PRINCETON – Crises, especially very severe ones, are often learning opportunities. Unfortunately, so far the world seems to have learned very little from the recent financial crisis. In fact, the situation today is just as dangerous as it was in 2007, with the United States now worried by its anemic economic recovery, Europe paralyzed by fears for the survival of its currency union, and emerging markets wrestling with asset-price bubbles.
Learning from crises is partly an exercise in analyzing what went wrong. But it is also about finding solutions. Collectively, we have done well on the former, and very poorly on the latter.
Most explanations of the causes of the post-2007 financial crisis point to five sources of instability. First, the crisis was precipitated by the peculiarities of the US real-estate market, by government incentives for increased homeownership, and in imprudent lending by financial institutions.
Second, perverse incentives led financial institutions to assume excessive risks. Internally, bankers had enormous potential to benefit from risky moves, but were insulated from the costs of failure. For individual institutions, this was not seen as a problem, because they were protected by the logic of being “too big to fail.” When the crisis erupted – owing to a downturn in the US housing market that was clearly foreseeable but willfully unforeseen – the public sector had to absorb the contingent liabilities built up in the financial system.
Third, global imbalances led to cheap money. Long-term current-account surpluses in some countries (China, other rapidly growing Asian economies, and Gulf oil producers) permitted the long-term financing of deficits in others (the United Kingdom, Australia, Spain, Ireland, and, above all, the US).
Fourth, central banks, especially in the US, mistakenly maintained loose monetary policy. With dollar financing by the Federal Reserve available to large institutions, the Fed became the equivalent of a world central bank.
Finally, once the crisis erupted, the fiscal consequences of bailing out too-big-to-fail financial institutions contributed to rapid public-debt unsustainability, which threatens to boomerang on the banking sector.
None of these issues, with the possible exception of the first, has been resolved. Of course, some discussion of financial-sector reform is taking place in a variety of forums, with a gradual consensus building around sliding or incremental capital-adequacy rules. But many systemically important banks became bigger rather than smaller as a result of the crisis.
Moreover, while global imbalances were immediately reduced in the course of the initial crisis, with the US adjusting its deficit relatively rapidly, they are now re-emerging.
The world’s major industrial economies, meanwhile, are maintaining very low interest rates. Before 2007, such a policy was seen as a mistake at worst; now it is interpreted as a malign strategy. There is a widespread suspicion that the US is deliberately pursuing dollar depreciation (or “currency wars,” in the words of Brazil’s finance minister).
We do not know how to handle the fiscal issues posed by the financial crisis. Doubts about the sustainability of government debt produce sudden surges in interest rates, as risk premia rise dramatically with perceptions of the likelihood of default. Such surges are, by definition, abrupt – and thus highly disruptive.
For countries on the brink, a merciless logic follows. Government debt service has in general become easier, owing to low interest rates. But hints of new fiscal imprudence or of backsliding on long-term debt consolidation and reduction can drive up borrowing costs dramatically. In these circumstances, the additional costs of debt service easily outweigh any gains that might come from some measure of fiscal relaxation.
As a result, fiscal uncertainty is affecting all major industrial countries, and producing political paralysis. So, while we understand very well what may have produced the financial crisis, we find ourselves helpless to draw usable lessons from it.
In a longer historical perspective, this policy paralysis may not be surprising. It took a good deal of time to learn what we all now take to be the lessons of the interwar Great Depression. It was only 30 years later, in the 1960’s, that Keynesian fiscal policy was widely accepted. It was also only in the 1960’s that Milton Friedman clearly formulated the Great Depression’s monetary lessons.
It was only in trade policy that the lesson was learned more quickly. During the Great Depression, a spiral of protectionist trade quotas and tariff restrictions was used to combat monetary deflation, as popular demand for political action met legislative “log-rolling” by representatives of groups with very different – and often very locally oriented – policy priorities. The political scientist E.E. Schattschneider’s analysis of the process was influential in transferring responsibility for trade measures from the US Congress to the President.
The modern equivalent of that learning about trade policy would be to think about mechanisms to ensure long-term improvement in fiscal policymaking. In particular, it would be helpful to devise a way to identify potential risks to fiscal stability (such as those implied by an over-extended banking and financial system). Moreover, there is a need to limit legislative pressure for additional spending on locally important projects that fuel overall fiscal dysfunction.
The constructive (and relatively quick) trade-policy response in the aftermath of the Great Depression did not pay off immediately. But, in the long run, it produced a much better policymaking environment. Now is the moment to launch an analogous effort to reform and rationalize the political process that produces fiscal policy.