Persaud, D. A. (2014) “Why We Must Break Up the Financial Herd“, Peterson Institute for International Economics – Article in QFinance, 16 October.
Background
Memories are short. But those in finance are even shorter. Before the credit crunch began in 2007, policymakers in advanced economies were flirting with the idea that we should just accept that financial crises occur every seven years or so and plan accordingly, as seeking to avert or limit them would suffocate the financial system. At the time, greater financialization of the economy, which is when the financial sector accounts for an ever rising portion of gross domestic product, was seen as an unambiguous measure of progress. The most financially liberalized economies—the United States and the United Kingdom—were held up as exemplars for others to follow, and the rallying cry was “set finance free.”
The credit crunch ended such talk. It reminded the financial crisis-deniers just how traumatic crises can be and how slow and hesitant the recoveries are. It also reminded us of the Faustian pacts that policymakers are forced to make at the height of a severe financial crisis—for example, trying to revive an economy after a debt-driven bust through more debt, or employing the very same individuals who caused or contributed to the crisis to try to mend things, simply because only they understand the instruments that need to be disentangled.
During the 2008 US Democratic presidential primaries, one of Senator Hillary Clinton’s mantras was that she was more able than rival candidates to take that 3:00 a.m. phone call from the generals about some overseas calamity. During a financial crisis, the 3:00 a.m. phone call invariably comes not from a general but from a banker. And invariably he will tell you that unless you bail out his institution, the whole financial system will collapse.
It’s all very well to sound brave in the abstract and say the banks should not be bailed out, but when the authorities tried just that in September 2008 and allowed Lehman Brothers to fail, financial meltdown followed. In the wake of that collapse, no major financial institution was able to fund itself without state support. Calling the bankers’ bluff is much harder than it seems to the wider public. Where possible, it is best to avoid having to make that call.
In the shadow of the crisis we have returned to a more nuanced consensus, along lines similar to that which existed in a previous age: Financial firms can play an important role in financing growth, but only as part of a financial system that does not accentuate boom and bust. Let us hope that we do not forget this lesson too quickly.
In the 10 years prior to the crisis, financial policy was driven by three main objectives: transparency, standardization (of value and risk measures), and the removal of restraints on financial trade-like transaction taxes or capital requirements for the trading books of banks. Bankers persuaded everyone else that achieving this holy trinity would deliver an effective financial system and therefore greater prosperity for all—though it was also considered foolhardy for regulators to second guess what an effective financial system should look like.
While there is undoubted merit in transparency and standardization, and in the removal of trading restrictions, the manner with which these goals were pursued caused financial systems to become larger, yet more fragile. It also led to financial systems with high degrees of trader liquidity, but which lacked systemic resilience.
False Gods?
Regulators must dare to consider what a resilient financial system would look like. I would venture that it is one where a shock in one part of the system can be absorbed by another part and not spread and amplified across all the others. For this to happen, we need a financial system in which the different parts assess, value, hedge, and trade the same assets or activities differently, not because they have different information, different forecasts of the world economy, or different risk appetites, but because they have different objectives, or, more precisely, different liabilities.
Relevant posts:
- Verney, S., Bosco, A. & Lobo, M. C. (Eds.) (2014) “Southern Europe and the Financial Earthquake – Coping with the First Phase of the International Crisis“, South European Society and Politics, Routledge Publications, October.
- Joyce, P. J. (2014) “International Debt and Financial Crises“, Economonitor, 09 October.
- Zartaloudis, S. (2014) “The financial crisis has badly damaged the Greek and Portuguese welfare states“, LSE EUROPP, 23 September.