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Sep 26, 2008

Quiggin: Wall Street crisis will spare no-one

Many previously held truths are being re-written virtually by the day as the financial crisis engulfing the US financial sector widens, writes Professor John Quiggin.


The casualty list from the stunning events of the last few weeks on Wall Street is an impressive one.

In this short space of time, the US Administration has effectively nationalised the main mortgage guarantors, Fannie Mae and Freddie Mac, and the world’s largest insurance company, AIG. The massively profitable Wall Street investment banking industry has ceased to exist, with Lehmans bankrupt, Merrill Lynch sold and Goldman Sachs and Morgan Stanley seeking the safety of commercial bank status. The largest remaining savings & loan firm, Washington Mutual is unlikely to survive in its current form into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.

The reputational damage is equally severe. The Bush Administration’s place as the worst in US history has been cemented, with a financial and economic disaster to match the Iraq catastrophe. Alan Greenspan, whose policies were responsible for the current mess, was still being treated as an elder statesman a few weeks ago, but his reputation is gone for good now. Henry Paulson and Ben Bernanke look set to follow a similar path.

But there is much more to come. Assuming (a big assumption) that the Democrats hold their nerve, any bailout will require the public to be compensated with equity for any losses they incur on the purchase of mortgage-backed securities and similar toxic sludge. Since such losses are inevitable if the plan is to have any real benefits, the result will be a further extension of public ownership, to include a substantial number of the main commercial banks.

No doubt, when the crisis is over, these businesses will return to the private sector. But it’s hard to believe (as most financial commentators seem to be supposing) that things will rapidly return to something like the situation prevailing before the crisis began. For a start, large areas of financial activity (auction rate securities, CDOs, subprime mortgages, monoline bond insurance) have collapsed, and seem unlikely to re-emerge. The massive market in credit default swaps will almost certainly be shut down, and the even larger interest rate swap market is likely to be scaled back to levels where financial regulators can manage it. Reductions in executive pay have already been accepted as a bailout condition, and it will be a long time before they are reversed.

Going beyond these obvious casualties are the implications for economic and political theories. The efficient markets hypothesis, badly wounded by the dotcom fiasco a decade ago, must surely be discredited now. The most sophisticated financial markets the world has ever seen have produced a situation where securities depending ultimately on debts owed by people with neither income, assets nor any incentive to repay have been treated as if they were (quite literally) as good as gold.

More generally, the whole free-market ideology variously referred to as economic rationalism, neoliberalism or the Washington Consensus, is in serious trouble, at least as regards the role of financial markets. The central element of financial neoliberalism is the claim that modern global financial markets can do a much better job of managing risks than can national governments. Given the array of sophisticated financial products available to individuals and households, for example, it is assumed to be much better to rely on markets to provide retirement income than on public pension schemes. The neoliberal view is the polar opposite of the Keynesian social democratic view, informed by the experience of the Great Depression. In this view, not only are governments the ultimate risk managers, but financial markets are part of the problem not part of the solution. While being necessary to mobilise private investment in a mixed economy, financial markets are seen, in the Keynesian view, as being inherently prone to destabilising speculation, which can induce large-scale macroeconomic failures.

The events of the last few weeks represent a striking failure of the neoliberal position. Although large-scale financial crises have been commonplace since the breakdown of the Bretton Woods system of financial controls in the 1970s, they have mostly taken place in the periphery of the global economy.

The debt crisis of the 1980s affected mostly the poorest developing countries. The crises of the 1990s hit middle-income countries in Asia, as well as Mexico, Argentina and Russia but had little impact on the main OECD countries. And, while the dotcom boom and bust can be seen in retrospect as a warning that the US was not immune to similar crises, the warning was ignored. Greenspan postponed any real adjustment with easy money and lower interest rates. Even the very modest responses that were made, such as the Sarbanes-Oxley Act were soon being derided as an over-reaction.

That’s not possible this time. The losses are so great that they threaten to bankrupt most of the major remaining financial institutions in the US. And even if the original plan of a bailout without any compensating equity stake were politically feasible, it’s no longer economically sustainable. The foreigners on whom the US is depending to finance the bailout are already losing faith. A massive handout would raise a large risk of extending the panic from the financial sector to the US government as a whole.

So, there is no alternative to a drastic cutback in the size and power of the financial sector and to a return to reliance on government as the ultimate risk manager. The events of the past few weeks have been so rapid that people have had little time to absorb them, let alone adjust their world views. But, as time passes, it will become steadily more evident that the day of neoliberalism is done.

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10 thoughts on “Quiggin: Wall Street crisis will spare no-one

  1. tim

    Spot on.

    I hope we have finally passed the point of no return towards a more rational way of running the world, the next few months will be very interesting indeed.

    Whoever thought we needed a superclass to tell us how to think? The superclass?

  2. John Quiggin

    To Peter Clancy, it’s great to hear from you again after all these years. You were one of my most inspiring teachers, and you made a big difference to me.

  3. Richard McGuire

    Crikey,… only three responses so far. Where are all the disciples of Milton Friedman? You are so right RJG. If anyone is looking for the first example of cloning, forget Dolly the sheep. Look no further than the dismal science of economics. As for Rudds endorsement of the Wall St bailout, remember it came after his briefing with Rupert.

  4. Ian Sutherland

    take a bow Maynard, you were right!

  5. John James

    The Central Planning Committees are back from the dead! The socialists are dusting of their political economy textbooks! I love that line” the Keynesian view….governments are the ultimate risk managers..”. Robert Mugabe and Fidel Castro must be choking on their caviar as they read that.

  6. Gavin Moodie

    An excellent post Professor Quiggan, thanx. But I suspect that you over reach in suggesting that the day (surely the decade) of neoliberalism is over. While finance will be reregulated, will that extend to reversing the neoliberal policies for education, health and infrastructure?

    I’m not sure that the connection will be made between neoliberalism’s failure in the financial market and, for example, deputy prime minister Julia Gillard’s proposal to ‘establish a properly designed market that will allocate resources in the most intelligent way but without ignoring important quality and equity issues. Thanks to the existence of a large pool of high quality private providers Australia already has a market for vocational training provision. The point is to make it work at an optimal level by combining a strong institutional framework with fully empowered and informed consumers and measures to prevent the disadvantaged from being excluded.’ (29 August 2008, speech to the 2008 national conference of the Australian Council for Private Education and Training)


  7. JamesK

    Or Richard McGuire was it Gordon Brown and Bill Clinton?….

    Doesn’t matter as you point out he is quite incapable of thinking for himself.

    Actually that is the point.

  8. John Quiggin

    To Peter Clancy, it’s great to hear from you again after all these years. You were one of my most inspiring teachers, and you made a big difference to me.

  9. RJG

    As I asked last night where are Keynes, Roosavelt and Galbraith when you need them?

    Don’t be so sure JQ that neo greedism is done. The notion that there is any alternative to neo liberalism has been thrown out by all major political parties, and as a consequnce all of the government institutions that provided the basis for mixed economies and their intellectual horsepower are gone. The people who staff the Treasuries and offshoots liek the Productivity Commissions and the ABAREs are staffed with people who think roosters will lay eggs if you pay them enough. There is no countervailing power to these morons. Look at Rudd! He thinks the bailout of the financial parasites in the US by the good’ol US taxpayers is a great idea. I wonder if he would think that if he had to convince us to all chip in or put some in himself.

  10. Peter Clancy

    Brilliant, John Quiggin, brilliant.
    My thanks for continuing the good work you started back in 1968 or so (have to look it up).
    With best wishes, and congratulations on your academic and life-choice successes!!

    PETER CLANCY B.A., M.Ed., Dip T(prim/sec).

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