CAMBRIDGE – Will today’s ever widening global financial crisis mark the end of the era of financial triumphalism? Ask a lay person to list the ten great innovations that drive our world today and you probably won’t find too many who mention the Black-Scholes formula for pricing options. But for the financial community, pioneering formulas that paved the way for modern hedging strategies should get just as much credit for the passing period of rapid global growth as cell phones, computers, and the Internet.
Until the last 12 months, finance advocates seemed to have a strong case. By helping to spread risk, high-tech finance could help economies grow faster. Macroeconomists celebrated the “Great Moderation” of the global business cycle, with recessions seeming to become milder and less frequent. And, of course, the financial community was making money hand over fist, creating scores of millionaires and even billionaires worldwide.
Governments were cheerleaders, too. In anglophone countries, presidents and prime ministers, not to mention some leading central bankers, boasted of superior financial systems that were the envy of the world. When French and German leaders complained that the sprawling and unregulated tentacles of new finance posed huge risks to the global economy, they were derided as sore losers. Small countries such as Iceland decided to get in on the action by privatizing their banks and setting up their own financial centers. If you cannot be Silicon Valley, then why not create a mini-Wall Street?
Now Iceland’s banks, having borrowed several times the national GDP, are in desperate trouble, with debts far beyond what the small country’s taxpayers can absorb. Even the conservative Swiss gave into the temptations of high-tech finance and the riches it promised. Today, the two largest Swiss banks are sinking in liabilities that exceed seven times the country’s income.