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Why Did the GFC Happen?

September 4, 2011

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Post No. 1 in a series about prosperityThe list of people we can blame for the Global Financial Crisis (GFC) is endless: Wall Street investment bankers, naive home buyers, sharpish dudes selling them houses they couldn’t afford, rogues designing and trading crazy derivatives, credit rating agencies, regulators, unthinking fund managers and investors, governments who freed up financial markets, the economics profession – we could go on.

All of these people may have contributed, but blaming them explains nothing. If people act in a greedy or reckless way we should ask how the system in which they operate encourages such behaviour.

This is the first of several posts responding to two recent books which espouse diametrically opposed views on prosperity. This post looks at what they have to say about the GFC.

Growth is the problem, says Tim Jackson

In Prosperity Without Growth: Economics for a Finite Planet, Tim Jackson argues against continued economic growth in developed nations, because ecosystems are collapsing as an infinitely expanding economy pushes against the finite resources of the planet. He presents his vision of a prosperity that does not depend on never-ending growth and that will also foster greater well-being than that based on consumption of more and more novelties.

Growth is non-negotiable for governments as any slowdown threatens employment. This growth imperative, says Jackson, has shaped the architecture of the modern economy. It motivated the freedoms granted to the financial sector and the increase in the money supply to facilitate a massive expansion of credit in order to promote consumption and drive growth. Jackson quotes George Soros, who “traces the emergence of … a ‘super-bubble’ in global financial markets to a series of economic policies to increase liquidity as a way of stimulating demand. Loosening restraints on the US Federal Reserve, de-regulating financial markets, and promoting the securitization of debts through complex financial derivatives were also deliberate interventions. Their overriding aim was to promote economic growth.”

That is, the GFC was not caused by any of the supposed villains listed in the first paragraph of this post. The core problem is the imperative for growth.

Growth is the answer, says Matt Ridley

In The Rational Optimist: How Prosperity Evolves, Matt Ridley’s main idea is that when human beings began to barter goods, they discovered the division of labour and specialisation, which encouraged innovation and so promoted increasing prosperity. Ridley argues that this has resulted in life getting better at an accelerating rate, and he sees future economic prosperity growing without limit, provided government keeps out of the way and does not interfere with the free market.

Ridley is a zoologist and science writer, but he was also Chairman of the English Bank Northern Rock, which suffered a liquidity crisis in the run-up to the GFC, necessitating a bailout of £26 billion ($A39 bn) by the British government. He was forced to resign in October 2007, having been blamed in parliamentary committee hearings for not recognizing the high risks of the bank’s strategy and thereby “harming the reputation of the British banking industry.”

Ridley’s critics have had a field day with this history (see George Monbiot’s article, The Man Who Wants to Northern Rock the Planet, here). Ridley has expressed “intense regret” about his role in the disaster, but says that under the terms of his employment he is unable to comment on it. Logically we should not discount a person’s arguments because of past mistakes, although in this case we might see a connection between his optimism and the fate of the bank. Yet Ridley does draw an interesting lesson: “The experience has left me mistrustful of markets in capital and assets, yet passionately in favour of markets in goods and services.”

He quotes research by the economist Vernon Smith and his colleagues showing that markets in goods and services, such as hamburgers and haircuts, “work so well that it is hard to design them so they fail to deliver efficiency and innovation; while markets in assets are so automatically prone to bubbles and crashes that it is hard to design them so they work at all.” So what do we do – how can we regulate financial markets so that they work? Ridley does not address this, apart from warning us against too much government.

Who’s right?

That Ridley is right is almost a tautology – if asset markets had worked the way we want them to, there wouldn’t have been a “super-bubble” or a GFC. And Jackson is right – in our current economic structure, we need growth, so we are forced to stimulate consumption with credit and free financial markets that generate bubbles.

This is partly a question of what we want the economy to deliver. Do we want more growth, more novelty, with GDP per capita expanding without limit, and if so can we save the planet as well as stopping asset markets forming bubbles and causing crashes? Or do we want a different form of prosperity, one that we can have without growth? Is prosperity without growth even possible? Future posts will review both books and contrast their very different visions of what we can achieve.

*Image from Toban Black, photographer unknown

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