THE GREAT UNRAVELLING

Jayati Ghosh*

It is now clear that the prolonged
party for international finance capital is over, at least for now.
The US financial structure is crumbling, possibly even collapsing.
The collapse of the major Wall Street bank Bear Stearns and the
interest rate sops and enormous bailouts that are being offered to
financial institutions in the US by the US Federal Reserve are only
symptomatic of the wider crisis.

This crisis was created by the
unravelling of the real estate boom, which was itself based on dodgy
lending practices. Everyone knows that what has already come out is
only the tip of the iceberg. The financial crisis has already spread
quite dramatically: from "sub-prime" borrowers to "prime"
borrowers; from bad mortgage debt to bad credit card debt; and from
banks to hedge funds to insurance companies.

There is no doubt that there is much
more bad news to come within US markets. And most certainly, given
the sheer size of the US system and the complex forms of financial
pyramiding and entanglement with other financial structures in
different countries, the global financial system will feel the
impact.

But meanwhile, the actions of the
Federal Reserve – the US central bank – have at one level
declared the end of the recent era of freewheeling and deregulated
finance. The financial liberalisation of the past two decades across
the world was based on two mistaken notions. First is the "efficient
markets" hypothesis beloved of some economists and many more
financial players, which asserts that financial markets are
informationally efficient, in that prices on traded financial assets
reflect all known information and therefore are unbiased in the sense
that they reflect the collective beliefs of all investors about
future prospects. Second is the notion that financial institutions,
especially large and established ones, are capable of and good at
self-regulation, since it is in their own best interests to do so.
And therefore external regulation by the state is both unnecessary
and inefficient.

Both of these presumptions are now in
tatters, completely destroyed by the waves of bad news that keeps
coming from the financial markets, and by the growing evidence of
foolish and irresponsible behaviour that was clearly indulged in by
large and respectable financial players. It has emerged that
unreliable behaviours is not the preserve of a few relatively small
fly-by-night operators, but is endemic even among the largest private
players in the financial system.

It is also increasingly clear that
deregulated financial markets today are characterised by huge
conflicts of interest: between the different functions that
investment banks have taken on in recent times, between investment
banks and regulators, between financial interests and the media, and
so on. Financial deregulation allowed financial institutions to take
on different activities that were earlier clearly segregated. Thus
banks could take on non-bank financial services, and vice versa. It
is clear that in terms of the activities of the banks, the
integration of broking and underwriting, of proprietary and customer
trading, of market research and investment advice, all give rise to
huge conflicts of interest within the leviathan investment banks, and
these conflicts are seldom or inadequately regulated. As a result,
banks can carry on with problematic practices because they make their
profits on commissions and fees rather than on actual repayment by
borrowers.

Such a situation was obviously not
sustainable, and all these undesirable financial practices have now
led to an enormous mess in the very heart of capitalism, Wall Street.
And this has already required large public resources being made
available to save fragile financial institutions, with more spending
likely.

So finance capital, which has so far
systematically tried to undermine the state and demanded autonomy for
all its actions, is now calling to that same state to save finance
from itself. But can this occur without the state at least trying to
reassert some control over finance?

Not likely, if recent commentators are
to be believed. Several American economists, including Joseph
Stiglitz and Paul Krugman, have already called for more controls on
finance, most of all the separation of different types of financial
activity of banks and others. Now the normally free-market-oriented
columnist of the Financial Times, Martin Wolf, has comes out even
more strongly. In a recent article (March 25, 2008) he states:
"Remember Friday March 14 2008: it was the day the dream of
global free-market capitalism died. For three decades we have moved
towards market-driven financial systems. By its decision to rescue
Bear Stearns, the Federal Reserve, chief protagonist of free-market
capitalism, declared this era over. ..Deregulation has reached its
limits."

This has significance beyond just the
United States. All over the world, the Anglo-American style of
financial system and its pattern of financial deregulation has been
sold as the definitive model to follow. It already led to financial
crisis in Japan and a large number of developing emerging markets but
all of these were blamed on internal problems of those countries,
such as "crony capitalism". Now, with the implosion of the
US financial market, such arguments are no longer possible.

Martin Wolf also recognises this: "If
the US itself has passed the high water mark of financial
deregulation, this will have wide global implications. Until
recently, it was possible to tell the Chinese, the Indians or those
who suffered significant financial crises in the past two decades
that there existed a financial system both free and robust. That is
the case no longer. It will be hard, indeed, to persuade such
countries that the market failures revealed in the US and other
high-income countries are not a dire warning. If the US, with its
vast experience and resources, was unable to avoid these traps, why,
they will ask, should we expect to do better?"

In every crisis, the Chinese ideogram
states, there is also an opportunity. So in this current US financial
crisis there is a tremendous opportunity not only for the US but even
more for the rest of the world, to bring back the financial
regulation that has turned out to be so essential.

* Jayati Ghosh is Professor of
Economics at the Centre for Economic Studies and Planning, Jawaharlal
Nehru University, in New Delhi, India. She is on the executive
committee of the International Development Economics Associates
(IDEAS), a network of economists critical of the mainstream economic
paradigm of neo-liberalism.

http://www.networkideas.org/news/apr2008/print/prnt070408_Unravelling.htm