The credit crunch made everyone an economist. Politicians, intellectuals, journalists and the man on the street have their own theories about what went wrong and why, and even more worrying, what we should now do about it. The symptoms of the credit crunch could well be worse than the condition itself, as people around the world look with distrust and distaste at capitalism. It is clear that economics affects everyone, and as a consequence should matter to everyone. What is shocking is how little of it is understood, from the classroom to the cabinet. Alexander Pope got it right in 1711 when he noted that “a little knowledge is a dangerous thing”, and if we are not careful our recently reinvigorated scepticism of capitalism may well cripple the quality of life for many generations to come.

There are two aspects of globalisation that must be understood. The first is increased free trade between nations, which essentially results in access to a larger range and quality of goods at lower prices; as countries utilise their comparative advantages and economies of scale from larger markets and division of labour. The second is increased liquidity of capital and integration of capital markets which, for example, allows investors in developed nations to invest in developing nations. Both aspects of globalisation, the liberalisation of trade and the integration of capital markets, have been attacked due to concerns over a range of issues such as jobs, environmental degradation, cultural dilution, etc. Over time the gains from liberalisation of trade have been viewed as exceeding the costs, whereas capital market integration and interdependence has always been viewed with a healthy degree of suspicion and caution.

The reason for this is attributed precisely to situations like the credit crunch. When we have capital markets that are increasingly dependent on one another we increase the likelihood of an economic disruption in one nation affecting all nations. But capital markets also have many advantages. Increasingly, free flows of capital allow people, companies and governments to lend and borrow from around the world. However, whilst the basic functions of capital markets have many evident gains, the advantages of the increasingly complex financial instruments that caused the rapid and wide spread economic infection we witness today are far more contentious. The acronyms CDO, CDS, and SPV, are the relics of semi-mystical financial instruments that often meant little more to the banker that utilised them than they now do the general public seeking to understand them. The absence of intellectual property rights on such financial instruments meant that bankers continuously sought increasingly more ‘sophisticated’ and complex ways of gaining profit, looking with pity at the some of the more ‘primitive’ capital markets of other nations. Whilst Anglo-Saxon countries fuelled their growth rates with their rapidly growing financial sectors, countries like Italy were experiencing growth rates of a very European nature, slow and steady.

Empirical studies by financial regulators have all concluded that Italy’s direct exposure to the financial crisis is modest. The reason for this is that Italian banking is somewhat old fashioned, in that it is very retail orientated, and heavily reliant on manufacturing. In short, they have been reluctant to embrace the globalisation of capital markets that made personal borrowing so readily available in Anglo-Saxon countries, as financial institutions used increasingly more complex ways to boost corporate profit, and extend their ability to lend. Authorities in Spain banned the use of such financial instruments, and as a result some of its now relatively stronger financial institutions such as Santander are gobbling up UK banks like Abbey. For some members of Berlusconi’s government, the credit crisis is revenge for all the times Italy’s financial sector was viewed as backward.

The European Commission has stated that Britain is facing a deeper recession next year than any other major EU economy, and the IMF has forecasted that UK output will decline by 1.3% in 2009. In fact there are just two countries that the UK is forecast to do better than: Estonia and Latvia. It must have hurt The Economist, champion of Anglo-Saxon economies and an unwavering supporter of globalisation of all types to admit that, “With developments in global financial markets curbing growth in the UK's important financial services sector and tightening credit conditions for firms and households, GDP growth is forecast to contract in 2009.” Interestingly, we have seen a significant decline in attacks from The Economist against the Italian government for their policy in regards to Alitalia (a policy which is essential in maintaining the infrastructure of the Italian economy), as both Britain and the US go on a spree of nationalisation to save their financial sectors. Perhaps now we have learned the importance of government intervention in demanding circumstances? The market cannot solve everything, and sometimes even a process as ‘primitive’ as nationalisation may be best.

Bring back the Gold Standard perhaps?

But why is the forecast for Britain so bleak when data shows that the historical average real GDP growth for Britain in the last 5 years has been 2.8% whereas in Italy it has been 1.1%? The answer is in the question itself. Britain has been growing too fast. In Britain, a third of all recent growth has been attributed to the financial services sector, even more if you account for the indirect services that support it. But more significantly, with such strong and purportedly sophisticated financial institutions reaping profits at a scale unimaginable ten years ago, there has been more money to go around, and most importantly, more for individuals to borrow. This new-found increase in disposable income allowed consumers to go on a spending splurge, propping up all elements of the economy, and allowing for a growth rate that was distinctly non-European. It was a glorious time, but now the party is over and Britain has a significant mess to tidy. The bail out for British banks has cost an unprecedented amount of public money, people who were employed in the financial sector itself and those industries which supported it are finding themselves unemployed, and with a figure of over £1.4 trillion Britain has the highest level of personal debt in the world.

The situation has got so bad that some have started to question the efficacy of capitalism itself. That is why it is so important to highlight the destruction that could be caused if the current crisis results in a backlash toward capitalism as a whole. The problem with capitalism for the last decade has been that we have in the UK strongly criticised any nation which dares to question the perfect outcomes that free markets of any kind, including capital markets, would bring. We need to realise that as the economies of the world become increasingly interdependent, individual nations deserve a right to voice their opinion on different shades of capitalism, as we are all affected by a crisis when they occur. The US could have learnt a lot from the Italian scepticism of increasingly globalised and complicated capital markets. And Italy could learn a great deal from the US drive for increasingly flexible labour markets, competition and productivity. Even though the direct impact of the financial crisis on Italy is somewhat limited, the consequential downturn in the real world economy will significantly challenge the struggling Italian economy.

Capitalism is undoubtedly the best system with which to maximise both prosperity and quality of life. However, we need to realise that it may be necessary to manipulate the market in order to streamline agents into making decisions that are in society’s interests as a whole, and this will often mean intervention and regulation.. Although free market advocates argue that a perfectly competitive market will produce the best social outcome, they concede that intervention may be necessary to ensure such a market exists. This may lead to slower and steadier rates of economic growth than some countries have become accustomed to, but it will ultimately result in a significantly more stable economic environment. This doesn’t mean that we should start to question the basic ethos of capitalism, but we should question what we have sometimes allowed capitalism to become.