Ethos Perspectives
The Financial Crisis
What Can be Done?
Many believe that Wall Street and global banks should be made to bear the consequences of their own excesses. However, the economy is not a morality play, where justice is achieved through the punishment of villains. Failure of government to act decisively could prolong the crisis, with negative consequences for everybody. Governments and businesses should try to mitigate the economic damage, and lessen the frequency and severity of future crises — but the more difficult question is what, and how much, they should do.
While ongoing monetary and fiscal responses are necessary to forestall the catastrophic collapse of global finance, they are unlikely to result in swift recovery. Monetary policy relies on lowering interest rates and increasing the supply of money to stimulate lending and investment. However, this may have limited effect now as real interest rates in the US, Japan and EU are already very low. Furthermore, central banks have already made unprecedented liquidity injections into credit markets. Fiscal policy involves lowering tax rates and increasing government spending to stimulate demand. This is essentially what Keynesian economics is about, but research is divided on the strength of the multiplier effect from increased public consumption. There are also doubts over whether increased public investment — in infrastructure spending for instance — can be brought forward quickly enough without creating too much wasteful spending. Low business and consumer confidence — leading to de-leveraging and rising saving rates worldwide — will also hinder the effectiveness of fiscal policies.
Few question the need for corporate and regulatory reform. A recent OECD report concluded that member states’ corporate governance arrangements did not prevent excessive risk-taking. Lewis and Einhorn stress the need to close the "revolving door" between regulators and Wall Street, but this will be difficult given the political power of vested interests. Former IMF chief economist Raghuram Rajan has long argued for wage reform such as holding substantial portions of bonuses in escrow, to be forfeited in the event of future losses. The US and UK have also introduced greater restrictions on severance packages and capped bonuses in banks receiving assistance from public funds. In doing so, both countries have signalled a shift from "business as usual", but it remains uncertain whether this will lead to lasting reform.
The economics and finance professions have also been criticised for favouring complicated quantitative risk models that failed to anticipate this crisis. Nassim Nicholas Taleb argues that such models fail precisely because they do not cater for tail risks. He favours more robust risk management processes that consider inter-linkages and "black swans" — low-probability, high-impact events such as the terrorist attacks of 9/11 and the 2004 tsunami. Others note that threats to financial markets do not originate only from "black swans" but also "vicious snow-white swans that come along a lot more often than expected".
This crisis also serves as a sobering reminder of the limits of decoupling, and that risks are highly interconnected. Prime Minister Lee Hsien Loong has noted that there will also need to be global rebalancing, but this will be difficult due to the large scale and structural nature of the shifts required. Reform of key Bretton Woods institutions and greater involvement of major developing countries (e.g., through the G20) could support this objective.
Globally, the pendulum could well swing towards re-regulation and a renewed role for big government. Protectionist pressures might also increase, leading some analysts to predict a process of de-globalisation in the coming years. The World Economic Forum has highlighted that governments also need clearly defined exit strategies. Many have also raised the spectre of over-regulation, citing examples such as Sarbanes-Oxley and the EU’s insistence on regulating tax-free regimes despite the fact that tax havens had nothing to do with the crisis. The WEF notes that over-regulation could stifle market incentives to innovate, while the Economist suggests that optimal regulation levels should be based on an understanding of what regulation will achieve, and how much we actually benefit from financial innovation.
"Big Government Fights Back", The Economist, 31 January 2009.
Wolf, Martin, "Keynes Offers Us the Best Way to Think About the Financial Crisis", The Financial Times, 23 December 2008.
"Special Report on the Future of Finance: Greed—and Fear", The Economist, 24 January 2009.
Prepared by:
Wu Wei Neng
Senior Researcher
Centre for Public Economics and Centre for Goverance and Leadership, CSC
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