Global Financial Contagion - Have the risks been contained?

Wed, 25 Jun 2014 11:53:00 +1000

The Global Financial Crisis of 2008 has had devastating consequences, but have we learned from our mistakes?

Nobel Laureate and world-leading economist, Professor Joseph Stiglitz recently shared his insights on the GFC with Deakin students and staff in a lecture at the City campus.

In his address, Professor Stiglitz said that the pre-crash system was based on simplistic models - “where there were rational individuals with rational expectations.”

“It was striking that the models gained such popularity,” he said. “This was because they aligned with ideology, which said that the markets worked well, but all the assumptions were shown to be wrong.”

“We could have stopped the growth of the housing bubble just by greater regulation, but the ideology said ‘No. Let the party go on’. Yet, the cost to society of the GFC was close to $10 trillion.”

“The gung ho nature of the advocates of the markets focussed on one thing, diversifying the risks, but what were the incentives to avoid risks? There was no incentive not to engage in bad mortgages, but there were incentives to behave badly. The system really was perverse.”

He added that a “key economic insight” is that privately profitable transactions may not be socially desirable. “Don’t think that the pursuit of self-interest leads, by an ‘invisible hand,’ to the benefit of society. It seems the ‘invisible hand’ might not be there,” he said.

Highlights from Joseph Stiglitz' talk to Deakin

Alternatively, watch the full lecture from Joseph Stiglitz

Named one of the 100 most influential thinkers by “Time” magazine in 2011, Professor Stiglitz is known for his critical views on the management of globalisation and the free market economy.

Professor Stiglitz is a former Senior Vice-President and chief economist of the World Bank, and a former Chairman of the Council of Economic Advisors. He was appointed Chairman of the U.N. Commission on Reforms of the International Monetary and Financial System after the crash in 2009.

He is currently President of the International Economic Association and Professor at Columbia University, and he has authored 10 books, with the 2012 “Price of Inequality” hitting the “New York Times” bestseller list.

Professor Stiglitz was invited to Deakin by the Centre for Economics and Financial Econometrics Research (CEFER), and he will be keynote speaker at the Economic Society of Australia’s Annual Conference in Hobart.

Professor Stiglitz's visit to Australia has been sponsored by the Crawford School of Public Policy at The Australian National University.

Professor Chris Doucouliagos, Chair in Economics and Deputy-Director of CEFER, said that Professor Stiglitz’s visit to Deakin was “a wonderful opportunity for the Deakin community to hear from an economist with a unique understanding of the financial events that reverberated around the world.”

Deakin Vice-Chancellor Professor Jane den Hollander welcomed Professor Stiglitz to the City campus.

“Professor Stiglitz’s work has had an enormous influence on the shaping of global debate across almost every part of the world,” she said. “How interesting it is to hear from one of the most highly cited economists during the current financial climate in Australia.”

The lecture was chaired by Professor Pedro Gomis Porqueras, Chair in Economics within Deakin’s Faculty of Business and Law, who said that Professor Stiglitz “has been in the front line of public policy making and a very effective communicator - making sometimes-dry issues accessible to the public at large.”

During his address, Professor Stiglitz said that the Global Financial Crisis put the spotlight on many basic ideas of macroeconomics, with one of the key mistakes being a lack of understanding of the risks of inter-connectivity.

“Before the crisis, inter-connectivity was thought to reduce risk,” he said. “But modern macroeconomics has really shown that idea to be very flawed. We didn’t predict the financial crisis. Economists believed that bubbles couldn’t happen and markets were efficient and stable.”

Professor Stiglitz said that, prior to the crash, the prevailing economic theories were inconsistent with historical evidence.

“The models said large fluctuations don’t exist. They were exogenous (externally caused), but history has shown that they were endogenous (internally caused), such as when the technology bubble broke,” he said.

Professor Stiglitz explained that  the term “contagion” was borrowed from epidemiology, which concerns the study of the spread of disease.

“If you were to send each victim of a disease to a different state, this is how you would spread the disease,” he said.

In contrast, economic policy advocated diversification rather than isolation. “In relation to the economy and globalisation, no one thought about this ahead of time. They thought there were strong buffers, such as inventories, but, in fact, the buffers acted as amplifiers.”

In relation to Australia, Professor Stiglitz emphasised that the GFC was a North Atlantic Crisis, which “did not hit Australia.”

“Most countries in the North Atlantic have a GDP well below what it was in 2007. The trend line in the US is more than 15 per cent lower than it would have been if we hadn’t had the GFC. In Europe it is almost 20 per cent lower and the gap is growing. In Greece, for instance, there is over 60 per cent youth unemployment.”

So can we prevent a future financial crisis?

Professor Stiglitz believes that economists have learnt the value of circuit breakers, such as restrictions on capital flows, and he praised the huge field of study in macroeconomics externalities that has emerged, including the use of new maths tools and network analysis.

“There is a general recognition of systemic risk and there have been some improvements in buffering,” he said.

However, he identified two major causes of concern for the future: growing inequality, which will have adverse effects on macroeconomic behaviour; and the major structural transformation currently occurring - with the move away from manufacturing to a service economy, not unlike the transition from agriculture to manufacturing that occurred 100 years ago.

“These transition periods are often associated with under-utilisation of human capital, particularly for those who don’t have the capacity to move to new sectors without government support,” he said.

“The Great Depression came after the earlier transition. This was solved with WWII, where the governments did spend - with no choice - but it did get us out of the Great Depression.”

“However, today, many countries, such as Australia, the US and the UK, are going the opposite way and spending less on services, such as education and health.”

Finally, he has tremendous concerns about the US banking system.

“In the United States the too-big-to-fail banks have become worse. If you have adequate regulation, you can live with big banks, but they don’t like adequate regulation. In the US, we say that the Federal Reserve and US Treasury are a wholly-owned subsidiary of Wall Street,” he said.

“In the US, banks are too inter-linked to fail, too correlated to fail and they are too big to jail.”

“Over the past three decades - since we’ve stripped away regulations - we have had over 100 crises. It is not just a balance-sheet recession. There are deeper problems we have to address."


(From left) Professor Chris Doucouliagos, Professor Barry Cooper, Nobel Laureate Professor Joseph Stiglitz, Professor Mike Ewing and Vice-Chancellor Professor Jane den Hollander.
(From left) Professor Chris Doucouliagos, Professor Barry Cooper, Nobel Laureate Professor Joseph Stiglitz, Professor Mike Ewing and Vice-Chancellor Professor Jane den Hollander.
Showcase facts
  • “In the US, banks are too inter-linked to fail, too correlated to fail and they are too big to jail.”
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20th August 2012