The great crash of 2008: causes and consequences.

• Author: Lal, Deepak
• Position: Report

In the early 1980s, I was working as the research administrator at the World Bank, while the Third World was engulfed by a debt crisis. The current global financial crisis has eerie similarities, but different outcomes. Why?

First, both the crises arose because there was a surplus of savings in a number of countries--the oil producers in the 1970s, the Asian economies and commodity exporters today--which was recycled through the international banking system. Second, highly liquid banks imprudently funneled cheap credit to uncreditworthy borrowers: the fiscally challenged and inflation-prone countries of Latin America and Africa ha the 1970s, the ninja (those with no income, no jobs, no assets) subprime mortgagees of the current crisis. Third, there was a rise in commodity prices and a worsening of the terms of trade of the OECD, posing the stagflation dilemma for their central banks, having aided and abetted the earlier asset boom. Fourth, the imprudent banks sought bailouts from taxpayers, claiming their demise would fatally damage the world's financial system.

But, the outcomes have been different. The 1980s crisis was finally solved "after a prolonged cat-and-mouse game when the banks accepted substantial write-downs of their Third World debt, sacked their imprudent mangers, and shareholders suffered large losses. But no systemic threat to the world's financial system (or the global economy) emerged. By contrast, today the Western financial system seems to be dissolving before our eyes, and with the U.S. Federal Reserve's ever expanding balance sheet, bailouts are no longer the exception but the norm. Many now foretell a deep and perhaps prolonged recession, with deflation, rising unemployment, and Keynes' famed liquidity trap about to engulf the world's major economies.

Changing Financial Structures

What explains this difference in outcomes? It cannot be purported "global imbalances," which were the origins of both crises. It is the differences in financial structures within which these temporally separated but largely similar crises occurred. In the 1970s the recycling of the global surpluses was undertaken by the offshore branches of Western money center banks, which were neither supervised nor had access to the lender of last resort facilities of their parent country's central bank. Hence, when their Third World Euro dollar loans went into "default," there was no direct threat to the Western banking system.

The present crisis emerged in a radically different financial structure: the rise of universal banks from the United Kingdom's "Big Bang" financial liberalization in the 1980s, and the Clinton era abolition of the Glass-Steagall Act, which had kept a firewall between the commercial and investment banking parts of the financial system since the 1930s. The former had implicit deposit insurance and access to the central banks' lender of last resort facilities. The latter did not. It is worth explaining why this matters.

This distinction between what were previously nonbank financial intermediaries and banks is important because it is only clearing banks that can add to (or reduce) the stock of money. A clearing bank holds deposits in cash (legal tender base money) from nonbanks, repaying deposits in notes and making payments for depositors by settlements in cash through an account in the central bank. When a clearing bank extends a loan it adds to its assets and simultaneously creates deposit liabilities against itself, increasing the broad money supply at "the stroke of a pen." This ability to create money out of thin air is limited by the bank's capital and cash. As cash can be borrowed from the central bank, the ultimate constraint on its ability to create money is its capital. But it is only because banks take in cash deposits--Keynes's "widow's cruse"--that they can create money.

By contrast, a nonbank financial intermediary, say a mortgage lender, when it takes deposits or makes a mortgage loan has to "clear" these through deposits held at the clearing banks. Thus, when someone deposits "cash" at an S&L, this comes out of the depositor's bank account with a clearing bank. Similarly, when the S&L makes a loan to a mortgagee, this comes from the S&L's bank account with a clearing bank. Thus, the essential difference between nonbank financial institutions and clearing banks is that they cannot create the bank deposit component of broad money (M2 or M4).

When the FDIC was created as part of Roosevelt's New Deal to prevent the bank runs that the earlier universal banks' gambling had engendered, Marriner Eccles, who redesigned the Federal Reserve system for FDR in the Great Depression, insisted that with deposit insurance the banking industry must be split in half: the public utility part of the financial system, which constitutes the payments system, must be kept separate from the gambling investment banking part, which is an essential part of a dynamic economy. For these gambles impart the dynamic efficiency through the cleansing processes of creative destruction. But if these gambles are protected against losses by taxpayers, as the payment system activities have to be because of deposit insurance, the gamblers will always win: keeping their gains when their gambles are correct and passing their losses onto taxpayers when their gambles turn sour. Hence, the Glass-Steagall Act.

Given this "moral hazard," many classical liberals have favored free banking. Banks combining the payment mad investment functions and issuing their own notes should be monitored by their depositors, who would stand to lose if their banks undertook imprudent lending. But with the near universality of deposits as a means of payment, there is little likelihood of this monitoring function being effectively exercised. While the rise of Demos precludes any government being able to resist pressures to bail out imprudent banks to protect their depositors. This makes deposit insurance inevitable, and to prevent investment banks from gambling with the taxpayer insured deposit base, something akin to Glass-Steagall remains essential.

Policy Errors

The recent emergence of universal banking was followed by a number of public policy mistakes on the path to the current crisis.

The first was the bailout of LTCM in 1998. Its failure posed no obvious...