The fact is that the financial crisis was rooted in a failure of politics in the first place. The changes to mortgage regulation under President Clinton forced US banks to enter the "sub-Prime" Market in the first place. The Banks, attempting to improve- as they hoped- the riskiness of these loans, bundled them with safer loans in order to try to insure themselves.
Meanwhile, the monetary management by the global central banks was very loose: interest rates were historically low for a prolonged period. The implication was that there had, under the influence of new technology, been a significant improvement in capacity. In fact as we now know, both low rates and nominally higher growth were being maintained by a dramatic expansion of bank balance sheets. The innovation was simply in finding ways to expand global liquidity. Finally the banking system imploded. The next- disastrous- decision was political: to take the banks into public ownership. This transferred a private sector crisis into a sovereign debt crisis.
Now the markets are on the edge of another nervous breakdown: there is not enough growth to finance the debts. Either the taxpayer has to take the whole hit, or banks have to write down their sovereign liabilities- requiring another painful recapitalization of the banking system. The Governments have reached the end of the borrowing road- and yet, the process of de-leveraging- unmitigated- will plunge nations into a long and deep depression that will take at least a decade to work through.
The political choices are all toxic. Reducing sovereign debt is a must, but if there is no growth, then the need to continue to take money out of the economy in order to reduce debt means painful real spending cuts and risks destroying any signs of recovery. A vicious circle of of debt payments reducing growth, requiring bigger debt repayments, reducing growth faster then ensues.
The problem is that the political leadership across the world remains paralysed. The failure of leadership is terrifying the markets. The politically dysfunctional United States remains locked in a deadlock ahead of the next stage in the electoral cycle. The Germans make occasional radical gestures without adequate thought as to the consequences- and yet at other times, are dangerously inert. The Japanese are in a perma-crisis, France in elections, Italy has no credibility. All of this leadership vacuum adds to uncertainty in the global financial markets.
Yet, although the markets are jittery, the crisis has also exposed their limitations: The once all powerful bond market no longer sets the weather in quite the same way as once it did. After all the market was not so efficient: it permitted the unsustainable explosion of credit in the first place- without questioning whether the quantum of debt was repayable or not. Ironically, for the first time since the Bretton Woods agreement, policy makers have a free reign to reshape the global economy. Yet the failure of leadership is so total that no coherence - indeed few actual decisions at all- are emerging as the basis for a new consensus.
A new financial architecture is now needed- a new Bretton Woods.
Yet our leaders can not understand the new situation- and unless the Western leaders rediscover their mojo pretty soon, then the new financial architecture will be dictated by Beijing- to the permanent discomfort of the West.
It is not that China is such a giant- their economy is still much smaller that the US or the EU- but the are used to creating plans and sticking to them, and this is giving them an edge in the current turmoil. They can provide leadership by default. Yet it is time for leadership in the West- who can provide it?