VoxEU Column Financial Markets

The wrong financial crisis

Catastrophic failures of risk management throughout the entire banking sector multiplied a relatively minor collapse in housing prices into a paralysis of the global finance system not seen since the Great Depression. To fix it, governments should embark on a coordinated fiscal and monetary expansion and a coordinated bank recapitalisation.

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

The first good thing about this situation is that it does not call for different central banks and Treasuries to do different things, but rather for them all to do the same thing in unison without fouling each other’s oars. That should be relatively easy to arrange.

What we need right now are:

  • Coordinated fiscal expansions across the globe.

If the world economy is not now in something close enough to a liquidity trap to make no difference, it soon will be.

  • Coordinated monetary expansions across the globe.

A bank is any organisation that borrows or accepts investments short and lends long; the durations of its assets and liabilities are deliberately mismatched; when the entire banking sector is insolvent at current market prices, anything that reduces interest rates all along the yield curve helps reduce the magnitude of the insolvency.

  • Coordinated banking sector recapitalisations across the globe.

Since at least 1844 there has been broad consensus that the short-term price of safe liquidity is too important to be left to the market; now there is growing consensus that the price of risk is too important to be left to the market as well. For the government to operate on the price of risk through Operations-Twist on a Galactic scale is infeasible. That means that the aggregate degree of capitalisation of the banking system must become the object of policy choice. Call it socialism in one sector.

What we need in the longer term are:

  • Global rules to make outsized compensation incentive-compatible.

The Princes of Midtown Manhattan and Canary Wharf need to know that their fortunes will be lost if their institutions blow up within a decade of their handing over operational control – only in this way can you make them truly long in the fortunes of their firms and of the global economy rather than simply long in volatility.

  • More progressive global tax systems.

We wish we could build a better global economic system, but we do not know how to build one that does not contain a solid safety net for plutocrats, and the systems we do know how to build are politically unsustainable unless all voters know and believe that from those who have much will be taken away. The global market economy continues to evade all our attempts to make it foolproof – in large part because our greater fools are so ingenious. But there is not yet any requirement that this global economic downturn reach the magnitude of 1982, or even 1975.

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