Financial reform: Call to arms
By Martin Wolf – Financial Times
Post-crisis efforts to bolster economies and create safer banks have only preserved a flawed system
The financial crises and the years of economic malaise that followed represent profound failures of the economy and of policy. Above all, they were failures of understanding. We have learnt much since. But we have not learnt enough to avoid a repeat of this painful experience. As I argue in a new book, we retain unbalanced and financially fragile economies. We need to be substantially more radical than we have dared to be hitherto.
Policy makers did not expect the crises that began in 2007. Not only did they not expect them, many prided themselves on their role in creating something called the “great moderation”. As long as inflation was stable, they believed, everything would be for the best in the best of all possible economic and financial worlds.
That was the pre-crisis “old orthodoxy”. Those in charge saw little danger in the rapid growth of credit; they were largely unconcerned by rising leverage; they thought financial innovation added to rather than reduced stability; and they believed it was easier to clean up after asset-price bubbles burst than to prevent them from growing in the first place.
On all this they were proved wrong, as the late and disregarded Hyman Minsky had sought to warn them. Among his many insights into how financial systems actually work, as opposed to how too many economists believed they did, was his realisation that stability ultimately destabilises.
The longer a period of stability endures, the more risks people will see as potentially rewarding. Worse, the associated increase in leverage will accompany – indeed drive – rises in asset prices. This will validate the risks the creators of the leverage take.
This pleasant outcome will continue to be true, until – suddenly and unexpectedly – it ceases to be so. That was also the case this time. The period before 2007 saw exceptional risk-taking. In a globalised and liberalised financial system, this spread contagiously across borders.
When asset prices and the appetite for risk collapsed, the outcome was a panic, a deep recession and a prolonged post-crisis malaise, as economies not only lost the fuel of extra borrowing but also grappled with the overhang of debt.
Behind this story, I argue, were global economic stresses: a savings glut (or rather investment dearth); global imbalances; rising inequality and correspondingly weak growth of consumption; low real interest rates on safe assets; a search for yield; and fabrication of notionally safe, but relatively high-yielding, financial assets.
Expected to maintain inflation in economies subject to strong disinflationary pressures, central banks felt obliged to provide generous amounts of monetary fuel. But the financial industry determined how it was used. It could have ignited in a blaze of productive investment. Instead, it generated soaring house prices, rising debt and rapidly increasing leverage inside the financial sector itself.
The most important regulatory result of the great depression was the Glass-Steagall Act, which ran to 37 pages. This time, the Dodd-Frank Act ran to 848 pages
Credit booms and the apparently inevitable subsequent busts are hugely costly. All the empirical research underlines this reality. In retrospect, the insouciance of policy makers about the risks being run seems terrifying. But this also raises a big question now: have they learnt the right lessons for the future?
My book outlines a “new orthodoxy”, which effectively replaced the one that died in the great recession. Ben Bernanke partly laid out this new orthodoxy in lectures he gave while chairman of the US Federal Reserve in 2012.
Under this new orthodoxy, monetary policy remains the principal tool of macroeconomic stabilisation, with fiscal policy playing a subordinate role, if any. The target of monetary policy is to keep inflation low and stable, though some central banks (notably the Fed) explain that the aim is the highest level of activity subject to hitting its inflation target. But central banks have broadened their instruments to include unconventional measures, notably “quantitative easing”.
Meanwhile, the financial sector is also to remain broadly the same as before, albeit vastly more tightly regulated and with somewhat higher capital requirements. There is also to be enhanced oversight of the systemic fragility of the financial system under the rubric of macroprudential policy.
This new orthodoxy is merely a chastened version of the old. But is it workable?
There are a number of reasons for believing the answer is no.
First, policy makers rely overwhelmingly on monetary policy as the stabilisation instrument of choice. But monetary policy works via asset prices and credit expansion. This combination certainly risks a repeat of crises. This is particularly the case if, as seems plausible, there is structurally deficient demand. Policy makers may be doomed to create new bubbles to replace old ones.
Second, experience shows that the low inflation targets to which policy makers are committed are not high enough to ensure short-term interest rates can remain above zero in all circumstances. Yet there are big risks in raising the targets, since that would inevitably undermine the credibility of any target. This is a dilemma.
Third, potential exists for conflict between monetary policy on the one hand and macroprudential policy on the other. Consider the dilemmas confronting US policy makers in the first half of the last decade. If regulators had halted the flow of credit associated with the housing bubble, they would have reduced consumption and residential investment. The response of the Fed, concerned about low inflation, would probably have been to lower interest rates still further, so working against the consequences of its own macroprudential policies.
As a paper co-authored by Andrew Haldane of the Bank of England notes, the most important regulatory result of the great depression in the US was the Glass-Steagall Act, which ran to 37 pages. This time, the Dodd-Frank Act ran to 848 pages and requires almost 400 pieces of detailed rulemaking by regulatory agencies. The total response may amount to 30,000 pages of rulemaking. Europe’s rulemaking will almost certainly be bigger still.
All this regulatory activity demonstrates a breakdown in trust between governments and finance. It does not demonstrate a workable new modus vivendi between them.
Cynics may be reminded of the remark in Giuseppe Tomasi di Lampedusa’s Il Gattopardo (The Leopard): “If we want everything to stay the same, everything must change.” They may conclude that this manic rulemaking is designed to disguise the fact that the thrust of it all has been to preserve the system that existed before the crisis: it will still be global; it will continue to rely on the interaction of vast financial institutions with freewheeling capital markets; it will continue to be highly leveraged; and it will continue to rely for profitability on successfully managing huge maturity and risk mismatches.
Among the most important, though certainly not the only, issues for the future concern the financial sector and the economic role of debt. It is essential here, I argue, to go well beyond the new orthodoxy.
A ‘new orthodoxy’ replaced the one that died in the great recession. But it is merely a chastened version of the old
The business model of contemporary banking has been this: employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; promise a high return on equity; link bonuses to the achievement of this return target in the short term; ensure that as few as possible of those rewards are clawed back in the event of catastrophe; and become rich. This was a wonderful model for banks. For everybody else, it was a disaster.
The new regulatory regime is an astonishingly complex response to the failures of this model. But “keep it simple, stupid” is as good a rule in regulation as it is in life. The sensible solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.
So how much capital would do? A great deal more than the 3 per cent ratio being discussed in Basel is the answer. As Anat Admati and Martin Hellwig argue in their important book, The Bankers’ New Clothes, significantly higher capital – with true leverage certainly no greater than 10 to one and, ideally, lower still – would bring important advantages: it would limit the implicit subsidy to banks, particularly “too big to fail” ones; it would reduce the need for such intrusive and complex regulation; and it would lower the likelihood of panics.
An important feature of higher capital requirements is that these should not be based on risk-weighting. In the event, the risk weights used before the crisis proved extraordinarily fallible, indeed grossly misleading.
This is inevitable: risk weights are almost certain to fail. In general, there will be a tendency to overinvest in what is seen to be relatively low risk. In the most recent case, these were assets backed by property. Such lending will seem safe so long as a general fall in property prices is ruled out. If that turns out to be untrue, the lending will suddenly emerge as risky. Unfortunately, the labelling of a particular form of activity as relatively safe makes over-lending more probable. Its relatively low level of riskiness is a self-denying prophecy: the market response will itself make it false.
Holding much higher capital would limit the implicit subsidy to ‘too big to fail’ banks and reduce the need for complex rules. It would also lower the likelihood of panics
The new orthodoxy, while recommending more modest reductions in leverage than I now believe necessary, puts greater weight on resolution: that is the ability to convert certain categories of debt into equity when institutions appear de-capitalised. But this idea, while attractive in theory, is likely to prove difficult to operate successfully in practice. This is particularly likely in the midst of a systemic panic, unless the liabilities of vulnerable institutions have large amounts of credibly “bail-in-able” long-term debt held by investors that are able to bear the losses. Yet such debt is, by its nature, quite close to equity. The only justification for such a second-best proposal is that debt is tax deductible. But that argues for radical tax reform.
An equally, if not even more important, proposal is for the deleveraging of economies. Perhaps the most important single lesson of the crisis is that beyond some point the growth in debt adds to the fragility of the economy more than it adds to either personal welfare or aggregate demand. Atif Mian and Amir Sufi argue this persuasively in House of Debt.
Ideally, new financial contracts would have elements of equity built into them from the start. Such contracts would automatically generate risk sharing between lenders and borrowers. Take lending against residential property as a crucial example. Under the new contracts, loans would be automatically reduced if the general level of house prices fell, according to some relevant index, and vice versa if it rose. Under such “shared equity contracts”, the suppliers of finance would share in the risks and the rewards of movements in house prices. These new contracts could be very attractive to long-term savers.
A shift away from over-reliance on inflexible debt contracts, with all the fragility they create in the economy, would require complementary policy changes. The existing favourable tax treatment of debt needs to be ended: debt should be taxed, not subsidised.
The dominant role of highly leveraged institutions makes it far more difficult to develop such equity contracts. The over-reliance on such institutions is also highly destabilising, in both boom and bust. In booms, they produce too much credit and debt. In busts, they generate panics, as their creditors come to believe that the institutions in which they hold their money are not as safe as they hoped.
The need to shift away from reliance on highly-leveraged intermediaries fits with another and still more radical option: a move towards 100 per cent reserve banking, with financial intermediation occurring outside the banking system. Many have proposed variants of this radical reform, on the left and the right of the political spectrum. It makes a great deal of sense.
If people think the money they have in banks is safe, while the latter lend it out freely to risky borrowers, crises are inevitable. Worse, under current arrangements, banking institutions create the vast bulk of the money in our economy as a byproduct of often irresponsible risky lending. Since people view money as the one safe asset, this has to be a fundamentally crisis-prone system. It could be replaced, at least in theory, by returning the ability to create money to the state.. . .
Such proposals are unavoidably controversial. The transitions would certainly be demanding. But the advantages could be large, provided it was possible to police the borderline between the new narrow forms of banking and the rest of the financial system at least reasonably effectively.
Moreover, even if one did not go that far, one could recognise that the current experiments with quantitative easing represent a limited step in this direction. It would be possible to raise reserve requirements to today’s higher levels right now, so moving to permanently higher proportions of government-backed money.
It would also be possible to use the ability to create money not just to manipulate asset prices, as in QE today, but to fund government directly. The direct monetary funding of public spending, particularly higher investment, or tax cuts would be a debt-free and highly effective way to generate additional demand. This idea, which the late Milton Friedman called “helicopter money”, remains relevant.
Such radical proposals carry risks. But, provided the decision on how much money to create was left to central banks, those could be managed. Not least, the distributional consequences would be more desirable than using the central bank’s capacity to create money merely to raise the prices of assets owned by the rich.
The story is not over. Yes, economies are recovering. But the losses are huge and likely to be enduring. The pre-crisis orthodoxy proved defective. The new orthodoxy is an improvement. But it is open to question in important respects. The financial system remains fragile. The risks of further crises are not small. Far greater ambition is needed.
The Shifts and the Shocks: What We’ve Learned – and Have Still to Learn – from the Financial Crisis (London and New York: Allen Lane and Penguin, 2014)