Global financial crisis: Did the system really work?

Much of the mountain of commentary and analysis of the 2008 Great Recession has been either critical (Paul Krugman might be typical), or a self-interested defence (Tim Geithner and Larry Summers provide examples). Daniel Drezner's The System Worked is atypical in two respects: he was not a protagonist yet he thinks things turned out pretty well; and he comes at this issue from an international relations/political economy vantage point, rather than as an economist.

Of course all such judgments are relative. Drezner's main comparison is with the 1930s Great Depression. The core of the defence is that we didn't make as many mistakes or end up in such a parlous position. If this is the benchmark, it's easy enough to agree.

The main achievement is that the market-based globalised trading and finance system survived. Even though the initial fall in GDP and in world trade was worse this time round, the trajectory of trade didn't mimic the extended contractionary spiral of the 1930s (depicted in this famous graph). There was a surge in protectionism in 2008, but this was swiftly pin-pointed and largely wound back.

Nor did the GDP fall continue. International macro-policy coordination has been rare in history, but the G20-orchestrated fiscal stimulus in 2008-9 was an undoubted success.

The international cooperative framework not only survived (where the League of Nations didn't) but improved a bit. The G20 Leaders' meetings supplemented the G8 (although not superseding it). If the communiques are constructed of boiler-plate platitudes, the peer pressure of regular meetings is still a great advance on the failed 1933 London Conference. A start was made on fixing the governance deficiencies of the International Monetary Fund by enlarging the quotas of the emerging economies. Membership of the Basel-based finance-oriented arrangements was similarly enlarged. [fold]

The 'international received wisdom' improved a bit. The core of the Washington Consensus (market-oriented globally open policies) survived and was improved by softening its doctrinal insistence on free capital flows. More inward-looking alternatives (the 'Beijing Consensus') didn't get any traction, even in China. Balkanising alternative forums such as BRICS (invented as a Goldman Sachs marketing ploy) are fumbling for substance.

There were complaints about 'currency wars', but exchange rates remained market-determined and volatility was not excessive. The US dollar retained its key role and underlined this with the swift provision of currency-swap facilities between major central banks to assure the flow of international finance. Perhaps in response to international pressure, China allowed its exchange rate to appreciate markedly and its huge current account surplus to shrink.

If the World Trade Organisation has not been able to make much progress, the so-called free-trade agreements compensate for this. If 2008 revealed the inadequacies of the international financial rules, significantly tougher rules (Basel III) were devised in record time (two years).

Drezner is so surprised by this list of successes that he trawls through the political economy and international-relations literature for some explanation. Was it a result of interest groups pushing their own agenda, for the good of all? Are there now more people who directly benefit from open-market globalisation? Have the vested interests which emasculated earlier attempts at global rule-making for banks (Basel I and Basel II) been neutralised in the Basel III rules, which not only toughened capital requirement but will introduce a liquidity requirement?

Was the success a reflection of the continuing hegemonic role of the US in maintaining a globalised system? This ongoing US hegemonic leadership contrasts with the 1930s, when the UK was too weak to provide global leadership, while the US was unwilling to do so. Drezner notes that the rising power of China is not yet able to offer any convincing international global cooperative paradigm as an alternative to US-dollar-based open-market globalisation. China actually helped put the system back on track, with its huge stimulus in 2009, holding up world growth in the middle of a deep global recession.

In short, if you set the bar low enough — just to do better than in the 1930s — then you can have the satisfaction of clearing the hurdle.

Judged against the higher bar of what was possible, the assessment might be harsher. The recovery has been weak in all the advanced economies (UK GDP is only just back to the 2007 level). The global collective fiscal stimulus was stopped too early. Europe mistakenly tightened fiscal and monetary policy in 2011. QE is a measure of monetary policy desperation, with as yet unclear longer-term effects. Policy incompetence in a tiny economy like Greece was allowed to trigger contagion and depression in the European peripheral countries, leaving an unsustainable debt burden unresolved.

The World Trade Organisation seems unable to make any substantive progress. Basel III might be an improvement (when it is eventually implemented, towards the end of the decade) but the international financial sector is still top-heavy with risky transactions of doubtful benefit to society. The incomplete IMF governance reforms are woefully inadequate, still vigorously resisted by Europe and awaiting US Congressional blessing. The economic cooperation framework is fragmented between the G20 and G8, unable to adapt to a world where the like-minded G8 countries no longer dominate.

Drezner's analysis seems to confound policy issues with are intrinsically domestic with those which might, in an ideal world, be handled globally. The similar fiscal and monetary policies of 2009 were not so much a triumph of international policy coordination but rather were the coincidence of countries responding to a similar environment with similar policies. There is scant evidence that policies will be coordinated where interests differ, or when powerful domestic interests bring effective pressure to bear. Climate change, taxation, intellectual property rights and many other issues are still in the 'too hard' basket.

As Drezner notes, there are worse examples of international governance, topically demonstrated by FIFA's 'buffoonery'. But how much comfort should we take from knowing that international economic governance is better than FIFA?

Stephen Grenville