Some thoughts on the global financial crisis

How can we make sense of the recent meltdown in the global economy? Most commentators focus on the immediate sources of the crisis—excessively low interest rates which enabled the housing bubble, the rise of subprime mortgages in the US, increasingly complex financial instruments and over-leveraged financial institutions. All of these factors are important. But we also need to consider some of the underlying problems and pathologies in financial markets and in our attitude towards them if we really want to understand the current crisis and prevent future ones.

My recent work on the financial crisis has focused on three of these underlying dynamics: the ambiguous character of financial markets, the limits of risk management, and the international community's failure to draw the right lessons from the Asian financial crisis of 1997-98.

The ambiguous character of markets

Every time a financial crisis errupts, we realize that recent financial behaviour has been less than perfectly rational—prone to excessive optimism followed by panic. Yet between crises, we seem to forget the tendency of markets towards excessive behaviour and assume that markets are the most efficient way of organizing larger and larger areas of our lives. While this selective amnesia may seem odd, it is in fact completely consistent with the social and interpretive character of markets—what I call their ambiguity.

We often treat markets as if they were simply the (almost magical) aggregation of rational individual actions. Yet, market actors are actually engaged in a complex game of interpreting each others' expectations about the market's direction. John Maynard Keynes, writing after the last great financial crisis of 1929, described this as the "animal spirits" of investors, in which each is trying to guess what the others are guessing what others' are guessing that the market is about to do. If you can get this guessing game right, you make a lot of money.

Unfortunately, the down side of this particular process is a financial market subject to enormous volatility, driven by excessive optimism (those moments when we think the markets can do no wrong and housing prices, or dot.com stocks will continue to increase in value forever) and desperate pessimism (what we've been living through for the past few months).

The limits of risk management

We therefore live with a profoundly ambiguous financial world. Our systems of financial governance should recognize this fact and respond to it. Yet over the past several decades we have tended instead to treat these complex ambiguities as risk—something that can be calculated, priced, bought and sold. Risk management has become increasingly central to the current financial system. Because financial leaders believed that it was possible to accurately measure risk, they relied more heavily on a logic of self-regulation, in which banks and other major financial institutions became responsible for determining their capital adequacy requirements based on internal risk management models. More faith was also placed in credit rating agencies' ability to assess and grade credit risks.

Yet the recent financial crisis has revealed the very serious limits in our ability to measure and manage financial risks—and on the system of self-regulation that dependended on this ability.

The lessons of the Asian financial crisis

Just a decade ago, the global financial system suffered from another serious financial crisis, which started in Southeast Asia and ultimately spread to various emerging markets. While this crisis was different from the current one, there were some eerie similaries—excessive leverage, poor risk management and a property bubble were all central problems in both crises. Why then didn't we see the Asian crisis as the canary in the coal mine?

Because we drew the wrong lessons. Put simply, the dominant interpretation of the crisis was that the problem was the Asian economies', not ours, and that it was a problem with governments, not with markets. Although critics like Joseph Stiglitz, Dani Rodrik and Jeffrey Sachs argued otherwise, this was the position adopted by the IMF, the US Treasury, the G7 and other major players. The response to the Asian crisis was therefore not to re-examine the logic of financial de-regulation that had driven the financial system since the early 1980s, but rather to rely more on self-regulation, transparency (for governments far more than markets) and risk-management.

What next?

We should instead have drawn the same lessons from the Asian crisis that we need to draw today. The problem of financial market instability is with us to stay, and opacity is at least as much a challenge for markets as for governments. Unfortunately, this does not mean that transparency is the panacea that so many seem to think it is: the inherent ambiguity of financial markets means that the best that we can hope for is to manage and accommodate their uncertainties and unpredictabilities rather than hoping to eliminate them.

This means that we cannot rely as much on industry self-regulation and risk-management. It also means that difficult decisions will need to be made, which means that politics and public policy need to play a bigger role in financial markets than they have since the post-war era. But the limits of risk management also pose serious challenges for public policy, since it means that there are no easy technocratic fixes. Instead, we will need to experiment, be open to new ideas and above all seek to develop flexible and adaptable policies.

It will likely take years rather than months to develop the policies and institutions that will prevent future crises of this magnitude. During this process, it is worth keeping several basic principles in mind:

• If the public is going to take responsibility for the private sector's failures, there needs to be better public regulation.
• We need more comprehensive global and national financial regulation —including counter-cyclical provisions.
• We also need to make sure, however, that policies remain flexible and adaptable to future unexpected changes.
• We must also respect national autonomy (including that of emerging and low-income countries) and foster diversity, rather than trying to create a new global economic monoculture linked to rigid standards.
• We need to reform the international financial institutions (the IMF and World Bank) not only by making them more democratic, but also by creating a more open-minded institutional culture.
• Above all, since all of these changes will have political consequences, we need to make sure that we pursue these debates as openly, democratically and inclusively as possible.