Spineless stance compounds turmoil

This is my regular weekly Perspective column for Fund Strategy magazine.

Anyone of a fragile disposition is likely to have suffered from frayed nerves over the past three years. Since the collapse of Lehman Brothers in September 2008 the world seems to have been trapped in a permanent state of crisis.

For the first year or so America was widely seen as the epicentre of the turmoil but since then the focus has gradually shifted to the eurozone. Concerns about the American economy have not disappeared, but generally Europe’s problems have seemed more acute.

In parallel with the first shift has come another. Concern over the banking system’s survival has largely given way to anxiety over sovereign debt. Government bail-outs have, in effect, transferred much of the troubled debt from the banks to governments. As a result the fiscal positions of many states have deteriorated much more than they would have done otherwise.

This is not to say that the banking crisis has entirely disappeared. Worries about the integrity of the banking system still haunt the eurozone. A default of one or more of the troubled peripheral countries could cause more banks to collapse.

The challenge facing anyone trying to comprehend these developments is to work out how to relate all the different elements. One approach would be to lump everything together as a gigantic crisis of capitalism. An alternative might be to treat every event as more-or-less autonomous.

A better approach would be to tease out how each of these crises are related. The aim would be not just to draw out the connections between them, but to work out which factors are more important than others. To do this exercise comprehensively would be a mammoth task. But it is possible here to sketch some of the key relationships between financial, economic and political crises.

The first point to grasp is that the financial crisis is probably the least important of the problems facing the world. This is not to deny that financial volatility can do harm. But the financial crisis should be seen as an expression of more fundamental difficulties rather than a force in itself.

Too often the context in which financial crises emerge is forgotten. The Wall Street turmoil of 2008 provides the perfect example. As Raghuram Rajan, a former chief economist at the International Monetary Fund, argued in his book on the crisis, the Clinton administration was encouraging the liberalisation of lending rules as far back as the 1990s. There is nothing inherently wrong with such a policy, but combined with low interest rates and high public spending it helped create the conditions for credit expansion. The surge in American mortgage assets in the run-up to 2008 did not happen in a vacuum.

The next level at which the crisis needs to be understood is economic. In broad terms western governments have shied away from tackling their structural economic weaknesses since the 1980s. To a greater or lesser extent the main developed nations suffer from relatively low levels of corporate investment. Although there is much talk of innovation the real levels of research and development also tend to be low.

Such problems can only be properly resolved through economic restructuring. Weaker sectors need to be strengthened or shut down and new ones created. Governments can assist the process by helping to create the necessary infrastructure and encouraging a culture of risk taking.

Instead what has happened is that the authorities have typically tried to muddle through without tackling the underlying problems. They have promoted the extension of credit to create an artificial boost while shying away from the difficult challenges. As a result the fundamental economic weaknesses have simply manifested themselves in a different way at a later date.

The bursting of America’s technology bubble in 2000 provides a textbook case. Interest rates were kept artificially low for a long time, which in turn created the conditions for the inflation of the mortgage bubble that burst dramatically in 2008. Indeed, problems in the American housing market were already becoming apparent as far back as 2006.

Ultimately, the most important crisis is the political one. Neither the financial or economic crises can be solved unless politicians are prepared to put the right conditions in place.

The political class only intensifies problems by avoiding difficult challenges. Indeed, it worsens matters by fostering a culture of extreme risk aversion. It takes the easiest path whenever possible.

On both sides of the Atlantic the instinct of governments is to promote bureaucratic fixes and elaborate rules. The politicians seem to think they can regulate crises out of existence and are constantly bemused when this approach fails to work. Their preferred solution is invariably to suggest an even more elaborate regulatory framework.

The eurozone provides the most grotesque example of this bureaucratic approach. As this column has previously argued (September 12) the system is inherently unstable as it locks together much stronger economies with weaker ones. In an attempt to achieve this objective it ties them all together in a rigid policy framework. The wonder is not that the eurozone faces the possibility of collapse but that it has lasted so long.

Not all of the answers lie in the hands of politicians but they need to play a central role if the crises on both sides of the Atlantic are to be resolved. It needs to be a process that involves the mass of society rather just a narrow ruling clique.

It is all too easy for those who work in finance to become preoccupied with market volatility. But the problems facing the world economy cannot be properly understood, let alone resolved, on that level alone.