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We
are at a moment when the range of uncertainties
facing the global economy is unusually wide. We have
just passed through the worst financial crisis since
World War II. The only relevant comparisons are with
the Japanese real-estate bubble, which burst in 1991
(and from which Japan has not recovered), and the
Great Depression of the 1930s - except that this
crisis has been quantitatively much larger and
qualitatively different.
Unlike the Japanese experience, this crisis involved
the entire world, rather than being confined to a
single country. And, unlike the Great Depression,
this time the financial system was put on artificial
life-support, rather than being allowed to collapse.
In
fact, the magnitude of the problem today is even
greater than during the Great Depression. In 1929,
total credit outstanding in the United States was
160pc of GDP, and it rose to 250pc by 1932. In 2008,
we started at 365pc - and this calculation leaves
out the pervasive use of derivatives, which was
absent in the 1930s.
Despite this, artificial life-support has worked.
Barely a year after the bankruptcy of Lehman
Brothers, financial markets have stabilised, stock
markets have rebounded, and the economy is showing
signs of recovery. People want to return to business
as usual - and to think of the Crash of 2008 as a
bad dream.
Unfortunately, the recovery is liable to run out of
steam, and may even be followed by a second economic
downturn, though I am not sure whether it will occur
in 2010 or 2011. My views are far from unique, but
they are at variance with the prevailing mood. The
longer the turnaround lasts, the more people will
believe that it will continue. But in my judgment,
this is characteristic of far-from-equilibrium
situations when perceptions tend to lag behind
reality.
To
complicate matters, the lag works in both
directions. Most people have not yet realised that
this crisis is different from previous ones - that
we are at the end of an era. Others - including me -
failed to anticipate the extent of the rebound.
Overall, the international financial authorities
have handled this crisis the same way as they
handled previous ones: They bailed out failing
institutions and applied monetary and fiscal
stimulus. But this crisis was much bigger, and the
same techniques did not work. The failed rescue of
Lehman Brothers was a game-changing event: Financial
markets actually ceased to function.
This meant that governments had to effectively
guarantee that no other institution whose collapse
could endanger the system would be allowed to fail.
That is when the crisis spread to the periphery of
the world economy, because countries on the
periphery could not provide equally credible
guarantees.
Eastern Europe was the worst hit. Countries at the centre used
their central banks’ strong balance sheets to pump
money into the system and to guarantee the
liabilities of commercial banks, while governments
engaged in deficit financing to stimulate the
economy on an unprecedented scale.
But the growing belief that the global financial
system has escaped collapse, and that we are slowly
returning to business as usual, is a grave
misinterpretation of the current situation. Humpty
Dumpty cannot be put together again.
The globalisation of financial markets that took
place since the 1980s allowed financial capital to
move freely around the world, making it difficult to
tax or regulate. This put financial capital in a
privileged position: Governments had to pay more
attention to the requirements of international
capital than to the aspirations of their own people.
Individual countries found it difficult to offer
resistance.
But the global financial system that emerged was
fundamentally unstable, because it was built on the
false premise that financial markets can be safely
left to their own devices. That is why it broke
down, and that is why it cannot be put together
again.
Global markets need global regulations, but the
regulations that are currently in force are rooted
in the principle of national sovereignty. There are
some international agreements, notably the Basel
Accords on minimum capital requirements; and there
is also good cooperation among market regulators.
But the source of the authority is always the
sovereign state.
This means that it is not enough to restart a
mechanism that has stalled; we need to create a
regulatory mechanism that has never existed. As
things stand now, each country’s financial system is
being sustained and supported by its own government.
But governments are primarily concerned with their
own economies. This gives rise to what may be called
financial protectionism, which threatens to disrupt
and perhaps destroy global financial markets.
British regulators will never again rely on the
Icelandic authorities, and Eastern European
countries will be reluctant to remain dependent on
foreign-owned banks.
Regulations must become international in scope.
Otherwise, global financial markets will be
destroyed by regulatory arbitrage. Businesses would
move to countries where the regulatory climate is
the most benign, exposing other countries to risks
that they cannot afford to run.
Globalisation was successful because it forced
countries to remove regulations; but the process
does not work in reverse. It will be difficult to
get countries to agree on uniform regulations.
Different countries have different interests, which
drive them towards different solutions.
This can be seen in Europe, where the European
Union’s member states cannot agree among themselves
on a uniform set of financial rules.
How, then, can the rest of the world?
In
the 1930s, trade protectionism made a bad situation
worse. In today’s global economy, the rise of
financial protectionism constitutes a greater
danger.
George Soros is chairman of Soros Fund Management
and of the Open Society Institute. His most recent
book is “The Crash of 2008“. This article is
provided to Fortune by Project Syndicate.
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