Fri, Jan 08, 2010 - Page 9 News List

After the crash: Why we can’t go back to business as usual

International financial authorities handled this crisis the same way as previous ones. But this crisis was much bigger, and the same techniques did not work

By George Soros

We are at a moment when the range of uncertainties facing the global economy is unusually wide. We have just passed through the worst financial crisis since World War II. The only relevant comparisons are with the Japanese real-estate bubble, which burst in 1991 (and from which Japan has not recovered), and the Great Depression of the 1930s — except that this crisis has been quantitatively much larger and qualitatively different.

Unlike the Japanese experience, this crisis involved the entire world, rather than being confined to a single country. And, unlike the Great Depression, this time the financial system was put on artificial life-support, rather than being allowed to collapse.

In fact, the magnitude of the problem today is even greater than during the Great Depression. In 1929, total credit outstanding in the US was 160 percent of GDP, and it rose to 250 percent by 1932. In 2008, we started at 365 percent — and this calculation leaves out the pervasive use of derivatives, which was absent in the 1930s.

In spite of this, artificial life-support has worked. Barely a year after the bankruptcy of Lehman Brothers, financial markets have stabilized, stock markets have rebounded, and the economy is showing signs of recovery. People want to return to business as usual — and to think of the Crash of 2008 as a bad dream.

Unfortunately, the recovery is liable to run out of steam, and may even be followed by a second economic downturn, though I am not sure whether it will occur this year or next.

My views are far from unique, but they are at variance with the prevailing mood. The longer the turnaround lasts, the more people will believe that it will continue. But in my judgment, this is characteristic of far-from-equilibrium situations when perceptions tend to lag behind reality.

To complicate matters, the lag works in both directions. Most people have not yet realized that this crisis is different from previous ones — that we are at the end of an era. Others — including me — failed to anticipate the extent of the rebound.

Overall, the international financial authorities have handled this crisis the same way as they handled previous ones: they bailed out failing institutions and applied monetary and fiscal stimulus. But this crisis was much bigger, and the same techniques did not work. The failed rescue of Lehman Brothers was a game-changing event: financial markets actually ceased to function.

This meant that governments had to effectively guarantee that no other institution whose collapse could endanger the system would be allowed to fail. That is when the crisis spread to the periphery of the world economy, because countries on the periphery could not provide equally credible guarantees.

Eastern Europe was the worst hit. Countries at the center used their central banks’ strong balance sheets to pump money into the system and to guarantee the liabilities of commercial banks, while governments engaged in deficit financing to stimulate the economy on an unprecedented scale.

But the growing belief that the global financial system has escaped collapse, and that we are slowly returning to business as usual, is a grave misinterpretation of the current situation. Humpty Dumpty cannot be put together again.

The globalization of financial markets that took place since the 1980s allowed financial capital to move freely around the world, making it difficult to tax or regulate. This put financial capital in a privileged position: governments had to pay more attention to the requirements of international capital than to the aspirations of their own people. Individual countries found it difficult to offer resistance.

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