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How to address the global crisis

With the world engulfed in the aftermath of a financial crisis and the midst of another one, have mainstream economists changed their theories and policy prescriptions to be more accurate in depicting reality and more relevant to policy-makers?



To a large extent, the crisis sparked by the Lehman Brothers collapse of 2007, and the Euro crisis, sparked by the Irish and Greek debt problems, have shaken the dominant assumptions that the financial markets are efficient and governments should leave them alone.

But Western governments and the International Monetary Fund (IMF) were able to divert blame away from developed countries' speculative funds and recipient countries' deregulated credit markets to allegations of crony capitalism and government mismanagement. With the crises in the US and Europe, it is more obvious now that the financial institutions and markets themselves are the cause.

At a conference last week in Izmir, Turkey, well-known economists and policy-makers debated the state of the global economy and of economics. Most speakers concluded that the crises were caused by deregulation that unleashed the beast of financial speculation by big banks and investment firms. They also agreed that economists and policy-makers have not yet learnt the right lessons.

As a result, the needed basic reforms have been avoided while wrong policies are being pursued. The world is on the brink of new financial crises and a recession.

Joe Stiglitz, Nobel laureate and former World Bank chief economist, gave a blistering critique of how the standard economics model has failed to deal with the financial crisis because wrong assumptions were made and wrong questions posed.

The orthodox model also could not handle current issues being debated, such as the multiplier of government spending, the nature of deleveraging and the liquidity trap. In the aftermath of the crisis, orthodox economists and the policy-makers in the US made wrong policies.

On the sidelines of the conference, the Turkish Central Bank co-organised a roundtable on capital flows. The central bankers and international institutions seemed to agree that volatile short-term flows were having damaging effects on developing countries, including financial instability, housing price, stock market bubbles, currency appreciation that made exports uncompetitive, and destablisling effects of sudden stops or reversals of the inflows.

The Turkish Central Bank's governor spoke of new policy tools being used by Turkey to discourage unwanted short-term capital inflows.

While most of the discussion on capital controls was on regulating inflows, I brought up the successful Malaysian example of controlling outflows selectively, accompanied by several other measures.

The position of the IMF, which championed free capital flows and once wanted to prevent countries from using capital controls, was interesting. Its official recognised the adverse effects that free capital flows can have, and the possible benefits of capital controls, which are significant changes from the Fund's old rigid view. But this IMF official also cautioned against using these measures as they could have bad effects on the country itself and on other countries. One example given was diverting unwanted funds to other countries that did not regulate.

The counter to this was that more attention or even blame should be placed on "source countries" that allow banks and investment funds to move their massive funds around the world in search of quick profits, with devastating effects on recipient countries, rather than prevent or discourage targeted countries from taking defensive measures.

At sessions on developing-country issues, He Fan of the Chinese Academy of Social Sciences analysed the present imbalances in China's economy and the prospects of future growth driven by urbanisation and consumer spending on services to offset falling exports.

The South Centre's chief economist Yilmaz Akyuz argued that developing countries had not de-coupled their economies from the developed countries. With the prolonged slowdown, they have to change their export-dependent development strategies.


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