The Failure of Laissez-Faire

On Friday night, September 12, 2008, the heads of each of Wall Street’s largest financial firms were summoned to an emergency closed-door meeting at the New York Federal Reserve. There, U.S. Treasury Secretary Henry Paulson briefed them on news that would soon rock the foundations of the global economy: Lehman Brothers, then one of Wall Street’s “big five” investment banks, was on its last legs, and Paulson refused to bail it out (Sorkin 2010). After a frenzied weekend spent trying to pawn off Lehman’s toxic assets on other firms, the company filed the largest bankruptcy suit in U.S. history that Monday. The finance world had been in crisis-mode since the August before, but the decision to let Lehman fail was what first truly crashed the system (Blinder 2013). The loss in confidence it caused immediately infected economies across the globe. As the Dow Jones plunged 500 points that day, Asian and European indices similarly tanked. Ireland became the first Eurozone country to fall into a recession the next week. One tumultuous year later, Greece’s government announced that it had previously misreported its debt as 6 to 8 percent of GDP when the actual figure was closer to 120 percent. The crash had driven up lending rates for Greece and other countries in the periphery of the Eurozone, and track records of reckless borrowing pushed their governments to the brink of bankruptcy (Snow). Wall Street had become the epicenter of a global catastrophe, and reverberations from that fateful Friday meeting left a scar on world markets that has yet to fully heal.

The simultaneous market crashes and lingering recessions are a testament to just how intricately entangled the world economy has become. The fiscal havoc that the 2008 meltdown was able to wreak on states and industries seemingly far-removed from its point of origin is a metastasis of globalization — the all-encompassing trend towards unprecedented interconnectivity between people, organizations, and states, for better or for worse. Technology, removal of trade barriers, and emerging markets have made trade between countries more efficient and widespread than ever. The benefits can be seen in growth of global wealth and cheaper production of goods. But empirical evidence shows that globalization is also widening income gaps and driving down wages for many workers (Piketty 2014). Financial regulations set down by individual states become irrelevant when multinational corporations have the leverage to boost growth and employment in any state that accommodates its interests. If anarchy is the natural state of the international political arena then laissez faire is the natural state of the globalized economy, and a critical question is if or how it should be mitigated. While distorted incentives in the financial sector and subprime lending catalyzed the crisis, globalization exasperated it to new heights. And just as policymakers are now re-examining the free-market ideology that drove the banking industry into the ground, it’s important to look at how the globalized structure of the world’s economy also caused the collapse.

Globalization is a broad term, and it has different implications in each political paradigm. To a liberal commercialist, the growing degree of economic interdependence is a good sign. It means states have more to lose by making war with one another and are thus less likely to do so. A liberal institutionalist might add that globalization manifests in intergovernmental institutions that ensure its benefits are distributed in the collective interest of states (McGrew and Lewis 2013). Economic structuralists argue that the basic structure of capitalism inevitably results in a system in which a wealthy few exploit the labor-class masses. In this paradigm, globalization is this consolidation in action. On the other hand, constructivists expect the forces of globalization to transcend the individual identities of nation-states and reconstitute a new international society with its own constructed norms (Wendt 1992). Structural realism does not has as much explanatory value because its exclusive focus on state actors is not as relevant to the premise of globalization. Still, a structural realist could argue that globalization is actually a facade for the realities of a unipolar balance of power (Mearsheimer 1999).

Economic structuralism is arguably one of the most appealing models to explain the financial crisis. The build-up to the crash involves many of the elements of a Marxist narrative: growing divides between the rich and poor, a global recession caused by a wealthy upper-class that came out relatively unscathed, and “a ‘reserve army’ of the unemployed — capital’s finest weapon in beating down the minimum wage and increasing the hours of the working week” (Hitchens 2009). Even John Micklethwait and Adrian Wooldridge, two staunch globalization advocates, claim that Marx’s “description of globalization remains as sharp today as it was 150 years ago” (2001). Richard Wolff, a professor of Marxian economics, argues that the collapse was the direct result of the disproportionate allotment of wealth in the U.S. According to Wolff, the disparity traces back to the decline in real wages in the U.S. during the 1970s. Worker productivity rose but wages stagnated, and companies invested the saved money into more capital. As companies accumulated capital at a greater rate than they expanded payrolls, workers were forced to borrow more and more in the form of mortgages and credit cards. Consumer debt piled up. Globalization prompted companies to move jobs overseas and invest more abroad. With Americans left unemployed and unable to pay off debts, the banking system collapsed from the bottom up (Wolff 2012). This Marxian emphasis on capital as the driving force of economics has seen a resurgence recently due to the growing prominence of Thomas Piketty’s Capital in the Twenty-First Century. Piketty looks at tax data from twenty countries and shows that global capitalism is trending towards a shrinking concentration of wealth. His analysis is based on the simple fact that the rate of capital returns always trumps the rate of economic growth (Piketty 2014). Like Wolff, Piketty claims growing household debt and the free-for-all financial sector that handled it factored into the crisis. Economic structuralism is a good analytical starting point because its broad-sweep approach illustrates the “state of nature” of global laissez faire. It exposes fundamental economic mechanics that govern the unchecked free market without getting bogged down in nuts-and-bolts financial details.

The counterargument to economic structuralism, in this case, comes from commercial liberalism, which stresses the importance of economic interdependence and free trade in maintaining a peaceful and stable international system. Some proponents of commercial liberalism make the case that the paradigm is more than a repackaging of laissez faire policy. The supposed difference is that economic competition functions more equitably in an aggregated global context, since states, ideally acting in the best interest of citizens, compete on the same market plane as economic actors. The paradigm concedes that increased interconnectedness will likely have income disparity consequences in the short run, but in the long run, it will increase equity by removing isolated oligopoly or monopoly markets that are propped up by limited exposure to global competition (Press-Bartham 2006). Many argue that the 2007-2008 financial crisis dealt a severe blow to the paradigm’s validity, since the model is predicated on the idea that economic interdependence maintains global stability. In addition to the 2008 crisis, financial system shocks like the Asian financial crisis of 1997, the Russian financial crisis of 1998, the Brazilian crisis in 1999, and the Long Term Capital Management Crisis in 1999 have repeatedly shown that globalization has actually made states somewhat more vulnerable to economic instability (Rudd 2011). Capital investment between states has now proliferated to such a level that “every country is to a large extent owned by other countries” (Piketty 2014). Even in terms of security, economic ties can barely be considered an ironclad deterrent when foreign investments are so diluted that war can be justified through cost-benefit analysis (Press-Bartham 2006). Even with the collective understanding that the invasion of another country would jar the entire economy, this consideration would not be a factor because the essence of commercial liberalism is comparative advantage. Timothy Geithner, who worked for the U.S. Treasury international team during the spate of crises in the 1990s, described how the capital flow between borders instigated the shocks:

“Globalization unleashed enormous sums of “hot money” that could instantaneously flow across borders, while the aspects of human psychology that had helped produce financial booms and crises for centuries remained unchanged” (Geithner 2014).

Before the financial crisis illustrated the dangers of systematically stripping away regulations and letting market forces govern the economy, free market ideology was widely championed — on a global and domestic scale — by prominent economists and policymakers such as Alan Greenspan, Lawrence Summers, and Arthur Levitt (Blinder 2013). Perhaps the most important transformational effect the crisis had in the policy realm was that it definitively disproved the notion that economies function most efficiently without regulatory intervention. The implication was so clear that even Greenspan, a lifelong believer in the power of Adam Smith’s “invisible hand,” admitted before Congress that he had been wrong his whole career.

With the need for regulatory reform now made abundantly clear, a strong argument could be made that the most effective and efficient approach to regulating a globalized economy is through a universal policy set down by an intergovernmental institution. In 1999, amidst bouts of global financial turbulence, an economic report from the Clinton administration claimed that globalization had severely diminished the power of individual states to create meaningful economic regulatory policy:

“Financial liberalization and innovation have rendered national boundaries irrelevant. If regulation was necessary within national boundaries, then it is now equally necessary in the international market” (1999).

From a liberal institutionalism standpoint, intergovernmental institutions must always be predicated on some type of common interest between each of the states involved. They can serve a variety of functions such as “reducing transaction costs, making commitments more credible, establishing focal points for coordination, and in general facilitating the operation of reciprocity” (Keohane 1999). However, as the sovereign debt crisis triggered by the financial meltdown in the Eurozone showed, the flipside of this shared economic interest is that states within the institution also assume a collective financial risk. While each of the 18 countries in the Eurozone share a common monetary policy based on the Euro, fiscal policy is dependent on the particular priorities of the individual states. Countries in southern Europe such as Greece, Italy, and Spain tend to borrow more heavily and spend more on social welfare while countries like Germany are more financially austere. The shared currency gave the less austere countries access to much cheaper lending rates than they had previously, and they racked up severe debts that eventually crashed down with the credit crisis.

The narrative highlights an inherent structural flaw in institutional liberalism. Like realism, the paradigm posits that states are rational actors that act only in their own self-interest. Institutions are organized when states share a common interest that can be bolstered through their mutual cooperation. But self-interest can also undermine the entire institution, as was the case when Eurozone countries took advantage of the benefits they were afforded and it ended up costing the institution as a whole. In this case, another international institution, the IMF, had to step in to bail out the indebted governments and mitigate the damage. If states never act in interests of the institution that are separate from their own interests, then the institution is a meaningless label for a group of states acting in a mutual alliance. This is the view held by structural realists like John Mearsheimer, who claims that international institutions have no real independent power as actors. The collective action problem with institutions, Mearsheimer says, is that they have no authority in actually governing how each state acts beyond coercion, which is still a function of state power. (Mearshiemer 2008). It is important not to discount, however, that despite opposing interests within the institution, the Eurozone continues to persist and critics that doubted it could withstand the crisis are gradually changing their minds. The institution has also been able to impose austerity measures on the indebted countries that these countries have adhered to despite significant political opposition. This authority suggests the problem in the Eurozone may have simply been a contained organizational problem between states or an economic short sight rather than an overarching indictment of the nature of international institutions.

Perhaps the best argument for institutionalism is the empirical fact that despite realism’s insistence on their irrelevance, institutions continue to play a major role in the international arena and receive considerable resources from states. While Mearsheimer predicted that NATO would dissolve after the Cold War ended and states no longer had a common rival, the institution has carried on in a world with a unipolar balance of power. Many studies have taken a more thorough look at whether or not states comply with institutions and the evidence is by and large in institutionalism’s favor (Stein 2008). This idea that institutions matter because the world has recognized their importance and identity is backed up by the foundations of social constructivism. In the context of economic globalization, constructivists emphasize that with the growing interconnectedness of the world, new international norms and perceptions will dictate how a post-state world approaches the global economy. Wendt (1992) says the realism-dominated field of international relations puts too much emphasis on structure and power and not enough on ideational models. The role that norms and beliefs played in shaping the response and determining the outcome of the 2008 financial crisis is often understated. The collective recognition on the part of regulators and central banks in states and in international institutions of the necessity of intervention in the event of economic failure is often cited as the reason the global recession did not devolve into a global depression (Picketty 2014). The same understanding was not as present when the economy crashed in 1929 and this was part of the reason it caused the extent of devastation that it did. The financial chaos caused by the decision to let Lehman fail alone show how much more destruction the global crash could have caused had governments and central banks not kept the financial system afloat.

The far-reaching effects caused by the 2008 financial meltdown and the subsequent global recession illustrated the extent that globalization has transformed the nature of the international economy and underscored the necessity of global structures to regulate it. It definitively disproved the liberal commercialist insistence that a global free market could bring order to the international system and affirmed economic structuralist concerns about the dangers of capitalism in massive income disparity. While the sovereign debt crisis in Europe shows that there are clear risks with delegating international institutions to regulate the international economy, the fundamental difference in the response in 2008 from that in 1929 indicates that collective ideas play a huge role in the fate of international politics. The ideational transformation the financial crisis has instigated with regard to laissez faire capitalism gives hope to the prospect that a collective global understanding could mitigate the current drift in global income disparity.  

Works Cited

Altman, Roger. 2009. “The Great Crash, 2008.”Foreign Affairs (January).<http://www.foreignaffairs.com/articles/63714/roger-c-altman/the-great-crash-2008>.

Blinder, Alan. 2013. After the Music Stopped. London: Penguin Books.

Blinder, Alan S. 2008. “Stop the World (and Avoid Reality).” The New York Times.http://www.nytimes.com/2008/01/06/business/06view.html(June 2, 2014).

Blythe, Mark, Leonard Seabrooke, and Wesley Widmaier. 2007. “Exogenous Shocks or Endogenous Constructions? The Meanings of Wars and Crises.” 51: 747–59.http://www.cerium.ca/IMG/pdf/widmaier_blyth_seabrooke_2007-2.pdf.

Hitchens, Christopher. 2009. “The Revenge of Karl Marx.” The Atlantic.http://www.theatlantic.com/magazine/archive/2009/04/the-revenge-of-karl-marx/307317/ (June 2, 2014).

Keynes, John Maynard. 2005.The Economic Consequences of the Peace.http://www.gutenberg.org/ebooks/15776?msg=welcome_stranger(June 2, 2014).

Kirk, Michael. 2012. “Money, Power and Wall Street Part II.” FRONTLINE.http://www.pbs.org/wgbh/pages/frontline/money-power-wall-street/ (June 2, 2014).

Krugman, Paul. “The Macroeconomics of European Disunion.” Paul Krugman Blog.http://krugman.blogs.nytimes.com/2013/06/03/the-macroeconomics-of-european-disunion/ (June 2, 2014).

McGrew, Anthony G., and Paul Lewis. 2013. Global Politics: Globalization and the Nation-State. John Wiley & Sons.

Piketty, Thomas. 2014. Capital in the Twenty-First Century. First Edition edition. Belknap Press.

Press-Barnathan, Galia. 2006. “The Neglected Dimension of Commercial Liberalism: Economic Cooperation and Transition to Peace.” Journal of Peace Research 43(3): 261–78.http://jpr.sagepub.com/content/43/3/261 (June 6, 2014).

Rosato, Sebastian. 2003. “The Flawed Logic of Democratic Peace Theory.”American Political Science Review 97(04): 585–602.

Sorkin, Andrew Ross. 2010.Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem–and Themselves. Updated edition. New York: Penguin Books.

Wendt, Alexander. 1999.Social Theory International Politics: International Relations and International Organisations. Cambridge: Cambridge University Press.http://www.cambridge.org/us/academic/subjects/politics-international-relations/international-relations-and-international-organisations/social-theory-international-politics (June 2, 2014).

Wolff, Richard D., and Stephen A. Resnick. 2012.Contending Economic Theories: Neoclassical, Keynesian, and Marxian. Cambridge, Mass.: The MIT Press.

  

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