Less ideology, more economics

Four years ago the BBC screened The Man who Broke Britain, an eerily familiar drama in which a bank collapse triggers a global recession. The intriguing question is how a team of scriptwriters predicted a collapse the world's regulators didn't see coming.

This question cuts to the central paradox of the global financial crisis. While many elements of the crisis are familiar, its speed and depth have shocked policymakers. It is this mix of familiar and unpredictable that makes the downturn so hard to address.

At least four recent developments have shaped this crisis: banks' inability to properly value their liabilities; the savings imbalance between Asia and the West; the emerging divide between executives and other corporate stakeholders; and governments' failure to demand reciprocal obligation in corporate welfare.

To draw meaningful lessons, we must distinguish structural causes from cyclical ones. The cyclical elements of the crisis - recessions, bank collapses, job losses - are most familiar.

Recessions fall into two categories: wage-inflation spirals or asset price bubbles. This one's a classic house price bubble. The trigger for the bubble bursting was a banking crisis.

Again, no surprise; in recent years, banking crises have struck Sweden, Japan and Mexico.

Once the slump begins, familiar symptoms appear. Confidence turns to pessimism, demand stalls, businesses fail and unemployment soars. Unsurprisingly, these classic cyclical stages have provoked classic responses. Lower interest rates were tried with little effect. Policymakers then turned to older remedies - fiscal stimulus and printing money - with mixed success. Already critics claim that more radical steps are needed.

Why have conventional measures failed? The answer lies in the structural changes that have contributed to the crisis, those genuinely new elements whose effects are still poorly understood. Four important structural developments have played a role.

The first is the emergence of a vast, opaque web of cross-liabilities within the global financial system. Banks bet each other huge sums on the likelihood of loans defaulting. Yet when Lehman Brothers collapsed, no one knew the value of its outstanding bets. Worse, no one knew whether these would set off a chain reaction in which banks across the world fell like dominoes. The ensuing fear froze global credit markets.

This was a gross regulatory failure. No accurate accounting of assets and liabilities existed. As most credit derivatives were traded privately or over the counter, no external party knew the traded item's price or how many other parties held claims over it.

So one lesson from the crisis is the need to rethink the design of capital market trading.

Financial markets require transparent trading exchanges that disclose price and contingent liabilities. This must be part of the new "international financial architecture" championed by Kevin Rudd, British Prime Minister Gordon Brown and friends.