As SIFIs reach a critical mass by becoming too big to fail, they must continue to engage in endless expansion of credit during booms, followed by rapid contractions during financial crises.
Credit and Stability
The author is one of several CIGI-sponsored Canadian university students who attended the INET conference, Crisis and Renewal: International Political Economy at the Crossroads, at Bretton Woods, NH, April 8-11, 2011. Each student was asked to write a short reflection on the conference themes.
Economic crises arise as a result of the breakdown of key components of the financial system, which need to be addressed in order to promote recovery and continued stability. The INET conference held at Bretton Woods was an ideal place for a discussion of these components. Andrew Sheng, chief adviser to the China Banking Regulatory Commission, expressed warnings about the size of systemically important financial institutions (SIFIs) in the session on large complex financial institutions. INET Founding Sponsor George Soros asserted that markets are equally capable of forming bubbles or equilibrating the economy. When credit is involved, reversal of bias leads to a financial crisis and while some, like Alan Greenspan, would argue that the financial system is too complex to be regulated, the case can also be made that a financial system that is deregulated is too dangerous for the economic system as a whole. The role of democratic institutions in economic life was also considered during the first panel.
The failure of SIFIs is well studied, and the availability of prescribed solutions to their recent inadequacies may be the result of a tendency for macroeconomics to distract itself with overarching, but excessively elegant solutions. We need only be reminded of the first Bretton Woods system and its failure to incorporate a clearing union, to see that important details often remain unaddressed. Attributing financial instability to the existence of SIFIs leads to proposals such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, adding to existing efforts to reform the financial sector under the Basel III accords. Such efforts do not address the fact that any capital ratio may be inadequate given a large enough crisis and the continued existence of financial incentives to circumvent capital rules and regulations to increase the scale of activity. Although the complexity of mortgage-backed securities suggests the need for supervision by authorities with advanced technical expertise, the basic building blocks of these securities are mortgages, considered a basic financial instrument. The international nature of the financial system today limits the ability of any single government to enact policies to promote the stability of the financial system as economists warn of a regulatory race to the bottom. Sovereignty may need to be reigned in if an interconnected banking system is to benefit from the stabilizing effects of coordinated policy.
Strengthening the US financial system through a more rigorous application of the existing regulations and anti-trust rules may be hindered by political capture resulting from financial institutions’ large contributions to political campaigns in the United States. Breaking up existing SIFIs may be equally impractical and it is clear that regulators cannot compete for talent in terms of compensation. As SIFIs reach a critical mass by becoming too big to fail, they must continue to engage in endless expansion of credit during booms, followed by rapid contractions during financial crises. Although consumer credit can hardly be defined as an economic right, recent government intervention demonstrates that the availability of credit is now in the public sphere of responsibility. Bailouts are provided under the premise that continued provision of credit is necessary to support demand in the economy. Given the implicit guarantees, money can be lent out with little consideration of the possibility of default.
As a result of continuous stability and a tamed business cycle, economists have found themselves unwilling to routinely incorporate default decisions in macroeconomic models, despite their key role in the understanding of risk and the contagion of financial crises, preferring instead to assume this option away. Trust and a commitment to the repayment of debts may be key pillars of the financial system, but default decisions become more attractive during financial crises and are, therefore, an ideal candidate in the study of economic contagion. Although clustered defaults can significantly amplify economic contraction, they keep the banking system in check by causing failures among reckless lending institutions, which can then be replaced by more prudent ones. Implicit guarantees restrict the ability of the banking system to regulate itself and may be one of the main causes for increasing debt in the years preceding the crisis.
Credit expansion has also been driven by improved credit scoring technology, which reduces the cost of evaluating the credit-worthiness of borrowers (Athreya, 2004). The savings from this decrease in transaction costs have not, however, been passed on to the consumer. In the presence of overwhelming marketing and legal machinery financed by the scale of operations behind it, consumers are unlikely to exert much negotiating power when contracting new debt from SIFIs, especially in the absence of careful prior deliberation, as is often the case with revolving credit. According to Novel Laureate Joseph Stiglitz, financial innovation in the secured credit market has been focused on increasing the short-run profitability of these transactions, rather than reducing the cost of borrowing. Without a reduction in interest rates, an increase in the level of debt leads to an increase in the absolute burden of debt on household finances. The amount of work required in order to meet payment obligations takes away from people’s leisure time and diminishes their ability to engage in the development of civil society.
At the INET conference, Jean-Paul Fitoussi reminded us of the dangers of a strong form of “laissez-faire,” and suggested that if we are to be successful in our search for the optimal level of regulation, we should first repair the link between capitalism and democracy. He asserted that politics must not subject itself to economics, as this is just as likely to create instability as a capitalist system may be the result of movement toward autocracy. A clear advantage of the democratic system is its ability to self-reform, and the statement that capitalism has survived thanks to democracy, echoes the interdependence of political freedom and economic freedom proposed by Nobel Laureate Friedrich Hayek. The development of an active civil society would then be the hallmark of a healthy political system, just as steady growth and the expansion of business is the hallmark of a healthy economic system.
In his keynote speech, Lord Adair Turner, chairman of the Financial Services Authority, questioned the primacy of GDP growth over other economic ends, as there are benefits to economic liberalism, such as economic choice, which are not the result of economic growth and the existence of growth may be more important than its actual level. He also questioned the narrow focus on national accounts, as it can lead policy makers to mistake rent-extracting activities, which are purely redistributive, for real economic growth. The changes in allocation resulting from these activities are unlikely to reduce inequality due to the size of SIFIs and the private nature of the gain. Simon Johnson illustrated that US$2 billion was paid out to five SIFI managers before a bailout and noted their compensation was justified by leverage-driven returns, which are one of the main sources of instability in the financial system. Andrew Sheng asserted that the excess leverage of SIFIs is a symptom of excess consumption rather than its cause, and that the underlying problem can only be addressed by a decrease in consumption. The required reduction in debt growth, which leads to a reduction in economic growth, may not be undesirable, as long as this cost is lower than the cost of continued instability of the financial system.
For more information and videos from the INET conference, visit http://ineteconomics.org/initiatives/conferences/bretton-woods/agenda.
Sebastien Forte is a second year Ph.D. student in economics at McGill University.
Athreya, Kartik (2004). "Shame as it ever was: stigma and personal bankruptcy," Economic Quarterly, Spring: 1–19.
Series: Canadian student perspectives on new economic thinking: reflections from the INET conference at Bretton Woods
The short essays in this series are by CIGI-sponsored Canadian university students who attended the INET conference, Crisis and Renewal: International Political Economy at the Crossroads, at Bretton Woods, NH, April 8–11, 2011. Each student was asked to write a short reflection on the conference themes.