CAN THE WORLD AVOID ANOTHER GLOBAL FINANCIAL CRISIS?
New research suggests that rising social inequality must be addressed to reduce risk within the world’s financial system
More than a decade later after the bankruptcy of Lehman Brothers triggered a global economic crisis, experts still debate the question: How could one incident endanger the world’s entire financial system?
In new research published by the journal Risk Analysis, sustainability scientist Carlo Jaeger and his colleagues argue that increased social inequality and a lack of appropriate regulatory networks contributed to the 2008 financial crisis, and that these factors are still in play today.
The researchers examined historical evidence about the financial crisis and its aftermath together with quantitative U.S. data about productivity, household incomes, and hourly wages, and historical evidence about the long-term evolution of the global financial system. To identify root causes of the 2008 disaster, these data were analyzed by means of the theory of extended evolution (a theory based on new evidence about biological evolution beyond genetic mechanisms).
The researchers paint a dim picture of future scenarios if no changes are made to overcome the financial system’s vulnerabilities, and identify an urgent need for integrated research on the global financial system and other rising global systemic risks like pandemics and climate change.
“The world is trying to tackle these systemic risks by attempting to control the relevant system through agreements between governments,” says Jaeger, study leader and an expert in modeling social systems who works with Potsdam University in Germany, Arizona State University, and Beijing Normal University in China. “Today’s global systems are way too complex for that to be sufficient.”
The researchers employed the concept of “normal accidents”, influential in risk analysis, together with extended evolution theory, to examine the root causes of the 2008 crisis and evaluate actions that could help prevent a future crisis.
Research on normal accidents suggests that, while accidents are hard to avoid in tightly-coupled complex systems, a strong safety culture can help prevent them from occurring. The 2008 crisis demonstrated that the safety culture of the global financial system is inadequate. Fixing this, the researchers argue, requires overcoming forms of social inequality that enable “privileged agents” to erode the safety culture “for their own gains.”
Extended evolution theory takes into account that the evolution of complex systems relies on niches (as the oceans of the world with their saltiness and fishes are the niche of sperm whales) and on regulatory networks (like the biochemical mechanisms that let a sperm whale’s genes develop into fins rather than into the limbs of other mammals). Jaeger explains that the niche of the global financial system is the world economy with its currencies, companies, households, and more.
Today, the global financial system is structured around the U.S. dollar, which serves as its key currency. Over time, different currencies have played this role: first the Spanish dollar, then the British pound, and now the U.S. dollar. The key currency plays a vital role in the global financial system by providing the foundation for reasonably stable exchange rates for international transactions.
Robust social cohesion and stable and strong institutions (regulatory networks) within the key country sustain the role of its key currency. Today, the authors argue, that social cohesion is at risk. Since the 1970s, in the U.S. stagnant hourly wages and household incomes have led to increasing inequality as productivity kept increasing. This is due to the breakdown of a previous systemic rule that wages and productivity should grow roughly in sync.
The problem of inequity is a global issue. “For decades, wages have been growing much slower than productivity in the United States, China, Germany and other places,” says Jaeger. “The results are profits so large that investors have a hard time finding attractive opportunities for investment in real production. Instead they pursued increasingly un-transparent financial instruments like the subprime mortgage backed securities in the years before the 2008 financial crisis.” This development, he adds, was a key mechanism leading to the crisis.
“Without a fair sharing of wealth across the U.S., which includes tangible wealth increases for the bottom 50 percent of American households, the role of the U.S. dollar as the key currency will come with increasing levels of risk,” says Jaeger.
The solution, Jaeger and his colleagues argue, is to retool the financial system by establishing new global regulatory networks. This will not be easy, they admit, and cannot happen at once. An example of a first step in this direction might be to establish a working group of governments, construction companies, NGOs, research institutes, professional associations, and trade unions to address the global systemic crisis of climate change in the buildings sector. The target could be to bring down carbon emissions from buildings while making decent housing affordable for everyone, suggests Jaeger, who is co-founder and chairman of the Global Climate Forum.
“We have to transform the world economy in order to reduce risks like those of climate change and of pandemics,” says Jaeger. “This creates new opportunities for investment worldwide, thereby creating more jobs and letting wages catch up with productivity. It won’t be easy, but is certainly worth the effort.”
In addition, the authors call for urgent research to identify new tools for dealing with global systemic risks, including identifying warning signals that indicate a major transition within the present global financial system and looking at past transitions between global financial orders and their key currencies to prepare for the next transition, “which has possibly started with the 2008 crisis.”
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