GLOBAL FINANCIAL CRISIS

Global Financial Crisis Revealed The Rotten State Of Capitalism

Global Financial Crisis Revealed The Rotten State Of Capitalism

Introduction

The global financial crisis that began in Thailand on July 2, 2007, has now grown far larger than almost anyone expected at the time. What many expected to be no more than a slight blip in the unrelenting advance of international capital markets has instead become the gravest threat to the stability of the world's market economy since the Great Depression.

As recently as three months after the Thai crisis, the IMF at its annual meetings called for an expansion of its charter to allow it to promote capital market liberalization. In his address to that meeting, to be sure, the IMF's managing director was careful to note that important precursors - such as strong financial markets - had to be put into place before full capital market liberalization could take place. (Stiglitz, 2008)

Today, 16 months into the crisis, there is a wider recognition of just how important those precursors are and of how few developing countries (and perhaps developed countries as well) satisfy those preconditions. Furthermore, many now worry that with or without those preconditions in place, short-term capital flows may be so volatile as to contribute greatly to international economic instability and that indeed such flows might be at the root of the current crisis. Although the risks of these short-term capital flows are now more apparent, there is scant evidence that these flows bring benefits that are commensurate with those risks. (Calvo, Leiderman, Reinhart, 2003, 108)

Main Body

Several factors determine how great a risk the volatility of short-term capital poses for a given country. One factor is the structure of the economy, including the effectiveness of automatic stabilizers; different structures may either dampen or even amplify the shock to an economy arising, say, from a sudden change in investor sentiment. A second factor is the efficacy of the discretionary policy responses to the economic fluctuations set off by the shocks. A third is the risk absorption/transfer mechanisms within society, which determine how those risks are distributed and thus the welfare losses that may be associated with them. (Artis, Berle and Means 2003)

When we measure the East Asian crisis economies against this list, we see that they had few automatic stabilizers and lacked both effective market-based risk-distribution mechanisms and publicly provided safety nets. As a result, the welfare losses, especially to workers and small businesses, have been enormous, as unemployment has soared and real wages have plummeted. (Rodrik, 2008)

Given these risks, it was all the more important that the third factor I mentioned - discretionary policy responses - be used to cushion the economic downturn. There is now a growing consensus, however, that the actual crisis - response measures exacerbated the downturn: At least in retrospect, the monetary and fiscal constraints imposed after the onset of the crisis were excessively contractionary. More problematic is whether those policies were misguided from an ex ante perspective. I argue in this paper that the answer ...