Crisis Economics a Crash Course in the Future of Finance by Nouriel Roubini and Stephen Mihm (Book Review)

Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini and Stephen Mihm The man who predicted the credit crunch argues that it's not just banks that must change to avert more trouble Ruth Sunderland The Observer Nouriel Roubini lays claim to be the man who foretold the credit crunch, a boast some of his critics treat with scepticism. He may or may not possess a unique gift of foresight, but Roubini and Stephen Mihm have produced a cogent analysis of the causes of the crisis and some bold and uncomfortable proposals on what needs to be done.

They sweep away the self-serving mythology still being dished up by the finance industry, particularly the notion that the crunch is a freak event. The past 20 years were littered with crises in emerging markets – it was just that these did not impinge on the consciousness of the policymakers in the US or the UK. Roubini's central thesis is that crises are an inherent part of capitalism. The ingredients are always similar: easy money coupled with financial deregulation, irrational euphoria which leads to a bubble, followed by the inevitable bust. In some cases, the bubble is driven by genuine innovation: the railroads, for example, or dotcom fever, which at least leave the world some benefit when the wreckage is swept up. The current crisis, however, was not driven by real world invention, but by the financial variety, which is of dubious value to anyone other than the bonus-laden bankers. Roubini is a persuasive advocate of radical reform to neutralise capitalism's self-destructive streak. As he points out, we averted what looked like "the end of the world", but our escape was purchased at a huge cost in terms of ballooning public debt in the US and elsewhere. The balance sheets of the Federal Reserve and other central banks are now stuffed with dodgy assets; banks, businesses, people and even countries are likely to go under in the years ahead, and policymakers still have not dealt with the core problem of moral hazard, where banks have an incentive to behave recklessly because they know they will be bailed out. In fact, the scale of the rescue operation has ingrained moral hazard even more deeply into the financial sector psyche. So how do we deal with it? High on the agenda is reform of "warped" bonus structures with the aim of "making banking boring once more". One "diabolical" suggestion is to make the bankers eat their own cooking by paying them with the esoteric securities they cook up in their laboratories – a nice idea. But as the book concedes, "if recent history is any guide, it's easier to get money back from Bernie Madoff than it is to claw back a trader's bonus".

Central bankers should use monetary policy to control bubbles, which might seem obvious, but was dismissed by former Fed chairman Alan Greenspan, whose laissez-faire attitude became embedded in orthodox thinking. The authors also argue for "Glass-Steagall on steroids", a modern version of Depression-era US legislation that separated banks' risky activities from their utility functions, a reform for which I have argued many times in the business pages of this newspaper. Bankers say that gigantic institutions cannot be broken up, but we should turn a deaf ear: "For all their whining, one fact remains indisputable: these firms' reckless attitude to risk helped create a crisis that has inflicted suffering around the world... In future, they should be kept on a very short lease." Roubini hits back at some of his detractors, who claim he wrongly suggested global imbalances – namely that the US is such an enormous borrower – would be the prime cause of the crisis, by explaining the looming threat these still pose. The Chinese, who have accumulated massive reserves of US dollars, are in effect underwriting US healthcare, wars in Afghanistan and Iraq – and, of course, the bailout of the financial system. As the authors pithily put it: "China lent Americans the rope they used to hang themselves." In the short term, China cannot pull the plug on the US because it is dependent on exports and it would be suicidal to bring down one of its biggest markets. But the two are locked in a version of the old cold war standoff – mutually assured economic destruction. The imbalances need to be unwound: Americans (and Britons) need to borrow less; the Chinese need to save less; emerging economies should be given a bigger voice in international financial institutions such as the IMF. History suggests international banking crises are often the harbinger of sovereign debt defaults and collapsed currencies, as we are seeing in Greece – if the imbalances persist, that could be just a taste of things to come. This book is a tightly argued, convincing assault on the free-market ideology that allowed the finance sector to hijack the global economy. It has a strong message for governments, including our own newly minted coalition. Making markets function better demands a bigger role for government, not a smaller one. Politicians will have to square up to the banks, and if workers are to navigate an uncertain world of employment they will need support in education, retraining, portable pensions and a benefits safety net, along with tax systems that reduce inequality. Its most important insight is its simplest: that economists, politicians, and Wall Street traders allowed themselves to be seduced by the free market, and the limitless wonders of financial innovation. So, whether we were aware of it or not, did many of the rest of us. We were lulled into thinking we could carry on living beyond our means. This is a wake-up call.