How Realism caused the Global Financial Crisis

1196 words (5 pages) essay in Economics

5/12/16 Economics Reference this

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“The global financial crisis is commonly believed to have begun in July 2007 with the credit crunch, when a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis. The housing market in the United States suffered greatly as many home owners who had taken out sub-prime loans found they were unable to meet their mortgage repayments. As the value of homes plummeted, the borrowers found themselves with negative equity. With a large number of borrowers defaulting on loans, banks were faced with a situation where the repossessed house and land was worth less on today’s market than the bank had loaned out originally. The banks had a liquidity crisis on their hands. The housing collapse in the United States is commonly referred to as the trigger for the global financial crisis.”

“Liberalism is built on the fundamental assumption that human nature is rational and thus good. Humans are capable of cooperative behaviour, and destructive behaviour is a result of bad societies, institutions and/or governments. As such, the Liberal school of thought has a strong belief in progress, particularly the notion that humans are perfectible. Thus all humans deserve basic rights, liberty and equality. Consequently, Liberalism has a deep concern with improving the welfare of all people.” In a highly developed nation like the USA, many would argue home-ownership is a vital aspect of welfare. In the modern world, constant economic growth is essential for progress of this nature.

“Liberals believe the optimal way of achieving economic growth is through free trade and markets. There must be freedom for private powers (business) at the expense of public power (government.) Free markets and trade will organically synchronise the supply and demand of resources and government attempts to control or regulate the market will only make that process less efficient.”

Free trade enables the execution of other core Liberal beliefs, such as the concepts of cooperation and integration. Through economic interdependence based on mutual benefit, the possibility of conflict between nation-states is reduced. Furthermore, economic cooperation creates wealth, development and growth for all involved. This process of rapid cross-border movement of goods, services, technology and capital is known as globalisation. However, with the positives of economic interdependence come the risks – financial toxicity in the USA economic system spread world-wide like wildfire.

“Realism, created as a response to Idealism, is currently the dominant school of thought in international relations. The premise is that nation-states are the dominant actors in a value-free system of international relations, which take place in an environment of permanent international anarchy and revolves around power. The main tenets of the theory are statism, survival, and self-help.”

“Realism accepts the power of the free trade, but not only rejects the notion that government intervention causes market inefficiency, but believes that public power exerting regulatory control leads to the optimal outcome. Realism favours the use of high tariffs to protect infant or venerable domestic industries from foreign competition until they have built up the capacity to compete on the world market. “The Realist hijack (through intervention) of the Liberal free-market has undermined the Liberal system overall and is the primary cause of the global-financial-crisis.

Other views of international relation schools of thought in the context of global economics include the Marxist view and the Constructivist view. “Marxists believe that only vigorous application of strong public power can check the innate tendency of private power benefiting the elite at the expense of the population at large. Constructivist’s trust that a unit, in addition to its material interests, will also act based on political and economic identities and values.”

According to Realist’s, the global-financial-crisis was a result of the Liberal free market enabling Wall Street to act upon its greed unchecked. “And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.”

The classical Liberal perspective is quick to point out that Realist public policy, hoping to control the market in order to achieve optimal outcomes (in this case a push for greater home ownership), distorted the natural market feedback loops of profit and loss. “Capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. When taxpayers absorb the losses, the distorted result is reckless and imprudent risk taking.”

The governments Realist policy to push for greater home ownership led to government-sponsored enterprises to, in essence, guarantee mortgages. “In the US, householders can hand their property over to the bank and walk away if they cannot pay their mortgage.” As the aforementioned government intervention significantly reduced the risk of underwriting mortgages for banks, they began to underwrite mortgages to anyone, even unqualified borrowers – who were getting mortgages for houses they could never afford.

“As many of the sub-prime borrowers got behind in their repayments, they were evicted or they walked away. But with so many houses now coming up for sale, prices fell sharply.” With so many borrowers defaulting on mortgages, the supply of houses far outweighed the demand. Consequently, the banks’ repossessed houses were worth less on ‘today’s market’ than when the banks had originally loaned them out. This liquidity crisis triggered the global-financial-crisis. “Public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector.”

Liberals argue that this is the reason the markets must be free of government control. As long as Realists believe that interfering with the market can make their nation-state better (i.e. greater home ownership for Americans), there will be opportunity and incentive for corporate lobbyists (in this case from Wall Street) to attempt to manipulate government for its own advantage. Free-markets work because they align the individual greed of man (ironically a fundamental aspect of Realism) with the common good of the nation-state. Realism intervention corrupts that alignment by creating a system that can be ‘gamed.’

Realists often accuse Liberals of being idealistic to a fault. Ironically, it was the Realists making reality conform to their ideals that created the distortion of government economic policies, leading to short-sighted intervention in the relatively free market. This resulted in the unintentional long-term consequence of perverting the natural incentives of productivity – profit and loss – which, in turn, ultimately triggered the global-financial-crisis. “It was government intervention in the markets that created the crisis and that less, not more, regulation is what the system needs to heal and to survive.”

Marcell Acs


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