In mid-2007, the United States began experiencing what turned out to be its worst financial and economic crisis since the 1930s. In short order, economies and financial markets around the world were severely affected. Vast numbers of workers and families were badly hurt and continue to be seriously affected. Many analysts think, as I do, that the recovery could be long and slow, with stubbornly high levels of unemployment persisting—even if we have two or three stronger quarters first. All of this has raised serious questions about the best way for long-term economic policy to promote growth, widespread participation in that growth, and personal economic security.
In the six decades since the end of the Second World War, there has been a broad movement around the world toward a model of market-based economics, public investment, and global integration. With that move came enormous economic progress in industrial countries, including the recovery of war-torn Europe and Japan and, as time went on, in various developing countries. South Korea's GDP per capita grew from roughly $350 50 years ago to close to $20,000 today. In 1960, Singapore was a small fishing village with an average per capita GDP of $427; today it is $38,000. Since China began market-oriented economic reform in 1978, its GDP per capita has risen from roughly $400 to $3,000, with hundreds of millions of people moving out of poverty. India began economic reform in 1991 and, on average, has grown in excess of 6 percent per year since, and has also lifted hundreds of millions of people from poverty. And there are many more examples, especially in Asia.
But despite this history, in the wake of the financial crisis, there are many policy issues that need to be examined. The question of which economic model works best was recently subjected to rigorous analysis by a task force called the Commission on Growth and Development, established by the World Bank and other sponsors in April 2006. The commission was chaired by the Nobel Laureate economist Michael Spence and included Trevor Manuel, then South Africa's finance minister; Gov. Zhou Xiaochuan of the People's Bank of China; Montek Ahluwalia, the deputy chairman of India's planning commission and a key economic adviser to Prime Minister Manmohan Singh; and others, including myself. In May 2008, the commission completed its study of developing countries that had grown 7 percent or more over an extended period (and then reaffirmed its fundamental findings in October 2009, with discussion of adjustments for the crisis). While the specifics differed from country to country, the commission concluded that these highly successful economies shared a set of common characteristics: sustained movement toward market-based economics; governments that effectively provided sound fiscal and monetary policy, substantial public investment, and increasing integration with the global economy; high savings and investment rates; political stability and the rule of law; and considerable focus on widening the distribution of income. The commission also found that no economy anywhere in the world had been successful with largely state-directed activities and high walls against global integration.
The evidence, in other words, strongly suggests that a market-based model is still the best way forward. But substantial change must be made in many key areas. The terrible toll the recent crisis had on people around the world underscores the need to reform the financial system to better protect against systemic risk and devastating crises in the future. Even before the recession hit, our current model had displayed major shortcomings that markets, by their nature, won't address and that need to be met through public policy. For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries. In the United States, median real wages have lagged behind productivity growth for more than three decades (except for the second half of the 1990s), and income has become more heavily distributed toward the most affluent. In China and India, although great numbers of people have risen out of poverty, substantial portions of their populations remain very poor, while a very small group has developed immense wealth. Other issues the market-based model has not successfully addressed include serious, ongoing global trade and financial imbalances, climate change, and poverty.
Among all of the critical issues, this essay will address three that are essential to the future success of the market-based model, with special focus on the United States: 1) certain dilemmas in promoting crisis recovery and job creation now; 2) financial-system reform; and 3) the fundamental policy challenges the U.S. must meet for long-term success. The broader point here is that the market-based model must be combined with strong and effective government, nationally and transnationally, to deal with critical challenges that markets won't adequately address. The fundamental question is whether governing institutions will meet that test.
Government must also address the immediate need to strengthen the economy, create jobs, and protect people affected by the crisis, but that is a vital topic of its own.
To determine the lessons of the crisis and the necessary reforms, we must first understand what caused it. My discussion here relates to the United States. About four years ago, a well-known London investor said to me that the only undervalued asset in the world was risk. I had the same view, as did many others, and often said that markets, including credit, had gone to excess and that would probably be followed by a cyclical downturn—perhaps a sharp one—though the timing, as always, was unpredictable. But that's not what happened. Instead, these excesses combined with other powerful factors that occurred at the same time: low interest rates that led investors to an unsound reaching for yield; massive increases in the use and complexity of derivatives that heightened systemic risk in stressed markets; misguided and powerfully consequential AAA ratings for many subprime-mortgage derivatives; stagnant median real wages and rising housing prices that led consumers to overborrow to maintain living standards; a subsequent dramatic decline in housing prices; lax and often abusive mortgage practices; overleveraging by financial institutions and deterioration in the quality of their asset acquisitions; and, as time went on, greatly tightened credit availability, growing unemployment, and a falling stock market.
It was this extraordinary combination that led to the worst financial crisis in 80 years. In addition, there has long been a disproportionate focus on the short term in corporate earnings, markets, compensation, and other matters that contributed to this dangerous mix.
While some people saw one or more of these factors, virtually no one involved in the financial system—whether institutions, investors, regulators, analysts, or commentators—recognized the breadth of forces at work or the possibility of a megacrisis, and this included the most experienced among us. More personally, I regret that I, too, didn't see the potential for such extreme conditions despite my many years involved in financial matters and my concern for market excesses.
Once underway, the crisis spread around the world due to developments in the United States, but also due to vulnerabilities in other countries, and was heightened by the failure of Lehman Brothers. The policy response in the United States and a number of other countries was unprecedented in both size and scope and has had great effect.
Looking forward, however, U.S. policymakers face two serious dilemmas in crafting further recovery and job--creation measures. First, their tools have been heavily stretched toward their limits. Short-term interest rates are at a quarter of 1 percent. Putting another major stimulus on top of already huge deficits and rising debt-to-GDP ratios would have risks. And further expansion of the Federal Reserve Board's balance sheet could create significant problems. Second, while the measures taken were absolutely necessary, unwinding the stimulus, restoring a sound fiscal regime, undoing the expansion of the Federal Reserve Board's balance sheet, and reducing government's involvement in the financial system will be very difficult, both substantively and politically. Moreover, the timing is complex. Today's economic conditions would ordinarily be met with expansionary policy, but our fiscal and monetary conditions are a serious constraint, and waiting too long to address them could cause a new crisis.
Financial history suggests, in my view, that markets have an inherent and inevitable tendency—probably rooted in human nature—to go to excess, both on the upside and the downside. The systemic risk caused by this susceptibility has now been greatly increased by the size, speed, complexity, and global nature of modern capital markets and financial systems. The answer, however, is not to abandon our basic economic model, including a market-based financial system, but to make the regulatory regime as modern as the markets.
Given my views as to the causes of the crisis, I would recommend the following:
Each one of these actions would be tremendously complex. The perfect should not be the enemy of the good, however, and reform, once begun, can always be adjusted for difficulties or for market changes. The economy and financial institutions would all benefit from greater focus on the long term in corporate earnings, compensation, and other areas.
Let me now turn to the three long-term policy challenges the market-based economic model must address in order to realize its potential.
First, there must be sound fiscal and monetary policies. The United States faces projected 10-year federal budget deficits that seriously threaten its bond market, exchange rate, economy, and the economic future of every American worker and family. Those risks are exacerbated by the context of those deficits: a low household-savings rate, even after recent increases; large funding requirements for federal debt maturities every year; heavy overweighting of dollar-denominated assets in foreign portfolios; worsened fiscal prospects in the decades after the current 10-year budget period; and competing claims for capital to fund deficits in other countries.
The conventional concern here is that private investment will be crowded out, which would result in a reduction of productivity, competitiveness, and growth. In addition, the very early 1990s showed that unsound fiscal conditions can have a symbolic effect that broadly undermines business and consumer confidence. But finally, and far more dangerously, our bond and currency markets could react with severe distress to fears about imbalances in the supply and demand for capital in the years ahead or about the possibilities of inflation. Those effects have been averted so far by a number of factors: large inflows of capital from abroad into Treasury securities; concerns about other major currencies; the low level of private demand for capital; and the psychological state of the market. But this cannot continue indefinitely, and change can occur with great force—and unpredictable timing.
The American people are growing increasingly concerned about deficits, creating a public environment more conducive to political action. And the Obama administration, in my view, has a deep understanding of the critical importance of addressing this issue. But the substance and the politics of returning over time to a sound fiscal position are very difficult, and the timing is even more complicated because of the current economic circumstances.
Second, public investments and other policy measures must deal with areas that are absolutely critical to growth and widespread income participation that markets will not adequately address, such as education, health-care coverage and cost constraint, a sound energy regime, basic research, infrastructure, fair labor markets, equipping the poor to enter the economic mainstream, and much else.
Third, sound international economic policy is critical. Most immediately, as President Obama and the other G20 leaders warned, restrictive trade measures in response to the current crisis could lead to highly destructive trade wars. For the long run, we should continue pursuing the open markets that the Peterson Institute for International Economics, a Washington think tank, estimates have added $1 trillion to America's current GDP. But the United States must make an even greater effort to reduce trade-distorting practices in countries less open than ours. And the U.S. must increase its savings rate over time, while countries with trade surpluses must reduce theirs and increase domestic demand to reduce global trade and financial imbalances.
Open markets in today's transforming global economy—with new technologies and the rise of developing countries such as China and India—create both new opportunities and new pressures on competitiveness and wages. This makes it even more important that the U.S. political system rises to meet its challenges. For American workers, sustained growth is the most powerful force for higher wages and greater personal economic security. But more must be done, including ensuring greater public investment, fair labor markets, a progressive tax structure, affordable health-care coverage, and an adequate social-safety net.
The dynamism of American society, its flexible labor and capital markets, its entrepreneurial spirit and the sheer size of its economy, are great strengths for succeeding in a rapidly transforming global economy. But like any country, the United States will only realize the potential and the benefits of its market-based model by addressing the lessons of the crisis and by enacting policies that effectively promote competitiveness, growth, widespread sharing of that growth, and increased economic security. In the United States, this will require far greater willingness to work across party and ideological lines, to base decisions on facts and analysis, and to make sound decisions on politically tough issues that may be difficult in the short term but provide long-term gain.
Finally, in an increasingly interdependent world, transnational issues key to all of us can only be addressed through effective global governance—which is a lot easier to proclaim in communiqués than to accomplish. Thus the ultimate challenge for the market-based economic model, perhaps somewhat ironically, is effective governance in each country and internationally.