You've heard the story. On the heels of tumbling shares and dire warnings from the U.S. president, as well as business and government officials across the globe, the British prime minister says, "The world economy is facing its greatest risk in decades." To halt the slide, he calls for a global response to prevent the crisis from spiraling out of control.
Sounds familiar, yes? Yet the prime minister described above is not Gordon Brown, the current occupant of 10 Downing Street, but rather Tony Blair in 1998, responding to the Asian crisis that had been accelerating since the collapse of the Thai currency many months before. There were many financial crises in the 20th century, several of which triggered panic that the system was on the brink of collapse: the oil shocks of the 1970s, the stock-market crash of 1987 and the collapse of the Mexican peso in 1994 all come to mind. But the Asian crisis was particularly acute. Throughout the fall of 1997 and into the spring of 1998, the Clinton administration held numerous meetings with various heads of state throughout Asia and Europe to work on a coordinated response. Eventually, the pieces came together, and the spiral was halted, but not quickly and not without considerable inertia.
Contrast that with what took place last week: over the course of one weekend, finance ministers of the G7, a club of the world's largest economies, sized up the extent of the financial crisis. They recognized that the credit system had simply ceased to function. Led in part by U.S. Treasury Secretary Henry Paulson, and also by European leaders including Gordon Brown of the U.K. and Nicolas Sarkozy of France, as well as IMF head Dominique Strauss-Kahn, they worked throughout the weekend to make a series of rolling announcements on Monday, Oct. 13. First, more than $3 trillion of funds would be committed to shore up banks and jump-start a frozen system. In addition, trillions of dollars of deposits would be guaranteed by governments around the world. China's central bank maintained its commitment to purchase U.S. Treasuries, a controversial issue for the presidential election, but an imperative part of a functioning global financial system. All this followed a global, coordinated rate cut by more than a dozen central banks.
The magnitude of the action was staggering, but even more extraordinary was that it happened so quickly, and that it happened virtually. If this is the first financial crisis of the Internet age—a crisis triggered by vastly complex quantitative models on the one hand, and global flows of capital facilitated by electronic trading systems on the other, then it is also shaping up as the first solution of the Internet age. It is a solution that takes place nowhere and everywhere, with no governing body, no place where everyone gathers to speak, and at a pace that earlier generations could not have fathomed.
Think about it. After the financial crisis of the Great Depression, followed by World War II, there was universal agreement that what was needed to prevent the next collapse was more global governance. The United Nations and the Bretton Woods system emerged from the ashes of war after many months of meetings and more months of debate. Other institutions followed, all connected by the principle that there had to be someplace where people could gather at times of crisis to talk until things were resolved. These institutions were governed by mutually agreed upon protocols and rules, and were maintained by permanent staffs and bureaucracies.
They had the virtue of giving physical form and substance to diplomacy for both economic and political crises, but they were not made for the world we live in today, where trillions of dollars of capital flow in dark pools that no government controls and no bank ever physically holds, where unregistered hedge funds domiciled in the Cayman Islands or on the island of Guernsey transact and borrow and trade, and where triggers in one place become triggers in every place.
That reality was recognized with the Asian crisis and the collapse of Long-Term Capital Management in the late 1990s, but they were dry runs for today. The leverage and exposure then was alarming by way of comparison with what came before, but only a fraction of what is at stake in today's crisis. The total amount of outstanding derivatives is in the neighborhood of $600 trillion, and even if only a small portion of those represent "real" money and potential losses, that still could approach the entire GDP of the planet.
As is usually the case, innovations have outpaced institutions. To put it another way, the global financial system catalyzed by New Economy technology has evolved at light speed, while the world's governing systems and bureaucracies are legacies of a time not far removed from the telegraph. That explains how things could have gone so far, so deep without any regulator sounding the alarm bell—that and a prevalent ideology in Washington against the notion of regulation, period. Yet that should also have meant that governments and governors would be paralyzed in the face of the crisis.
They haven't been. In fact, the very tools that enabled the crisis empowered the response. Each national bank, finance ministry and treasury department worked independently and in tandem across great distances, sharing information about balance sheets, outstanding liquidity and potential obligations with the same clicks of a button and the same models. They were able to act with emergency powers as national governments but more in sync than they would have been sitting next to each other in the assembly hall of some international ministry. They were, in short, able to act as a global virtual institution.
The model—not surprisingly—is the Internet itself. Dispersed among multiple servers, it has no physical location, but it acts as a system by virtue of its ability to link many other locations so seamlessly. Today, state governments, or at least central banks and treasury/finance departments, are functioning in similar fashion. Just as the Internet enabled financial contagion to spread more quickly than ever before, so it has allowed national agencies to respond with unprecedented speed and efficiency.
Of course, there's the rub: no one knows if what has been done so far will work. The crisis hasn't ended, and equities across the world continue to go up and mostly down with startling volatility, causing massive erosion of wealth. But the fact that action has been taken the way it has so far should be a sign that what got us into this mess may be a way out, as surely as a vaccine carries the seeds of the disease that it seeks to eradicate. This globally coordinated bailout isn't finished, not by a long shot, but the way it has been handled so far signals that the brave new world may contain its share of positive innovations as well as creative destruction.