Ending the Doomsday Cycle of global finance

March 4, 2010

     By Duncan Green     

‘Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises appear to be getting worse and worse.’ So begins a sobering analysis by Peter Boone and Simon Johnson in the CentrePiece, the journal of the LSE’s Centre for Economic Performance.

The argument is contained in the two graphics. First the  historical record – as private sector doomsday cyclecredit has grown relative to the economy, the Fed (US Central Bank) has been forced to socialize bad debts and drop interest rates lower to dig the economy out of each successive crisis and start inflating the next bubble. ‘When the bailout is done, we start all over again. This has been the pattern in many developed countries since the mid- 1970s.’

But in the latest crisis, the interest rate has pretty much hit zero – there’s nowhere else to go – and ‘The real danger is that as this cycle continues, the scale of the problem is getting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse.’

‘So what should be done? First, consider the regulatory problem: there are two broad ways to view past regulatory failure that has helped us arrive at this dangerous point. One is to argue it is a mistake that can be corrected through better rules. That has been the path of successive Basel committees.’

Doomsday cycle 2But it won’t work because of politics – the second graphic: ‘In our view, the long-term failure of regulation to check financial collapses reflects deep political difficulties in creating regulation. The banks have the money, they have the best lawyers and they have the funds to finance the political system.’

So what might work better? Something so crude that the lobbyists can’t mess with it: ‘We believe that the best route to creating a safer system is to have very large and robust capital requirements, which are legislated and difficult to circumvent or revise. If we triple core capital at major banks to 15-25% of assets, and err on the side of requiring too much capital for derivatives and other complicated financial structures, we will create a much safer system with less scope for ‘gaming’ the rules.’

And get stuck into the incentives system: ‘Second, we need to make the individuals who are part of any failed system expect large losses when their gambles fail and public money is required to bail out the system…. This requires legislation that recoups past earnings and bonuses from employees of banks that require bailouts.’

And a wonderfully simple way to overcome the ‘too big to fail’ syndrome: ‘We could impose rising capital requirements on large institutions over the next five years, thus encouraging them to develop orderly plans to break up and shrink their banks.’

The alternative is truly scary: ‘With our financial system now well-oiled to take on very large risk once again, and to gamble excessively, can we be sure that we can continue this cycle of bailing out eventual failures? At what point will the costs be so large that both fiscal and monetary policies are simply incapable of stopping the collapse? Last year, we came remarkably close to collapse. Next time, it may be worse. The threat of the doomsday cycle remains strong and growing.’

This may all sound an insider City/Wall Street argument, far removed from the gritty realities of shanty town and village in developing countries, but as the current crisis has shown, the chaos of the rich world’s casino capitalism casts a long shadow. It matters who wins this one.