Dealing with the financial crisis

Since I moved to The Times full time in the summer, I've written mainly about the financial crisis. I wrote a post a few weeks ago setting out how, in my view, the crisis came about. In this post I comment on the policy responses.

There are three principal ways in which the developed economies, and in particular the US, are trying to resuscitate the world's financial system. First, policymakers are injecting huge sums into the system. There are widespread problems of insolvency; it is essential to provide adequate liquidity so that those problems don't get worse. Secondly, governments are recapitalising the banks. In the UK, the bank rescue has involved acquiring equity stakes directly in threatened institutions. And thirdly, governments are attempting a major stimulus to the economy so that the financial sector is not weakened even further. This is of course being discussed urgently within President-elect Obama's transition team. (The high quality of Obama's Treasury appointments is excellent news, incidentally.)

All of these approaches are right, including the type of bank rescue that's being attempted. (I support the acquisition of equity stakes in the banks, on the assumption that these will be sold once market conditions allow.) And while I might be disastrously wrong on this, I am hopeful that these three elements in a rescue of the financial system will work. If they don't, then - apart from the terrible economic consequences - some ugly and xenophobic political currents are likely to grow.

Beyond those short-term measures, there need to be institutional reforms to the financial system to prevent such disasters happening again. Here are some that I think are necessary:

1. Reform of the capital adequacy regime for banks (known as Basel II) so that it is countercylical, i.e. more capital is required during an economic expansion.

2. Overhaul of financial regulation. In the UK, the tripartite system of regulation - divided among the Treasury, the Bank of England and the Financial Services Authority - has plainly failed. When Labour took office in 1997, Gordon Brown gave operational independence to the Bank of England in setting interest rates (a good thing), while removing banking supervision from the Bank's remit and giving it to the newly formed FSA (a total shambles). Apart from any other weakness, this division of responsibility between monetary authorities and regulators meant that neither tried to moderate the destructive bubble in house prices.

3. Reform of the ratings agencies. There is clearly a conflict of interest in a system where the income of the agencies comes from fees paid by the issuers of the debt that they're rating.

4. Reform of bankers' compensation. I do not mean by this that the Government should set bankers' pay. Governments have no legitimate interest in deciding the proper rent of ability in the marketplace; their role is to redistribute through the tax system in order to reduce inequality. But, as I argued in this post, there is not a genuine market in top bankers' pay. Pay needs to reflect the risks that bankers take on - so that if, say, a trading position taken in Year 1 blows up in Year 3, something should be clawed back from the bonus paid in Year 2. The regulators can create incentives for banks to operate this kind of compensation scheme, through the system of capital requirements.

Those are reforms I support. But having followed a lot of press coverage of the crisis, I'm concerned that some bad ideas are becoming popular. Two in particular should be dismissed out of hand. These are a ban on short sales, and a so-called Tobin tax on capital market transactions. I argued the case on short sales in this article. Targeting short-sellers is a nice example of punishing the messengers of bad news. And among the many problems of a tax on supposed financial speculation is that, if it were big enough to make any difference, it would ensure that trading would migrate from organised exchanges to over-the-counter derivatives instead. The notion that this would moderate speculation and asset bubbles is absurd: it's a guaranteed way of increasing systemic risk.

One last observation on this subject: it is a hot debate whether financial crises are an intrinsic feature of capitalism or are merely the outcome of specific policy errors. The work of a theorist once regarded as a maverick, Hyman Minsky, has suddenly become fashionable. (I've debated the crisis recently with Nouriel Roubini of NYU and - just this morning - George Magnus of UBS, both of whom were eerily prescient in their predictions and who cited Minsky in our discussions.) Minsky believed that financial crises recur and follow a predictable pattern of speculation, credit expansion, asset-price euphoria and crash.

I'm agnostic on this. But I worry that if we buy into the notion of inherent financial instability, we might overlook an important point. The Times argued in a leading article this week that the crisis has roots in errors that might have been corrected. The virtue - and it is a great one - of a market economy is that it enables us to learn from past mistakes rather than be doomed to repeat them.

Comments

[David Duff]

I am a novice when it comes to director's remuneration, so please, anyone, feel free to tell me wher I have gone wrong with this idea:

By law, the total salary/bonuses of directors of all public companies should be divided in the ratio of, say, 60/40. The 40, representing the bonus element, should be further divided 20/20, that is, 20 as cash paid on an annual basis (if earned) linked to targets; and 20 as shares issued annually (if earned) but *not* redeemable for 5 years.

Thus, the directors would be forced to contemplate the medium term effect of their actions and would suffer, or enjoy, the fate of their shareholders.

[sherry]

Not enough credit is being given to the high gas prices this past year and it's serious damage on our economy and society. That one factor alone has caused serious stress in both individuals and businesses. A record number of homes and jobs have been lost as a direct result. And, while we are doing the happy dance around the lower prices at the pumps OPEC is announcing cuts to manipulate the prices upward again. We must get on with becoming energy independent.We can't take another year like this past. There is a wonderful new book out about the energy crisis and what it would take for America to become energy independent. It covers every aspect of oil, what it's uses are besides gasoline, our reserves, our depletion of it. Every type of alternative energy is covered and it's potential to replace oil. He even has proposed legislative agenda's that would be necessary to implement these changes along with time frames. This book is profoundly informative and our country needs to become more informed and move forward with becoming energy independent. Green technology would not only provide clean cheap energy it would create millions of badly needed new jobs. The Book is called The Manhattan Project of 2009 Energy Independence NOW. Our politicians all need to read this book. www.themanhattanprojectof2009.com

[Craig]

"Minsky believed that financial crises recur and follow a predictable pattern of speculation, credit expansion, asset-price euphoria and crash."

What role did Minsky think that central banks played in this speculative pattern?

Surely the question of whether markets are inherently unstable can't be answered without acknowledging that in all modern economies the supply of loanable funds is decided on by a government agency with a monopoly on note issue.

We reject the idea of central planning in the production of goods and services, yet we continue to believe that central bankers can know how much money the economy needs at any given time. Surely their propensity to supply too much or too little capital must have something to do with bubbles.

[Matthew]

Oliver, when you say the Boe/FSA split meant no-one took responsibility for high house prices, is this actually the reason? Or was it that enough influential voices didn't believe there was a housing bubble, or that there could be a housing bubble given rational consumers? I'm just wondering whether merging the two would help, or whether they would have to be given an explicit target for house price increases, or at least a series of warning indicators. I don't see why instutional reform on its own would make a huge differenc.

For instance Quoting your colleague David Smith in Oct 06 argued "Perhaps not at all, because housing was not overvalued [referring to start 06" and quoted "Professor Steve Nickell, then a member of the Bank of England's monetary policy committee" who cited "three factors -low levels of housebuilding, low short- term interest rates and, most importantly, low long-term real (after- inflation) rates -and said: "It may be legitimately argued that there has been no housing bubble whatever." Indeed, it could be argued on the basis of his analysis that prices were still undervalued.

That was in Sep 05, and prices clearly rose after that quite some way, but if that's what an MPC member and leading commentator were arguing, would putting the BoE in charge have made a huge difference?

Sorry for length of this comment

[Peter T]

Oliver,

A few weeks ago you recommended a book by Robert Shiller (The Subprime Solution) that also contains some remedies for the current financial difficulties.

I'm struck by the fact that Shiller's most ambitious reform, the creation of a liquid market in real estate, is not on your list. Shiller's point, as I'm sure you will recall, was that, by giving investors the chance to engage in the much maligned practice of short-selling, bubbles in real estate could be tamed.

The reason for this was alluded to by Matthew in the post above. The regulators failings did not cause the bubble; the bubble caused their failings. I.e. the feeling that property was a "one-way" bet spread like a contagion through society and justified irrational decisions, a lack of enforcement of regulation and malpractice by credit rating agencies to name just a few examples.

Surely the best remedy is to prevent the formation of bubbles in the first place? (Obviously reform of the regulatory infrastructure could be carried out in parallel)

Given this, I would be interested to hear your views on Shiller's proposal. Do you think it is unworkable?

[Richard T]

Whilst I agree with the general tenor of what you write, the Bank of England was not necessarily a competent regulator of the banking system - BCCI anyone?

[JOHN CHUCKMAN, TORONTO]

Gee, you were on such a tear over Noam Chomsky, I would have thought you'd give us his views here.

[Jack]

Short selling didn't stop the the equity market bubble which peaked in 2000. The only remedy I can see is large sovereign wealth funds which follow a contrarian investment strategy. If banks were forced to match their deposits with treasury bills (thereby eliminating gearing from their balance sheets) the government would raise huge funds which could be invested in the equity and property markets. When the appetite for these assets rose, they could sell into the market to prevent bubbles developing.

[andrew]

'Government's role is to redistribute through the tax system in order to reduce inequality'-You say this as if it is a given. As far as I'm concerned, tax is to pay for government services, not dole it out to people too lazy or stupid to earn their own living. Yes, this government is redistributing like crazy, but it doesn't have to be this way.

[The Dandiprat]

I'm puzzled as to how it is considered right, when banks are losing money, for the taxpayer to acquire equity stakes in them, only on the understanding that such stakes must be sold off 'when market conditions allow' ie when they might start showing a return on the investment.

[Simon Stephenson]

ANDREW : 29 Nov : 07:39:49

Weren't you aware that your idea has been disproved? The Labour Party decided that it was never going to get anywhere discussing the use of taxation for redistribution, so it "moved on" to making its public statements on the basis that there was no debate - redistributive taxation was established as an unquestionable "good".

All sorts of other ideological debates were wound up as part of the same initiative, with Labour politicians refusing to become involved in any discussion that questioned the validity of the new absolute truths.

So politics has become no more than a slanging match as to which party will best manage a state of affairs to which no substantive alternative is possible.

Finally, politicians have devoided themselves of the burdensome duty of taking responsibility for their actions by contracting out implementation to bodies purposely beyond their direct control.

Clever, eh?