COMMENTARY
By Tommaso Padoa-Schioppa
Former Minister of Economy and Finance, Italy; and Former
Member of the Executive Board, European Central Bank.
With the view of causing an increase to take place in the mass of national wealth, the general rule is, that nothing ought to be done or attempted by government. The motto, or watchword of government, on these occasions, ought to be – Be quiet.
(Jeremy Bentham, Manual of Political Economy, Chapter 1)
I. Introduction
The crisis we are experiencing is not a single, isolated illness, but rather the interaction of three separate illnesses, each with its own features, dynamics and required treatment: (a) the day of reckoning for the US external deficit, (b) the bursting of the housing bubble and (c) the great fear. We can say that (a) underlies (b), which in turn underlies (c). The three components interact with each other in various ways, ultimately producing a single overall disruption in the body of the global economy; they are, however, distinct, and each needs to be understood on its own. Therefore, let us consider them one by one, in order to examine their respective causes, symptoms and cures. Our understanding of the past, present and future will be facilitated if we examine the deepest component first and then proceed to the more superficial and visible ones.
In most commentaries and debates, differences of opinion revolve – implicitly or explicitly – around one key question: should we think of the present crisis as the correction of a wrong path or as a detour from the right path? In this context, ‘right’ and ‘wrong’ should be given the positive meaning of ‘sustainable’/‘unsustainable’, not the normative connotation of socially and politically desirable/undesirable. According to the ‘correction view’, the post-crisis trajectory for the global economy will have to be different from the pre-crisis one, and the task of public policy is to help design and implement the new path. According to the ‘detour view’, the original trajectory does not need to be changed, and the task of public policy is to help bring the economy back onto it. This article takes the first view and argues that the correction will have to be substantial.
II. Growth Without Savings
At the root of the crisis lies the ‘growth-without-savings’ model of the United States economy and the latter’s dependence on two supporting factors: (i) globalization and (ii) the condition of the dollar. For many years, the largest and richest economy in the world ceased to save and became structurally reliant on external financing. With public and private spending in excess of revenues, America’s debt to the rest of the world kept growing. It went to finance a high level of public and private consumption, rather than the capital formation capable of generating the additional income necessary to service and repay it.
Under normal circumstances, a firm, a household or a country would have been forced by its creditors to rebalance revenues and expenditures. Indeed, all available statistical records suggest that the size and duration of the US external deficit are without precedent; for much less, many other countries encountered crises of confidence and were compelled to adjust.
As Herbert Stein once put it, ‘what is not sustainable won’t last’. Yet, defying the economic laws of gravity, the US economy remained up in the air for much longer than common sense and the laws of physics predicted. Indeed, the laws were suspended for so long that a number of fine arguments were developed to argue that common sense no longer applied.
The two factors that helped prolong this temporary suspension of the economic laws of gravity were globalization, combined with the emergence of Asia, and the condition of the dollar. Regarding the first factor, the free movement of goods, services and capital allowed a widening of the geographical gap between savings and investment and permitted the financing of massive US imports of manufactured goods and tradable services from China and India, whose economies are experiencing the rapid growth typical of a catching-up process. It would be inaccurate, however, to
classify their growth as being in the same export-led category as that recorded by the small Asian tigers. The share of exports in China’s and India’s GDP has been significantly lower than those of Korea, Hong Kong, Taiwan and Singapore in their years of highest growth. In the case of China and India, it is the size of the country that is huge, not the share of exports.
The abnormal size of global imbalances is sometimes presented as reflecting ‘savings glut’ or excessive Asian surpluses. In a historical perspective, however, what appears ‘excessive’ is rather the external indebtedness of the world’s most affluent and advanced economy.
The second factor helping to suspend the economic laws of gravity was the condition of the US dollar. How could exceptional monetary expansion sustain the ‘growth-without-savings’ system for so long without triggering a significant warning, much less a corrective mechanism? Why did no alarm bells ring? Under ordinary circumstances, a call for discipline would have rung out in the form of a loss in the internal and/or the external value of the currency. For the United States and the dollar, however, the circumstances were anything but ordinary. Internal consumer price inflation was kept down by an unlimited supply of low-priced goods and services from Asia. As for the exchange rate, the depreciation of the dollar was delayed and dampened by the seemingly insatiable appetite for dollar-denominated assets of the surplus countries, most of which were still – three decades after the demise of the Bretton Woods regime – on a dollar peg. In a pre-15 August 1971 world, surplus countries might have converted the bulk of their net export proceeds into gold (as Germany,
France and Italy did at the time), thus making the precious metal ever
scarcer and eventually triggering an adjustment. Today, however, the role of ‘gold’ is played by US government debt, of which the debtor possesses inexhaustible mines.
Until the bubble burst, virtually nobody found anything to complain about in this unsustainable dynamic. The United States was the locomotive of an extraordinary period of global growth and the appetite for dollar assets seemed as inexhaustible as the mines of public debt. Even the usual ‘political’ dialectics between creditor and debtor failed to develop. Perhaps for China, the political value of being the main creditor of the global superpower outweighed the risk that the financial value of the credit it extended might eventually depreciate. Be that as it may, no significant risk premium emerged for dollar-denominated securities.
Thus, the goods whose prices were inflated by ‘too much money chasing too few goods’ were – through the quest for yields – the assets in the portfolio of the investor, rather than the items in the basket of the consumer. And, of course, the difference between ‘basket’ inflation and ‘portfolio’ inflation is that the former makes everybody poorer, while the latter makes everybody richer, at least for a short while.
Eventually, however, the economic laws of gravity began to apply again. And when housing (rather than an asset less fundamental to the economy, such as technology stocks in the dotcom era) turned out to be the latest bubble, its bursting triggered an adjustment process that is likely to go well beyond the limited effect on the ‘real economy’ of a boom– bust cycle. Indeed, it is likely to reach the deep geological stratum where the present earthquake has its origin. We have not yet seen the correction of an external imbalance not accompanied by a depreciation of the currency and a slowdown of the economy – and the bigger the imbalance, the deeper and longer the correction. Underlying the subprime crisis is the long overdue correction of the massive US external deficit. This has not yet been fully recognized.
III. A Special Bubble
The second component of the crisis, the bursting of the housing bubble beginning late in 2006, appears at first glance to be just another episode in the long series of post-Bretton Woods boom – bust cycles brought about by the 1982 Latin American debt crisis. Indeed, its dynamics largely resemble those of other recent ones, which, in turn, followed the classic pattern of financial crises described in history books. This analogy, however, would be a reductive interpretation. In this crisis, a number of factors have combined to create a complex mosaic without equal.
The subprime bubble has an unprecedented global and systemic nature. It began at the centre of the world economy, unlike previous episodes based in emerging countries such as Mexico, Argentina, Korea, Indonesia and Russia. In contrast with previous US-centred crises, such as the Savings and Loan crisis, the institutions now in the eye of the storm are the largest, most globally connected US financial institutions.
Moreover, the bursting of the bubble has unusually large economic and social implications. It has economic implications because it destroys what, for the last 10 or 15 years, has been a major engine of US economic growth: the high propensity of households to spend. This consumption boom relied, in turn, on continuously rising house prices. For the average US family, these were the predominant source of new wealth. During this period, US households gradually adopted the habit of spending not only the capital gains that had already been generated but also those expected from a future increase in house prices. Lending institutions encouraged this behaviour. Observers and politicians praised the access of low-income families to this particular form of affluence, all the more so because it counterbalanced the granting of tax relief to the rich rather than the poor, as well as widening income inequality. The social implications of the collapse in house prices are profound. Millions of low-income American families are now discovering that their ‘wealth’ was
simply an illusion, and are suddenly faced with a dramatic reduction of their living standards. Moreover, mortgage contracts themselves contain a strong incentive for the borrower to abandon his home if its value falls below the amount of the mortgage. This may be an easy way out of an unbearable financial obligation, but it entails the pain of social and psychological uprooting.
Lastly, the bursting of the housing bubble has a high degree of financial technical complexity, a complexity that was difficult to master in the winding-up phase, and that is all the more so during the unwinding. With private corporate governance and public regulation and supervision exercising little control, ingredients such as the ‘originate and distribute’ model, the perverse incentives embedded in the compensation schemes for managers of financial institutions, the procyclicality of regulatory and accounting standards and the inadequacy and misconduct of rating agencies were allowed to become an explosive mixture that nobody seems capable of defusing.
The bursting of the housing bubble thus presents a much greater economic, social, financial and policy challenge than any of the previous episodes of financial instability experienced during the last several decades, even leaving aside its close relationship with the two other components of the crisis (the ‘day of reckoning’ for the US external imbalances and the panic). No other bursting bubble combined so many adverse factors. There is no map for navigating through this typhoon.
IV. The Great Fear
When Lehman Brothers filed for bankruptcy on 15 September 2008 a dramatic shock was added to a crisis that had already been rocking markets and policy makers for a year and a half. What happened was the unthinkable. Virtually all operators in the United States and around the world had considered Lehman too big and too connected to fail. This belief was so strong that they had stood ready to lend to each other without scrutiny. This readiness was weakened by the August 2007 shock and destroyed entirely
when Lehman disproved the idea of ‘too big to fail’. Money and credit ceased to flow almost completely.
The demise of Lehman spread the crisis far more widely than before, across the global financial sector and into the so-called ‘real economy’. The liabilities and products of the fallen investment bank were in the portfolios of innumerable institutions worldwide. Once unleashed, fear quickly spread from the credit sector to the stock markets. The ‘run’ did not consist of widows and orphans queuing at the doors of banks to convert their deposits into cash, but of sophisticated financiers blocking lines of credit, hoarding liquidity on their books and refusing to roll over maturing debt. It was a sudden shift from a voracious risk appetite to a state of extreme risk aversion. As a collective sentiment, the fear was irrational. From the point of view of each individual operator, however, it was entirely rational to run with the herd.
Just as imaginary wealth created by market euphoria can be made real by those capable of correctly timing their entrances and exits, so too can real wealth be destroyed by an irrational panic. An otherwise healthy firm can be driven into bankruptcy by the public believing false rumours about its health. This is particularly true for financial institutions and especially for banks, which are highly leveraged and engage in maturity transformation. Collective fear can only be overcome by a powerful and rational force that stands outside the panicking crowd and stops the herd before it runs off a cliff. By definition, this is what public authorities such as central banks, supervisors, treasury departments and parliaments are mandated to do. If the herd does not spontaneously recover its sanity, these institutions must use their authority to restore order. They are the last resort.
V. A Correction, Not a Detour
At the end of 2008, the great fear was not yet over. Like a child after a fit of hysterics, global finance could still, at any moment, be thrown into disarray by the slightest noise or hiccup. To avoid serious damage to the economy, it is urgent to get the financial system working again quickly, just as promptly restoring the flow of oxygen to the brain after a stroke is necessary to avoid irreparable neurological damage. At the same time, the need to treat the other two illnesses involved in the crisis – the subprime bubble and the macroeconomic imbalances – was growing more urgent every day.
These concurrent needs created two major complications: each illness affects the course of the other two, and a remedy for one might worsen the others. For example, widespread fear and panic could bring about a veritable paralysis of economic activity, rather than the simple slowdown that is necessary to spur an increase in the US savings rate and thus correct the macroeconomic imbalances. This paralysis, in turn, would call for an economic stimulus, pushing the United States deeper into negative savings and delaying the eventual correction of the imbalances. Likewise, the massive liquidity injections needed to restart interbank lending carry some of the same risks as the excessively expansionary monetary policy that inflated the housing bubble in the first place. These examples show how the composite nature of the crisis has created a difficult conflict between short- and long-term policy requirements.
The oft-repeated cliche´ that this crisis was originally financial and has become economic is incorrect. The roots of the crisis are just as much on Main Street as they are on Wall Street. The fact is that for a long time there has been a fundamental economic imbalance, the correction of which was unduly delayed by a financial bubble. When this bubble eventually burst, it sparked a panic across the markets. The result is that the economy is simultaneously facing three challenges: the correction of the fundamental imbalances, the deleveraging imposed by the bursting of the housing bubble and a credit crunch caused by extreme risk aversion.
The previous analysis shows that the economy’s post-crisis trajectory needs to be significantly different from the one it was on before the crisis hit. The crisis calls for a fundamental correction rather than a temporary detour. The correction needs to be much more than an ordinary price or quantity adjustment of the kind normally produced by the market mechanism. Yet, it should not be a complete regime change. It needs to be something in between. We know that the market system’s strength is not to avoid mistakes, but to permit and then correct them. Its philosophical foundation is not the Utopia of a flawless economy, but the acceptance of human fallibility.
In such a system, prices are the essential vehicle of adjustment. And prices are in a restless movement, resulting in hourly, daily, quarterly and even multi-year changes and trends. All these movements are ‘adjustments’, triggered by new information or revisions of judgements concerning previously available information.
But the importance and consequences of such adjustments vary. Most are harmless. Some may be deadly to individual firms or households but harmless to the system. Yet others may affect the entire economy, even if they do not permanently impair it. The word ‘crisis’ is appropriate when the adjustment is particularly disruptive and the return to a sustainable path is particularly laborious. Where does the present crisis belong on this scale? This is not an ordinary episode of financial instability, unavoidable in a market system. Its gravity surpasses that of the financial crises experienced in the past two or three decades. It is not, however, as some pretend, the final collapse of capitalism or of the market economy; it is not the equivalent of the fall of the Berlin Wall, which marked the end of the system of central planning. This is ‘only’ the final crisis of one particular brand of market economy. For the market system to be saved and indeed to be made both more functional and more acceptable to people around the world, we have to identify and correct the flaws that have allowed the unsustainable ‘growth without savings’ model to prolong its course for so long.
VI. Identifying the Flaws
Two different items – corresponding to the distinct functions of managing and preventing a crisis – are inscribed in the policy agenda: how to steer the economy out of its present quagmire and how to reform the economic and financial system in order to avoid repeating the crisis. Before turning to the latter question, which constitutes the object of the next sections, the interaction between prevention and crisis management should be highlighted.
When thinking about reforms, we should be aware that the crisis and the policies adopted to manage it shape a new reality, that is by itself a sort of reform. And it is with this new reality, rather than the pre-crisis configuration, that the planning of the future is confronted. This point is exemplified by the revival of universal banking, with Goldman Sachs, Morgan Stanley and American Express transforming themselves into bank holding companies, and by the fall of Lehman and the takeovers of Bear Stearns and Merrill Lynch, producing further consolidation.
Moreover, we should keep in mind that the task of reforming the system starts before the task of crisis management is completed. Indeed, a number of actions undertaken by public authorities to steer the economy out of the quagmire have been chosen with the post-crisis world in mind; the planning of this world has started well before the crisis is over. To use a World War II analogy, we should remember that the conferences of Havana, Bretton Woods and San Francisco (which designed the post-war order) were held while the war was still raging, and that the strategy of the powers fighting in Europe was focused not just on ending the war victoriously, but also on redrawing post-war borders.
Lastly, the system bequeathed by the crisis ought not to be treated as sacred by those in charge of the post-crisis reconstruction. Indeed, certain public interventions required and justified by the emergency should be quickly reversed after the storm has abated; injections of public capital into private institutions and the acceptance of dubious collateral by central banks are cases in point. A key aim of reforms is precisely to avoid the repetition of certain undesirable measures needed to deal with the emergency. This also holds for structural changes produced by the storm, such as the further banking consolidation, which has exacerbated the existence of many institutions that may be deemed ‘too big to fail’. There may indeed be good reasons to pursue deconsolidation as part of the post-crisis reconstruction.
That said, the following sections will not review the numerous and very relevant technical issues inscribed in the long reform agenda, such as the role of regulators, a respecification of the institutions subject to regulation, accounting standards, access to central bank facilities, compensation policies for directors and managers, the procyclicality of regulatory requirements, rating agencies and the financial infrastructure. Rather, it will deal with what, in my view, should be regarded as the fundamental flaws that have developed over the last three decades in the market system. The conceptualized form in which I shall present such flaws may appear somewhat removed from the frontline of the present debate. However, conceptualizing is the way of reaching the heart of the reality, not a way of escaping from it.
I suggest that three flaws underlie this crisis: market fundamentalism, nationalism and short-termism. None of them was unknown before the recent events, although not all of them were, or are, equally recognized as flaws. We would delude ourselves if we contended that the ravages of this crisis were produced by new and mysterious features of either human nature or financial activity. The plague was not caused by an unknown bacterium; to a large extent, it could have been avoided with ordinary prophylaxes. It was known that greed is a dangerous propeller, which easily degenerates into manipulation and fraud. It was known that the proper functioning of a market economy rests on a mix of private and public actions and that the invisible hand only produces collective prosperity when it operates within a framework of legislation, regulation and supervision. It was also known, by and large, how this framework should be constructed and operated. That the public side of the equation was progressively omitted over the last three decades can only be called a policy failure. That private actors grew beyond the control of their public regulators is the fault of policy makers, who permitted them to do so, or even actively dismantled the public sector’s role in overseeing the market. This amounts to saying that it is policy, rather than animal spirits, which is to blame. Policy failures are usually seen as arising from excessive government intervention; here, they were due to the
lack of it. It should thus be accepted that correcting these flaws is the task of
public policy, and not of the market itself. Of course, there is no certainty that policy can solve all the problems that emerge, but there can be little doubt that most of the needed changes can only come through public policy and not via a spontaneously generated Hayekian order.
VII. Market Fundamentalism, or the Abdication of Policy
The most important policy failures underlying this crisis derive from the field of economic ideas; in particular, the fallacious proposition that markets in general, and financial markets in particular, are capable of regulating themselves and therefore do not need public regulation. This radical idea, which can be labelled ‘market fundamentalism’, is held by the extremist wing of the wider intellectual pro-market movement that has guided economic thinking and policy-making over the last 30 years. The movement arose as a reaction to the previous period’s excessive policy activism and distrust of markets.
In the five decades following the mistaken response to the crash of 1929 and the experience of the New Deal, the contention that government intervention is a necessary component of the market economy evolved from a provocative opinion, to become the accepted orthodoxy, and finally the dominant policy framework. In the 1950's, the acceptance of active government intervention was still cautious, but by the mid-1960s it had become mainstream thinking. It often went too far, to the point of producing an excess of policy activism that suffocated economic freedom and multiplied political and bureaucratic interference in business activity.
By the end of the 1970s, against a background of slow growth, high inflation and large government deficits, the time had come for the pendulum to swing back. The process began in Chile with the Chicago economists hired by Pinochet and continued with the accession to power of Margaret Thatcher (1979) and Ronald Reagan (1980). Jeremy Bentham’s presumption that government ‘interference is, at the same time, generally needless and generally pernicious’ was finally restored (in opposition to this idea, Keynes had famously invoked The End of Laissez-Faire in 1926). ‘Be quiet!’
was Bentham’s admonishment to governments. ‘The market knows best’ was the battle-cry of the growing phalanx of new volunteers fighting – in universities, trading rooms, newspaper editorial boards, think tanks, central banks, treasury departments and parliamentary committees – for less government, fewer rules and more Darwinian selection (although in the field of science, some of these same volunteers were
creationists).
Market fundamentalism took a number of forms. For the last two decades, the public policy agenda regarding the financial sector has mainly consisted of removing regulatory barriers, resisting calls to regulate new players, blurring the frontier between licensed and non-licensed institutions and getting close to a return to free banking. Deregulation became the top, sometimes almost exclusive, item on the economic policy agenda. In the words of Alan Greenspan: ‘. . . our regulatory roles are being driven increasingly towards reliance on self-regulation similar to what emerged in more primitive forms in the 1850s in the US’. An eminent member of the EU
Commission argued that ‘less is more’. Policy makers became not only noninterventionists but also active deregulators. They even professed agnosticism on such key economic concepts as the equilibrium exchange rate, the neutral interest rate, core inflation and the full employment level. The difficulty of calculating these and similar measures was seen as an argument for excluding them from the analytical policy toolkit. The only ‘reality’ was the view of the market; any attempt to form a policy view constituted illegitimate interference and was considered circumstantial evidence of heresy. All this can be seen as an abdication by policy makers (politicians and officials alike) of their institutional responsibilities. The three decades in which the pendulum swung from excessive activism to market fundamentalism are those in which public agencies (central banks,
financial regulators, etc.) fought and won their battles for independence from political bodies. They fought not only in the name of the technical nature of their tasks but also in pursuit of a revival of market principles.
What has perhaps been insufficiently understood is that the emancipation of these institutions from politics threatened to make them subservient to business interests, particularly at a time when the intellectual and social prestige of the private sector obscured the pride of public service. It is regrettable that not many officials were familiar with the economic literature dealing with the risk of the capture of the regulator.
Unfortunately, one excess paves the way for its opposite. The total retreat of policy makers from the task of crisis prevention helped produce a systemic collapse that has now led the same officials to abandon their former freemarket beliefs and embrace sweeping government interventions in the market. Now that the pendulum has swung to this extreme, those (such as this author) who prefer it in the centre, comfortably between economic anarchy and government intrusion, must prepare to fight in defence of market principles once again.
VIII. Nationalism, or the Market-Policy Gap
The second flaw in the policy setting underlying the crisis is in the institutions: it is the unfilled gap between the reach of markets and that of public policy. nstead of narrowing, this gap has widened over the years, making policies increasingly ineffective. Over the last six decades, international trade has expanded at an average annual rate approximately double that of world GDP. Cross-border capital mobility – virtually non-existent in the aftermath of World War II and repressed under the Bretton Woods regime – has been gradually established and faces no obstacles today. Thanks to information technology and modern communications, many services, above all those with a high value-added, have become tradable. Borders are crossed not only to exchange finished goods, but during the production process as well.
Yet, with only minor exceptions, the public policy institutions necessary to sustain markets have remained the exclusive prerogative of nation-states, which interpret sovereignty in absolute terms and refuse to recognize any authority superior to their own. It is obvious that under such conditions, no ‘domestic’ economy can possibly meet the requirements for its proper functioning because the essential and irreplaceable public policy component is lacking. Broadly speaking, this component, which makes the difference between anarchy and economic liberty, is an apparatus comprising the rule of law (which includes both the making and the enforcement of laws and standards, etc.), the provision of essential public goods and command over
the power and resources necessary to accomplish its mission.
The domestic economy has become the globe. An unbiased Martian landing on earth with a knowledge of introductory economics would find it plainly evident that a global market lacking a public policy counterpart would be unstable and dysfunctional. The span of what is ‘public’ should – by definition – match or exceed that of ‘private’ market players. The approximately 200 allegedly absolute sovereigns are ‘public’ only within their own borders. In the global arena they are ‘private’ players.
The absence of a system of international rules and discipline is clear. Meek communique´s routinely issued following international summits stating that global imbalances need to be corrected have not been followed by real pressure and even less by resolute action. The IMF lacks the power necessary to oversee and influence the policies of the largest countries. In the financial sector, international committees of regulators (the Basle Committee, IOSCO, etc.) and the recently created Financial Stability Forum – commendable as they are – have not really changed the fragmentation of policies. Composed of national representatives, such committees are fundamentally unsuitable to act as supranational powers. Moreover, financial institutions often circumvent internationally agreed rules by locating their business in offshore centres where regulation and supervision are lax. In the monetary field, the overabundance of international liquidity and the absence of an established exchange rate regime long ago ceased to be on the agenda for international discussion. The composition of international bodies and forums reflects past realities rather than the present situation and thus undermines their
representativeness. Economic nationalism contributed to the incubation of
the turmoil and hindered its management after the crisis erupted. It would be unfair to denounce the flaw of nationalism without immediately acknowledging the enormous difficulty of fixing it. Even our Martian would soon discover the complexity of such an undertaking. But we would be deluding ourselves if we failed to see the urgent necessity of narrowing the market-policy gap.
IX. Short-Termism, or the Time Illusion
Finally, the crisis has its roots in a third flaw of the particular brand of market system that has prevailed in recent years: the excessive narrowing of time horizons in the conduct of both private and public affairs. Short-termism – a trait of our behaviour that belongs more to the fields of social habits and psychological attitudes than to that of ideas or institutions – shows that we have not yet learned to master the revolutionary change modern technology has wrought in the scale of time.
Short-termism has spread throughout Anglo-Saxon society and beyond. The clearest sign of this is the elimination of saving, because saving is the very essence of incorporating time into economic decisions. We save for the future, but if the future has no value because we do not look beyond today, why should we save? The model of ‘growth without savings’ described above can only be sustained if someone else saves and lends; when the lender asks to be repaid or stops lending, Herbert Stein’s dictum comes true. Further evidence of the spread of short-termism is the narrowing of the time horizon of economic policy and of the political process in general. Elected governments no longer benefit from full terms of office; their de facto legitimacy, and hence their strength, lasts only as long as they are sustained by opinion polls, as if they had to be continually re-elected. Planning a multi-year
economic policy is a highly risky political investment that few politicians dare to make, and indeed politics as a profession may not attract people with such a penchant. The implication for the United States, for example, where the presidential term lasts four years and the election campaign at least two, is that the incumbent administration requires a permanently expanding economy and is almost forced to act with short time horizons.
The shortening of the time scale has other seemingly less fundamental and merely technical manifestations, which nevertheless played a major role in setting the stage for the crisis. The evolution of the financial system from bank-based to market-based, the rise of the ‘originate and distribute’ model of finance and the development of securitization and negotiable instruments (the transformation of financial clothing from tailor-made to ready-to-wear) are all changes that encourage economic calculations based on short horizons. Assets are continuously traded on the basis of a view of how their market value could change in the near future. Estimates of their value at maturity matter much less than guesses as to how the market will price them in the next few months, weeks or even days. This phenomenon is comparable
to the impact of instant polling on politics. Similarly, the compensation of managers and CEOs is based on short-term results. Accounting standards are based on the principle of mark-to-market, as if the ‘true’ value of a firm was the price at which it could be liquidated today.
The spread of short-termism is not a superficial trend. It should be seen as part of a genuine anthropological change caused by the sudden disruption of the scales of time and space with which we live. In the short span of six or seven generations (and much more rapidly outside theWestern world), a scale that had remained immutable in the human mindset for millennia has suddenly been transformed by technology. Indeed, technology has collapsed the time traditionally needed to produce a good, dig a tunnel, move people and merchandise across the planet, deliver information and make a calculation.
Referring to a proverb that exists in every language (‘time is money’), we can describe this change as a huge appreciation of a particular currency, time. In terms of a quantity of manufacturing, transportation or communication, the value of an hour in this new world has grown to what – in the old world – used to be the value of a month, a year or a decade.
Short-termism is insidious because it disregards the many aspects of human life and economic reality in which the time scale has not changed. A short-term perspective may prolong a bubble and delay the moment in which economic fundamentals impose themselves; it cannot permanently sustain what is unsustainable. When it tries to do so, it becomes a form of time illusion doomed to a rude awakening. Our speed has climbed from ten to 100 miles per hour, but our headlights still light the same length of road. When the obstacles in our path were finally illuminated, we discovered that there was not enough time to brake.
Learning to reconcile the new time scale with the old one is not only a task for individuals and private institutions, it should also be on the public policy agenda. Some readers may think that the deficiencies due to the shortening of time horizons should only be a matter of private concern. Closer reflection, however, shows that public policy safeguards against the risk of stealing from the future are warranted and increasingly needed. For example, the public’s role in protecting natural resources and managing intergenerational redistribution deals with time-related externalities that ordinary market mechanisms are unable to manage. The purpose of a
constitution, after all, is also to defend future governments from the risk of
being deprived of their prerogatives by the present government. Dealing with the pitfalls of short-termism and thinking about institutional ways to encourage a more balanced relationship between short- and long-term considerations in the economic and political decision-making of both private and public actors is a major challenge. The events of the last two years suggest, however, that it cannot be avoided.
X. Conclusion
The third year of the crisis, 2009, is beginning in a climate of uncertainty and anxiety. The sequence of financial cracks and scandals has not come to an end. Distress has spread worldwide. Production, employment and living standards are being affected. It is true that the policy mistakes that precipitated the world into a long depression after 1929 have not been made so far, but this appears insufficient to avoid a dramatic fall in economic activity. And the contraction in global trade signalled by the latest data tells us that it is much too early to declare that the worst experiences of the 1930s will not be repeated. While the bursting of the housing bubble and the panic gripping markets are now well understood, there is still reluctance to recognize the macroeconomic imbalances and the ‘growth without savings’ model as deep causes of the turmoil. Without full recognition of this, the prospects for successful reforms are dim.
This article highlights three flaws in the particular brand of market economy experienced in the last three decades, up to this final crisis: market fundamentalism, economic nationalism and short-termism. The first flaw, a relapse into past and well-known errors, is well identified and will probably be corrected. We should even be careful to avoid over-correction. As to nationalism, economists, political scientists and historians have provided a thorough analysis of its nature and indicated the cures. The institutions created after World War II at the global level and, more successfully, at the European level, are effective and promising examples of the needed reforms. Here, the major difficulty lies in established powers’ fierce resistance to change. Short-termism is less well understood and perhaps not even recognized as a key factor underlying the crisis. I have attempted to explain its importance and why it should be a matter for policy reform.
Reforming the market economy on a global scale is the condition to resume the spread of prosperity, to defeat poverty and, very likely, to preserve peace. There is no need to stress how arduous the task is. Now is the time for political leadership. We are in one of those rare moments when the clay that forms systems, institutions and mindsets softens and is ready to take on new shapes. It is urgent to understand our present crisis so that we can mould the clay before it hardens into its new form, a form that could last for decades to come. Crises open our eyes, while ordinary times tend to close them. This is why crises are also opportunities.
Tommaso Padoa-Schioppa
tps@palinurus.it
Copyright 2008 The Author.
Journal compilation r 2008 Blackwell Publishing Ltd 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street,
Malden, MA 02148, USA
International Finance 11:3, 2008: pp. 311–325
DOI: 10.1111/j.1468-2362.2008.01230.x
Journal compilation r 2008 Blackwell Publishing Ltd
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