Fixing the financial system

Axel Leijonhufvud 13 January 2009



The American financial system is in shambles. There is a myriad of issues to be dealt with in order to put it back in working order. Many of the markets for recently invented instruments lack transparency1 and some require legal clarification of the rights and obligations of the contracting parties. Securitisation as practiced until now is beset with agency problems. The problem of institutions “too big to fail” has gotten worse than ever. The boundaries of matters for which the Federal Reserve takes responsibility have lost all definition. In the scheme of things, however, these are “details” – even if there be a devil in each one.

The central focus of any reform effort must be on how to deal with the two systemic problems I identified in yesterday’s Vox column, the ones that are not subject to market-driven negative feedback control, namely the price level and system-wide leverage.

Thinking beyond ideology

The early stirrings of political debate on reforms have been unthinkingly ideological. Proponents of free markets argue that none of our present problems would have happened except for government interference in housing and mortgage markets. Others regard markets in general as unreliable and would like to see virtually all financial markets tightly regulated and all financial institutions closely supervised. One side needs to recognise that system-wide leverage is not stabilised by market forces and that fluctuations in it are destabilising to the real economy. The other side needs to recognise that properly structured financial markets will generally work well and that governments are unlikely to find competent supervisory talent that could improve their functioning.

What stabilised the system for the last 75 years?

The factors that make overall leverage unstable have long been in operation. What kept the threat of another Great Depression from materialising for all of 75 years?
The Glass-Steagall Act regulations, which were abolished in 1999, are not the whole answer but nonetheless they are a big part of the answer. They effectively constrained the leverage of the American banking system. For a variety of reasons there cannot be a return to this system of regulations. To construct a regulatory framework that does the same job and has global reach will not be easy.

Ideas for the new financial regulatory system that is needed

Two elements of a reconstructed system of regulatory control may be suggested.

  • First, re-impose effective reserve requirements on deposit-taking banks and extend them to all types of institutions that carry demand liabilities (e.g. money market funds).

There is another reason – apart from the desirability of constraining leverage – that argues for the re-imposition of effective reserve requirements on banks.
At present the economy faces strong deflationary pressure. If, however, all the extraordinary measures taken by the US Treasury and Federal Reserve were to succeed in stopping the slide towards depression, output in the economy would stabilise surrounded by an enormous pile-up of inflationary tinder. If inflation once got under way under such conditions the Fed’s control of the overnight federal funds rate would be a slender reed indeed to lean on in trying to stop it. Effective reserve requirements would restore a bit of a nominal anchor to the system and enable the Fed to operate with a tighter rein on the banking system than at present.2

  • Second, extend reformed capital requirements to virtually all financial institutions.

The Basel-type capital requirements, however, need to be reworked. As presently structured they have tended to amplify leverage movements, permitting expansion in the boom and forcing liquidation in the bust. A desirable property for the capital requirement formula would be to gradually tighten on the upswing and relax on the downswing.3

Finance and income distribution

The policy issues raised by recent booms and busts are not confined to problems of stabilisation and financial reform. Over this period, income inequality has also risen dramatically, especially in the US but also elsewhere. The upper tail of the distribution has moved farther and farther away from the median and nowhere more so than in the financial sector.

High leverage can be immensely profitable as long as the going is good. During the years of the “Great Moderation” the going was good indeed. Executives of financial institutions were able to appropriate for themselves a good share of the profits generated by the new financial engineering. High salaries and astounding bonuses seeped down into lower hierarchical levels of the industry even as the financial sector grew considerably faster than the rest of the economy. Competition from finance pulled up managerial compensation in other sectors as well. The lessons of high leverage also spread beyond Wall Street as many non-financial corporations learned to issue debt and buy back equity.

For most of the powers on Wall Street, serving the common good was probably “no part of their intention.” Nor in the end was it the result. The invisible hand did not transubstantiate private greed into public harmony. But the sense of entitlement of our new managerial class has gained strength over recent decades that it did not have 40 or 50 years ago. Resistance to taxation is correspondingly hard. Constraining leverage in the financial sector may serve to moderate income inequality or at least slow down its growth.

Editors' note: A slightly fuller version of this two-column series appears as CEPR Policy Insight No. 29.

1 The most critical matter at the present time is the market for credit default swaps which needs to be thoroughly restructured so as not to pose an imminent danger to the stability of the entire system.
2 Until recently the US federal debt was on the order of some 60% of GDP. Although unfunded liabilities for Social Security and Medicare would add huge numbers to the debt, the situation was still generally regarded as manageable. According to the Los Angeles Times (Nov. 30, 2008) Treasury and Federal Reserve commitments to the current stabilisation effort total approximately $8.5 trillion. This impressive number is made up of actual spending, lending against collateral, loan guarantees, etc., so how much of it will end up adding to the national debt is highly uncertain. Yet, one has to worry that the US is edging into a zone where a potential inflation would be hard to deal with.
3 Spain which is facing its own housing bubble has capital requirements based on a weighted sum of the bank’s assets, the weights determined by past default frequencies for different asset classes. As a consequence the Spanish banks have loan-loss reserves that at least so far vastly exceed defaults.




Topics:  Financial markets

Tags:  Inequality, financial crisis, regulation