On Wednesday, 26 March, Martin Wolf of the Financial Times proclaimed, “The dream of global free-market capitalism (has) died.” According to Wolf, three decades of movement towards market-driven financial systems, the core of capitalism, supposedly ended with the US Fed’s rescue of Bear Stearns. Wolf sees a reversal of deregulation in the US, and countries such as India and China, being influenced by the “failure” of deregulation. As if to bear him out, a few days later the US treasury secretary proposed the most sweeping overhaul of financial system regulation since the Great Depression. Subsequently, the news has only seemed to get worse.
But I think Martin Wolf gets it mostly wrong in his analysis of the global financial system. The US treasury proposals are closer to the mark, but they also miss the target in some dimensions. Understanding the variety of financial systems is critical to designing regulations that reduce the chance of further messes. Wolf lumps everything together in his characterization of the liberalized financial system as an “unregulated, but subsidized, casino”, but his greater mistake is to neglect the nature of financial systems and their role in the economy.
The fundamental role of financial intermediaries is to channel funds from those who have them to those who can put them to productive uses. Those uses involve risks of failure, and intermediaries also devise ways to pool and spread the risks. So, the financial system increases aggregate risk, but it also increases returns. Along the chain from source of funds to final use, some intermediaries exist only to invent new ways to pool and spread risks, or to look for profit opportunities through arbitrage, which then competes away those very opportunities. The whole system benefits from better disclosure, and from clear and enforceable penalties for fraud. It is also subject to risks associated with loss of confidence among the suppliers of funds — this leads to liquidity crises (“credit crunches”).
Governments (and international financial institutions set up by governments) have learned to play a key role as ultimate managers of risk, through their size and ability to provide liquidity as creators of money. Ever since the Great Depression, banks and other retail deposit institutions have been protected by explicit insurance provisions. With each step towards a more unified financial system, the insurance role of government has grown.
In the US, the government stepped in after the savings and loan crisis of the 1980s and the Long-Term Capital Management (LTCM) crisis of 1998, to maintain confidence in the financial system. In the first case, retail depositors were protected, but shareholders sometimes lost. In the LTCM fiasco, the company’s investors certainly took a big hit. That is true for Bear Stearns’ shareholders as well. The Fed’s provision of liquidity to JPMorgan Chase, the acquiring firm, will ultimately cost taxpayers, but this is effectively an everyday cost, collectively borne by society to spread risks in a way that allows greater average returns.
The latest financial crisis, and the Fed’s responses, while different in specifics, are very much in character with previous episodes of instability. And, a closer look at the US Treasury proposals shows they are mostly long-term and overdue adjustments to the regulatory framework. Integrating regulatory oversight of financial exchanges, and broadening the Fed’s monitoring of the health of the system beyond commercial banks, are changes required both by previous liberalization, and by the increased complexity and interconnectedness of financial markets. There is no sharp reversal of financial liberalization—instead, just a recognition that regulation needs to catch up with the changes. Catching up is also one aspect of the US proposals to change regulatory oversight of mortgage origination. The problem there has partly been that state-level regulation has been lax and poorly implemented—federal standards and federal scrutiny will help fix this. And, the “small guys” who were duped into unviable subprime mortgages will probably get better protection than the shareholders of Bear Stearns.The US Treasury also proposes more light-handed, “principles-based” regulation and more self-regulation, again expressing confidence in modern financial systems, contrary to Wolf’s pessimistic views. This regulatory shift may be harder to justify in the current climate, especially politically, but also in terms of economic principles. But that debate is a subtler one than a general condemnation of markets. The issue is the practical matter of how best to control fraud and negligence, not of broad ideology. Ultimately, the financial system will manage most of the risks it creates in the search for higher returns — government regulation provides the enabling environment for this, and the critical role of lender of last resort. Risks are managed and spread, not necessarily reduced.
The ultimate lesson for countries such as India and China is that financial liberalization is here to stay. The US is moving to correct the specific mistakes it made, as well as allowing regulation to catch up with previous structural changes in the financial system. Emerging economies can learn from US mistakes without panicking, and build vibrant financial sectors.