Page 80 - The Economist Asia January 2018

The Economist January 27th 2018
64 Finance and economics
Free exchange What could possibly go wrong?

Blame recurring financial crises on the political temptations ofderegulation
OR a phenomenon with such predictably bad outcomes, a fi- regulation, but these rules are now beingweakened, even as exu-
Fnancial boom is strangely seductive. Not a decade after the berance returns. America’s Congress is expected to tweak the
most serious financial crisis since the Depression, the world Dodd-Frank Act in coming months to limit the application of
watchessoaringmarketswith a mixture ofserenityand glee. Nat- some rules to the largest banks. Republicans seem to lack the
ural impulses make finance a neck-snappingly volatile affair. votes to eliminate the new Consumer Financial Protection Bu-
Governments, though, deserve heaps of blame for policies that reau, but President Donald Trump’s choice to run it, Mick Mulva-
amplify both boom and bust. As regulators begin picking apart ney, has long expressed a desire to neuter it. The Federal Reserve
reforms only just enacted, it is worth askingwhy that is so. is drafting plans to reduce bank-capital requirements. (Post-crisis
Finance ishopelesslyprone to wild cycles. When an economy revisions to the Basel bank-capital standards for global banks en-
is purring, profits go up, as do asset values. Risingasset prices flat- couraged regulators to set a countercyclical capital buffer, which
ter borrowers’ creditworthiness. When credit is easier to obtain, should rise with financial excess; the Fed’siscurrentlysetat zero.)
spending goes up and the boom intensifies. Eventually percep- Not every element of the deregulatory push is reckless, and
tionsofriskshift, and talesofa “newnormal” gain credence: new America is tougher on some aspects of capital than others, but
technologies mean profits can grow for ever, or financial innova- the timingispoor—comingamid historicallyeasyfinancial condi-
tion makes credit risk a thing of the past. But when the mood tions and soaringasset prices (see chart).
turns, the feedback loop reverses direction. As asset prices fall,
banks grow stingier with their loans. Firms feel the pinch from Technical defaults
falling sales, get behind on their debts and sackworkers, who get One reason is that regulators are, like everyone else, too eager to
behind on theirs. The desperate sell whattheycan, so asset prices conclude that this time is different. Many proposed post-crisis re-
tumble, worseningthe crash. Mania turns to panic. forms offered technical solutions to the industry’s problems,
The pattern is an ancient one. In their book “This Time is Dif- such as better measures offinancial instability or reforms to CEO
ferent”, Carmen Reinhart and Kenneth Rogoff, two economists, pay to improve bank behaviour (and reduce the need for robust
point out that eight centuries of financial pratfalls have not per- regulation). Yet in finance, as in much of economic policy, pro-
suaded investors to treat financial booms with the requisite cau- blems that looktechnical are in fact political. As Charles Calomi-
tion. You might expect Joe Daytrader to succumb to the lure of fi- ris and Stephen Haber describe in their book“Fragile by Design”,
nancial excess, butthe chronicallypoorresponse ofgovernments governments are not neutral observers of the financial system;
is more perplexing. Regulators could dampen frenzies by asking theyalso depend on it, fortheirown financingneeds, among oth-
banks to raise their equity-to-assets ratios or to tighten lending er things. This co-dependency means that the evolution of bank-
standards. Regulation could be “countercyclical”, in other words, ingregulation isshaped bybargainingbetween bankersand poli-
leaning against the natural financial cycle in order to limit excess, ticians, not all ofwhich aims to maximise social welfare.
prepare financial institutionsforbad times, and leave more room In a newIMF workingpaper, Jihad Dagherexaminesthe polit-
for leniency when the economy is on the ropes. Governments ical-economyelementsoften financial crises, beginning with the
have got better at leaning against turns in the business cycle, so South Sea Bubble in Britain, and finds they had much in com-
that recessions are less common and less severe than they once mon. They were often preceded by periods in which light-touch
were. It seems strange that finance should be different. regulatory thinking was in the ascendant. Such an approach be-
Indeed, regulation isoften “procyclical”: itaddsfuel to the fire. comeslesstarnished asmemoriesofpastcrisesrecede, and open-
In the decade up to the global financial crisisAmerica rolled back ing credit taps often brings short-run political rewards. As dereg-
Depression-era bank regulations, protected liberal trading rules ulation proceeds, politicians’ electoral hopes—and, sometimes,
for derivatives, presided over a wave of banking-industry con- their own financial interests—rely on the burgeoning booms. So
solidation and tolerated a dangerous drop in mortgage-lending they become more sympathetic to financial interests. When Brit-
standards. The ensuing crisis prompted a wave of new financial ain’s Parliament voted to protect the value of shares in the South
Sea Company, for example, many of its members owned some.
Crisesare usuallyfollowed bya political backlash, which sweeps
When the sun shines in new leadership with a mandate to regulate. Warren Buffett’s
US capital markets famousfinancial axiom—thatonlywhen the tide recedescan you
S&P 500 stockmarket index National Financial Conditions Index* see who has been swimming naked—also applies to politics. At
1941-43=10 Long-term average=0 times of financial excess, voters cannot easily tell responsible
3,000 3 leadersfrom recklessones. Negligence becomesobviousonly lat-
er. That makes recklessness an attractive political strategy.
2,500
2 Is there any hope of escaping such cycles? Central-bank inde-
2,000 TIGHTER pendence helped depoliticise business-cycle management. Giv-
ing central banks more regulatory responsibility, as many coun-
1,500 1 tries did afterthe crisis, might therefore help (though it might also
+ encourage politicians to meddle more with central banks). Curb-
1,000
0 ing the power of the financial industry might prove more effec-
500 tive, but fornow there is little political appetite for bold strategies
–
such as breaking up large banks. If this time is different, it is only
LOOSER
0 1
1998 2005 10 15 18 1998 2005 10 15 18 because the lessons ofhistory have been discarded so quickly. 7
Sources: Thomson Reuters; Federal Reserve Bank of Chicago *Includes risk, credit and leverage
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