The financial crisis: a similar effect to a terrorist attack?

Much like a terrorist attack, the financial crisis has the potential to destabilise states

François Melese argues that the impact of the financial crisis on security cannot be underestimated. And he looks at whether it originated in the private or public sector.

NATO’s 60th Anniversary has been overshadowed by a grim statistic. Global output is set to contract for the first time in over 60 years. In percentage terms, world trade is expected to fall even further. What began as a case of financial flu in the U.S. has rapidly spread into a global epidemic. The economic and security implications for NATO and its partners are staggering.

There are two key challenges for the Alliance: first, a drop in defence spending; second, drawing the right lessons from the crisis.

The U.S. Director of National Intelligence recently told Congress the economic crisis has replaced terrorism as ‘the primary near-term security concern.’

The U.S. Director of National Intelligence recently told Congress the economic crisis has replaced terrorism as ‘the primary near-term security concern.’ What he failed to mention is how eerily similar this crisis is to a terrorist attack.

To destabilise states, terrorists typically leverage limited destruction of life and property into massive economic and social costs. By threatening key financial or physical infrastructure (eg transport, energy, communication, etc), terrorists force governments and populations into costly defensive actions. Frightened consumers shy away from markets, stunting economic growth, and contributing to unemployment and political instability.

Some might see similarities in the collapse of the U.S. housing market. The subsequent financial disruption quickly spread from Wall Street to Main Street. Frightened by falling house prices and rising job losses, many consumers stopped shopping. Meanwhile financial markets, overloaded with mortgage-backed securities and rapidly depreciating hedges, began to fail. In a desperate attempt to rescue faltering banks and insurance companies the government stepped in with massive bailouts. The steep drop in consumer spending on top of lending moratoriums brought even the healthiest companies to their knees, prompting even more bailouts.


All roads lead to Wall Street?

Combined with global financial institutions’ exposure to toxic assets, the collapse in U.S. consumption and investment soon spilled into international markets. The impact on international trade and global finance has left no country untouched.

Many transition countries had taken advantage of low lending costs and high foreign investment to increase government borrowing. Today government debt and current account deficits are much harder to refinance. If foreign banks cut off new lending or refuse to roll over outstanding loans, bankruptcies and unemployment could skyrocket.

Some member and partner countries face debt restructuring, or worse, default and currency collapse. Since this raises risks of political upheaval, lenders of last resort like the IMF, World Bank, and European Central Bank are stepping in to avoid political chaos.

So how does all this affect NATO?

The first challenge it faces is an impending drop in defence spending. Discretionary defence programmes are prime targets for officials desperate to manage ballooning budget deficits. The second challenge is to draw the right lessons from the crisis, and to resist protectionism.

On defence spending, many countries face serious cuts to offset the major debt they incurred in battling bankruptcy and unemployment. Many NATO members and partners will undoubtedly see their already modest defence spending constrained. Independent defence forces will become an unaffordable luxury. Collective security should begin to look increasingly attractive.

Article 3 of the North Atlantic Treaty (Washington 1949) states “parties…will maintain and develop their individual and collective capacity to resist armed attack.” Today’s economic crisis is likely to be reflected in more ‘collective’ and less ‘individual’ capacity.

On the bright side, NATO is at the heart of a vast and expanding network of partnerships that now includes 28 members. Through strategic coordination of its collective contributions, NATO can act as a force multiplier, in effect offering each member a complete defence package in exchange for their contributions.

Section 8 of the Alliance’s Strategic Concept (North Atlantic Council, Washington 1999) states that “common commitment and mutual co-operation…ensure that no single Ally is forced to rely upon…national efforts alone in dealing with basic security challenges. he alliance enables them through collective effort to realise their essential national security objectives.”

A serious risk in the drop in defence spending is that the U.S. will find itself bearing an even greater share of the burden at precisely the time its defence budget is also squeezed. With its banks and financial system weakened, and the dollar’s role as the global currency called into question, the world’s largest debtor may find itself in no position to continue subsidising global security.

Regardless, savings from joint security efforts will come from an aggressive search for efficiencies in collective resources. One vital source is to promote cross-border defence industrial integration—including transatlantic links—to help spread the fiscal burden of new system development and production, and defence-related activities.

Competition between cross-border and transatlantic industrial teams can facilitate access to new technologies, and generate innovative products that offer higher returns on defence investments. Competition stimulates innovation and offers incentives to adopt efficiencies that reduce costs and cycle times. An added benefit of promoting cross-border transatlantic industrial integration would be greater political-military cohesion within NATO. This could strengthen the alliance and boost NATO’s effectiveness by increasing interoperability and obtaining better value for money.

The second major challenge that threatens the alliance is the risk that countries draw the wrong lessons from the crisis

The second major challenge that threatens the alliance is the risk that countries draw the wrong lessons from the crisis. Are we witnessing a fundamental breakdown of capitalism and globalisation, or is there a more mundane explanation?

In his new book, a noted economist, John Taylor of Stanford University, argues the latter. He provides convincing empirical evidence that ‘government actions and interventions caused, prolonged, and worsened the financial crisis.’

It is tempting to blame economic hardships on Wall Street, greedy bankers and market failures. Some draw the lesson that capitalism has failed and that governments should protect their industries and rethink their reliance on global markets for future growth and prosperity. That lesson would be wrong. Capitalism is not the culprit.

In fact, I believe that well-intentioned U.S. government monetary and housing policies are the root cause of the current crisis. Clearly, predatory mortgage brokers, greedy investment bankers, incompetent rating agencies, overly optimistic investors, shortsighted homeowners, and financial innovators of complex derivatives all played a role in the financial crisis. But it is a mistake to blame them for doing largely what government policies were designed to encourage.

Several key U.S. policies to increase home ownership were designed to address alleged discrimination, attempting to protect minorities and reduce income disparities. Unfortunately, as the world discovered, these well-intentioned policies have had devastating unintended consequences.

These policies forced financial institutions to relax mortgage underwriting standards. Sub-prime mortgages were thus offered to individuals with low incomes, poor credit, and even zero down payments. A 2002 government report hailed this as ‘mortgage innovation.’ Soon everyone had access to these risky “innovations.”


The growth of subprime mortgages led to an unsustainable bubble

Two Government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, played a crucial role in government guarantees of subprime mortgages. In the 1990s, the U.S. government’s Department of Housing and Urban Development (HUD) directed them to sharply increase mortgage financing to the poor. To further increase lending, they were encouraged by Congress to expand and buy mortgage-backed securities, including those backed by risky sub-prime mortgages. The expansion of Fannie Mae and Freddie Mac funded the dramatic growth of subprime and adjustable rate mortgages. As the financial crisis hit, the two companies owned or guaranteed roughly half of residential mortgages in the US.

As mortgage lending increased, the demand for housing increased, contributing to the bubble that started in the 1990s. From 2000 to 2003 the housing bubble was further fuelled by the Federal Reserve’s expansionary monetary policy which led to short-term interest rates as low as 1%.

House prices finally stalled in 2006, partly due to a return of higher interest rates. Under U.S. law, a home owner with little or no equity whose house price falls below the value of their mortgage can walk away from their financial obligations.The subsequent collapse in housing prices and decline in value of mortgage securities rocked the global financial system, and lead to the current economic crisis. In 2008 Fannie Mae and Freddie Mac both failed and were nationalised.

Section 25 of the Alliance’s Strategic Concept (North Atlantic Council, Wash DC 23-24 April 1999) states that the “Alliance is committed to a broad approach to security, which recognises the importance of…economic…factors in addition to the indispensable defence dimension.” Since populist movements against markets would weaken a country’s business climate and undermine future growth and security, it is incumbent upon NATO to spread the message that government policies were at least as important as market failures in creating this crisis. Lax regulation and oversight of markets played a role, but more importantly, so too did lax regulation and oversight of government policies. Globalisation is not the culprit.

Prosperity from trade, financial flows, and foreign direct investment have provided a solid foundation for future growth in most NATO member and partner countries, in the Asian tigers, and more recently in India, China, Brazil and other rapidly developing economies. The risk is that populist policies could stall future growth unless the correct lessons are learned from the current crisis.

Economic policy and national security policy are mutually reinforcing. Since World War II, many of our most important economic partners have also been our closest allies. Security threats tend to recede as the imperative of international business expands. Globalisation through trade and finance has created unprecedented wealth and an opportunity for hundreds of millions around the world to lift themselves out of poverty.

There is overwhelming evidence that trade tend to reduce conflicts. In fact, when measures of both economic freedom (including free trade) and democracy are included in a statistical study, Columbia University political scientist Erik Gatzke finds ‘economic freedom is about 50 times more effective than democracy in diminishing violent conflict.’ It’s bad for the bottom line to shoot your customers and suppliers. As Montesquieu once observed: ‘Peace is the natural effect of trade.’

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