One crisis, many reasons

A crisis in the real economy usually leads to deregulation. A crisis in the financial sector usually leads to increased regulation. It may be no different this time around

The wide-eyed admiration for financial innovation has been quickly replaced by sweeping doubts about the entire gamut of products that have been rolled out by financial engineers. Is this wave of scepticism strong enough to sink the ship of financial sector reform?

Don’t bet against the possibility. I had earlier pointed out in this column to an interesting policy paradox. A crisis in the real economy usually leads to deregulation. A crisis in the financial sector usually leads to increased regulation. It may be no different this time around.

The credit crunch in the West keeps getting worse, and it will be just a matter of time before pressure to impose new regulations on the financial industry builds up to an extent that governments are forced to act. There is already a perceptible change in the attitude of commentators, with financial innovation now more condemned than celebrated. From here, it is a mere hop, skip and jump to the hasty conclusion that an economy is better off without a relatively free financial system.

The jury is still out on what exactly this financial crisis is all about—and what regulatory lessons can be drawn from it. There are several ways to analytically slice and dice the credit crisis that has stalked the developed economies since the middle of 2007. Here, I focus on three popular theories on why the unstable edifice that is now close to tumbling down came to be built in the first place:

1) Blame it on the central bank. The monetary masters at the US Federal Reserve and the Bank of Japan held the price of money down to unrealistic levels, making it easy for the financial industry to borrow and invest. Low interest rates were also the reason why people went on a home buying spree in the US, sometimes to live in those homes and sometimes to flip them for a profit. In short, central banks inflated asset bubbles—especially in real estate and equities—that are now deflating.

2) The financial industry is too clever by half. It is always finding ways of convincing the world that one and one is three. Economist John Kenneth Galbraith put it in a typically succinct manner. He wrote in his book A Short History of Financial Euphoria that financial innovation through the ages is merely the quest for new ways to create more debt that is leveraged against limited assets. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version,” he wrote. The same trick gets played over and over again under a new guise.

3) Modern finance is inherently fragile. The prophecies of economist Hyman Minsky have found an enthusiastic audience in our times. He said that markets and economies inevitably go through a boom and bust cycle. Financial instability is endogenous to a modern market economy. Firms go through three styles of financing through this business cycle—hedge finance, speculative finance and ponzi finance. The last is the most dangerous. At the end of the cycle, there is a financial crisis and the economy goes back to less risky ways. And then the house of cards starts getting built all over again.

There are obvious overlaps between these three theories, but there are many unique elements as well. It is disconcerting to see these three theories carelessly criss-crossing each other in many recent analyses of the credit crunch, with comments on asset bubbles, the dodgy ways of the finance industry and the inherent instability of financial capitalism being used more or less interchangeably.

The policy lessons could be quite different in each case. If the problem is low interest rates and asset bubbles, then central banks will have to ensure that market interest rates do not fall below some undefined natural rate of interest that helps the economy achieve equilibrium. In case the problem is the tendency of investment banks to pile toxic debt, then the challenge is to regulate the incentives within the industry (bonuses, for example) that push risky behaviour. And if we buy the Minsky argument that financial instability is inherent in a modern market economy, then the financial industry is better off in tight regulatory chains at all times.

There is enough research to show that financial crises have become more common over the past few decades. One reason is undoubtedly the financial deregulation that took place after the mid-1980s. But then there are also cases such as Japan, where very conservative financial methods did not prevent a meltdown that condemned the world’s second largest economy to more than a decade of stagnation. So, financial repression has created its own crises.

In short, there is too much ambiguity right now. While there is enough reason to be wary of some of the more fancy bits of financial innovation, policymakers and regulators should also take care not to chuck the baby out with the bathwater.