Four words—complexity, inflexibility, speed and scale—set the current crisis apart from the previous ones. Robert F. Bruner offers antidotes for all four.
When J.P.Morgan saved the New York financial community from the Panic of 1907, the US finally awakened to the need for a strong central banker: one who could marshal resources, organise bankers, and galvanise society to fight the crisis. The growing financial demands of modern society changed the minds of consumers, business people, and eventually the Congress. Virtually every financial crisis in the past 100 years has been followed by hearings, civil and criminal litigation, and ultimately, new laws and regulations.
The current crisis overshadows previous crises in four key ways: complexity, inflexibility, speed and scale. Complexity appears in the exotic securities, the complicated financial institutions, and the innumerable linkages among firms and markets—making it difficult for decision-makers to know what is going on.Inflexibility is reflected in the historically low reserves and high borrowing of firms and individuals in early 2007. Speed appears in our ability to get news and transfer funds at the speed of light—this means that trouble can travel rapidly. Scale is evident in the massive losses on subprime loans and other debt.
Leaders should address these four novelties as they design the new global financial system. The antidote to complexity is transparency. Complexity can hide the reality about financial conditions. This leads to greater uncertainty in the minds of investors and can cause irrational behaviour among players. Runs on solvent banks arise where depositors cannot tell the difference between those banks which can meet their financial obligations and those which cannot. The first remedy to future crises is greater transparency in the form of stronger reporting requirements to the public. The antidote to inflexibility is insurance.
Firms and individuals who want to borrow should be required to purchase “shock absorbers” with which to withstand a loss of income, natural disaster or default. The most basic kind is a “rainy day account,” a reserve fund of cash that a firm or individual could use in case of adversity. The Basel Accords have dictated an international standard of the minimum amount of capital banks should have—the leaders should evaluate the standard in the light of recent experience with the risky assets (such as subprime loans) in which banks can invest.
The antidote to speed is a coordinated braking mechanism. Trading in markets can be suspended, as can cross-border capital flows. The theory is that suspensions can provide a “cooling off” period in which news and information can disperse, allowing panicked players to assess the situation more fully. The brakes need to be applied infrequently and carefully. If players in the market can correctly anticipate a reaction by governments, the players will begin to game the system. The word, coordinated, deserves special consideration by the leaders: it makes no sense for the New York market to suspend trading when many of the same securities can be traded in London or Tokyo—in this era of global financial markets, players can simply end-run the interventions of any one country by moving their trading to another venue. We will likely see greater coordination among countries in the future.
The antidote to the massive scale of losses will be the creation of larger reserve institutions. The International Monetary Fund (IMF) was created at Bretton Woods in 1944 to be the lender of last resort to countries experiencing financial crises. But the capital base of the IMF today is only $265 billion. This is insufficient to make a dent in the scope of America’s financial crisis. Global leaders will have to create a more muscular multilateral institution.These antidotes, however, are not a panacea; they can only influence the occurrence and severity of future crises; they cannot prevent them. Worse, over-exuberant regulation in any of these areas could have costly side-effects on economic growth, innovation, and global trade. No doubt, there will be more aggressive proposals, such as a global currency, wealth redistribution schemes, or tariffs on foreign trade. Finally, though the sense of urgency is laudable, to start tinkering in the depths of a crisis seems hasty. As the saying goes, the road to hell is paved with good intentions.
The “new deals”
Several governments are trying an encore of FDR’s New Deal of 1933.
US: $4.6 trillion—The largest in American history. This includes $100 billion each to Fannie Mae and Freddie Mac, $150 billion of capital to AIG, $245 billion to save Citigroup. The US Congress is considering another stimulus plan worth $700 billion
Germany: $675bn— The financial rescue package approved by Parliament in October will add to a $31-billion stimulus plan.
Japan: $51bn— Approved in October, on top of the $119-billion package in August.
South Korea: $10.9bn— Announced in November to avert a recession.
China: $586 billion—plans to spend this by 2010 on infrastructure and welfare projects.
India: Rs 46,940 crore—is the Planning Commission’s estimate for the bailout and fiscal stimulus packages so far.