Like most authors, I tend to cringe when I read something I wrote more than a few years ago. But while engaging in some authorial auto-archeology recently when preparing the index for a new paper (after all, if I don’t cite myself, who will?), I was pleasantly surprised with a few bits from a paper I wrote in 1999 and published in 2000 in the Bank of England’s Quarterly Bulletin, titled “The new economy and the old monetary economics”.
The paper takes aim at the assertion, rampant in 1999, that the behaviour in recent years of the world economy, led by the United States, could only be understood by abandoning the old conventional wisdom and adopting a ‘New Paradigm’. Prominent among the structural transformations associated with the New Paradigm were the the following: increasing openness; financial innovation; lower global inflation; stronger competitive pressures; buoyant stock markets defying conventional valuation methods; a lower natural rate of unemployment; and a higher trend rate of growth of productivity.
I argue, first, that the New Paradigm has been over-hyped. “…Unfortunately, the ‘New Paradigm’ label has been much abused by professional hype merchants and peddlers of economic snake oil.”
Second, I argue that, to the extent that we can see a New Paradigm in action, its implications for monetary policy have often been misunderstood.
I was particularly pleased that I had written following about financial innovation:
“Financial globalisation and innovation are a mixed blessing. Properly functioning financial markets improve the global allocation of resources, by offering effective vehicles for channeling saving into domestic capital formation and foreign investment and by providing the means for efficient trading of risk. Efficient risk trading means that risk ends up with the economic agents and institutions most willing and able to bear risk. The superior availability of risk capital in the United States is widely thought to have contributed significantly to the New Economy lead the United States has taken.
Unfortunately, financial markets also can and do shift the non-diversifiable risk in the economy to the imprudent, the reckless, and the fraudulent. The misalignment of the private and social costs of risk that causes such perverse risk trading occurs for legal and institutional reasons and because of asymmetric information among the parties trading risk.
ICT provides unprecedented means for collecting and processing information and for tracking economic agents and performance across space and time. It also provides unprecedented means for concealing information or for creating false audit trails. Normal human greed and widespread access to the Internet, combined with ignorance and hubris, create an unhealthy and possibly dangerous stew of speculative excess at the retail level. Day traders and Internet financial chat rooms are manifestations of this.
When risk is mispriced and misallocated, financial crises and collapses can occur. Financial crashes and associated defaults and bankruptcies are socially costly because they involve a waste of real resources as well as a reshuffling of property rights. When that happens, the aggregate non-diversifiable risk in the economy is not just distributed inefficiently, but its total quantum is increased. Risk that should be diversifiable under orderly market conditions ceases to be so.
Despite inadequate supervision and regulation, the financial innovation process that started in the final quarter of the 20th century probably improves overall economic performance during normal times. It does, however, increase the likelihood of abnormal times—panics, manias and crashes—occurring, and exacerbates the scope and severity of financial crises.”
The purpose of this quote is not just to blow my own trumpet – although, as my father puts it, it’s OK to do so, because if you don’t who will – but also to send out a reminder as to how difficult it is to discern the scope and magnitude of a looming financial disaster, even when you pay serious attention and are naturally inclined not to believe what you are told. By early 2006 I knew that the global financial system was on an unsustainable trajectory that would end in tears. The ludicrously low spreads on anything risky and the shockingly low long-term real interest rates convinced me we were living in financial Lalaland.
But I had no idea about the scale of the excesses, the scope of the mispricing of risk and the crazy ultimate distribution of the risks – often right at the backdoor of those who thought they had sold it. I never anticipated, even when the crisis started in August 2007, that by late 2008, most of the crossborder banking system in the north Atlantic area would be insolvent, but for past, ongoing and anticipated future financial support of the tax payers.
I had no idea that central banks, regulators/supervisors and ministries of finance would decide that, give or take a Lehman or two, all crossborder banks were too big, too complex, too interconnected, too international and too politically well-connected to fail and would therefore be bailed out in a variety of ways with tax payers’ money.
When it was pointed out that ‘a bank failure’ did not have to mean the army corps of engineers blowing up the organisation and permanently wrecking its ability to engage in financial intermediation and new lending and borrowing, but could merely refer to the simple legal process of converting unsecured creditors into new shareholders, in inverse order of seniority and on a sufficient scale, a new argument for not bearding the unsecured creditors of the banks rather than the tax payers was invented. This was the inability of the unsecured creditors (often institutional investors like insurance companies and pension funds) to take the strain of a write-down or write-off of their claims on the banks, or even of a mandatory debt-to-equity conversion.
This argument is bogus. Insurance companies and pension funds, and their beneficial owners and other beneficiaries of course don’t like suffering capital losses. No-one does. But the losses are there. They have been incurred. The only question is who will bear them. The rules of the market game require hard budget constraints. Both fairness and efficiency – incentives for future appropriate risk taking and for minimizing moral hazard require that the unsecured creditors of the banks feel the pain of the banks’ misadventures before the taxpayers do. There are also no systemic externalities associated with having the losses fall on the unsecured creditors, including insurance companies, pension funds and other institutional investors, rather than on the tax payers.
So despite being a keen observer of the financial scene for many years, I did not anticipate anything like the financial disaster that has befallen us, nor the reckless disregard and staggering shortsightedness that is leading those responsible for financial stability to jointly create the mother of all moral hazard machines and thus to virtually guarantee an even bigger financial blow-out in the not too distant future.
One of the reasons for my ignorance (widely shared, I may say in my defence) was the pace of financial innovation in instruments and institutions. Most of the new instruments and institutions were motivated purely by regulatory and tax arbitrage, domestic and crossborder. But some it it was genuine. Even those that were genuine and potentially socially useful (interest rate swaps, securitisation, CDS). Even the genuine innovations were, however, often abused and became socially damaging. CDS provide an example. Just as short selling equity is potentially efficiency enhancing but naked short selling is just gambling, so insuring credit default risk is potentially efficiency enhancing when the buyer has an insurable interest and the writer of the CDS is sufficiently capitalised. Current arrangements permit ‘naked’ CDS buying (buying CDS on a security in excess of the face value of your holdings of that security).
I would not follow George Soros and ban CDS outright. I would require that any writer of CDS or other forms of credit risk insurance be properly capitalised and post additional collateral immediately when his creditworthiness is adversely affected. In addition, I would stipulate that it is only possible to buy CDS when you have an insurable interest in the security it is written on, and that you cannot make good, following default on a security, any claim under a CDS written on that security unless you can present to the writer of the CDS an amount of that security with the same face value as your claim.
Likewise, securitisation will return, but only with an obligation on the originator of the underlying assets to retain a hefty chunk of the highest risk trance (equity tranche or first-loss tranche) it is written on. The five percent figure tossed about in the EU and the US is way too low. At least 10 percent would be required to retain sufficient incentives for the originator to verify the creditworthiness of the ultimate source of the cash-flows underlying the securitisation, and to monitor the relationship over the life of the contract.
I don’t think most of the disasters with securitisation of subprime and alt-A mortgages or with CDS would have happened if there had been a proper vetting of these products before they were permitted. What I have in mind is an FDA for new financial instruments and institutions. Like new medical treatments, drugs and pharmacological concoctions, new financial instruments, products and institutions are potentially socially useful. They can also be toxic and health-threatening.
So there would be a positive list of approved financial instruments, products and institutions. Anything not on the list is forbidden. New items get on the list after thorough testing, scrutiny, gaming, pilot projects etc. It would slow down financial innovation. It would not kill it. We may delay the introduction into the marketplace of socially useful new instruments. So be it.