Recent Crisis - Repair or Write Off?

The recent financial crisis, like many of its predecessors, has been met with an assertion that “this time is different” (Reinhart and Rogoff, 2008).  Yet, Reinhart and Rogoff suggest that factors such as interest rate shocks and commodity price collapses have been common in financial crises throughout the last 8 centuries.  With this in mind, they suggest the 2008 “US sub-prime financial crisis is hardly unique”.  Moreover, Demirgüç-Kunt and Detragiache (1998) argue that financial liberalization and subsequent innovation have been important factors in financial crises throughout history, and Mishkin (2009) proposes that mismanagement of this resulting innovation is of particular significance. 

In the US, deregulation of the financial markets, and low interest rates gave rise to a housing bubble which would act as a catalyst for the 2008 crisis.  More specifically, securitization fostered a culture of lax credit control to meet the demands of a liquid market, and so the housing bubble grew.  Interestingly, Alan Greenspan, former Chairman of the Federal Reserve (1987-2006), and a keen advocate for capitalist free markets, commented in 2008, “the immense and largely unregulated business of spreading financial risk widely, through the use of exotic financial instruments called derivatives, had gotten out of control.”  (Full article here)

The magnitude and severity of the recent crisis cannot have gone unnoticed by even the most vehement supporters of capitalism.  In particular, the ‘violent’ nature of this creative destruction emphasizes the social costs such a system can generate, especially to the most deprived in society.  For example, it could be argued that financial innovation enabled the less well-off to ‘afford’ housing through lax credit requirements, but then entrenched many of these same people in a life of debt, whilst sophisticated banking institutions and investors profiteered from the speculative bubble, cushioned by limited liability and a lender of last resort.   However, we should also remember that whilst capitalism does not generate an earthly utopia, it has provided a powerful and unparalleled growth mechanism.

So what’s the future for capitalism, and have we learned anything from the recent financial Armageddon?  BBC business editor Robert Peston has examined this issue in two special reports for BBC News.  I will focus more on answering these questions next week, but I will post the first video here as it summarizes the recent financial crisis and provides a sneak peak of what’s to come!