Financial Crisis

The financial system in the USA and much of Europe had a heart attack in September 2008.  As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient.  Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues:  What created the rising risk of an attack?  And what combination of actions post-crisis will reduce the risk of a repeat in the future. 

It is difficult at this point in time, with little benefit of hindsight, to determine whether we are passing through yet another financial crisis that has punctuated economic history from time to time, or that we are indeed at a turning point that will change macroeconomic policy and management in fundamental ways.

The ‘Great Moderation’ preceding the current crisis turned out to be simply the proverbial calm before the storm. It seems odd, even appalling, that economists, policy makers and multilateral surveillance bodies like the IMF should not have seen the storm coming, especially since the calm was associated with several macro-economic anomalies.

The last decades have seen a tremendous improvement of the situation for girls and women in developing countries. Today, more girls attend school. More women earn an income in the formal labour market. Women participate in society to a greater extent.

In an op-ed in the Financial Times’ Economists Forum on November 24th, Growth Commission Chair Michael Spence elaborates on the endogenous nature of the asset pricing problem, and its role in the current global financial crisis. The piece, entitled Balance sheets and income statements: breaking the downward spiral , highlights the uncertainty investors face in determining the intrinsic value of assets, and their consequent reluctance to enter the market.  Dr. Spence discusses the channels underpinning the decline in economic activity, and suggests that government can play a positive role in limiting the negative overshoot in assets and economic activity.  Additionally, he points to the need for a significant stimulus package and a more systematic program of purchasing assets to stem the downward spiral.

Debate among economists about the $700 billion Paulson plan reveals a deep divide between realists and fundamentalists. If economists and policy makers pay attention to how the tension between these two positions plays out in this particular debate, it will help us know how to deal with it in other areas, including development.

The formal, model-based approach of the fundamentalists has contributed much to progress in economic analysis. At key junctures, it has also made important contributions to policy. The challenge is to maintain an intellectual environment that leaves space for a conversation with realists as well. In complicated policy contexts where models don't yet capture key forces, the realists have much to offer both policy makers and fundamentalist modelers. By giving voice to observations that strike realists as obvious but that are not accepted in conversations dominated by fundamentalists, the report by the Commission on Growth and Development could encourage a richer, more open debate about the policy options for poor countries.