Sudip Bandyopadhyay’s Blog

Why did we mostly get “it” so sensationally wrong?  How did something that looks increasingly like the precursor of a  slowdown or slump creep up on almost all of us last  year?  It is a pretty good question.  It is a pretty embarrassing one, too.  Perhaps this was more than could reasonably be expected.  But we need to ask ourselves whether we could have done a better job of understanding the processes at work.  The difficulty was that we all tend to look at just one bit of the clichéd elephant in the room.  Monetary economists looked at monetary policy.  Financial economists looked at risk management.  International macroeconomists looked at global imbalances.  Central bankers focused on inflation.  Regulators looked at Basel capital ratios and then only inside the banking system.  Politicians enjoyed the good times and did not ask too many questions.  What of commentators?  They tended to indulge in the fantasy that the above knew what they were talking about.  One big lesson of the experience is that economics is too compartmentalized and so, too, are official institutions.  To get a full sense of the risks, we needed to combine the worst Scenarios of each set of experts.  Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of asset price bubbles, financial innovation deregulation and risk management systems might interact.

Just as financial systems act as both lubricant and engines of market economies, we can also now see that today’s leveraged financial systems are inherently unstable. That is why the state needs to be involved in safeguarding systemic stability. The social costs of a systemic failure are otherwise too high. Yet clearly early warnings were not acted on and measures that might have mitigated disaster were not taken.Much is being written about the need for new regulations but this largely misses the point. What has been lacking is a framework for systemic scrutiny that “hard-wires” mechanisms for both sounding early warnings and providing the necessary architecture and instruments to produce a more effective response to the build-up of systemic pressures. At the root of the crisis is the huge increase in leverage in recent years – at the level of banks, asset managers and consumers, embedded within products and now, increasingly, used by governments. We have long known that once leverage reaches certain levels, the system can be vulnerable to shocks that cause a catastrophic loss of confidence. Once this point is reached, the result is panic and a dash for cash, creating the self-feeding vortex of reduced asset prices we see today. Historically most financial crises have during their course destroyed 15-25 per cent of a year’s national income of affected states. We risk this happening today on a global level, given the joined-up nature of the financial system in the liberalised and information technology enabled world.

What should individual states do to prevent a recurrence? First, they should ensure the architecture exists both to help limit the build-up of leverage and to minimise the damage if instability ensues; and, second, create an effective range of policy tools to mitigate the build-up and its impact.