I don’t know whether this crisis will turn out to be the worst for more than 60 years, as Chancellor Alistair Darling suggests. If so, I wonder if it will change the world as profoundly as the last great global financial crisis – the Great Depression.
Many of today’s challenges can be traced back to the 1930s and the responses to the Depression. Fannie Mae and Freddie Mac, effectively nationalised by the US government last weekend, were Depression-era inventions, designed to shore up the US housing market by providing banks with a government guarantee on mortgage debt. They did their job so effectively that they helped fuel the world’s biggest housing bubble and acquired such stupendous liabilities – $5,400trn – that their collapse threatened to bring down the entire global financial system.
And former Fed chairman Alan Greenspan’s approach to monetary policy can be seen as an attempt to avoid a repeat of the 1930s. At the first sign of trouble, Greenspan was quick to slash interest rates, inflating one bubble after another, until the Fed ran out of assets to inflate. The Depression was also partly responsible for the rise of fascism in Europe and, by extension, for World War II. The demands of total war brought governments even further into people’s lives, making the establishment of increasingly extravagant welfare states easier. As countries discovered that their new liabilities were threatening the value of their currencies, they simply broke free of the gold standard and embraced the brave new world of paper currencies – with all the temptations for further borrowing that entailed.
The Depression created a new role for government, in which the benevolent state stands ready to bail out market failures and underwrite risks in both the economic and social spheres. Angry voters around the world demanded that governments should never again allow the appalling human misery caused by the Depression to happen again.
Could the current crisis lead people to challenge these post-1930s ideas? After last week’s events, it’s hard to believe things can just go back to the way they were when this crisis is over. When the US government has to assume $5,400trn of liabilities over a weekend – equivalent to doubling its debt burden – the full cost of the implicit socialisation of risk in the financial system starts to become apparent.
And this crisis may have a lot further to run. The US housing slump has only been running for about 18 months – typical housing bear markets last four and a half years, according to Credit Suisse. And the crisis is spreading well beyond America and Britain, with large parts of the eurozone faltering badly and pressure mounting in emerging markets. And the costs of these bail-outs come on top of the other ballooning debts of Western governments – from unfunded pension liabilities to rising healthcare costs, to picking up the tab for social and family breakdown. The scale of these liabilities is a reminder that the response to this crisis is not just a matter of domestic politics, to be left to the discretion of individual governments. When Hank Paulson, the US Treasury Secretary, was rescuing Fannie and Freddie, foremost in his mind were the foreign governments who own more than 60% of Fannie’s and Freddie’s debt. Wiping out those holdings could have led to a run on the dollar. Similar concerns will have been behind George Osborne’s announcement that he may have to slash spending to restore the UK finances if he becomes Chancellor.
So what changes may come from the current crisis? Will governments decide that underwriting risk-taking on the scale that voters have come to expect is unworkable? Will we see a smaller state? Or a recognition that governments can no longer afford to guarantee banking deposits; keep house prices rising; fuel prices low; and at the same time insure people against the costs of ageing, ill health, joblessness, drunkenness, drug-taking and the threat of violence from knife-wielding youths and suicidal Islamic fanatics? If governments must choose which risks to continue underwriting, which will they choose?
Or will the world draw a different conclusion – that this crisis came about because governments did not do enough, rather than too much? That the crisis in the banking system and at Fannie and Freddie came about because they were allowed to act as private participants in a free market, rather than being regulated like the state agencies that we now know them to be? Or that the huge rise in “risky” social behaviour reflects the fact that people have been allowed to behave like economically free agents while putting the costs of their behaviour on the state? If no one is to be allowed to fail, should governments have greater rights to control our behaviour? And if so, are we prepared to pay the price, in terms of greater taxes, loss of competitiveness and further erosion of our freedom?
• Simon Nixon is the author of Credit Crunch: How Safe is Your Money? Priced £5.99, www.pocketissue.com.