Thursday, September 09, 2010

The Financial Crisis - Causes and Cures

A new book from our friends at think tank Re-Define, which looks to be useful:

"The financial system, with its many institutions and channels for transfer of money closely resembles a road transport system. Well-managed roads enable people and goods to move where they need to go, quickly and without too many accidents; a good financial system efficiently allocates resources to where they are needed in the real economy without too many crises en route. Clearly we do not have such a system.

Imagine cars cruising down a road on a clear day: the occasional speed bump to slow them down, cameras reminding drivers they are being watched and the odd police patrol just in case. That is how finance in general and banking in particular worked for decades after the reforms triggered by the Great Depression. The world saw substantial economic growth in the decades following World War II and the financial system was fairly stable.

Next think traffic, fuel tankers, racing down the road in thick smog. Sparser police patrols, spray painted cameras and dismantled speed bumps and barriers complete the picture. This was the new face of finance that first started to emerge in the 1980s.

Cars and finance have always crashed. But crashes have become more frequent, more severe and ever harder to clear up. We are still emerging from a financial pile up of unprecedented proportions that brought financial traffic to a near standstill. Even as the rescue operation was in full swing, with governments taking unprecedented action, too many inebriated drivers kept careening down the road out of control. Truck after truck kept crashing into the rescue operation. Bear Sterns, Lehman Brothers, AIG followed in quick succession and the flow of financial traffic is still blocked.

Given hazardous driving conditions, hysterical daily news reports of accidents and poor visibility, most prudent drivers stay at home. They keep their cars in the driveway, their money close to the chest. This is what led the economy to seize up.

Governments, regulators and central banks have been in action clearing up the debris of road accidents but the scale and scope of the accidents was so great that it will take a long time before drivers would venture out again with confidence.

It is clear that going back to the old system is no longer an option. It was far too dangerous and failed to fulfil its purpose of directing funds where they would have best served the real economy.

This book provides some thoughts on how best to redesign the system.

What would such a system look like?

The system would need to be much safer without being inefficient. At 1km/h, there are no accidents but clearly this is bad for the economy. Some risk-taking is essential for the success of capitalism: it drives entrepreneurship and productivity gains. So we need measures that best increase safety and confidence without slowing down traffic to a trickle

Next we need to tackle smog. Opacity in finance comes from 1) trading poorly understood derivative structures 2) the use secretive tax havens and 3) growth in the shadow banking system which lies outside regulatory reach. This has jeopardized safety and undermined confidence. These three aspects of finance pollute through secrecy and need to be tackled upfront. Furthermore, better road signs in the form of full disclosure will no doubt help increase public safety and restore confidence.

Next we need to limit the size of ‘too large to fail’ financial institutions by breaking them up. These fuel tankers of the financial system have threatened the safety of whole countries such as Iceland and Switzerland. More speed bumps are also needed in the form of financial circuit breakers and transaction taxes which slow the speed of finance. Traffic cameras in the form of more regulatory oversight would ensure financial institutions know they are being watched and discourage reckless behaviour. More patrol cars i.e. more regulatory power for greater deterrence, faster rescue services and sharper punishments for offenders will help ensure that the smooth flow of financial traffic is not interrupted by dangerous driving.

Seat belts and airbags for the ordinary driver are also needed. These can come in the form of better deposit insurance and social insurance clearly increase safety in the event of a crash and help restore confidence to drive amongst the prudent. These measures will need to be part-financed by a differentiated road toll scheme with those driving big or dangerous vehicles which endanger financial safety and erode the road being asked to pay higher insurance, tax and capital levies. This could take the form of a levy on the balance sheet of large financial institutions.

Traffic management incentives which ensure that traffic does not ‘herd’ too much at peak times translate into what are commonly known in finance as ‘counter-cyclical’ policies. These ensure that regulation and fiscal policy lean against the wind to prevent the build up of bubbles or busts. It was the absence of such policies that inflated the recent asset price bubble in the first place.

No traffic system is complete without public transport which connects areas under-served by private vehicles. Similarly, governments need to support small and medium enterprises, green investments and infrastructure provision critical elements of a sustainable economy that the private financial sector almost always under serves."

The whole book can be downloaded here.


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