The Financial System

Preface

When I was appointed Secretary-General of the OECD in the summer of 2006, it was a pleasant, if unexciting, time to be an economist. The Great Moderation had already solved the problem of having continuous growth while keeping inflation under control. Deregulation had unleashed the creative energy of the financial system, ensuring that the economy would always have the funds it needed. And the science of economics had finally solved the problem of depressions, according to Nobel laureate Robert Lucas. A year later, that world fell apart. As I write these lines today, in the autumn of 2020, we are facing an even more serious situation, provoked by the Covid-19 virus. It is therefore important to identify significant parallels and differences with the great financial crisis (GFC), and to apply the policy lessons we have learned.

The first similarity is how crises arise. The traditional school of economic thought essentially sees the economy as a machine which almost always operates in a predictable, linear way. Occasionally, the machine gets knocked off balance, or out of equilibrium, and needs some resetting to get back on track. But the economy is not a machine, despite all our talk of “engines of growth” controlled by “policy levers”. It is a complex adaptive system, with massive interdependencies among its parts and the potential for highly non-linear outcomes. In such systems, there is no equilibrium to return to. The crisis is not something that hits the system from outside. It is made possible and generated by the nature of the system itself.

Andy Haldane, Chief Economist of the Bank of England, discussed the similarities between financial crises and epidemics:

“Both events were manifestations of the behaviour under stress of a complex, adaptive network. Complex because these networks were a cat’s-cradle of interconnections, financial and non‑financial. Adaptive because behaviour in these networks was driven by interactions between optimising, but confused, agents. Seizures in the electricity grid, degradation of ecosystems, the spread of epidemics and the disintegration of the financial system – each is essentially a different branch of the same network family tree.”

Our approaches to economic analysis and policy anticipated neither the crisis, nor how it would cause an economic recession, and how the pain of that recession would provoke social and political crises in its wake. The results were rising inequalities, erosion of trust in governments and institutions, and growing populism which is influencing politics and economic policy. We created the New Approaches to Economic Challenges (NAEC) initiative to help policymakers design the analytical and practical tools they would need to address the kinds of interconnected challenges the 2008 crisis exemplified and foreshadowed.

An important lesson coming from NAEC is that the “system” in systemic is not one of the categories we traditionally used to identify and deal with crises – financial crisis, health crisis, political crisis… These are all subsystems of the greater system of systems composed of planet Earth and the human systems it supports. When NAEC calls for a systemic approach to avoiding collapse, that means understanding how an incident in one subsystem, even an initially insignificant one, can quickly be amplified and transmitted to become a threat to that system itself, and provoke cascading failures through other, interconnected systems. In 2007-2008, the spark was people defaulting on their debts in the US home loans market. In 2019-2020 it may have been a virus passing from bats, to pangolins, to humans in a Chinese wildlife market.

Cascading failures cause crises to lose their identities. We have to face not “just” a financial crisis or a pandemic. We have to deal with a crisis in which these are only two of the elements. Policymakers throughout history have said that their task is more difficult than before, but today there are good reasons to agree. In 2008, there was one immediate problem to solve – the imminent collapse of the banking system – and a limited number of actors involved, financial institutions and governments. Getting co‑operation and immediate action in those circumstances is far easier than dealing with whole populations and whole economies.

There is however one major conclusion we can draw when comparing 2008 and today: policy decisions are central to producing the breeding ground for crises, to shaping how they will expand and evolve, and therefore to dealing with them. Governments decided to deregulate financial markets and decided on austerity as a response to the financial crisis that deregulation itself helped to bring about. In turn, austerity, and the drive for efficiency, left many health systems without the means to tackle Covid-19 effectively.

Both the 2008 and today’s crises are teaching us another lesson: governments are the only system with the necessary fiscal and political ‘firepower’ to deal with the planetary emergencies we will continue to face throughout the 21^st century. The OECD is ready to help our Member and partner countries, by sharing its expertise across the full range of policy domains that have to be incorporated into a systemic response to systemic threats of such magnitude.

 

Angel Gurría

Secretary-General

OECD