Economic Governance and the Political Economy of the 2008 US Financial Crisis: A Taxonomic Essay

Abstract

This chapter argues that the smooth functioning of the financial system and the economy of a country depends upon its system of governance which is subject to the dynamics of its political economy. The analysis uses the 2008 US financial crisis as a case study. Prior to the Great Depression of the 1930s the US economy was governed under the purist laissez-faire model. In light of lessons learned from Great Depression the political economy dynamics led to the adoption of mixed laissez-faire model of governance. Governance under this model led to legislation that resulted in a regulatory framework including the Glass Steagall Act and the empowerment of the FED and the SEC to closely monitor the banking system and the financial sector respectively, while simultaneously assigning the government an activist role in the economy. This direction of governance kept the US economy by and large stable for nearly three decades (1960–1991) with minor fluctuations which were generally controlled within two quarters. The advocates of purist laissez-faire model and the finance industry were opposed to this change in governance but they were ineffective as they were a very small minority in the American democratic system. However the political economy dynamics started to change in the 1980s in reaction to the liberal activism of the government on a number of social issues (e.g. Abolition of school prayer, Civil Rights Act, support for women’s rights, etc.). The onslaught of these liberal ideas and policies created a clash of values and angered the traditionalists (i.e. social conservatives and religious fundamentalists). The only way for traditionalists to win in this clash was to find a way to change the direction of the system of governance. This called for their political participation in the democratic process. So they formed a political coalition with the advocates of purist laissez-faire model and the finance industry. This new coalition worked hard to gain mass support and eventually succeeded in winning majorities in both the houses of the Congress, and also the White House. This enabled them to pass new legislation that abolished or weakened the regulatory infrastructure and the monitoring powers of the FED and the SEC. These efforts over decades succeeded in restoring the purist laissez-faire model of economic governance. This restoration was done by changing the political economy dynamics of the country. It was done with sincere commitment to achieving a number of goals, such as high growth rates, efficiency of the economy, full employment and prosperity of the society; and indeed it delivered the goods. But in the absence of effective regulations and monitoring there were some unintended consequences that led to the events that caused the 2008 financial crisis. These findings show that governance plays a central role in the performance of a country’s economy. In the contemporary world there are a large number of Muslim countries which are resource rich but their economies have not been able to achieve meaningful performance and their masses continue to bear this burden. It is hoped that the studies analyzing the role of governance in their economies would help bring awareness to rectify the situation.