Strategic aspects of the credit crunch

By Ron Smith, Professor of Applied Economics, Birkbeck, University of London and Associate Fellow, RUSI

Economic dislocation always has political consequences, and global crises have geopolitical consequences. Unfortunately, these consequences are rarely predictable. Globalised bond markets are usually sensitive political indicators, but they failed to anticipate the First World War. In addition, the global financial crisis that started in August 2007 has moved in mysterious and very volatile ways, so any speculations about its possible political and strategic consequences must be very tentative.

The initial collateral damage from the credit crunch includes faith in free markets. Market sceptics, particularly in France, have already exploited this and the political centre of gravity could shift as more conservative politicians are displaced or reverse their policy on state intervention. The US outcry against bailing out bankers may also be symptomatic of a wider divergence between popular and elite opinion. Governments all over the world are sharply increasing their debt to provide financial guarantees, and these deficits, combined with the increased social spending required by the likely rise in unemployment, will put pressure on defence budgets. Government budgetary pressures, political shifts and economic hardship may raise questions about the affordability of both existing defence policies and wars of choice such as in Iraq and Afghanistan. Despite the increases in national debt, the credit crunch means that governments will be able to borrow much more cheaply than companies, casting doubt on the benefits of acquiring weapons by leasing, or by PFI type arrangement as for the future UK tanker.

Unlike most financial crises, the credit crunch has not been quick and localised, but instead a slow-motion train crash, with carriages apparently running on smoothly until they hit the pile-up. The impact was delayed by the initial belief that contamination by the hidden toxic assets was limited to parts of the Anglo-Saxon financial plumbing from which the rest of the system was decoupled. So while credit markets seized up, equity markets and non-Anglo-Saxon countries stayed relaxed for almost a year until widespread bank failures and realisation of the extent of the contagion caused panic. As yet, the repercussions for the real economy have been quite small: a slow-down towards recession rather than immediate drop into depression. This slow motion crisis inevitably prompts comparisons with 1929, when four years passed before the world economy hit bottom in 1933. Then, national beggar-my neighbour policies slowly led to protection, the collapse of the international trading system, mass unemployment and the rise of Hitler.

The credit crunch has also prompted calls for a new system of international economic governance. While central banks initially co-ordinated with some success, inter-government co-ordination has been less effective. As the tempo of the collapse picked up, individual governments had to improvise in response to national crises, often with inadequate consideration of the unintended consequences for other countries. While it is premature to see the crisis as signalling the end of US financial hegemony, US adjustment will probably involve lower consumption to pay off its debts, which could have both domestic and international political implications. Any new system of international economic governance would also have to reflect the eastward shift of economic power, and in particular the heavy economic artillery in the reserves of the Chinese and the sovereign wealth funds. While the Chinese government could increase the political use of its vast dollar reserves, the selection of targets would require it to make some fine economic judgements to avoid the dangers of unintended consequences.

The ‘millennium boom’, which peaked in 2007, was driven by an excess supply of financial services, which pushed down the price of risk, and an excess demand for commodities, which drove up the price of oil and other inputs. The credit crunch and subsequent slowdown then pushed up the price of risk, leading to the insolvency and exit of many financial firms, and pushed down the price of commodities. Commodity prices are always political because they are major sources of government revenues. Russian politics with a $50 a barrel oil price would have a rather different dynamic. After the conflict between Russia and Georgia in August 2008, the rouble exchange rate dropped rapidly and the Russian authorities had to intervene to defend it. Russian shares halved in value and the authorities had to close the stock market to restore order, and foreign investors pulled out an estimated $60 billion. Since international capitalism rarely gives the reasons for its actions, it is difficult to know how much of this flight of capital was a response to the Georgian war, the credit crunch or the fall in the oil price. It is equally difficult to know how the Russians will respond to such clear indications of their economic vulnerability.

The credit crunch is also making people think differently about risk and contemplate strategic analogies. There are three concerns. First there is the impact of highly improbable events, like the first run on a British bank since 1866. There are now more references to such possibilities, what Nicholas Taleb called ‘Black Swans’ or Donald Rumsfeld’s ‘unknown unknowns’. Second there is a danger that institutions that had been thought to reduce risk in fact make the system more vulnerable, as is the case with derivatives and the off-balance sheet shadow banking system. Third, there is the extent of unappreciated implicit commitments such as those discovered by banks and governments. There are obvious strategic analogies to all three. So one wonders whether there will be more improbable events like the Russia-Georgia War; whether our risk reduction mechanisms, like NATO, really do reduce risk; and the extent of our implicit commitments like NATO’s Article V. Possibly the main strategic danger is that politicians pre-occupied by financial crises will not respond to potentially explosive strategic issues with the necessary speed.

The views expressed above are the author's own, and do not necessarily reflect those of RUSI.