Market forces, the power of government and the 2008 financial crisis

I have recently finished two fascinating books: Alan Greenspan‘s The Age of Turbulence and Ha-Joon Chang‘s Bad Samaritans. For the purposes of this entry, I shall focus on two related themes, one drawn from the former book (market forces are all-powerful and mostly all-good) and one from the latter (governments should intervene to promote economic prosperity). In the light of these, I shall also discuss the outcome of the 2008 financial crisis and the prospects for a return to growth. 

In his memoirs, Greenspan makes clear that he regards the current economic and financial crisis to have been largely unforseeable and not preventable by policy-makers; that it was a product of forces of globalization, of the opening up of markets globally. He has stated in subseqent interviews that it is a ‘once in a century event’, and thus that we should not try and prevent such an event in the future through a greater regulation of capitalism generally.

In his latest book, Chang makes no apologies for his position in being committed to government intervention in the economy to promote and sustain the prosperity of the nation, particularly in countries which have yet to ‘develop’, industrialize, and catch up to some degree in terms of national income with the current group of rich countries. He makes a strong case for intervention to promote development, and is highly critical of neo-liberal theories of development policy and practice. Since his book is largely about economic development, Chang does not make clear in this volume what he regards as suitable policy prescriptions for countries once they reach a relatively high level of income per capita. He is clear that poor country governments need to use protectionism and other interventions to build their ‘capabilities’ (their ability to use more advanced technologies in production), but this is not a book primarily about the policies of developed economies. Since rich countries usually continue to develop their wealth and techological capabilities, I would imagine he would advocate certain discretionary interventions in support of this process. He does mention that rich country governments, for example that of the US, often behave in a ‘Keynesian‘ fashion during recessions, cutting interest rates and running budget deficits to stimulate growth and employment, while at the same time, via the IMF, prescribing high interest rates and deficit reduction to poorer countries if they undergo a financial crisis. Chang is highly critical of this ‘one policy for the rich, another for the poor’ behaviour. In general then, it would seem that Chang favours well-designed government interventions as an absolute necessity for promoting growth and prosperity throughout the global economy, and within all nations.

Greenspan, in contrast to Chang, favours the extension of market activity as far as is possible (Chang is not against the growth of markets, but he would not promote them as an ideology), while acknowledging the stressful and unsettling side of ‘creative destruction‘ and the consequent social change for human beings. He sees a trade-off between the creation of wealth and the mitigation or tempering of market forces. His writings make allusions to history and the success of market economies to date, but he gives few detailed examples of this outside the US. Chang’s book explores the history of development policies much more deeply and makes a convincing case that economic growth and development success stories have been made possible by detailed government intervention. While not always successful, ‘wise’ interventions can make a real difference to the growth of material wealth.
Greenspan makes quite a convincing case as well that the current financial crisis and the preceding boom were caused by forces of globalization. Specifically, the opening-up of markets in China and India especially, have increased the global supply of labour by a huge degree, putting downward pressure on global wages, inflation and long-term interest rates. The price of risk was thus very low for a number of years this decade. These forces caused a boom in asset prices, which provided collateral for credit booms in many economies around the world. As these forces, and the associated economic and financial imbalances, unwind, a severe global slowdown, and a recession in most if not all rich countries, is precipitated, with the consequent need for massive government intervention in the rich world to prevent financial collapse. Greenspan has since commented that his approach had had a ‘flaw‘. Nevertheless, he has taken little responsibility for either the financial boom or the subsequent bust. Is he right? Do policymakers bare little of the blame? We must remember that it was government policies, conscious choices on the part of officials, which led to the current form of globalization. This implies that different forms would have been possible.

Are policymakers helpless in the face of market forces, and do they merely give way to their inevitable power? If they are, this does not say much for the power of democracy, to counter the power of what are also corporate and financial interests, and more than simply ‘market forces’. The latter is too convenient an excuse for inaction or one-sided argument. The current system of the global economy has been deliberately created by a whole sequence of policy choices and, as argued above, different forms of organisation may have been possible. I remain hopeful that this is the case, and that we do have choices about what sort of future we want materially, socially and politically.

In Chang’s approach, government interventions are necessary to ensure prosperity. This, I would argue, should include promoting economic stability. Some others, including Greenspan, have argued that it was stability, in the form of low inflation, that triggered the boom in the first place, and thus the success of policies which have promoted globalization and price stability, have created new instabilities. I find this convincing too. But could governments have been more preemptive and nipped the boom before it created such problems? Well, this may have been difficult, given that it would probably have undermined prosperity to some degree, which is politically unpopular. Central banks are to some degree meant to be free from political influence, although they are charged with a political mandate. Had their mandate been to guard against more general financial instability and not simply price instability, mitigating action by central banks and regulators could have been taken sooner and maybe prevented a crisis of such major proportions. If a central bank is meant to promote sustainable economic growth, as the US Federal Reserve is, it is the responsibility of Greenspan, his advisors, and their successors, to nip inflation in the bud, and that could include asset-price inflation, which can obviously cause a wider systemic instability and undermine growth in the medium term. 

What defines sustainable growth? And does sustainable growth have to be as stable as possible? What is the link between instability and the long-run rate of growth? And will the population, particularly in a modern democracy, bear the hardships of short and even medium-run economic and financial instability? I would argue that the answer to the last question is no. The other questions require a deeper analysis. The important thing is that governments put in place new policies which lay the basis for a new round of sustainable growth across the globe. Barack Obama has promised to ‘create’ 2.5 million jobs in his first two years in office through public works projects to rebuild the infrastructure of the US. This vision could potentially increase US productivity and prosperity in the longer term. Elsewhere, EU countries have allowed budget deficits to increase to mitigate the downturn. In the UK, some public works projects are to be brought forward, as the budget deficit is forecast to reach some 8% of GDP in 2010. Probably more important to the longer-term restoration of growth is the ‘fixing’ of the financial system and the rebuilding of financial intermediation. According to Greenspan, the latter is ‘broken’ globally and part of the fixing is that banks needs to rebuild the capital base part of their balance sheets, while ‘toxic’ assets are wound down and removed. The whole process could take many years, but growth can be restored more quickly, as asset markets turn, particularly those that stimulate consumption and investment, the housing market and the stock market.

Clearly government intervention has been absolutely necessary in this time of crisis and only the most die-hard neo-liberals would argue against it now. Many of those who supported recent policies are probably reluctant interventionists even in the current situation, and may be saddened that it had to come to this. Interventionists by persuasion might be ‘happier’ that government stepped in in the way that it did, or at least feel vindicated. As the crisis begins to unwind and growth begins to return, government can either get out of the way as quickly as possible or else try to reshape public institutions and systems of regulation to ensure that the current form of global crisis remains a ‘once in a century event’, or even less so. I would argue for the latter.

So which approach is right, that of Greenspan or Chang? In the case of rich countries, both are partly right, depending on the circumstances. Policy choices shaped the current form of globalization, which gave rise to the financial boom and subsequent bust. New policies were and are needed to bring us out of the crisis, and even Greenspan has tacitly admitted this to be the case. The power of markets and of government, working together, will restore prosperity in the longer term.