Storm, The (21 page)

The world has experienced a financial and economic crisis of great severity and complexity, global reach and unpredictable
political and social consequences. Yes, a year after the crisis reached its peak with the meltdown in the banking system in
October 2008, there seemed to be a return of optimism, with strong growth reported in China, India and Brazil, with reports
of recession ending in Japan, Europe and East Asia, and signs of a recovery on the horizon in the USA and the UK. It was as
if there had been a massive heart attack but the patient in the Intensive Care Unit was alive and reviving, and talking about
a return home. Massive intervention through expansionary monetary and fiscal policies, and central bank resources, seemed
to have worked. But the patient was still attached to the life-support system, and it was not clear how it would respond to
the withdrawal of the monetary steroids. And long-term damage has undoubtedly been done. There is a danger of relapse. The
future remains uncertain.

When I was paid for attempting to predict future economic developments for a leading multinational company, I was frequently
reminded of the Arabic saying: ‘those who claim to foresee the future are lying, even if by chance they are later proved right’.
The extraordinary speed with which the crisis has unfolded and overwhelmed the unready should underline the need for caution
in anticipating the next few months, let alone years. It is perhaps more helpful to think of plausible scenarios
than likely developments, and to frame any policy proposals in a spirit of humility, recognizing that no one fully understands
what is happening or how the current drama will play out.

What we do have is historical experience and the accumulated knowledge that follows from it. There is much wisdom in the adage
that ‘history is an imperfect guide to the future but it is the only one we have.’ I have emphasized from the outset that
economic history provides a long record of cycles – in goods and raw material prices, house prices and construction, manufacturing
production, employment – and financial market manias and panics leading to banking crises. It is only extraordinary conceit
and complacency that have shielded those who should have known better from recognizing the danger signs – most notoriously
and eloquently in Gordon Brown’s claim to have abolished ‘boom and bust’. But a generation of bankers, regulators, government
officials and politicians were no less culpable.

It is now broadly recognized that the current upheaval has been much more serious in scale and scope than those experienced,
at least in the developed world, since the Second World War. We should not forget, however, that some Asian countries suffered
grievously from the financial crisis of the 1990s; there was an economic as well as a political collapse in the former Soviet
Union (Russia and Ukraine experienced a decline of over 50 per cent of GDP), and the Latin American debt crisis of the 1980s
inflicted major losses.

Parallels have been drawn with the Great Crash and then the Depression of the 1930s. In the USA, by no means the biggest casualty
of that period, GDP fell by 30 per cent from peak to trough and took a decade to recover 1929 levels. The 1929 share price
crash and what followed were in some obvious ways different from, and worse than, anything that seems likely today. The current
crisis has occurred after a decade – indeed decades – of rising prosperity and technological innovation, which provide a platform
for recovery, unlike the inter-war world which was weakened by war, hardship, hyperinflation in some countries and political
instability. The world today also has, at least for the moment, a dense network of international cooperative agreements covering
trade, standard-setting, banking regulation and overseas investment. These may be flawed and inadequate, but they are far
ahead of the pre-war world, which, despite the efforts of the League of Nations, was characterized by nationalistic hatreds
and imperialisms.

Another new development is the major impact on global demand of China, India and other emerging economies, which in the inter-war
period were impoverished by civil war (China), colonial stagnation (India), or revolution and autarky (Russia). China and
India, at least, have demonstrated commendable resilience, with strong domestic demand and well-diversified economies. Their
state-controlled banking, until recently derided as a source of inefficiency, has insulated them from the worst of the banking
crisis.

And, not least, there has been a rapid global policy response to prevent a wholesale collapse of the banking system and to
allow rapid cuts in interest rates together with fiscal expansion. A vast amount of economic firepower is now being deployed
to counter the global recession, whereas in the 1930s governments dithered, endlessly pursuing what they thought were sound
fiscal policies: balancing budgets and, in the name of market forces, allowing banks to go bust, thus deepening the systemic
crisis. It was fortunate that the general now in charge of the armoury, the Chairman of the US Federal Reserve, made his professional
reputation as a historian of the Great Crash and the policy response to it.

These are the optimistic factors that have led many commentators and political leaders to conclude that the crisis will be
relatively mild and will lead to recovery in a couple of years at most. Even if the analysis is wrong, optimism has intrinsic
value as a source of consumer and business confidence, and it should not be blithely dismissed. It is worth recalling Dr Johnson’s
advice about over-reacting to economic crisis, as in the ‘general distrust and timidity’ that followed in the wake of the
bursting of the
South Sea Bubble in 1722: ‘little more than a panick terrour from which when they recover many will wonder why they were frightened’.
And it has always been the case that those at the centre of a financial crash see the world in more apocalyptic terms than
those somewhat removed, in the real economy. The confidence of the British financial establishment, for example, was shaken
to the core, not merely by the humiliation of the run on Northern Rock but by the realization in October 2008 that British
banks could no longer rely on overnight lending and faced total collapse. They were in the same position as was described
in 1825 by William Huskisson, the President of the Board of Trade, who noted that ‘if the difficulties had continued only
eight and forty hours longer… the effect would have been to put a stop to all dealing between man and man, except by way of
barter’. Within a year, sentiment in financial markets had reversed itself, as in these earlier historical episodes.

But the current crisis could still prove as threatening as the convulsions of the inter-war period. The financial system is
more complex and more interconnected than in previous crises. The shocks have been bigger and were transmitted more quickly
at home and abroad through instant communications. The extraordinary scale of the derivatives markets, many times bigger than
the world economy, points to the risk of even greater financial shocks. The degree of leverage now being reversed is on a
staggering scale, and the underlying global imbalances – notably between the savers and the spenders – will require long and
painful adjustment. The pain to be faced – in unemployment, home repossessions and loss of savings – will produce a political
reaction that could put at risk many of the post-war gains, such as international consensus over the merits of trade, which
we have come to take for granted.

It is possible to envisage two broad scenarios. One is that the rapid policy response, and the necessary adjustments, will
indeed work, leading to recovery, but with some painful and difficult legacies, including unemployment and damage to government
budgets. Another possibility, at least for some countries, is that the policy response will not work, because the problems,
especially in the banking system, are too deep-rooted and difficult. Japan has never really recovered from its banking crisis
of almost two decades ago, due in part to an unwillingness to acknowledge and deal with the losses to the banking system acquired
in the property and land bubble of the 1980s. Lessons have been learned from the Japanese experience about the need for prompt,
transparent intervention to sort out bad banks. Japan also taught us that a sophisticated, developed economy can be disabled
for a long period as a result of a deep financial crisis, even when, in that particular case, it had the advantages of a benign
international environment and a stable, quiescent political system.

The problems faced by some countries, especially Britain and the USA, are not just technical and economic, but represent a
blow to the underlying value system, the social contract. Most people’s sense of fairness and equity had already been assaulted
by widening extremes of wealth and income. By 2007 the value attributed in assets to ‘high net-worth’ individuals (dollar
millionaires) was three times greater than US GNP, and higher than the combined GNP of the G7 countries. The income of the
world’s richest 500 billionaires exceeded that of the world’s poorest 420 million people. However, widening inequality of
wealth and income – in the case of the UK income inequality is very close to, and wealth inequality greater than, that at
the end of the Thatcher era despite redistributive measures – has been tolerated, and politically endorsed, because it appeared
to be a consequence of economic progress. A rising tide lifted all boats, it was argued, even if the biggest boats derived
the biggest benefit. The rich should get richer, because they were seen to be applying entrepreneurial talents that, apparently,
benefited the common good – even if some of them were rogues. The richest man in the world, Bill Gates, did something useful,
and was generous too. Even the less obviously useful people in the City of London or the New York markets, or Russian and
Arab billionaires, who flaunted wealth of
questionable provenance, were part of a success story that provided full employment and rising living standards.

That has now changed. A lot of people have been hurt: hardworking, thrifty, law-abiding people. Many are losing their jobs,
their homes and businesses. Shareholdings have been shredded and, with them, many defined-contribution occupational and private
pensions. Yet the losers can see that some of those who made a fortune in bonuses brought their banks to their knees, and
that those banks are now being rescued by the taxpayer. The reckless and incompetent are being rewarded, the prudent and socially
responsible punished. The sight of Sir Fred Goodwin in the UK walking away with his big pension from RBS mostly intact and
Mr Adam Applegarth returning to profitable work in the City of London makes even bankers feel queasy. Therein lies a great
sense of unfairness. We do not yet know how this sense of grievance will manifest itself politically. There is unlikely to
be a return to the freewheeling ways of before the crisis, but a dangerously large number of financiers are seeking to do
just that.

What should be done? There are some who argue that nothing much should be done, that the crisis will, like a forest fire,
in due course burn itself out, and that to intervene would prevent a necessary purge of past excesses. We know from the various
interventions by the US Federal Reserve in the Greenspan era – the sharp cut in interest rates during the dot.com bubble and
the Asian financial crisis – that one of the consequences was to encourage even more irresponsible lending practices than
thitherto. Past guarantees given by governments have undoubtedly encouraged banks to operate with less and less capital and
liquidity relative to assets. There are legitimate anxieties that the bail-out and rescues today will sow the seeds of an
even bigger crisis in years to come. It is not difficult to make a theoretical case, based on moral hazard, for non-intervention.
The influential Austrian school of economics, including great thinkers like von
Mises and von Hayek, argued throughout the twentieth century that ‘malinvestment’ in previous boom periiods must be purged
and liquidated without government intervention. Indeed, in earlier eras there was simply no scope for governments to intervene.
There were automatic, rules-based, systems such as the gold standard that prevented governments from intervening in monetary
policy. Non-intervention did not guarantee stability. But banks behaved very carefully, because they could go bust if they
became insolvent. Economic cycles happened and bottomed out without active government intervention.

The 1930s spelled the end of that passive approach to financial and economic crises. In an era of universal adult political
participation, it was increasingly politically impossible to accept mass unemployment or to force big wage cuts as the gold
standard required. Whatever the economic niceties of Keynesian economics, and its critique of the Austrians, it started from
a political assumption that societies would not accept a laissez-faire approach and that wages were ‘sticky’. Equally, in
the current context there has been little support for the proposition that governments should stand by while a downward spiral
develops of evaporating consumer and investor confidence, disappearing credit, large-scale bankruptcy, mass unemployment,
collapsing housing and other asset prices, and home repossessions – in the quiet knowledge that at some point the economy
will hit rock bottom and the spiral will go into reverse. Barack Obama has used the image that when a house is on fire and
the fire is in danger of spreading across the neighbourhood, the fire brigade should not stand and watch in the hope of encouraging
greater awareness of fire risk and discouraging foolish habits like smoking in bed.