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Danger money

22 January 2015 By Edward Hadas

Which is the bigger threat to the world’s peace and prosperity – geopolitical conflict or financial disarray? In a more violent world, it is easy to forget the significant danger posed by finance.

The comparison can easily become inhumane, since dysfunctional finance almost never directly kills people. However, it can be helpful to rank potential sources of disorder. A sense of relative danger should lead to a better use of time and influence by everyone, from voters to the world leaders gathered at the World Economic Forum in Switzerland.

Finance and geopolitics are not the only global problems. Each nation has its own difficulties, and there are other worldwide challenges including epidemics and climate change. Still, the political and financial systems are basic. If they are not working well, it is almost impossible to deal with anything else.

Compared to a year ago, the political world looks in worse shape. The deterioration is clearest in the Middle East and in everything to do with Russia. Cross-border tensions are also higher around China, despite a small rapprochement with Japan at the end of 2014. No big outstanding international conflicts have been defused. In domestic politics, the overall trend is no better than neutral. There are signs of reform in India and perhaps Indonesia and Mexico. China seems more committed to a reform agenda. On the other side, extremist parties are rising in much of Europe. A reasonably strong U.S. economic recovery has done little to break America’s political gridlock.

Still, it could be much worse. The euro’s struggles have not killed the European project. There are few signs of looming chaos in the United States, Japan or China. Cross-border trade is expanding. The accepted order is not collapsing, despite the slow economic recovery after the 2008 financial crisis. Indeed, it is not fanciful to believe the existing systems of government and diplomacy will manage to deal – eventually and imperfectly – with all of the current trouble spots.

Finance is another story. The financial world broke six years ago and remains fragile, fickle, harmful and expensive. The weakness was on display last week in Switzerland, before the Davos conference kicked off. The central bank abandoned its support of a maximum value for the Swiss franc against the euro and the currency rose by 18 percent in a day. Switzerland is too small a country to disrupt the whole globe, but the precedent is ominous. A well-respected central bank lost control of a basic financial variable.

The Swiss situation is special, but the global system is marred by high leverage, preternaturally low policy interest rates and large trade imbalances. That means it would take no more than a few policy errors and mood shifts to bring a repeat of the 2008-9 crisis.

The halving of the oil price certainly looks fickle. The decline is not entirely a financial phenomenon. Industrial and international politics provoked Saudi Arabia’s decision not to defend the price. However, finance has a great deal to do with the scale of the fall. If there had been less cheap money sloshing around, oil’s value would never have risen so far above the cost of production in the first place. And if the U.S. central bank was not busy trying to lessen its monetary stimulus, the decline would most likely have been less steep.

The economic harm done by the financial system is impossible to quantify, because no one knows how the world would look with a better arrangement. It’s safe to say, though, that in a financially sound world China would not be trying to deflate a housing bubble and the euro zone would not be stuck in what seems to be an endless existential near-crisis. It is likely that the United States would have avoided its housing boom and bust and at least possible that many governments would be better at creating jobs and funding investments.

All the actual and potential harm comes at a high cost. As the financiers in Davos are pleasantly aware, the industry remains highly remunerative. In the United States, the finance share of GDP has doubled to more than 8 percent in the last 50 years. The economic drain from more productive uses of labour is bad enough. The moral cost is probably higher. An industry which consistently pockets its gains while passing the largest losses on to taxpayers sets a terrible example.

Can all these problems be solved within the current financial framework but with better policies? Perhaps. But after six years of extreme monetary stimulus, it is hard to be optimistic. A structurally inadequate global financial system threatens to undermine the accomplishments of politicians, or amplify their failures.

 

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