Introduction
A global financial crisis, hereafter called GFC, is a crisis related to liquidity of financial institutions and/or the volatility of the value of money, which happens in one or more countries and affect other countries. The role the state plays in global financial market, in regard to the concern of preventing and resolving the GFC, has been the focus of ongoing debate among economists and policy makers. For the purpose of this essay, state will be defined as a nation-state and international trustee. Nation-state includes government and 'the lender of last resort', while international trustee includes international institutions such as the World Bank and International Monetary Fund (IMF). This essay will argue that GFC has led to a shift in thinking and calls for measures to strengthen the role of the state.
Comparing Theories: Middle Way is Necessary
Economists and policy makers have different view on the role of the state in regard to financial market and GFC. This paper limits the discussion into three groups; these are the Left (Marxist), the Middle (Keynesian), and the Right (Neoliberalists). The last two groups can be identified as liberal, which have been dominating the debate since great depression of 1930s. Marxists believe that the state must do full-control to economic development as well as capital. They argue that credit, means of production, and means of communication (and transport) must be centralized under the state (Marxist n.d.). On the other hand, the liberals (both Keynesian and Neoliberal) believe in the power of the free-market especially in terms of allocating scarce resources. However, they disagree on how far the state should intervene in the market. F.A.Hayek, as the central figure of Neoliberal beside Milton Freidman, argued that the advances or growth or progress could be achieved mainly because of 'spontaneous forces' from free market, therefore the state control must be limited (Hayek 1960, p. 38). On the other hand, John Maynard Keynes, although he was a liberalist and free-trade believer, argued that the spontaneous process through laissez faire will create instability; therefore the state must play an active role in certain circumstances on economy (Keynes 1936) [1].
As a result, the three groups share different view in financial market and GFC. Marxists believe that financial (capital) market must be fully controlled by the state in order to maximize the benefit for the proletarians. This is because Marxists believe that state is an instrument of 'political domination with specific effects on the class struggle' (Jessop 1990, p. 28). By contrast, Neoliberalists believe that the state must limit its intervention to monetary policy. One important part in monetary policy is to control the rate of interest indirectly through managing the supply of money, buying or selling securities, and increasing or decreasing the quantity of reserves available to banks (Friedman 1960, pp. 30-35)[2]. On responding to GFC, instead of prioritizing the demand side, Neoliberalists recommend securing the supply side by lending to firms early and freely (Friedman 1963, p. 407)[3]. Neoliberalists do not like fiscal policy because it is costly, and they believe it is not an effective way to resolve a crisis. Neoliberalists also believe that unemployment during a crisis will only happen in the short term; in the long term those who lose their job will return to the workforce although they will get lower wages. This means there will always be a full-employment level of output to meet the Long Run Aggregate Supply Curve (LRSS)[4] as long as there are no disturbances to the free-market; for example, minimum wages or demands from trade unions. Keynesians, on the other hand, believe that intervention in monetary policy alone will not be enough to promote aggregate demand and aggregate supply. Therefore, unemployment would be permanent in the long term without direct state intervention. This means deeper recession. Keynes argued that the state must act on more than monetary policy by actively stimulating aggregate demand and aggregate supply with focus on fiscal policy. He also argued that the state budget not necessarily balanced. During crisis the deficit budget is needed to allow state intervention through fiscal policy, while during conducive economy the state can make surplus because few state interventions are needed (Keynes 1936)[5].
It can be argued that the Keynesian theory is more plausible. All decisions about resource allocation cannot be given to the state as suggested by Marxists. Giving all resource allocation decisions to the state will make the state a super power which will lead to an increase in corruption. Furthermore, whoever is in charge of managing that super-power state will not be able to control all the complex relationships associated with resource allocation even if their intentions are good. This is simply because of the 'bounded rationality' which is the limitation of human being in dealing with complex environment (Simon 1991, p. 132). On the other hand, all economic development and recession recovery cannot be left to the market's 'invisible hand'[6] as argued by Neoloberalists. In the long term, the free-market combined with laissez faire will not be efficient for the whole society. For example, free market will leave incapable people out of market which will lead them in extreme poverty and create high divergence[7]. The divergence and poverty will trigger social disorder which could be ended with the collapse of the entire social and economic system. A middle way is necessary because the society can get benefit from the efficiency of free-market but in the same time the state play an active role to prevent instability as well as to improve the capability of the "losers".
The Keynesian will also work better in financial market compare to Marxists and Neoliberalism. The centralization of 'financialisation' to the state will make 'financial market' not efficient. There will be many potential buyers (investors) who cannot participate in the market because the supply will be limited, while potential sellers (firms) cannot supply the market because of the monopoly by the state. By contrast, the Neoliberal who emphasis more on the long term will not satisfy those people who are concerned only with short term problems during crisis. If the state relies only on monetary policy and increases the supply of money to decrease interest rates, it may increase consumption and investment (as components in aggregate demand); however, the change may be slower than the impact of fiscal policy. Leaving the market with low aggregate demand and low employment will trigger social and political crisis which will lead to a deeper economic recession. By adopting Keynesian theory, the financial crisis can be recovered relatively quickly because the intervention is mainly on the demand side through fiscal policy supported by appropriate monetary policy (particularly to ensure the balance of aggregate supply in response to the progress of aggregate demand). The increase of aggregate demand will lead to increases in employment and economic output. The cost of fiscal policy can be financed by the state's saving gained during economic surplus. However, the increase of aggregate demand toward the full-employment level of output will create inflation (Bruno & Sachs 1985, pp. 26-29), this is why fiscal policy must be balanced by monetary policy which would help to increase the aggregate supply to mitigate the inflation in the short term during crisis recovery.
Key Measures to Strengthen the Role of the State
In addition to fiscal and monetary policy, the state must take an active role in ensuring the free and accurate information for financial market actors, particularly the 'Main Street' group[8]. Hayek argued that an important component in individual liberty is 'knowledge'. Any individual will use their 'knowledge' to make the best decision for his or her self, and no one (including the state) knows what is best for them (Hayek 1960, p. 95). Efficiency in free-market is based on the assumption that all market actors are 'well-informed' (Frank et al. 2009, p. 150)[9]. The information asymmetry has caused GFC[10]. For example, in the case of Enron crisis in 2001 and the subprime crisis that started in 2007, even with the role of independent auditors, the U.S. government failed to uncover the truth and sufficient information for investors (BBC News 2002; Fooks 2003, pp. 21-22; Randle 2010). As a result, investors have low trust in the information given out by corporate executives and brokerage firms (Fooks 2003, p. 23). This will reduce number of investors in the market, particularly of those who are committed for medium or long term investment. What will remains are mostly 'gambler' investors who are only interested on a high gain from short term investment which could trigger crisis. Free and accurate information for all market actors will only be possible if the state play an active role because information is a public interest, therefore it cannot be given to the market or private sector.
The state can avoid the bubble in asset price by providing "reference price" information as addition to the free and truth information. Reference price reflects the 'real' value of the asset. For the stock price, the reference could relate to information about return on equity (RoE) and return of asset (RoA); for property the reference could be inflation rate. This information could be shown side by side with market price on an information board. Investors will be then alerted to possible bubble when there is a significant gap between market and reference price.
In the context of globalization, the state must apply capital control policy. Capital control aims to protect the country from the volatility caused by large in and out flows of money in a relatively short time. According to Keynesian theory, capital control can help to control the marginal efficiency of capital. The state must ensure that the marginal efficiency is not lower than the interest rate in order to prevent the high fluctuation of marginal efficiency (Keynes 1936, pp. 135-137). One of the causes of Asian crisis was that the Japanese, European and North American banks withdraw their money in short time, not only from Thailand, but also from other Asian countries. The money was then used to increase lending to Latin America and Eastern Europe which then prevented the crisis spread to other regions (Allen & Gale 2007, pp. 260-261). Malaysia reacted to crises by applying capital control policy through lowering interest rates and applying an exit tax. As a result, they suffered less and recovered quickly compared to neighboring countries (Stiglitz 2002, pp. 93; 124-125)[11]. With capital control, the state can prevent an excess supply of capital which in Asian crisis became the cause of bubble (Stiglitz 2002, p. 101). A bubble can happen when an excess supply of capital combined with a progressive advertising campaign of one corporate or brokerage firm leads to concentration of large amounts of capital in few assets (Harman 2009, pp. 152-153). This will inflate the price of those particular assets thus creating a bubble price. This was the case in the Asian Crisis and also during subprime crisis in the U.S. (Gowan 2009, pp. 17-21). These demonstrate that capital control policy will prevent one country from suffering a financial crisis and also prevent the contagion effect with the result that a crisis in one country will be relatively easy to keep localized. Moreover, capital control also helps a country to utilize the capital for the most productive purposes which will increase economic output and create employment.
In order to strengthen the role of the state, support is needed from international trustee, particularly IMF and the World Bank. They role is important, not only as the international lender of last resort, but also to ensure and promote the stability of global financial market. The focus of financial market stabilization is to prevent the worldwide financial market from 'gambling investment' (created by firm, broker, and investor speculators) by promoting a better regulations that provides incentive for the real investors; that is investors who expect to gain from the firms' profit or the real value of the asset rather than from the 'artificial' price of the stocks or asset. The basic idea is to bring back the function of financial market as instrument to support investments, where firms can collect cheap funds and investors have opportunity to make their surplus more productive than just make a bank deposit. Therefore, international trustee must promote regulations to prevent the practice of alternative investments such as the hedge funds. Another necessary role in global level to create stabilization is the GFC early warning system (Reinhart & Rogoff 2009, pp. 277-278). The system must be able to detect any crisis symptoms so then international trustee and nation-states can react quickly to fix the issues. One practical example is to monitor the bubble in financial market.
Although state intervention is important, it must be carried out in a proper and careful way. For example, during great depression of 1930s and stagflation of 1970s, many economists debated the role of the lender of last resort[12]. Some scholars, such as Freidman, argued that monetary policy taken by the lender of last resort who reduced the money supply was the cause of the great depression. That was because the officers in charge were incapable to handle the situation (Freidman 1963, pp. 354-363) [13]. Moreover, the challenge to make balance interventions on demand and supply clearly need capable policy makers. Therefore, it is very important to have highly capable decision makers in the lender of last resort and also in the Ministry of Finance[14]. People in those positions must be neutral from politics but possess high integrity, capability and knowledge in managing monetary and fiscal policy. In other words, the strengthening of the role of the state must be supported by good and capable government.
Conclusion
More participatory role of the state is important, not only for the recovery, but also to prevent GFC. Information asymmetry has caused the bubble which lead to crisis in the past. This information asymmetry has violated the fundamental assumption of liberalism that all market actors must have equal information. However, free flow supply of information is not enough. A stronger role by the state is needed to ensure honest and accurate information, including reference price information, and basic skills are available to small investors to enable them to make use of information for their best decision. The state, particularly those in developing countries, must apply capital control policy to avoid volatility and bubble price in financial market as well as to ensure that capital is mostly used for real investment rather than just another form of gambling. The role of international trustee is important to ensure stabilization of global financial market through promotion a better regulations and facilitating an early warning system. Too much state intervention will create inefficiency whereas, too little will create many losers and divergence and make the crisis stay longer. Therefore, the middle way would be the best solution. However, the middle way needs highly capable and honest persons in fiscal and monetary authority. In short, the middle way needs good governance.
References
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[1] In the "General Theory", Keynes declared that he was 'brought up' in and influenced by 'classical economists'. However, "The General Theory" was made to 'contrast' his arguments with classical economists (Keynes 1936, p. 3). See page 333-335 about free trade, and page 217-210 and 268-269 about price and marginal efficiency of capital in regard to instability.
[2] This is why they also called as "Monetarist".
[3] This is what we now call "bailout". This approach follows Bagehot dictum, see more in "Lombard street" (Bagehot 1873), also in Tucker (2009, p. 8). More about bailout policy can be seen in "A short history of neoliberalism: twenty years of elite economics and emerging opportunities for structural change (George 2000, pp. 27-41).
[4] LRSS also called Non-Accelerating Inflation Rate of Unemployment (NAIRU). NAIRU curve is vertical at full-employment level output which means in the long run there will be no trade-off between unemployment and inflation (Phelps 1968, pp. 704-705). NAIRU is further development of Philips curve which the name after the inventor Alban William Philips who study the relation between unemployment and the rate of change of money wages in the
[5] This conclusion come from page 25-29; 98; 134-136; 164; 219-221; 236; 318-320. Fiscal policy aims to increase aggregate demand through increasing government spending and tax cuts (particularly income tax) which expected to increase consumption.
[6] Invisible hand is a term introduced by Adam Smith and refers to the two functions of price, rationing and allocating function. Both are related to the basic of economic science which is allocating scarce resources (Frank et al. 2009, p. 233)
[7] The losers or incapable people are not necessarily because they are lazy, it can be also a result of illness, age, pregnancy, perceived failure or simply because of economic circumstances (George 2000, pp. 31-32)
[8] The "Main Street" group, as a contrast to Wall Street, is referred to investors (particularly individual and household investors) who invest their money in stock exchange or property by using financial services such as banks or other financial institutions.
[9] After Asian crisis, the constitution of Thailand guarantee information for citizen through 'right to know' policy which include information in financial market (Stiglitz 2002, pp. 131-132)
[10]Information asymmetry is referred to situation where sellers and buyers do not have equal information. In this case, the Wall Street dominates information while the Main Street has not sufficient information. This means the Wall Street, who is mainly the seller, is price setter, not price taker. This violates the basic assumption of "perfect competition" (Frank et al. 2009, p. 150).
[11] More observation about Malaysia's capital control can be learned from "Why capital control and international debt restructuring mechanisms are necessary to prevent and manage financial crises" (Khor 2000, pp. 140-158)
[12] The lender of last resort function aims to ensure the solvability and liquidity of banks. During crisis they lend money to the banks with low solvability and liquidity. To do this function, in many countries, they need back up from government, particularly the Ministry of Finance. Ministry of Finance is usually the one who responsible for fiscal policy that must be well coordinated with monetary policy taken by the lender of last resort.
[13] Other comprehensive study on global financial crises argues that, although the failure of the lender of last resort was recognized, but without that function the depression would stay longer (Kindleberger, p. 190). Polanyi argued that the cause of great depression of 1930s was the absent of the state intervention (1944, pp. 73;201;249)
[14] Similar to this argument can be found in "When state fail: causes and consequences", particularly in chapter written by Snodgrass (pp. 256-268), and De Walle (pp. 94-115).
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