Past posts have examined how monetary policy has adapted since the 2007–08 global crisis and how fiscal policy is still unresolved. But neither monetary nor fiscal policy caused the 2007–08 crisis: the direct blame lies squarely with the financial sector. Financial regulations have been enhanced over the past decade, but at the economy-wide macro level, the asset price bubbles, credit cycles, and volatile expectations that characterise the financial sector have not yet been satisfactorily incorporated into academic theory or policy practice.
Shoring up the prudential framework was the first priority after 2008 – a microeconomic task focused on the behaviour (or misbehaviour) of individual financial institutions. Although the Basel rules that guide national bank regulators have been revised, it remains to be seen whether these enhanced rules will get the political backing needed to be effective. Already in the US, only a decade after the crisis, the huge effort embodied in the Dodd–Frank legislation that imposed regulation on the financial sector following the crisis is under threat from President Donald Trump’s deregulation agenda. The political power of Wall Street seems as strong as ever.
However, the problems were not all at the level of individual financial institutions. The unfolding crisis also revealed misunderstanding at the macro level.
Of course, the financial fragility of 2008 did not come as a total surprise. The inherent systemic vulnerability in banking has long been understood: one tottering bank can cause contagious runs on the whole banking system. But the 2008 crisis demonstrated that financial-sector instability was more deep-seated. Standard economics says that markets have strong self-equilibrating processes: a fall in price encourages greater demand, thereby supporting prices. In textbooks, demand curves slope downwards. Aren’t markets like a marble in the bottom of a bowl, quickly returning to normal after being disturbed?
But in financial markets, investors’ common response to a price fall is to sell rather than buy, sending prices down further. Momentum traders, portfolio managers with fixed mandates, and even the risk-reducing rules imposed by the regulators all serve to give financial markets an unstable dynamic. These processes reverse eventually, but in the meantime collateral is inadequate, lenders call for more margin, and sound balance sheets can be in deep trouble.
These problems have become worse, rather than better, as financial markets have become deeper, globalised and more sophisticated. Financial investors ride waves of momentum and carry-trades, relying on liquidating their position ahead of other investors. This results in hair-trigger responses to minor news, and lemming-like investor stampedes. Sudden mood swings are the norm. Few financial investors can hold a position throughout the cycle, waiting for normality.
The result is a financial cycle with asset-price booms and busts. Pre-crisis, central banks argued whether they should respond to credit-driven asset-price booms and potential bubbles – the ‘lean or clean’ debate. Post-crisis, this quandary has been addressed with macro-prudential measures – actions taken to rein in overall bank lending by regulating loan-to-value and debt-to-income ratios. Micro instruments are being directed at macro problems. These measures, however, amount to ‘old wine in new bottles’. The regulations used to control bank lending before deregulation in the 1980s have been dusted off in recent years and reapplied. These regulations were abandoned three decades ago because they were discriminatory and distortionary, with the inventive energy of the financial sector being devoted to circumventing such constraints. Macro-prudential measures are likely to prove a weak instrument.
This unstable dynamic is driven by psychology more than economics, so doesn’t fit easily into economic theory or models. Even the most sophisticated models rarely incorporate a detailed financial sector. More seriously, models routinely envisage a self-correcting economy. Subjected to shocks, these models plot a return path to full capacity, without much need for policy action.
These macro models have been largely irrelevant for issues of financial stability. But even if prudential regulators can ignore such models, they still need ways of incorporating the inherent dynamic instability of the macroeconomy and cyclicality of finance into their largely micro-focused supervision of individual financial institutions. This needs to be embodied in a politically endorsed policy framework that can stand up against the pressures of powerful interest groups.
