Federalism and the financial and economic crisis

Richard Laming

By Richard Laming

Thank you for the opportunity to speak on this subject. I should make clear that what I propose to say is not strictly true. I do not think that any economic or political theory can ever be strictly true: what matters is whether it is useful. Does it explain things that have happened? Does it help predict future events or courses of action? I believe that the analysis that I will put forward this afternoon is a useful way of understanding the financial and economic crisis and I hope that you think so too, even if it is not strictly true.

I want to start with some of the earliest seminars I have attended here in Ventotene, when one of the subjects for discussion was federalism as an ideology. Federalism was presented as a challenge to existing political philosophies, rather than as a complement to them. At the time, I thought that this approach was wrong. Federalism is a means by which political movements can better achieve their objectives, yes, but it does not falsify or invalidate those objectives as such. In the light of the recent financial and economic crisis, and particularity in the light of the scale of that crisis, I want to revisit my earlier assumption.

For the scale of the financial and economic crisis is truly unprecedented in modern times. It is not simply another recession – we are used to recessions – but it is more than that. It is a profoundly important moment in European history. I want to illustrate this in two ways.

First of all, let us consider the countries that have tried to follow policies of deregulation in the financial markets. These countries have suffered, and suffered very badly, and they have suffered in proportion to the extent that they pursed financial deregulation.

Take Iceland, for example. The banking sector in Iceland grew and grew and ended up with overseas assets worth 800 per cent of Icelandic GDP. When those overseas investments ran into trouble, there was absolutely no possibility that the Icelandic state might save them: they were simply far too big. The Icelandic currency has subsequently halved in value and the Icelandic economy is thrown deep into recession. Moreover, Iceland now has new and distinctive foreign obligations in addition. Icelandic banks, such as Landsbanki, were active in soliciting retail deposits from individuals in the UK and the Netherlands. These deposits were lost in the bankruptcy of those banks, and the British and Dutch governments are now looking to the Icelandic government for GBP 3.4 billion in compensation for those retail investors. A schedule for repayment has been agreed, reluctantly by the Icelandic parliament you can be sure, and payments will start in 2016 and last for 15 years.

To put this payment into context, it amounts to USD 20,000 for each and every citizen of the country or 20 per cent of Icelandic GDP. The reparations demanded from Germany after the first world war amounted to USD 33 billion, similarly around 20 per cent of GDP. The situation Iceland finds itself in is, therefore, just as severe.

In the UK, too, there are consequences from the crash. The City of London was not quite as disproportionate in the UK economy as its equivalent was in Iceland, but the British economy is nevertheless very severely damaged. British public finances have plunged suddenly, deeply into deficit. The projected deficit for the current financial year is around 12 per cent of GDP: a deficit on this scale is unknown in peacetime. As with Iceland, for the UK, this recession is economically comparable with war.

European federalism has its origins in the desire to prevent the consequences and dislocations of war. While, for very obvious reasons, I should not overstate the consequences of the financial and economic crisis, it would be a mistake to understate them nevertheless. Federalism has to take an interest in sudden, dramatic and damaging events like this, to explore how they might be prevented from recurring. The scale of the crisis demands it.

My second measure of the scale of the financial and economic crisis goes further. Its consequences are not only the scale of war; they also amount to a revolution. For it is not only an economic policy that has failed but also an economic philosophy. To appreciate this, we need to go back to the days when the financial crisis first unfolded, to examine what had to be done to limit the damage.

The immediate problem was that a number of banks discovered that their assets were worth less than they had thought and that their liabilities were worth more. Their trading and risk management strategies had failed and they were now in, or heading rapidly for, insolvency. Some of them were allowed to go out of business; others, deemed too big to fail, were saved by rapid and massive injections of capital from the public purse. For example, in the UK, the Royal Bank of Scotland became 70 per cent owned by the taxpayer (after 281 years in private hands) and the US government took stakes in Bank of America, J P Morgan Chase, Citigroup, Merrill Lynch, Goldman Sachs, Morgan Stanley, Bank of New York Mellon and State Street. Private banks became, in effect, partially or fully state-owned. Thus was their solvency protected.

But this is less than half the story. Such was the scale and extent of the problems that emerged, a chill settled over the whole financial market. Normal day-to-day activities of lending and borrowing ground to a halt because of the uncertainty about which banks might be able to repay any new loans that were made. This struck at the second need that banks have, in addition to solvency, if they are to continue to operate, namely liquidity. And the public authorities stepped in here, too. Trillions of dollars, the equivalent of a year or two’s public expenditure, were guaranteed in order to enable the banking system to keep functioning. (1) Without that government intervention, in the US, in the UK and in the major countries of the eurozone, both banking and capitalism as we know it would no longer have existed.

A viable, functioning banking system is a public good, so it makes sense for government to have acted to save it. But I want to reflect on the consequences of this action from the perspective of an ideology.

It bears repeating: the banking system was saved from collapse by the actions of government. The enormous sums of money needed to guarantee the continuing liquidity of the financial markets could only have been credibly found by governments, relying as they can on future streams of tax revenue raised using the police power of the state. The free market turned out to depend for its very survival on its polar opposite.

Let me put it like this. In the same way that the socialist economic system was exposed and discredited by the collapse of communism, the free market system has been similarly exposed and discredited by the financial crisis last autumn. It might not be so visible – there is no television footage equivalent of people breaking through the Berlin Wall on 9 November 1989 – but it is nevertheless real.

It is important to understand that the financial crisis was not a sudden change in the economic course of events, that things were going well and then started to go badly. No, the course that was being followed meant that the bad things were inevitably going to happen. Apparently positive economic indicators were being misread. It is like the thirteenth strike of the clock: not only do we not believe that the thirteenth strike tells us what the time is, we realise that the previous twelve did not tell us what the time was either. On the thirteenth strike, we discover that the clock is broken and was never to be relied upon in the first place. Reassurance about the state of the economy in the period leading up to the crash was based on reading the wrong signals.

After 1989, the left, even the democratic left, was forced to rethink its economic attitudes, given the evident failings of collective ownership and the attempt to replace the price signal with bureaucratic planning. It has been obliged to search for a new basis on which to found its economic strategy, and from its rather weak response to the latest economic crisis appears to be struggling to do so.

But the right should now be forced to do the same. The Pavlovian reaction that lower taxation and less regulation is always preferable to the alternative needs to be unlearned. Both left and right need to pursue economic approaches based more on balance and less on the extremes. One extreme after another has been tried, with failure in each case.

Exactly what will follow the failure of the free market in finance is as yet unknown, and is in any case outside the scope of the debate about federalism. But there is one aspect of this debate which is relevant indeed. For the right will have to return to something resembling the idea of government and regulation.

Federalism, as has been remarked earlier in this seminar, is a species of representative government. It aims to use the power of the state to solve problems in society, in a manner and towards objectives founded on popular consent. The recent, failed ideology of the free market in finance rejected the role of the state in regulating such markets: coming to terms with the need for a role for the state is now the great challenge for the right, and there will be much denial of the need to do so.

This leads me back to my earlier remarks about ideologies. I have set out the reasons why perhaps the characterisation of federalism as existing in addition to, and not instead of, other ideologies might no longer be the best way of looking at things. The economic philosophy that was dominant in the Anglo-American world is at odds with federalism. Perhaps this explains why its advocates have been so hostile to federalism hitherto; it certainly points the way towards an ideological argument in the future.

To argue for federalism, therefore, is not to argue for the best way to achieve commonly accepted goals for the economy or for society, but it is actually to engage in a debate about what those goals should be. Low taxation and deregulation have not merely been held to be economically more efficient but morally superior. This is the argument that has to be taken on. This is a debate not about the means to be employed by liberal democracy but about the ends to be achieved. That is the second, and more serious, measurement of the scale of the crisis.

I conclude by repeating my opening remarks: I do not think that the picture I have painted here is literally true. However, I think it is a useful and powerful way of examining the crisis and its consequences, and I hope in the discussion that follows that you will agree.

(1) According to the IMF’s Global Financial Stability Report of April 2009, total support for the financial system from the governments and central banks of the US, the eurozone and the UK has amounted to $8,955bn (£5,436bn, €6,132bn) – $1,950bn in liquidity support, $2,525bn in asset purchases and $4,480bn in guarantees. For the US, eurozone and the UK, this exposure amounts to 90 per cent, 40 per cent and 190 per cent respectively of annual public spending.

Based on a talk given in Ventotene, 4 September 2009. Richard Laming may be contacted at richard@richardlaming.com. The opinions expressed are those of the author and not necessarily those of Federal Union.

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