Neoliberalism and the GFC (2008)

Globalisation and the ascendancy of neoliberal policies underpinned the multiplicity of causes that led to the 2008 Global Financial Crisis (GFC). The global governance system failed to prevent this disaster because it inadequately dealt with the consequences of these two phenomena. It was the most damaging crisis to the global economy since the Great Depression (1930’s).[1] This essay will provide a short explanation of the direct financial causes that triggered the GFC. It will then focus on analysing how these causes were the result of a range of wider long-term factors. It argues that the global governance system failed to prevent the intertwined causes of the GFC because of the effects created under neoliberal direction. Furthermore, ineffective deregulation, especially of the financial system, allowed for more complex and risky behaviour by institutions. As such the system became more unstable and contributed to the conditions for a crisis.[2] Globalisation as well as the inherent nature of the international system also facilitated the GFC. It meant that troubles in one region quickly spread globally. Furthermore, crises are an inherent pattern of capitalism, history has been full of such bubbles and crashes.[3] A third cause of the GFC that the global system failed to prevent can be attributed to financialisation. The rising importance of the finance sector over the ‘real economy’ and the innovation of complex financial tools was instrumental to the conditions necessary for a crisis.[4]

Direct Financial Causes

The most direct cause of the GFC was the collapse of the United States (US) real estate market, and the burst of its pricing bubble. It saw subprime mortgage loans default once higher interest rates kicked in.[5] This was coupled with excessive risk taking by banks, who traded complicated financial instruments[6] that essentially depended on a stable housing market.[7] In addition, the carelessness of ratings agencies such as Moody’s or Standard and Poor’s in rating poor assets as AAA was conducive to the crisis.[8] When big financial institutions and banks such as Lehman Brothers, American International Group (AIG), or Fannie Mae collapsed, it triggered massive panic.[9] A lack of transparency and the extent of interconnections among these institutions deemed “too big to fail” caused fear among investors and global financial markets seized up.[10] This panic dissuaded people from lending which also caused problems that extended to the real economy.[11] Furthermore, highly leveraged positions exacerbated losses.[12] Such financial instruments contingent upon the US housing market were securitised and resold worldwide. This meant that the crisis was spread globally.[13] These direct causes however remain the result of broader factors that the international system failed to address. Thus, by themselves they are a limited and incomplete explanation of the causes of the GFC.

Deregulation

Under an order guided by neoliberal economic tendencies, the global governance system failed to properly implement financial liberalisation and deregulation.[14] This push for deregulation happened even though it was universally believed that unregulated financial markets were inherently unstable.[15] Following this perspective, it was the integration of modern financial markets with an era of light government regulation that allowed the crisis to occur[16].  In agreement to this the International Monetary Fund (IMF) argued that the “main culprit” of the GFC was “deficient regulation”.[17]

After the Great Depression, the US Government created a strict regulatory system from the 1930’s to the 1960’s to protect it from such financial dangers.[18] These measures included the Glass-Steagall Act (to separate investment and commercial banking) or the Securities and Exchange Commission (SEC).[19] They were introduced to neutralise risk, and reflected the market theories of John Keynes and Hyman Minsky, that supported policies of tight regulation.[20] However, these Keynesian era policies were deconstructed in the global system by sweeping deregulation that was spurred on by the growing finance industry.[21] Consequently, over 30 years of deregulation pushed away safeguards so that the neoliberal capitalist system was far less protected.[22] 

For example, further deregulation occurred following successful neoliberal campaigns against government regulation of the finance industry.[23] Between 1999 and 2008, the finance sector spent $2.7 billion in reported federal lobbying expenses.[24] Consequently, in 1999 the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act.[25] This led to a vast increase in the market dominance of the major banks.[26] Hence, as the banks believed ‘too big to fail’ increased, they were incentivised to take further risks to increase profits.[27] Furthermore, the Commodities Futures Modernization Act (2000) banned the government regulation of derivatives.[28]

Global governance attempts at regulation were also ineffective. For example, the international 1988 Basel Accords were flawed. It made no clear statement regarding what failures it intended to resolve.[29] Rules for capital adequacy were too vague and so banks could easily evade this.[30] It also failed to create any mechanism to limit contagion to the whole system if one major bank collapsed.[31] This demonstrated a failure in the global governance system to enact effective global norms.

Another problem with this neoliberal era of under-regulation was it was too limited in scope. A highly interconnected network of institutions fell out of the regulatory framework.[32] These included investment banks, government sponsored entities (eg. Fannie Mae), and other institutions (eg. AIG).[33] The IMF termed these as the “shadow banking system”, where its lack of regulation made these institutions (often affiliates of banks) more attractive to push risk into.[34] They grew as large as the regulated American banking system and thus were systemically important.[35] The failure of policymakers to recognise the risk in this sector thus helped cause the crisis.

Deregulation under neoliberalism allowed for a large, complex and risky financial sector. Although the IMF claimed that a dispersion of credit “[had] helped to make the…financial system more resilient”[36] this was not the case. Rather a dramatic liberalisation of the banking markets increased fragility.[37]  However, realists would also view the human nature elements of greed, fraud and corruption also as contributing to the crisis.[38] Such factors can to an extent be outside the control of the global governance system. Overall, the governing bodies of the world did not take enough precaution.[39]

Globalisation and Nature of the International System

Neoliberal globalisation[40] was another phenomenon that the system failed to contain.[41] Globalisation (a manifestation of capitalism)[42], made markets more interconnected and interdependent.[43] It was facilitated by a “thickened web” of multilateral agreements[44] and new technology which intensified the speed and complexity of financial transactions.[45] Globalisation also meant that local developments or policy failures could acquire near instantaneous global repercussions.[46] It thus bound together the economic fortunes of states.[47]  For example, failures of the US finance regulatory system initially assumed a local rather than global character.[48] However, the consequent international shocks proved undoubtedly transnational.[49] This also related to the broader structural power of the US as the world’s hegemon and its importance to the vitality of the global system.[50] A globalised world also led to the denationalisation of power, and a changing role of the state where they no longer had a monopoly over economic and political power.[51] In total, globalisation under neoliberal direction was a landscape which the governance system pushed for, and it ended up precipitating the crisis.

In the years preceding the crisis, developing and postcolonial countries also became increasingly integrated into the global economy.[52] This happened with the encouragement of international institutions such as the IMF, World Bank and World Trade Organisation.[53] They pursued global modernisation, the extension of markets, and aimed help stem the spread of communism[54]. However, globalisation did not deliver ideal results in many countries.[55]

Under the backdrop of neoliberal globalisation, many, such as Hank Paulson saw “global imbalances” at the root of financial crises.[56] In the 1997 Asian Financial Crisis, many states turned toward the European and US dominated IMF for help.[57] The IMF, a “bastion of neoliberal thinking on financial regulation”[58], was important in coordinating emergency financing for economies.[59] It reinforced the Anglo-American models as it spread their standards across the world .[60] In exchange for bail outs, they imposed harsh austerity measures[61] As to avoid such unfairness by the IMF in the future, Asian countries (eg. China, Japan, South Korea) generated trillions of dollars in reserves to become economically independent.[62] The “savings glut”[63] in Asia saw them need to invest these savings offshore.[64] They invested most of these reserves into US mortgage backed securities and other debt instruments.[65] This massive demand for debt helped push down Federal Reserve interest rates by directing capital toward the richer states.[66] This Federal Reserve decision was also motivated by the collapse of the tech bubble in 2000 and the 9/11 terrorist attacks in 2001.[67] In this way, the structure of banking regulation was the result of ad hoc measures introduced in response to past crises.[68] This ‘savings glut’, can overall be considered as part of a “long term shift of economic momentum from West to East”, as well as capital also somewhat flowing “uphill” from emerging economies to developed ones.[69] Thus, the IMF as a key actor in global governance, failed to react properly to imbalances bred by globalisation. It’s actions instead, set off a chain of events that contributed to the GFC.

Additionally, government involvement in the finance sector provided short term benefits such as stability. However repeated patterns of government bailouts created a problem.[70] In the long run, it created issues such as a moral hazard.[71] The inevitability of government intervention to save collapsing institutions promoted excessive risk taking.[72] This problem was the result of a failure of neoliberalism, and its transnational dominance in policymaking.[73]

Overall, the adverse consequences of globalisation, and the impact of imbalances were a central cause to the GFC. It could also be viewed as a symptom of wider capacity problems in global governance, where institutions were insufficient to deal with the nature of these risks.[74]

Financialisation and Innovation

The financialisation of the international capitalist system and the innovation of financial instruments was a foundational cause of the GFC.[75]  After the 1970’s, as part of the global economic system’s neoliberal driven recovery, there was an increased reliance on finance for profits. Important non-bank financial institutions added to overall risk and increased systemic vulnerabilities.[76] [77] Financialisation encouraged speculation and resulted in a turn away from industrial production and investment in long-term projects as a source of profits.[78] This is because there were more profits in speculative trading rather than in the real economy of making things.[79]

Under finance driven markets, ‘bubbles’ were characteristic[80]. They were inherently prone to panics and runs, and this made the global system more fragile.[81] The system pursued financialisation because it successfully created wealth. Furthermore, it was rather the system’s failures in matters such as regulation, that created an environment which allowed the invention and proliferation of financial tools. The rules and institutions that monitor and regulate financial market activity did not keep pace with its unprecedented expansion. Financial innovation created products so complex that they were inherently non-transparent.[82] For example, thousands of mortgages can go into a single MBS.[83] As many as 150 MBS’s can be made into a CDO.[84] From this, CDS’s[85] and ‘Synthetic CDO’s’ were created.[86] The trading of derivates further interconnected the market, and automated trading merely exacerbated these problems.[87] A flow on issue created from this was the problem of the Tragedy of the Commons. Where “individually rational actions were collectively irrational”.[88] Here, banks could not afford not to trade in CDS’s because otherwise competitors would do so and gain at their expense.[89] Moreover, following an ‘originate and distribute’ model, securitisation allowed the banks that created the mortgage to pass on risk of default elsewhere such as to investors.[90] Lack of regulation in this sector saw speed overtake prudence, and once the MBS’s became toxic the system collapsed underneath itself.[91] By February 2009, almost half of all CDO’s had defaulted.[92]

In addition, dubious incentives, caused by a systemic failure in regulation, induced most financial institutions to want to ‘originate and sell’ as many mortgages as possible. This was because they were paid by how many mortgages they made, securitised or rated.[93] As a result they received huge bonuses, for example in 2006 Goldman Sach’s total bonuses totalled $16 billion.[94] Moreover, rating agencies were paid by, and therefore committed to, the banks that created the CDO’s.[95] Therefore, it was sellers, not the buyers who were the rating agencies customers.[96] Therefore, by giving unworthy AAA ratings, they were also key enablers of the GFC. Financialisation and innovation therefore contributed to conditions that formed the GFC. The global governance system failed to prevent this cause because by not addressing factors such as deregulation or globalisation, it made these tools possible. Without such carelessness by global regulators this recklessness would not have been possible.[97]

Conclusion

Neoliberal policies and globalisation were key underlying forces behind the GFC. The global governance system did not competently respond to the new order that was created, and thus failed to prevent these causes. Deregulation eased restrictions and protected the finance sector. This had a chain effect and caused market fragility. The failure of the system to implement effective regulation extended to neoliberal globalisation and its inability to address imbalances between economies. Under this context of insufficient attentiveness, financialisation and innovation grew to form a more direct trigger of the GFC. 

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 Carmassi, Jacopo, Daniel Gros, and Stefano Micossi. “The global financial crisis: Causes and cures.” JCMS: Journal of Common Market Studies 47, no. 5 (2009): 977-996.

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[1] John Baylis, Steve Smith and Patricia Owens. The Globalisation of World Politics. (Oxford: Oxford University Press, 2014), 19

[2] James Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’.” Cambridge journal of economics 33, 4 (2009). Viewed on webpage.

[3] Geithner, Timothy F. Geithner, “Are We Safe Yet?” Foreign Affairs 96, 1 (January/February 2017): 55

[4] “What causes financial crises?” The Economist. Date modified: September 9, 2016. https://www.economist.com/blogs/economist-explains/2016/09/economist-explains-economics-2

[5] Arthur J. Keown, John D. Martin and J. William Petty. Foundations of Finance. (England: Pearson Education Limited, 2017), 33

[6] Such as Mortgage Backed Securities (MBS), Collateralised Debt Obligations (CDO’s), or Credit Default Swaps (CDS).

[7] Craig Calhoun and Georgi Deruguian. Business as usual: the roots of the global financial meltdown, (New York: NYU Press, 2011), 19

[8] “The Global Financial Crisis 10 years on- Lessons learned and can it happen again?” TBA Financial. Accessed September 8, 2017. http://www.tbafinancial.com.au/the-global-financial-crisis-10-years-on-lessons-learned-and-can-it-happen-again/

[9] Eric Helleiner. “Introduction and Overview,” In The Status Quo Crisis: Global Financial Governance After the 2008 Meltdown. (England: Oxford University Press, 2014), 4

[10] n/a, “The Financial Crisis Inquiry Report” gpo.gov, (January 2011): XVI. Accessed: August 30, 2017. https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

[11] “The origins of the financial crisis: Crash Course,” The Economist. Date modified: September 7, 2013. https://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article

[12] TBA Financial, “The Global Financial Crisis 10 years on- Lessons learned and can it happen again?”

[13] For example, Greece’s Sovereign Debt Crisis was cause by the aftermath of the GFC.  

Keown, Martin and Petty, Foundations of Finance, 33.

[14] Stijn Claessens and Laura Kodres. “The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions,” IMF Working Paper, 14, 46 (2014): 6

[15] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[16] Ibid.

[17] “What went wrong?” The Economist. Date modified: March 6, 2009. http://www.economist.com/node/13251429

[18] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[19] Franklin Allen and Elena Carletti, “The Global Financial Crisis,” IDEAS Working Paper Series from RePEc (2010): 7. http://si2.bcentral.cl/public/pdf/documentos-trabajo/pdf/dtbc575.pdf

[20] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[21] Ibid.

[22] gpo.gov, “The Financial Crisis Inquiry Report”, XVII

[23] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 12, 27.

[24] gpo.gov, “The Financial Crisis Inquiry Report,” XVIII

[25] Robert E. Marks, “Learning Lessons? The Global Financial Crisis five years on.” Journal and Proceedings of the Royal Society of New South Wales 146, 447+448 (2013): 10

[26]The market share of the five largest US banks rose from 8% in 1995 to 36.5% in June 2010.”

Marks, “Learning Lessons? The Global Financial Crisis five years on,” 6, 14.

[27] Marks, “Learning Lessons? The Global Financial Crisis five years on,” 6

[28] gpo.gov, “The Financial Crisis Inquiry Report,” XXIV

[29] Allen and Carletti, “The Global Financial Crisis,” 8.  

[30] The Economist, “The origins of the financial crisis: Crash Course.”

[31] Ibid.

[32] Ibid. 22.

[33] Ibid.

[34] The Economist, “What went wrong?”

[35] The Economist, “What went wrong?”

[36] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[37] Ouarda Merrouche and Erlend Nier.“What Caused the Global Financial Crisis : Evidence on the Drivers of Financial Imbalances 1999: 2007” IMF Working Paper, 10, 265 (2010): 30

[38] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 11

[39] John H. Farrar, “The global financial crisis and the governance of financial institutions” Australian journal of corporate law, 24, 3 (2010): 231

[40] During the 1980’s for developed countries and the 1990’s for emerging markets.

Alan M. Taylor. “The Financial Rebalancing Act.” Foreign Affairs. 90, 4 (July/August 2011): https://www.foreignaffairs.com/articles/2011-07-01/financial-rebalancing-act

[41] John Bellamy Foster and Fred Magdoff. The great financial crisis: Causes and consequences. NYU Press, (2009), 75.

[42] John Baylis, Steve Smith and Patricia Owens. The Globalisation of World Politics. (Oxford: Oxford University Press, 2014), 2

[43] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 20

[44] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 21

[45] gpo.gov, “The Financial Crisis Inquiry Report,” XVII

[46] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 20

[47] Baylis, Smith and Owens, The Globalisation of World Politics, 16

[48] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 24

[49] Ibid.

[50] Helleiner, “Introduction and Overview,” 9

[51] Farrar, “The global financial crisis and the governance of financial institutions,” 242

[52] UN.org, “The Global Economic Crisis: causes and transmission.” 15

[53] Foster and Magdoff, The great financial crisis: Causes and consequence, 75

[54] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 20

[55] UN.org, “The Global Economic Crisis: causes and transmission.” 18

[56] The Economist, “What went wrong?”

[57] Allen and Carletti, “The Global Financial Crisis.” 4

[58] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 36

[59] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 24

[60] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 26

[61] Allen and Carletti, “The Global Financial Crisis.” 4

[62] Allen and Carletti, “The Global Financial Crisis.” 5

[63] US Federal Reserve Chair Ben Bernanke 

Taylor, “The Financial Rebalancing Act”

[64] Warwick J. McKibben and Andrew Stoeckel, “The global financial crisis: Causes and consequences.” Asian Economic Papers 9, no. 1 (2010): 56

[65] Allen and Carletti, “The Global Financial Crisis.” 5

[66] The Economist, “The origins of the financial crisis: Crash Course.”

[67] Allen and Carletti, “The Global Financial Crisis.” 1 – 3

[68] Allen and Carletti, “The Global Financial Crisis.” 7

[69] Taylor, “The Financial Rebalancing Act”

[70] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[71] “Can we prevent financial crises?” World Bank. Date modified: February 26, 2014. http://www.worldbank.org/en/news/feature/2014/02/26/can-we-prevent-financial-crises

[72] Geithner, “Are We Safe Yet?”, 57

[73] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 19

[74] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 23

[75] Held and Young. “Crises in Parallel Worlds: The Governance of Global Risks in Finance, Security, and the Environment,” 26

[76] Claessens and Kodres, “The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions,” 7

[77]“From 1978 to 2007 the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product.”

gpo.gov, “The Financial Crisis Inquiry Report” XVII

[78] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 10

[79] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 23

[80] “A bubble means rapid growth in the value of financial assets without strong foundations in the underlying economy or actual business performance.”

Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 25

[81] Geithner, “Are We Safe Yet?”, 55

[82] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[83] Ibid.

[84] Ibid.

[85] The Economist, “The origins of the financial crisis: Crash Course.”

[86] gpo.gov, “The Financial Crisis Inquiry Report” XXIV

[87] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 16, 23

[88] Keown, Martin and Petty, Foundations of Finance, 14

[89] Ibid.

[90] Allen and Carletti, “The Global Financial Crisis.” 2

[91] Calhoun and Deruguian, Business as usual: the roots of the global financial meltdown, 14

[92] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[93] Allen and Carletti, “The Global Financial Crisis.” 2

[94] Crotty, “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’,”

[95] The Economist, “The origins of the financial crisis: Crash Course.”

[96] Marks, “Learning Lessons? The Global Financial Crisis five years on,” 7

[97] Jacopo Carmassi, Daniel Gros, and Stefano Micossi. “The global financial crisis: Causes and cures.” JCMS: Journal of Common Market Studies 47, no. 5 (2009): 979