Higher Learning

There is no doubting the fact that we are currently experiencing an unprecedented phase in the context of global economic and financial markets. The nature of recent events is evident in the severe volatility in financial markets and in the fragile state of financial institutions and financial systems, the global and synchronous nature of the severe downturn in economic activity, and, most significantly, in the magnitude of the policy responses (both monetary and fiscal) across the world. Short-term policy interest rates, for example, have reached all time lows in the US and UK and look set to fall further, while the recent historically low levels of long-term interest rates indicate that the markets view the downside risks associated with prolonged recessions to far outweigh any potential risks associated with future inflationary pressures. Indeed, it is striking how quickly sentiment has changed in recent months from concerns over inflationary pressures to concerns over the spectre of potential deflationary pressures in many economies and, in particular, in the US.

The spectre of deflationary pressures emerging across the globe raises the very serious threat of debt deflation and the painful lessons learned in many countries during the 1930s and the 1990s in Japan. Debt deflation is a particularly corrosive economic phenomenon in which falling prices (negative inflation) conspire to increase the real value of debt levels. Clearly, the high levels of personal sector indebtedness which exist in countries such as the UK and US imply that the onset of debt deflation would have a particularly damaging impact on already weakened consumer confidence and spending. Households would be inclined to reduce consumption and increase savings in an attempt to reduce the real value of their outstanding debts, again, as we saw in the 1930s and in Japan during the 1990s.

In a deflationary environment there is also the temptation to delay consumption in anticipation of falling prices. Furthermore, this consumer retrenchment would reinforce the contraction in consumer spending associated with the powerful negative wealth effects on consumption emanating from the significant declines in house prices and in other asset prices such as equities.

The recent focus on the problems associated with the zero lower bound on interest rates (nominal interest rates cannot be reduced below zero %) also reminds us of the other corrosive aspect of negative inflation. Specifically, that negative inflation (other things being equal) tends to produce rising real interest rates. Hence, once policy-makers have reduced short-term interest rates to zero, any further falls in the general price level (associated with an increasingly negative inflation rate) will be associated with rising real interest rates.

It is a mistake, however, to argue that monetary policy ceases to become effective when nominal interest rates reach their lower bound of zero. Indeed, the failure to make effective use of monetary policy in a low interest rate deflationary environment was the grave policy error made by the US Fed in the 1930s and by the Japanese monetary authorities in the 1990s. Specifically, they failed to use expansionary monetary policy in order to prevent the emergence of the damaging spiral of falling prices, negative inflation and rising real interest rates. The extreme caricature of this policy is what Friedman termed "helicopter money", ie, the aim of monetary policy in such extreme circumstances is to be sufficiently expansionary so as to create some inflationary pressure in the economy and thereby prevent the emergence of economically corrosive deflationary and debt deflation pressures

Common causes

As in previous banking crises, large capital flows and asset price bubbles were associated with a rapid growth in lending (exacerbated by the incentive schemes operating in many banks and financial institutions) and an underestimation of both credit and liquidity risks. This time, however, the rapid growth in bank lending manifested itself largely in mortgage market lending, as personified by the lending boom in the US sub-prime mortgage market. Furthermore, the potential dangers of this sub-prime lending boom were accelerated by a number of factors:

1. The increasing tendency of banks to fund the growth in lending from the wholesale money markets rather than from deposits (thereby increasing liquidity risks).
2. The increased use of securitisation and financial innovations/derivatives, such as credit default swaps, in order to "slice and dice" and thereby to redistribute credit risks.
3. The associated opacity of the true risk exposures of numerous financial institutions including banks, insurance companies and hedge funds;
4. The increasingly globalised nature of the financial system which implied that any systemic problems in countries such as the US and even Iceland would be rapidly transmitted to other countries.

In turn, given the well-established empirical evidence that banking and financial crises tend to be followed by severe economic crises, this clearly increased the likelihood of a coordinated and severe economic downturn across many countries of the type we are currently witnessing.

The recent financial and economic turmoil will inevitably call into question existing business models, incentive structures and regulatory frameworks. Indeed, we are even seeing question marks being raised over the future of such "holy grails" as capitalism, the free market system, and the globalised and highly complex financial system.

As with all such episodes, however, there is a severe danger of over-reaction and of "throwing out the baby with the bath water." Capitalism and the free-market economic system have contributed enormously to the growth of wealth and prosperity around the world, although the recent financial crisis does underline very powerfully the fact that markets, and particularly banking and financial markets, cannot be allowed to operate in a completely unfettered manner without appropriate forms of government intervention, regulation, and supervision. It is also the case that financial systems and financial innovations have contributed enormously to the development of real economies and to economic wealth creation around the world. Once again, however, it must be recognised that many aspects of financial systems and financial innovations are double-edged swords with the potential to create enormous systemic risks and crises as well as enormous benefits.

Financial derivatives, for example, can be enormously beneficial in the context of hedging against various types of risks, but can also be responsible for dramatically increasing risk exposures while simultaneously reducing the transparency of these underlying risk exposures. As recent events have shown, the latter, combined with dramatic increases in leverage, can prove to be a potent and toxic combination. Hence, it is clear that governments and regulators will face an enormous task in the future in terms of ensuring that the undoubted benefits of financial markets and financial innovation can be secured by restoring confidence in the globalised financial system.

For the academic community, and business schools in particular, questions will inevitably be asked in the context of the standard curricula and the education of future business leaders. Many commentators have noted, for example, that many of the individuals at the centre of the global financial crisis were MBA graduates from leading business schools, while others have questioned aspects of the core of the traditional business school curricula, such as elements of the finance curricula, and particularly those elements relating to financial innovations and derivatives and to risk management techniques and practices, and the focus on shareholder value maximisation as the over-riding goal of firms.

Furthermore, the recent Madoff financial scandal reminds us of the importance of the ethical dimension in business, which was underlined so vividly by the corporate accounting scandals of Enron, Worldcom and others earlier in this decade. In short, all these recent events will call into question the appropriate relationship between business and society, and business schools around the world will need to find the appropriate answers.

At Nottingham University Business School, we take very seriously our responsibility to educate future business leaders to take a broader ethical and societal perspective on business practices and finance. Our world renowned International Centre for Corporate Social Responsibility (ICCSR), for example, was instrumental in developing the UK’s first MBA specialising in Corporate Social Responsibility (CSR) and in developing innovative modules such as ethical finance.

Furthermore, the integrative element of our MBA programme takes the theme of "Business, Stakeholders and Society" and offers a broader stakeholder perspective and an alternative basis for business strategy than the simple shareholder – oriented model. This integrative element also considers arguments for and against business attending to societal interests and values.

Nottingham University Business School has also developed Masters programmes in CSR and in Corporate Governance and Strategy and has made Business Ethics a compulsory module for Business and Management undergraduates. The School was also one of the first 100 signatories globally to the Principles of Responsible Management Education (PRME). The PRME are inspired by internationally accepted values, such as the principles of the United Nations Global Compact, and call on business schools and universities globally to adapt their research, curricula and teaching methodologies to meet the new and emerging business challenges, particularly in areas relating to CSR and sustainability.