The financial crisis: unorthodox thoughts

Grahame Thompson
3 October 2008

The crisis in the international financial system is still unfolding and continued short-term policy firefighting is absolutely necessary. But what about the longer-term response: how should the authorities react in terms of new regulatory initiatives? The answer depends in part on an analysis of the nature of the crisis, and of what is happening in the system more generally.

Grahame Thompson is professor of political economy at the Open University. He is the co-author (with Paul Hirst) of Globalisation in Question: The International Economy and the Possibilities of Governance (1999) and Between Hierarchies and Markets: The Logic and Limits of Network Forms of Organisation (2003)In addressing this more fundamental question, I want to propose two arguments that contest the dominant assumptions underlying much current commentary. The first is that this is not a "global" crisis at all - rather, it is almost exclusively confined to the United States and certain countries in northwestern Europe.

The second point follows: if the crisis is not global, this must be reflected both in the "geography" of the reactions to it and the character of any regulatory regime that might be installed in light of this sense of its scale. 

The implication of these two arguments is, again, twofold: that the authorities' emphasis should be on supranational regional responses rather than global ones per se; and that if financial crises are fundamentally "irrational" (driven by "excessive exuberances", "animal spirits", "bandwagon effects" and the like) then there is a need to prepare in quite a different way for the next crisis - because there will one.

The limits of the "global"

The first argument can be illustrated by noting the extent of the damage inflicted by the credit-crunch on commercial banks. This was estimated in early August 2008 as around $265 billion in terms of write-downs or outright failures. The sum has since increased by $25-$30bn after several large financial institutions were absorbed into other banks or effectively nationalised: among them Fannie Mae and Freddie MacLehmann Brothers, AIG, Bradford & Bingley, and Fortis.

These losses, taken together, have been incurred by thirty-five separate financial institutions. However, only one of these was outside of the United States or Europe (the National Bank of Australia, involving just under $1bn). There may be further failures and some contagion beyond the transatlantic world, but this is likely to be limited - as it has been so far.

What are the reasons for this concentration in the north Atlantic region? The main one is that this reflects the dominance in capital flows of this region and the "greater Europe" area (that is, the eurozone and other areas of western and eastern Europe, including Russia). Despite all the talk about the global nature of the crisis, some 70% of the world's financial flows and domestic financial assets remain tethered to these two regions (see McKinsey Global Institute, Mapping Global Capital Markets: Fourth Annual Report: 2008). This suggests that there is not yet anywhere near a truly global financial system - and indeed I would suggest this is an impossible dream.

If the system were truly global then losses of this magnitude would already have had a devastating "global" impact on commercial banks in countries beyond the core regions affected - but this has not happened. The absence of this global impact is also rooted in the structural disjuncture between domestic and international financial systems - which will remain unbridgeable as long as there are different currencies tied to different domestic financial systems (in other words, while there is no single global currency); no proper global central bank to act as lender of last resort for this single currency; and only a few countries that can borrow on the international markets in their own currency to finance their economic activity, while the vast majority of other countries must borrow in someone else's currency.

This is the structural basis of all the uncertainties and risks in the international financial system; and these conditions will not go away in the foreseeable future. These structural constraints inhibit the formation of a genuinely global financial system, leaving a much more differentiated system of national domestic and international financial relationships and interactions that need to be viewed in their specificity and singularity rather than as a single "system".

The financial-innovation cycle 

The lesson to be learned from this analysis is that further "global" rules to try to tame the financial beast are very unlikely to be successful. This is not an argument against strong regulation - but only against this regulation always being conceived as necessarily global in scope because the financial system is thought to be global. If it is not - and indeed will continue not to be so - then a different response is called for.

My analysis of the financial system - and of the "real" economy beyond -- is that this still remains largely supranationally regional in organisation and not global (see PQ Hirst, G Thompson & S Bromley, Globalisation in Question [Polity, 3rd edition, 2008]). If this is so, a supranational regional response would be more sensible. This would allow for the responses to be tailored to the specific conditions and features of such regional or national financial configurations; enable agreement on what to do to be reached more easily, since fewer players are involved; and encourage "regulatory innovation", since different frameworks would arise.

It is clear that the present financial crisis is deep and very serious. For the banking sector in particular it may be the worst crisis since the 1930s, and it threatens to spill over into the real economy of those countries most closely affected. But financial crises come and go - and the typical "financial-crisis cycle" as a whole contains regular phases and features that can be analytically useful. The phase involving "financial innovation", a central part of present concerns, is an example.

Such financial innovation always raises many fears as it takes hold; these are well documented and discussed at the time, with warnings offered as to their likely downside effects, which however are never properly headed by authorities or regulators. This then leads to another phase as a crisis -brought about largely by these innovations - hits the system. This results in a great deal of firefighting where authorities try - amid a lot of hand-wringing, soul-searching and recrimination - to gain control of the crisis and prevent it spreading.

As the crisis subsides this is followed by a longer, analytical and diagnostic post-mortem phase: what were the reasons for the crisis; who or what was to blame; what lessons can be learned and what done to prevent a further crisis? This is a difficult phase because there is never agreement about causes or consequences. However, alongside or just behind it, the authorities begin to act, putting in place frameworks to discuss measures needed to prevent another crisis of this type.

This phase requires a political mobilisation to gather momentum amongst the affected parties - a  difficult and lengthy process. Eventually, some consensus is reached, usually entailing a very watered-down and minimalist set of regulatory responses which is agreed and gradually implemented. Meanwhile, the system has moved on and a new set of financial innovations has taken hold - so the responses to the previous crisis now operating look as though they are unnecessary or addressing yesterday's problem. Meanwhile, the fact that the authorities are still grappling with the regulatory consequences of that previous round of innovations means their focus is not on the existing round or the threats these now pose. So the cycle goes on...

The forms of regulation

I was once at a conference where I asked a panel of regulators and central-bank governors what could be done, if anything, to break this cycle. Their response was intriguing: they said that this was an "existential question" and that such questions could not be answered!

On reflection, however, I think this answer should be taken seriously. Perhaps the mindset of such bank governors and regulators is so focused on traditional responses  that they cannot get out of this way of thinking and see that the system is actually "existential" in the sense that it is "irrational". It is not, therefore, amenable to systematic and calculative responses, where the IMF or BIS simply begins another round of negotiations for a comprehensive and consistent set of new global regulatory norms and rules to be adhered to by everyone. Rather what is needed is a realisation that financial insecurity is going to continue (amid the exuberances and bandwagon effects referred to above) to be a fact of life. If this is so, what is needed is to organise a highly flexible regulatory regime of "distributed preparedness" and "system resilience", that does not presume a single centre from which a new elaborate global regulatory regime emanates (see Collier & Lakoff, 2008).

This approach would have to pay particular attention to the necessarily fragmented nature of financial regulation in an attempt to forestall any exploitation of the gaps within it. This would involve a lot of contingency planning and attempts to coordinate the disparate array of "local" (supranationally-regional in this case) organisational and partial initiatives, requiring the application of improvisational skills and ingenuity. The task would be to map the vulnerabilities and network the relationship between them. And this regulatory world would always need to expect the unexpected.

Such a response is less likely than that the traditional financial-crisis cycle will recur. But imaginative thinking about the future - to try to create a robust alternative conception - is absolutely necessary, even if the precise terms of what has been suggested here proves wanting.

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