on virtually the entire world.

Poor nations will get less financing for development

The poorer countries do get foreign aid from richer nations, but it cannot be expected that current levels of aid (low as they actually are) can be maintained as donor nations themselves go through financial crisis. As such the Millennium Development Goals to address many concerns such as halving poverty and hunger around the world, will be affected.

Odious third world debt has remained for decades; Banks and military get money easily

Crippling third world debt has been hampering development of the developing countries for decades. These debts are small in comparison to the bailout the US alone was prepared to give its banks, but enormous for the poor countries that bear those burdens, having affected many millions of lives for many, many years.

Many of these debts were incurred not just by irresponsible government borrowers (such as corrupt third world dictators, many of whom had come to power with Western backing and support), but irresponsible lending (also a moral hazard) from Western banks and institutions they heavily influenced, such as the IMF and World Bank.

Despite enormous protest and public pressure for odious debt relief or write-off, hardly any has occurred, and when it does grand promises of debt relief for poor countries often turn out to be exaggerated. One recently described historic breakthrough debt relief was announced as a $40 billion debt write-off but turned out to be closer to $17 billion in real terms. To achieve even this amount required much campaigning and pressuring of the mainstream media to cover these issues.

By contrast, the $700 billion US bail out as well as bailouts by other rich country governments were very quick to put in place. The money then seemed easy to find. Talk of increasing health or education budgets in rich countries typically meets resistance. Massive military spending, or now, financial sector bail out, however, can be done extremely quickly.

And, a common view in many countries seems to be how financial sector leaders get away with it. For example, a hungry person stealing bread is likely to get thrown into jail. A financial sector leader, or an ideologue pushing for policies that are going to lead to corruption or weaknesses like this, face almost no such consequence for their action other than resigning from their jobs and perhaps public humiliation for a while.

A crisis that need not have happened

This problem could have been averted (in theory) as people had been pointing to these issues for decades. Yet, of course, during periods of boom no-one (let alone the financial institutions and their supporting ideologues and politicians largely believed to be responsible for the bulk of the problems) would want to hear of caution and even thoughts of the kind of regulation that many are now advocating. To suggest anything would be anti-capitalism or socialism or some other label that could effectively shut up even the most prominent of economists raising concerns.

Of course, the irony that those same institutions would now themselves agree that those anti-capitalist regulations are required is of course barely noted. Such options now being considered are not anti-capitalist. However, they could be described as more regulatory or managed rather than completely free or laissez faire capitalism, which critics of regulation have often preferred. But a regulatory capitalist economy is very different to a state-based command economy, the style of which the Soviet Union was known for. The points is that there are various forms of capitalism, not just the black-and-white capitalism and communism. And at the same time, the most extreme forms of capitalism can also lead to the bigger bubbles and the bigger busts.

Quoting Stiglitz again, he captures the sentiments of a number of people:

We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures — yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail.

America’s financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing … and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system … were exported to the rest of the world.

However, this crisis wasted almost a generation of talent:

It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America’s best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system. Unfortunately, they were far too successful, and we are all — homeowners, workers, investors, taxpayers — paying the price.

Each of these measures should no doubt come under scrutiny from opposition parties and the media, to ensure they are appropriate, but some, such as tax hikes during good times can be so politically sensitive, that governments may be afraid to make such choices, thus making economic policies during bad times even riskier as a result.

Even then, the severity of these economic problems means that these strategies are not guaranteed to work, or it may take even longer to take effect. For example, as quarterly figures for various companies start to come out, more and more companies are announcing losses, closures, layoffs or other problems; people are becoming very nervous about the economy and spending less.

The automobile industry in the US, for example, is feeling immense pressure with some of the largest companies in the world facing huge problems and are asking the government for some kind of bailout or assistance. Yet, the US public generally seems against this, having already bailed out the banks with enormous sums of money. If the automobile industry is bailed out, then other industries will all cry for more money; when would it stop?

In addition, as Joseph Stiglitz warns, some nations are turning to the IMF which is prescribing the opposite policies:

Many are already turning to the International Monetary Fund (IMF) for help. The worry is that, at least in some cases, the IMF will go back to its old failed recipes: fiscal and monetary contraction, which would only increase global inequities. While developed countries engage in stabilizing countercyclical policies, developing countries would be forced into destabilizing policies, driving away capital when they need it most.

In Iceland, where the economy was very dependent on the finance sector, economic problems have hit them hard. The banking system virtually collapsed and the government had to borrow from the IMF and other neighbors to try and rescue the economy. However, Iceland has raised its interest rates to some 18%, partly on advice from the IMF. It would appear to be an example where high interest rates may be inappropriate. The economic problems have led to political challenges including protests and clashes.

It may be that this time round a more fundamental set of measures need to be considered, possibly global in scope. The very core of the global financial system is something many are now turning their attention to.

Reforming the Bretton Woods Institutions (IMF and World Bank)?

The Bretton Woods system of international finance devised by 44 nations after the Second World War, mostly represented by the IMF, World Bank, was designed to help reconstruct and stabilize a post-war global economy.

In the 70s, the purpose of these international financial institutions (IFIs) shifted towards a neoliberal economic agenda, championed by Washington, (also known as the Washington Consensus).

It was at this time that policies such as structural adjustment started to be pushed to much of the developing world, following a one size fits all prescription of how economies should be structured, which had disastrous consequences for much of the world’s population.

As journalist John Vandaele writes,

From then on the Bretton Woods Institutions (BWIs) were very asymmetrical organisations. The rich countries didn’t need the BWIs any more, but with more than 60 percent of the vote they called the shots in both institutions. Developing countries really depended upon the BWIs, but didn’t have a lot to say there.

And so the BWIs developed into an instrument of western power.

The same policy prescriptions led to predictable problems such as

  • Developing countries opening markets before they were really ready to do so (something often forced through by gun-boat diplomacy during colonial times)
  • Rich countries became judge and party, as Vandaele puts it: When they forced developing countries to open their markets, it was no coincidence that western multinationals tended to be among the first beneficiaries.
  • Worsening poverty from things like structural adjustment policies that sapped the ability of poor country governments to make decisions about how their economies would be run.

Although such institutions have rarely been held accountable for such policies and their effects, for many years, people have been calling for their reform, or even for their abolition. Lack of transparency in these institutions has not helped.

There have been signs of discontent, however.

As mentioned on the structural adjustment page on this site, the IMF and World Bank have even admitted their policies have not always worked. For example, back in 2003, they warned that developing countries face an increasing risk of financial crisis with increasing globalization because effects in one part of the world can more easily ripple through an inter-connected world. Financial integration should be approached cautiously, they warned. In addition, they admitted that it was hard to provide a clear road-map on how this should be achieved, and instead it should be done on a case by case basis.

While former chief economist for the World Bank, Joseph Stiglitz is now a well-known critic of the IMF/Washington Consensus ideological fanaticism, as also mentioned on that previous page, others at the IMF have also started to question things, noting that developing countries have not benefited from following these ideologies so rigorously.

Fast forward a few years to this financial crisis and there are more calls for reform of the global financial system, perhaps with a difference: the crisis now seems to be so deep and affecting rich countries as well that even some rich countries that benefited from the inequality structured into the global order are now calling for reform. In addition, although developing countries had called for reform many times before, they now have a slightly stronger voice that in the past.

People within the IMF/World Bank are now themselves publicly entertaining the thought of reform. The World Bank’s own president, Robert Zoellick has said the idea of the G7 is not working and that a steering group of more nations would be better.

With the limited role the IFIs have played in this crisis, until recently, it seems their significance may be dwindling. Fewer countries have turned to them as last resort, and when they have, they have been able to push for far less stringent conditions than in the past. Some countries have looked to other countries like China, Russia and Arab countries, first.

French President and head of the EU presidency, Nicolas Sarkozy has called for major changes to the IMF and World Bank. Yet, as John Vandaele added This is as much a rescue operation for two organisations that have lost muscle as a call for a new financial architecture.

Sarkozy’s ideas include tighter supervision of the international banking system and a crackdown on international tax havens to address harmful tax competition between states. These and other proposals are not new however, as many have called for this—and more—in the past 2 or 3 decades.

As Vandaele also adds, if Sarkozy is serious about a Bretton Woods II, he’d better keep in mind that developing countries want more voice. Governance issues such as better representation, more transparency and accountability are some of the things these institutions have long tried to promote, but often faced charges of hypocrisy as these institutions lack many of these fundamentals.

Reform and Resistance

Will any of these changes occur in an effective way? In recent months these institutions have warmed to changes in these areas. For example, in April 2008, it was decided that rich countries at the IMF would give in 3 percent of the votes; 2 percent went to emerging countries and 1 percent to other developing countries. However, this is still not that much and this crisis shows that more is needed in a more deeper and meaningful way.

This will be hard to predict. If history is any indicator, power and greed politics always ruin good ideas. Those who benefit from a system are less likely to be receptive to change, or want to steer change in a direction that will be good for them, but that may not mean good for everyone.

And tensions, even amongst the more powerful nations are already showing. For example, the US has not invited Spain to a financial crisis summit for mid-November. As the world’s eight largest economy and home to 2 of the world’s top 16 banks, a meeting of the G20 (G7 plus some developing nations) sees Spain (the world’s 8th largest economy) missing out of either classification. Spain, however, sees this as US retaliation for the country withdrawing its troops from Iraq. It has full EU support for being present at this meeting as well as support from a number of Latin American countries. Like France, it wants to see in-depth reform of the global financial system and focuses on IMF reform as well as giving more representation to emerging nations.

Reform of the IMF and World Bank, however, will be crucial for much of the world. Whether that actually happens and to what extent those with power are willing to truly share power is something that we will find out in the course of the next year.

The promise of rearchitecting the global financial system more fundamentally seemed to wither away slightly. As the Bretton Woods Project noted, the G20 had little time to effect much and could not do it alone, any way:

G20 governments, swept off their feet by the financial crisis, were never going to be able to reach a consensus on deeper reforms within the few weeks taken to prepare the summit. Critics argue that the G20 can never tackle this agenda alone.

As Miguel D’Escoto, president of the UN General Assembly said: Only full participation within a truly representative framework will restore the confidence of citizens in our governments and financial institutions. He continued, Solutions must involve all countries in a democratic process.

Rich countries resist meaningful reform

More generally, as Vandaele also finds,

The most powerful international institutions tend to have the worst democratic credentials: the power distribution among countries is more unequal, and the transparency, and hence democratic control, is worse.

Yet, although history often shows that those with agendas of power tend to win out, history also shows us that power shifts. A financial crisis of this proportion may signify the beginnings of such a shift.

And so, it is perhaps only at a time of crisis that more fundamental rethinking of the entire economic system can be entertained.

Rethinking economics?

During periods of boom, people do not want to hear of criticisms of the forms of economics they benefit from, especially when it brings immense wealth and power, regardless of whether it is good for everyone or not.

It may be that during periods of crisis such as now, the time comes to rethink economics in some way. Even mainstream media, usually quite supportive of the dominant neoliberal economic ideology entertains thoughts that economic policies and ideas need rethinking.

Stephen Marglin, Rethinking Economics, May 21, 2007, © Big Picture TV

Harvard professor of economics, Stephen Marglin, for example, notes how throughout recent decades, the political spectrum and thinking on economics has narrowed, limiting the ideas and policy options available.

Some have been writing for many years that while the current economic ideology is flawed, it only needs minor tweaking to correct it and make it work for everyone; a more compassionate capitalism, but capitalism nonetheless. Others argue that capitalism is so flawed it needs complete doing away with. Others may yet argue that the bailouts by large government will distort the markets even more (encouraging bad practices by the big institutions) and rather than more regulation, an even freer form of capitalism is needed.

What is hoped is that fruitful debate will increase in the mainstream.

This will also attract ideologues of different shades, leading to both wider discussion but also more entrenched views. Those with power and money are less likely to agree to a radical change in economics where their power and influence are going to diminish, and will be able to lobby governments, produce compelling ads and do whatever it takes to maintain options that ensure they benefit.

It is perhaps ironic to quote, at length, a warning from Adam Smith, given he is held up as the leading figure of the economic ideology they promote:

Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their good both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.

Merchants and master manufacturers are … the two classes of people who commonly employ the largest capitals, and who by their wealth draw to themselves the greatest share of the public consideration. As during their whole lives they are engaged in plans and projects, they have frequently more acuteness of understanding than the greater part of country gentlemen. As their thoughts, however, are commonly exercised rather about the interest of their own particular branch of business, than about that of the society, their judgment, even when given with the greatest candour (which it has not been upon every occasion) is much more to be depended upon with regard to the former of those two objects than with regard to the latter.

Their superiority over the country gentleman is not so much in their knowledge of the public interest, as in their having a better knowledge of their own interest than he has of his.

It is by this superior knowledge of their own interest that they have frequently imposed upon his generosity, and persuaded him to give up both his own interest and that of the public, from a very simple but honest conviction that their interest, and not his, was the interest of the public.

The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers.

To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.

The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

With the mainstream media often representing such entrenched interests, true democratic participation will be very critical.

More information

A lot will be written about this crisis as more will certainly unfold. Here are some starting points to read more:

From the mainstream media:

The above are just small examples, and they will link to yet more resources for further information.

The Global Financial Crisis and The Role of Monetary Policy

Speech by Jürgen Stark, Member of the Executive Board of the ECB
at the 13th Annual Emerging Markets Conference 2020

Washington, 24 September 2020

Ladies and gentlemen, I am very pleased to address this distinguished audience.

Looking back over time, we see that the role and conduct of monetary policy has often changed in response to economic and financial crises. In fact, the international central banking community has always been eager to learn from past developments and experiences, also with respect to different experiences across countries. Of course, this does not imply that monetary policy in the past has always been the same everywhere. Certainly, differences exist in the way monetary policy is conducted across countries. But it is precisely because of the open-mindedness in discussing and the willingness to learn from each others’ experiences during the past century that monetary policy making went through an evolutionary process: an evolutionary process that improved the conduct of monetary policy over time and led to a great deal of convergence across countries.

Let me in my remarks briefly review this process. I will then discuss the specific lessons that we can learn from the recent episode of financial and economic turbulence, and conclude with the challenges ahead not only for monetary policy, but also for economic policies more generally.

It was in response to the major bank panics of the first half of the nineteenth century that the Bank of England adopted the “responsibility doctrine” proposed by Walter Bagehot. [1] This required the Bank to lend freely on the basis of any sound collateral, but at a penalty rate to prevent moral hazard. Half a century later, the Federal Reserve System was established in the United States in response to frequent banking crises, in particular the crisis of 1907, to serve as a lender of last resort similar to the Bank of England.

Under the gold standard gold convertibility served as the economy’s nominal anchor and was used as a way to ensure trust in a currency. Before the establishment of central banks, private banks and governments issuing banknotes had often overextended their gold reserves. In a sense, early central banks were strongly committed to price stability. However, from the 1920s onwards many central banks fell under public control. The Great Depression led to a major reaction against central banks, which were accused of exacerbating the crisis. In virtually every country, monetary policy was placed under the control of the Treasury and fiscal policy became dominant. In many countries, central banks followed a low interest rate policy to both stimulate the economy and to help the Treasury in marketing its debt.

In the 1950s independent monetary policy making by central banks was restored, and this was accompanied by a brief period of price stability until the mid 1960s. The belief that unemployment could be permanently reduced at the expense of higher inflation resulted in very accommodative monetary policy in the 1970s, which led to an increase in inflation as inflation expectations started to rise. Only a few countries, such as Germany, were an exception to this rule, as the Bundesbanks’s emphasis on monetary aggregates resulted in a much tighter monetary policy. By the end of the 1970s, central banks put renewed emphasis on credibility and started to tighten monetary policy so that inflation decreased significantly. In many countries central banks were granted independence and were given a mandate to keep inflation low. As a result, stable prices have become a fact of life for billions of people.

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Today we are experiencing the worst economic and financial crisis of the post-war period. I am convinced that the knowledge gained as a result will again change and further sharpen the way we conduct monetary policy. So let me now share with you some thoughts on the direction in which I expect – and hope – monetary policy thinking to change in response to the current crisis.
The role of monetary policy and lessons from the financial crisis

I think it is fair to say that there was a widespread consensus over some key elements of the pre-crisis monetary policy paradigm. [2] In particular, against the background of the high inflation experience of the 1970s in many industrialised countries, the central bank consensus comprised three key elements:

Central bank independence as a corner stone for an effective monetary policy;

Price stability as the primary objective of central banks; and

Solidly anchored inflation expectations on the basis of transparent communication.

In addition, not least against the background of the “Great Moderation”, that is, the period of low inflation and macroeconomic stability in most industrialised countries which was observed during the 20 years before the crisis, the central bank consensus also emphasised three elements, to which the ECB has never subscribed. These are:

Monetary policy has a primary role in the management of aggregate demand in the short-run;

Money and credit indicators can be disregarded;

Monetary policy should react to asset price busts; not to asset price booms.

Let me discuss how I see these elements from today’s perspective, particularly in the context of the recent experience of the global financial and economic crisis, and draw conclusions with regard to the usefulness of these elements for the future conduct of monetary policy.

Let me start with my general conclusion: In my view, the first three elements have proven to be very valuable assets during the crisis and I view them as absolutely essential to the success of monetary policy. The latter three elements of this consensus should be seriously reconsidered. I think the crisis has made a convincing case for a more medium term orientation of monetary policy, which takes into account information in money and credit indicators, and which tries to lean against the wind as financial imbalances start to develop and pose risks to price stability in the medium term.

Let me now elaborate on the above elements and draw some conclusions:

Firstly, the crisis has – in my view – crucially underlined the importance of central bank independence as a corner stone of credible and effective monetary policy making. Of course, central bank independence is a precondition of effective monetary policy at all times. It is an important lesson which is not only evidenced by events in the history of central banking, but also by the academic literature, that any blurring of responsibilities can potentially lead to a loss of credibility for the central bank. Such a situation would ultimately undermine the effectiveness of monetary policy. [3] The effectiveness of monetary policy on the basis of institutional and operational independence was, however, fundamental during the crisis. During the turbulent market conditions that we experienced central banks had to implement extraordinary measures, both in terms of reducing policy rates to levels that are unprecedented, and in terms of unconventional liquidity measures. If these measures – untested as they are – are to be expected to exert any impact on economic decisions, they have to be seen by market participants as the result of an autonomous decision by the central bank. They have to be seen as consistent with its overall policy framework, rather than as the result of pressures from fiscal authorities. The reason is simple. If a central bank comes under pressure in times of crisis, and succumbs to that pressure, it is very unlikely to exit from such extraordinary measures in a timely manner. This may unanchor inflation expectations and thus undermine the effectiveness of the measures implemented during the crisis.

Secondly, regarding the objective of price stability and the anchoring of inflation expectations, the crisis taught us that well-anchored inflation expectations can act as an automatic stabiliser when uncertainty becomes destabilising. This is always true, in good times as well. In fact, well-anchored inflation expectations in the euro area were instrumental in avoiding large interest rate hikes before the crisis, when commodity prices rose sharply. At the height of the crisis, they became a policy instrument in their own right. Thanks to well-anchored inflation expectations we could avoid deflationary spirals and real interest rates could be reduced in tandem with nominal rates. It is noteworthy that if inflation expectations are well anchored, and are not affected by transient shocks to actual inflation, there is no need to manipulate monetary policy frameworks: there is no need to increase the inflation target as a means of resisting deflationary risks in times of macroeconomic distress. [4] Opportunistic manipulations of the monetary policy framework of course damage the foundations on which that framework rests. So, being able to rely on the stabilising effect of inflation expectations is clearly a preferable option.

Let me now turn to the elements of the consensus that are, from the perspective of the ECB, somewhat more controversial.

Firstly, the crisis has demonstrated that a monetary policy aimed at fine-tuning short-term objectives carries serious risks. Before the crisis, there was a widely-held conviction that monetary policy could focus more on short term demand management because inflation was firmly under control. Proponents of this view found support in the phenomenon of the “Great Moderation” observed in the twenty years before the crisis, a time of widespread macroeconomic stability and low inflation in most industrialised countries. Nonetheless, there were clear signs – and also warnings – that this short-term orientation could have negative side effects in the medium to long term. [5] As you know, these side effects manifested themselves in a spectacular build-up of monetary and financial imbalances. Although monetary policy frameworks oriented towards the medium term could probably not have completely prevented the current crisis, I am convinced that they would have helped to make it less disruptive.

Typically, policies of short-term demand management rely heavily on inflation forecasts and output gap measures. Experience, especially prior to the crisis, has revealed the risks of constructing policy on indicators and variables which are not sufficiently robust. Let me take the output gap as an example. As the literature has clearly shown, the empirical proxies used to capture the output gap are subject to constant revisions. [6] Policy-makers who base their decisions mainly on such assessments of the cyclical position can be led very much astray. For instance, The Great Inflation of the 1970s occurred, to a large extent, due to measurement errors in the real-time estimates of the output gap combined with an overreaction to output gap measures when assessing the state of the economy. [7] Arguably, the same can be said of the low interest rates implemented for a prolonged period in the middle of the previous decade. [8]

Monetary policies aimed at fine-tuning short-term objectives also run a serious risk of inducing too much policy forbearance for too long. Exiting an extraordinary accommodative mode too late can sow the seeds of future imbalances. As the economy recovers from an exceptionally deep recession, real time output gap estimates and estimates of structural unemployment or the non-accelerating inflation rate of unemployment (NAIRU) are particularly uncertain. Potential output is likely to have fallen for a variety of reasons. This could be due to a mismatch between the skills of workers that lose their jobs and the skills required in new vacancies. Another phenomenon is that economic growth after a financial crisis tends to be much slower due to the debt overhang. [9] While emphasis on measures of the output gap can give the impression that output could be increased by monetary means, it becomes an illusion if the problem is due to a mismatch of skills or a debt overhang. Only structural policies can address these problems.

Second, with respect to the claim that money and credit do not matter for successful monetary policy making, the experiences of the past three years have proven that this conventional wisdom is simply wrong. By including an analysis of money and credit developments in their monetary policy strategy, central banks can ensure that important information stemming from money and credit, typically neglected in conventional cyclical forecasting models of the economy, is considered in the formulation of monetary policy decisions. There is compelling empirical evidence showing that, at low frequencies – that is over medium to longer-term horizons – inflation shows a robust positive association with money growth. [10]

Monitoring credit growth can also be useful in identifying other sources of unsustainable credit developments, even if some of them cannot necessarily be eliminated by monetary policy tools, and would instead require action of a macro-prudential nature. After years of oblivion, macroeconomic theory seems to have caught up with reality and shifted its attention to credit and leverage as critical parameters that a central bank should consult regularly to measure the pulse of the economy. [11]

The ECB had consistently used these indicators even when they were derided as relics of a defunct monetary doctrine. They proved useful. They gave information about financing conditions and the financial structure, as well as about the condition and behaviour of banks, when these sources of information were critical to the assessment of the health of the transmission mechanism and, more broadly, the state of the business cycle. This dimension of monetary analysis has proven particularly valuable in shaping the ECB’s response to the financial crisis. There is indeed evidence in support of the fact that, without duly taking monetary analysis into account, inflation in the euro area would have been distinctly higher at times of financial exuberance and would have fallen deep into negative territory in the wake of the financial markets’ collapse, starting in the autumn of 2008. The economy as a whole would have been more volatile. [12]

And thirdly, with regard to the pre-crisis consensus on monetary policy not to act on asset price bubbles, the crisis has vividly demonstrated that bursting asset price bubbles can be extremely costly. The public policy response to the crisis has – even when being successful in attenuating the immediate impact of a financial crisis on the real economy – carried substantial fiscal costs and has led to significant output losses. To confine ourselves to “ex-post” policies is, therefore, not enough and calls for effective “ex-ante” policies. The main policy tools in this regard are, of course, appropriate regulatory and supervisory policies. Before the crisis, these preventive tools were insufficient to deal with the build up of asset price imbalances in the pre-crisis period. Lessons have been learned, and with the re-design of the supervisory architecture in many countries around the world, and the Basel III regulatory reforms, enhanced preventive tools are underway.

But also from a monetary policy perspective, greater emphasis on “ex-ante” prevention is warranted. To the extent that financial imbalances are accompanied by excessive monetary and credit growth with possible implications for the medium term outlook on inflation, central banks do indeed have an obligation to take appropriate action. With respect to the ECB, our focus on medium term definitions of price stability, as well as the use of money and credit in our monetary pillar, already provides some ‘leaning’ against the build up of asset price imbalances. Therefore, in my view, a cautious leaning against excessive money and credit growth and building up of financial imbalances as part of our general monetary policy framework cannot only contribute to financial stability, but most importantly to achieve our primary objective of maintaining price stability.

Let me now turn to the economic challenges lying ahead of us, and the role monetary policy should play in overcoming these challenges.
The challenges ahead and the role for monetary policy

The global financial crisis is far from over. By now the global financial crisis has gone through a number of different phases. Initially the crisis started in the sub-prime mortgage market during the summer of 2007, and became very intense in September 2008 with the default of Lehman Brothers. Subsequently, financial woes spilled over into the real economy, resulting in recessions in almost all industrialised countries. Monetary and fiscal policy countered this with unprecendented vigour. Monetary policy responded with very low interest rates and a wide range of non-standard measures. Fiscal policy allowed public deficits to widen and set up rescue packages for troubled financial institutions. To a large extent thanks to these measures, economic activity rebounded in 2020. But at the same time, countries that had entered the financial crisis with large public and private debt burdens started to have serious problems accessing sovereign debt markets. In 2020 the tensions in sovereign debt markets intensified further due to increasing concerns about long-term debt sustainability in various parts of the world. These developments have further threatened financial stability as financial institutions hold a significant share of troubled countries’ government bonds.

Here, the onus is clearly on governments to engage in the necessary fiscal corrections. However, this does not only mean exiting from the fiscal stimulus and support measures taken in response to the crisis. Even with these measures reversed, fiscal policy still faces at least three important challenges. First, excluding crisis-related stimulus measures, most advanced economies are still left with historically high deficit-to-GDP ratios, which, in the context of today, are largely structural in nature. To put it another way, given the lower actual and potential post-crisis output and correspondingly lower post-crisis tax revenues, pre-crisis spending levels are no longer affordable. Secondly, government debt-to-GDP ratios are now much higher than before the crisis, and the guarantees provided to the financial sector have added to the potential liabilities. Thirdly, over the next two to three decades, governments face rising costs related to ageing populations. Due to the combination of these factors, questions are – unsurprisingly – being asked about the ability of some governments to bring their public finances onto a sustainable path over the medium term.

In this regard, let me point out that the state of public finances in the euro area differs significantly across countries. According to the IMF the debt-to-GDP ratio ranges from 6 percent in Estonia to 152 percent in Greece in 2020, while the aggregate debt-to-GDP ratio for the euro area stands at 87 percent. But let me also emphasise that restoring sound public finances is not only a challenge for the euro area. As I mentioned before, government deficits and debt levels in many advanced economies outside the euro area have also risen to historically high levels, at least in a time of peace. For the largest industrialised countries such as the US, UK and Japan, according to the IMF the debt-to-GDP ratio in 2020 ranges from 83 percent in the UK, to 100 percent in the US and 229 percent in Japan.

The state of public finances clearly matters for central banks. At least from a theoretical point of view, one of the reasons is that monetary policy could in principle be used – or abused – to alleviate a government’s budgetary woes. The regime that has prevailed in advanced economies over the last three decades has been a regime of monetary dominance, under which central banks can pursue price stability-oriented policies without having to take into account the government’s budget constraints. Central banks have been given an explicit mandate to maintain price stability and have been protected by legal provisions guaranteeing their independence.

Credible, stability-oriented monetary policy frameworks are assets that have been difficult to acquire and must not be put at risk. As I have pointed out, monetary policy thinking went through a remarkable evolutionary process during the last century which resulted in price stability for billions of people. As serious questions have arisen about the medium term sustainability of public finances in a significant number of industrialised countries, we cannot but conclude that the same evolutionary process did not happen to fiscal policy making. Fiscal policy making has not managed to converge to a framework with clear principles and medium term objectives. [13] Growing doubts about governments’ ability to deliver sustainable public finances could at some point also cast doubt on the sustainability of the prevailing regime of monetary dominance. This would lead to an increase in inflation expectations or at least heightened uncertainty about the inflation outlook in the medium term.

It is a fallacy to think that loose monetary policy can solve the large structural problems we are facing. Central banks must not become the victims of their own success and should not become overburdened. Historically, whenever policy makers tried to broaden the role of monetary policy beyond its original role as a guardian of the value of a currency, it had to compromise on its objective of price stability. For monetary policy to remain effective, its responsibilities must remain within clear limits.

Instead, we need a growth model that is different from the one during the years before the financial crisis. We need economic growth that is based on a genuine increase in productivity, and not on low interest rates and the accumulation of debt. The unlimited accumulation of private and public debt before the financial crisis has now become a burden on economic growth and should be reduced progressively. [14] To achieve this we need far-reaching structural reforms that increase competition in labour and goods markets, more financial supervision, and a stronger fiscal policy framework.

We must reform financial supervision and strengthen economic governance so that economic policy becomes less pro-cyclical. Basel III is a very important step in the right direction, as it should provide for higher minimum capital requirements and better risk provisions by financial institutions. Still, regulation of the banking system and financial markets has not yet progressed sufficiently. Fiscal policy should be more grounded in a rules-based framework with clear medium term objectives, similar to monetary policy. The adoption of fiscal rules by some countries is clearly an improvement. In the euro area, a number of steps have been undertaken to strengthen economic governance so that concerns about competitiveness and fiscal policy can be addressed pre-emptively. But for the ECB these steps do not go far enough. For rules and sanctions to be fully credible they should be stricter and automatic – not subject to the political process – so that countries have the right incentives to address their problems.

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The financial crisis

The financial crisis

The financial crisis has its origin in the US housing market, though many would argue that the house price collapse of 2007 – 2009 is a symptom of a problem running much deeper, revealing a fundamental weakness in the global financial system.


From the 1970s onwards, US and UK banks started to widen the scope of their business models by selling off their own credit risk to third parties. Increasingly they became reliant on computer-based systems for assessing that risk. Many have argued that personal judgment, perhaps the key attribute of the traditional bank manager, gave way to decision making by computer software.

(Source: Financial Times)

Relaxation of the rules regarding capital movements between countries, widespread de-regulation of financial markets during the 1980s, and a number of banking mergers also dramatically changed the global financial landscape at the end of the 20th Century.

During the 1970s and 1980s, increasingly complex financial products were developed and traded, providing a speculative income for traders and a method of spreading the risks associated with financial trades. New financial products, such as ‘derivatives’, ‘options’, and ‘swaps’, joined more traditional products, like mortgages and bank loans, in an ever-widening array of financial goods and services. In addition, this period saw the increasing securitisation of assets, most notably mortgages.


The increasingly complex nature of financial products did not deter banks from diversifying through increased securitisation.

Securitisation, which started in the US and spread to the UK in the late 1980s, is the creation of asset-backed debt. The assets used generate a flow of income, and the commonest asset is a mortgage, from which a regular flow of income is generated. In recent years a much wider variety of assets has been used, including income from credit cards and even from pub chains and football stadiums. (Source: HM Customs and Excise.)

One particular feature of the 2008 – 2009 financial crisis was the difficulty faced by many insurers, including the American giant, AIG. AIG, and other insurers, became heavily involved in insuring other institutions against credit defaults. Specifically, investors who wish to protect themselves against defaults on mortgage-backed securities may buy credit default swaps (CDSs). As an insurance against credit default, CDSs are bought and resold, and may end-up on the balance sheet of a wide variety of financial institutions. It has been estimated that, if one player in the market were to go bankrupt, it could take a decade to untangle the complex network or contracts between the financial institutions and intermediaries. It is primarily for this reason that the US Federal Reserve bailed out AIG and Bear Sterns.

Toxic assets

A bank or other financial institution, like all firms, must create a balance sheet which values its assets and liabilities, and from which it can calculate its net assets and its capital.

The value of a bank’s assets, that is, what it owns, is largely determined by how ‘healthy’ the debts are that borrowers must repay. A fundamental problem of the highly globalised financial markets at the time of the US housing crisis was that many of the mortgage backed debts on the balance sheets of the banks have turned out to be extremely ‘unhealthy’, referred to as toxic debts. The problem of the toxic debts, resulting from loans made to the sub-prime housing market, became more severe because banks could not quickly or accurately calculate their exposure to these debts. This was largely a result of the highly complex nature of their investments, including those related to derivatives and options.

Asymmetric information

What is clear is that financial markets failed partly because of the problem of asymmetric information.

In the context of financial markets, this means that parties to a transaction do not have access to the same quantity and quality of information. Considerable information is needed in order to assess potential risk and reward, and to make a rational decision about whether to purchase a financial product or not, and how much to pay for it.

The emergence of complex derivative products in the early 1980s, and the increased popularity of securitisation in the late 1980s, increased the inefficiency of many financial transactions. This inefficiency was the result of one party, usually the seller, possessing much better information than the other party, usually the buyer. Furthermore, with the rise in the importance of specialist third parties, like hedge fund managers, the actual buyer and seller may be unaware of the actual risks associate with a given transaction, and oblivious to the source of the investment income. Therefore, in 2007, when the mortgage market started to collapse in the USA, the scale of the problem remained largely hidden.

This failure of information could also be referred to as an example of the ‘principal-agent‘ problem, though many of the ‘agents’ involved were indeed fairly ignorant themselves!

Banking collapse

As the scale of banking losses were announced, and following the failure of leading investment banks like Lehman Brothers, growing uncertainly prevented the banks from lending to each other as they would normally do, and encouraged them to retain as much liquidity as they could. The result was that banks were failing to fulfil a key banking function, namely to make loans and ensure the adequate flow of liquidity into the economy.

Policy options

There are three fundamental issues facing policy makers:

  1. How best to control or regulate banks
  2. How to get liquidity into the global system
  3. How to deal with the after-effects of the banking crisis


One response to the banking crisis was to nationalise a number of key banks, including Northern Rock, and part-nationalise others, including the Lloyds Banking Group and the Royal Bank of Scotland (RBS). Many others have been heavily supported by their governments by extensive ‘re-capitalisation’.


Since 2001, financial market regulation in the UK has been the responsibility of the Financial Services Authority (FSA).

The aim of the FSA is to ‘promote efficient, orderly and fair markets and to help retail consumers achieve a fair deal.’ (Source: FSA)

Given that asymmetric information is a serious problem in financial markets, regulatory reform will involve the promotion of a more transparent system, with financial institutions forced to provide higher quality information on risks.

Some critics of the US regulatory system allege that it is too rules-based and should move towards the European model of principles-based regulation.

With rules-based regulation, the regulators interpret the rules as laid down in law, and there is little room left for judgement or interpretation.

Under a principles-based system, as well as having extensive rules, the general principles of regulation are contained in legislation. It is argued that this gives extra powers to regulators to assess the behaviour of financial or other institutions in terms of whether the general principles are being adhered to.

The London G20 Summit, held in April 2009, recommended the establishment of a Financial Stability Board to provide an early warning system of problems in the global financial markets. It also proposed close scrutiny of the activities of hedge funds.

Monetary stimulus – quantitative easing

Quantitative easing is a process whereby the Bank of England, or another central bank, under instructions from the Treasury, buys up existing government bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work.

When an economy is in recession and official interest rates are close to zero, further interest cuts are impossible. This is the situation that faced most national economies and monetary unions during 2008 and 2009. In this situation, quantitative easing may be necessary to boost liquidity and stimulate lending.

Fiscal stimulus

To help their ailing motor industries, several national governments provided special assistance, including loans and loan guarantees, and specific subsidies which enabled prospective car buyers to trade in their old cars for new ones – the so-called scrappage scheme.

One of the first measures taken by the UK government was a reduction in VAT, from 17.5% to 15%. (It was raised to 20% in 2020.)

As well as establishing a global regulatory regime, the G20 countries also agreed an extra $750 b stimulus package, in addition to the measures taken by national governments.

A Tobin Tax

A Tobin tax is a special tax on currency transactions, designed to penalise excessive short-term speculation in the currency markets. Advocates have suggested that such a tax could be imposed on a wider range of financial transactions to reduce speculation in financial markets and help restore some stability. The formal name for a Tobin tax is a securities transaction tax.

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