In October 2008, Alan Greenspan, the 1987 to 2006 chairman of the US Federal Reserve, testified before congressional leaders in Washington saying “I was shocked when the system broke down, my ideology and model that I always believed in proved me wrong.” He hastened to add that, “the crisis will pass” and that the then proposed $700 billion rescue package “is adequate to serve the needs.” In December 2008, he went on to say that “the global stock market value wiped out this year is $30 trillion, but human nature being what it is, we can count on a market reversal within six months to a year.”
Six months into the crisis, economic reality defies Mr. Greenspan’s assessments and predictions. The lost value in stocks has reached $50 trillion — nearly double his estimate and almost as much as last year’s world global output that is estimated to be $55 trillion.
In the meantime, the initial US rescue package was augmented by one trillion dollars this February, making the current US operation to save its economy more than 10 times bigger in real terms than the Marshall Plan of the late 1940s, which helped the European continent recover from a devastating war by increasing industrial production by 35 percent and restoring agricultural production to its pre-war levels in just four years.
A crisis like no other
This time it may take longer than four years for the world economy to get back to what it was before the crisis, as expectations for recovery are deteriorating by the day. Last November, the International Monetary Fund (IMF) predicted a slow down of the global output growth rate to two percent in 2009, from an average annual growth of five percent in the preceding years. In January, it revised this estimate to “possibly negative.” In economics, it is customary to qualify pessimistic expectations. Last December, the World Bank forecast a positive global growth of one percent, but in March that was revised to negative growth of possibly “up to two percent.” The Bank also expects that as a result of the crisis, global poverty will increase by 100 million, while the International Labor Organization foresees an increase in global unemployment by 50 million.
The ideology that Mr. Greenspan referred to is by now well known. It was practiced in its purest form, especially by the US and the UK. Since 1979, the year President Ronald Reagan was elected in the US and Margaret Thatcher in the UK. It was based on three pillars:
First, too much faith in unregulated markets — and there is a fundamental difference between ‘free markets’ and ‘markets’. Second, too much reliance on interest rates alone to manage the whole economy — at the expense of sensible fiscal policy, especially in the area of social services. Third, too much of a belief that central banks can and should avoid recessions happening on the watch of the government of the day — in defiance of the expected independence of central banks. This led to excessive leverage (debt creation) by financial institutions and unrealistic borrowing by households for housing (mortgages) and current consumption (read: credit cards).
Of course, elected politicians in democracies cannot have it their way unless the electorate is on their side. Both the UK and US have unquestionable democratic processes and educated voters in democracies tend to follow — with spasmodic deviations — what they believe is best for their own interests. The rhetoric that followed the so-called ‘neoconservative’ ideological revolution since the 1980s did just that: it used an array of populist arguments that made the majority of the electorate believe that free markets can best serve their interests and that economic insecurity can become a thing of the past.
Policies supporting this ideology followed suit. Firstly, shares of privatized companies in the UK were offered at low prices and appealed both to the short- sighted and the long-sighted. The short-sighted bought shares to make a quick profit by reselling them. The long- sighted bought them to start building a bigger nest egg as it was felt that returns on investments in stock markets were bound to increase fast.
Second, by offering subprime mortgages that have a high risk of default — one of the culprits of the crisis — house ownership increased (good for the citizens), corporate profits boomed, especially in the construction sector and the financial markets (good for economic growth), while the pressure on governments to fund low- cost social housing decreased (good for the public debt). What could be more appealing than this ‘triple win’?
Third, recommendations for securing the financial stability of the elderly overstated the growth and security of financial investments. Voters were aware that they had smaller families than their parents and that there would be fewer future workers to support their own pensions. In the meantime, they were facing increasing payroll taxes in the form of pension contributions, requirements for staying on longer at work and decreasing levels of pensions. Privately funded pensions based on returns on individual savings accounts invested in financial markets were marketed as another winning alternative and as a fair one. They were expected to provide higher pensions due to the then state-provided social insurance. And their ideological appeal was significant: those who earned and saved more would have a bigger pension than those who earned less — those with less were assumed to be lazy rather than unfortunate.
The model of greed
The rhetoric included many other arguments, but let’s mention just one more. In an interconnected, globalized economy it does not make much difference who saves and who consumes as long as the whole thing balances out. In such a world, over-spending by consumers in some countries — such as the US and the UK — can be the antidote to the thriftiness of other countries, notably China.
All in all, it was an ideology based on what is now widely termed as ‘greed’, though the word seems to be equally, and incorrectly, used both for workers and households who justifiably aspire to a better life in the already high income economies, as well as for financial executives and the 1,300 billionaires that have been created in the last couple of decades. In the words of economist Paul Krugman, the most recent Nobel laureate, it was the ideology of “private good, public bad” that prevented the development of sensible regulation for the expanding financial sector. Lack of regulation created asset inflation over time, which was deflated instantly after the onset of the crisis. The total 2008 financial losses were 40 percent for UK’s FTSE, 45 percent for the European FTSEurofirst, 42 percent for Japan’s Nikkei, 48 percent for Hong Kong’s Hang Seng, 39 percent for the New York’s S&P and 65 percent for China’s stock market.
None of this is surprising. Many people talked about the looming crisis, but strong arguments are not always enough to overcome strong political powers. Some of those in power did listen. For example, during the East Asian financial crisis in 1997, the prescribed rescue packages were criticized for being too based on ideological thinking — some called it the ‘Washington Consensus’. They said it put too much emphasis on fiscal austerity, raising interest rates and privatization. Furthermore, they said, “let the banks fail.” Today, Western economies follow the opposite track. Their recovery plan is based on expansionary fiscal policies, low interest rates and rescuing private companies and banks.
Similarly, soon after the 1997 crisis, the aforementioned Krugman became one of the many critics of the risk management model that replaced the role of regulation in the financial markets and eventually, and predictably, failed to ensure that the inrush of capital created in the financial markets was prudently invested. In 1999, Peter Warburton, a UK economist, published a 350- page book that focused on how the central banks were imperiling the world’s economy. The book’s message is obvious from its title, “Debt and Delusion.” In 2001, Joseph Stiglitz, a US economist who got a 2001 Nobel Prize, explicitly advised the Bank of Iceland what it had to do to avoid becoming the “champion victim” of the crisis. As recently as 2006, Nuriel Roubini, another US economist, earned a similarly unenviable title, “the prophet of doom,” after a lecture he delivered to an uninterested IMF, the international organization in charge of overseeing the global financial system.
Despite the warnings, the ideology crossed political boundaries. The Labor Party in the UK, referred to as “New Labor” after it took power over from the successive conservative administrations between 1979 and 1997, pledged to decrease child poverty by half to 1.7 million children by 2010 and to eradicate it by 2020. It is now estimated that 2.3 million children will still be in poverty in 2010, a discrepancy of 35 percent from the stated target, due to a financing gap of $6.15 billion a year. Let’s put these numbers in context. First, without any new policies to help low-income families — a likely scenario amidst the current crisis — child poverty could rise to 3.1 million by 2020, a number similar to the number of poor children in 1999 when the pledge was made. Second, the Royal Bank of Scotland paid nearly $5.87 billion in bonuses in 2007 and posted $35 billion losses in 2008, the largest corporate loss in the history of the UK. Third, the value of employees’ private pension funds dropped by nearly a third from $810 billion to $579 billion between October 2007 and October 2008. In the US, $2 trillion was wiped out in equity value from 401(k) and individual retirement accounts in the two months following the start of the crisis, nearly half the holdings in those plans.
The time has come to listen. This is already happening. In February, the new US administration under President Barack Obama added $1 trillion to what Mr. Greenspan thought was adequate to rescue the economy. Whether this will be sufficient, and how it will be spent in practice remains to be seen. For example, the faltering American Insurance Group (AIG), once the leading insurer in the world, is to receive $170 billion in rescue funds, but still faces hazards in its $1.6 trillion portfolio of complex derivatives.
This month, British Prime Minister Gordon Brown declared that he takes “full responsibility” for his role in the banking failures that led to the global recession. In the meantime, housing waiting lists have reached record levels, having increased by 55 percent compared to five years ago and they are expected to double by 2011. Some of this increase will be, of course, the result of repossessions and increasing unemployment as well as lower construction activity. However, much is also due to the shortage of social housing, whose availability decreased over time.
The economic gear shift
Probably nothing constitutes a more dramatic admission of change than the criticism of the now opposition conservative shadow housing minister saying, “The [Labor] government’s record on social housing is embarrassing — the average annual number of social rent properties delivered has halved since 1997.” The other main opposition party in the UK, the Liberal Democrats, is no more polite. “The government allowed the bubble in the housing market to get out of hand for many years. We are now seeing the results of that bubble bursting,” they said. Now the government’s target is to build 240,000 new homes each year until 2016, while Gordon Brown admitted that “the economic downturn marks the end of the era of laissez-faire government.”
One cannot but welcome a more balanced approach to managing the economy. The days of the glorification of financial markets as a magic creator of wealth have come to an end. Financial markets are not an end in themselves, but a means that enables the real economy to be more productive. Along with the individual efforts of the US, the UK and other high-income and developing economies, the UN set up a commission of experts chaired by Joseph Stiglitz to put forward “credible and feasible proposals for reforming the international monetary and financial system in the best interest of the international community.” There is also increasing recognition of the importance of multilateralism. Both the IMF and the World Bank are currently looking into governance structures that would increase their effectiveness.
Luckily, the attempt to create a one-sided global ideology failed. Hopefully, the attempt to find shared global solutions will succeed.
PROFESSOR ZAFIRIS TZANNATOS is a Beirut-based economist and was previously advisor to the World Bank and chair of the economics
department at the American University of Beirut