Monthly Archives: April 2014

Are Financial Crises Caused by Governments? Probably Not.

Ever since financial markets imploded in 2008, preventing the next crisis has preoccupied governments and academics across the globe. Most have argued for stricter government oversight of financial markets, claiming that unregulated markets are prone to irrational exuberance, which will inevitably lead to the next boom and bust.

In its recent cover story, The Economist takes a radically different approach. The paper argues that too much government involvement – rather than a lack of it – was to blame for the recent financial crisis. The editors base this argument on an analysis of five financial crises: 1792, 1825, 1857, 1907 and 1929.

Each crisis led legislators to bail out financial institutions deemed systemically important. This in turn encouraged banks to take on more risk, making every next crisis worse than the prior. Since banks (and other institutions) had reason to believe they would be bailed out anyway, they had little incentive to invest prudently.

Moral hazard created a spiral of worsening crises. This could have been prevented, the editors argue, if governments had let banks go bust and let the markets take care of themselves.

Blaming crises on governments is popular among neo-liberal thinkers, partially because it is such an easy claim to make. Since governments are always involved somewhere somehow, no one can disprove the claim that crises wouldn’t happen if markets were completely free.

But just because a theory can’t be disproven doesn’t mean it makes sense.

The Economist is certainly right to argue that bailouts encourage risk-taking and my do more harm than good in the long run. But its argument against government intervention in general is far more flimsy.

If government intervention encourages risk-taking while unregulated markets are more prudent, as The Economist claims, we should be able to find historical evidence for this. But the paper fails to present any.

In fact, much of the irrational risk-taking that led to crises was done by individuals and institutions that were hardly regulated and had no prospect of ever being bailed out. The markets crashed in 1929 because individuals took bets on overvalued stocks. These speculators were hardly regulated by the government and knew they would never be bailed out, and yet they still took risks.

In the lead-up to the 2008 crisis, largely unregulated private-equity funds and mom-and-pop investors were just as eager to jump on sub-prime mortgages as were more heavily regulated banks.

Moreover, The Economist itself points out that the financial crisis of 1907 was caused by investment trusts, which were far less regulated than banks.

It may well be that certain forms of government intervention, especially bail-outs, play a role in making financial crises successively worse. But history shows that unregulated financial actors are at least as prone to irrational exuberance as their more regulated counterparts. Rather than argue against government regulation in general, a more prudent argument can be made in favor of regulation that truly discourages risk-taking.

The Economist makes a convincing claim that deposit insurance and bail-outs encourage risk taking and should be done away with. But other regulations, such as stricter capital requirements for banks or rules forcing lenders to keep some of the mortgages they originate on their books, discourage risk-taking. Getting rid of them would almost certainly do more harm than good.

In Its defense, The Economist does acknowledge in passing that not all forms of government intervention are bad. But at the same time the paper criticizes laws that discourage risk-taking, such as the Dodd-Frank Act or transaction taxes. This leaves the impression that The Economist’s argument is driven more by anti-government dogma than by a calm assessment of which regulations help and which don’t.

We may all crave simple solutions. But, sadly, getting the government out of the markets won’t solve all our problems.

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The Ukraine Crisis Could End Globalization

Remember The Economist’s claim that our era of largely peaceful globalization could come to an end? Four months into the new year, the similarities between 2014 and 1914 have become a bit more obvious.

The magazine was wrong to assume that old-school geopolitics would make its return in East Asia, where disputes over maritime borders could still lead to war. Instead it was Ukraine – the site of the 20th century’s most horrific violence – that cast doubt on the stability of our current world order.

Brookings fellow Thomas Wright recently wrote an article that convincingly explains how much of a threat Russia’s annexation of Crimea is to globalization.

The annexation and following sanctions against Russia brought the world “to the cusp of a period of de-globalization,” he writes.

“The logical response to the prospect of economic warfare is for states and major companies to hedge against the risk of vulnerabilities created by interdependence. They will adopt a strategic approach to integration—pursuing it where it works to their benefit, but stepping away from it when it exposes them to potential actions by a hostile government. This will be a sea change in international economic policy and U.S. grand strategy more generally.”

This selective approach to interdependence would differ sharply from previous decades, when countries strove to participate in the global market as much as possible. Wright argues that this “sea change” would have happened anyway, even if Russia hadn’t invaded Crimea:

 “Globalization was always especially vulnerable to geopolitical shocks. The great power comity of 1991 to 2008 was never going to be permanent. It is perhaps better that this realization comes in a stand-off with Russia, the world’s eighth largest economy and one that has already been distancing itself from the global economy, than a crisis involving China, the second largest economy, which could do real damage to the United States and its allies.”

In theory, a more selective approach to globalization could lead to a boom in protectionism across the world. This is exactly what happened after 1914, when geopolitical disputes ended decades of unfettered globalization and ushered in an era of closed-off national markets and recurring economic crises.

But Wright is optimistic that history won’t repeat itself in this case. He argues that countries will seek to diversify trade rather than not trade at all, which will give them more security without having to resort to protectionism.

“Major powers will identify areas where interdependence creates a real strategic vulnerability—especially on finance, energy, and cyber—and reduce them gradually over time. Rather than erecting barriers, diversification could achieve the same effect with much less cost.  As they look to deter Russia, the United States and Europe should also be cognizant about the precedent they are setting.”

 (…)

 “Done right, a more strategic approach to integration and international order can put interdependence and globalization on more stable footing, which will serve the world well as it faces what could become a competitive and volatile couple of decades.”

Let’s hope he is right. But history – and Putin’s current foreign policy – show that governments often don’t act as rationally as we would like.

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