Five Lessons From The Economic Crisis

The economic crisis, as many have said, is too good an opportunity to waste. But what can we learn? Here are five things:

1. The financial services sector is bloated and inefficient. The market will correct some of the issues, such as those rating agencies more concerned with maintaining good relations with institutions than with adequate and risk assessment. Trust has been broken between many of the firms and institutions and will only be reestablished with better business practices in the market place. Now that everyone perceives the many under-assessed risk and over-promoted gains, returning back to the status quo is impossible. So self-reform will occur in the market.

2. Self-interest amongst financial institutions should ensure major changes, yet the sector is incapable of true self-regulation. They simply do not understand what’s best. They do not even know what’s right, what’s sound or in some cases what’s legal. So we now know that formal regulation is needed, necessary and long overdue.

3. The current systems of regulation are inadequate. The failure to identify the fraudulent Madoff enterprises despite many warnings and red flags indicate that the SEC basically failed. We need not only new regulations but also a new regulatory order with less cozy relations between the players and the regulators.

4. Economic deregulation as the dominant ideology has been dealt a deathblow--at least until the current interventionist mode is delegitimized. There have been three dominant economic ideologies in the US. At the beginning of the twentieth century, laissez faire capitalism held sway until the Great Depression rendered its underpinnings of limited government obsolete. The New Deal and Keynesian economics inaugurated a more interventionist government and mixed economy system. The stagflation of the 1970s forced a reassessment, and the election of Thatcher in UK and Reagan in the US reflected the political rise of a deregulated, minimal state. Opinion shifted to the right so that even New Labour and the Democrats boasted of cutting income taxes and of reducing the size of government. The latest economic crises have swept away the assumption that unfettered markets lead to untarnished growth. We are now at the beginnings of a new fourth era, one in which government has a larger and more central role in terms of both direct fiscal intervention and of greater regulation.

5. Our sense of time is affected. To live in period of sustained long-term economic growth makes it easy to believe in timely progress towards bigger and better and brighter things. All the pension funds, for example, are based on the assumption that investments will always just grow and grow. That linear sense of an upward trajectory is being replaced by a more circular sense of repeating cycles: our present condition is compared and contrasted with the Great Depression. Yet whether or not we are repeating or avoiding history is moot. What is not moot is that our confidence in a steadily increasing curve of growth and expansion is shattered. The future is now, but it is not the optimistic future we have been led to believe.

A moral economy

The great historian, E. P. Thompson, first raised the issue of the moral economy of the crowd in a paper published in 1971. He was referring to the food riots, which occurred every ten years or so in late eighteenth-century England. He demolished the old belief that the riots were spasms of hunger, suggesting instead that they represented a ‘highly complex form of direct popular opinion’. They were about establishing the moral price of food rather than the going market rate.

We have witnessed the moral economy of the crowd last week in the US with the public outcry over the $165 million retention payments to workers in the bailed-out insurance giant AIG. The company had followed some very risky practices, jeopardized the entire US financial system, lost a great deal of money and was eventually bailed out by the federal authorities.

On the surface, the retention payments are small compared to the $170 billion that the company received. With more to come. And many of the people responsible for the risky behavior had long left the company. But the popular sentiment was not a calibrated public policy response; it was a restatement of a moral economy in the face of a market economy out of step with current realities and popular concerns.

Crowds in Washington DC. Photo: John Rennie Short

The financial service sector at the top level is over rewarded. The system of bonuses and retention packages originated when both profits and risks were borne by partners in trading companies. Now, in large public companies, the upper executives overpay themselves, a practice authorized and condoned by compliant, collusive boards, while the risks and costs are socialized and paid by the shareholders or eventually the government and the public. The former CEO of Countrywide, a mortgage company that specialized in risky subprime mortgages, made out very well in the last six months of 2007. Angelo Mozilo, who looks like a lizard in an expensive suit, was paid almost $2 million in salary, given $20 million in stock and sold $121 million in stock. The company meanwhile lost $1. 6 billion while the share prices fell 80 percent. Bad luck for the shareholders, but no problem for Mozilo.

It is against the background of the widespread appreciation of privatized benefits and the public nature of the costs that people responded to the AIG bonuses. What is surprising is how quickly the political system responded to peoples’ anger: within a week of the bonuses becoming public, the House introduced a measure to tax the benefits up to 90 percent.

The close connection between the public mood and federal response is rare. The founders were distrustful of a full and functioning government by all the people. The Congress and the other two branches, the executive and the judicial (an oligarchy of lifetime appointees whose ideology always seems half a century behind the general public), limit and blunt the expression of the popular will into policies and politics. Policies in Washington DC are shaped by interest groups who hone regulations to meet their needs. The political system listens to the power of money. Politicians desperately need money to stay competitive, win races and stay in power. Those with most money have the best access: they have the power to influence and advise. Ordinary people exercise political choice at elections but those with money exercise real political power.

So the events last week in Washington were highly unusual. The consequent legislation may not stand up. Already experts are pointing to its haste and questioning its legality. The proposed legislation was not well thought out, and it was done in haste and anger. But so are much of US federal policies. It was a raw expression of a true democracy. It was the moral economy of the crowd armed with blogs and emails rather than pitchforks and street demonstrations, reaffirming values of fairness and community over greed and self. The moral economy expressed against an amoral economy.

The Neighborhood Effect or The Social Nature of a Capitalist Economy

Like many people I am appalled at the prospect of bailing out banks and feckless homeowners. And the pundits are having a field day with the notion of a rule-governed, tax-paying people--that’s us--subsidizing scoundrels and incompetents--that’s them. But much of the anger is based on the mistaken notion that our economic self-interest is undermined by such intervention. This individualistic ideology is particularly strong in the United States. And there is a very real issue of the moral hazard of the public subsidization of reckless private behavior. But we also have to be aware that our financial security and economic health is crucially dependent on other people. Let’s consider the housing crisis as an example. As an individual owner-occupier, I am concerned with the value of my home. But this value is based not only on the characteristics of the individual dwelling but also on the going price of my neighbors’ homes. If they go down in value, so do mine. The price of any home is a function of the homes around them. We can refer to this as the neighborhood effect. Foreclosures increase the number of vacant and abandoned properties and so home values, including mine, decrease. It is in our economic self-interest to have the mortgage crisis solved. And even if you live in a neighborhood untouched by foreclosures--less of a possibility as the crisis worsens--the housing market is based on long chains of purchase. House sales form chains from the top to the bottom of the market. When someone buys a property at the entry level, that enables the existing owner to sell and use the proceeds to buy a more expensive house that in turn allows the owner of a more expensive home to buy another place. A broken link has effects further up the chain.

Neighborhood effects and housing chains are just some of the ways that we as individual homeowners and purchasers are enmeshed in wider connections and ties. We need to remember this so that the debate can more effectively be about the details of stemming foreclosures and minimizing their neighborhood effects rather than on the principle of government intervention as an inherently bad thing. Underlying much of the criticism of economic policy is a mistaken assumption that we are economic isolates. We need to be aware of the social nature of even a capitalist economy, and more especially, of a functioning capitalist economy.