This commentary is based on an open letter sent to Prime Minister Gordon Brown and other leaders of the G-20 ahead of their summit in London on April 2, 2009. The unabridged version of the letter is published at http://capitalism.columbia.edu/files/ccs/CCSletterG20-2009_March%2024FINAL.pdf#. The letter sums up the main recommendations presented in New York City on February 20 at a conference at Columbia University’s Center on Capitalism and Society. The conference,“Emerging from the Financial Crisis,” brought together distinguished policymakers, bankers, regulators, journalists, and scholars. The list of conference panelists, video excerpts, including Paul Volcker’s luncheon speech, can be found at lhttp://capitalism.columbia.edu/files/ccs/6Program_0.pdf#. Participants’ presentations, elaborating the conceptual foundations and policy recommendations put forth at the conference, can be found at http://capitalism.columbia.edu/working-papers.
When the G-20 leaders convene in London next week to propose measures to address the global economic crisis, re-regulation of the financial sector will be high on the agenda.
Although the need for re-regulation is clear, the key issue is how to design regulation without discouraging funding for investment in innovation in the non-financial business sector. In regulators’ understandable desire to rein in the financial sector’s excesses, there is the danger that policymakers – often pushed by the public – will adopt rules that dampen incentives and competition to the point that the sources of dynamism in the economy are weakened.
The need to encourage entrepreneurship and ensure that young people have the opportunity to start new businesses is acute. Even in the usually innovative American economy, dynamism has declined over the current decade, with economic inclusion – high employment rates and careers permitting ordinary people throughout society to flourish – also decreasing.
The housing boom, of course, masked this decline in economic dynamism and inclusion. Now that the boom has ended, it is clear that a durable return to a normal degree of prosperity and inclusion will not take place until the financial sector is reoriented away from mortgage lending and reshaped to serve first and foremost the business sector.
A new regulatory framework must be internationally consistent, particularly in areas such as capital adequacy, liquidity management, and financial reporting standards for financial and non-financial corporations. The “non-cooperating centers” must also be regulated on a global and consistent basis. And new international arrangements should address the devastating impact of financial contagion from advanced countries on many emerging markets, in part by providing additional resources to multilateral lenders.
At the same time, several key areas should be on the reform agenda. The first concerns regulating the scope of activities of banks, which, since the extreme dismantling of the regulatory framework in the late 1990’s and early 2000’s, have engaged in highly speculative and leveraged trading activities.
Since the costs of financial conglomeration are not offset by its informational advantages, some have called for a return to “narrow banking.” Commercial banks would use their deposits to make loans to consumers and small and medium-sized businesses, which would also facilitate risk management by re-personalizing relationships between bankers and their clients. Investment banks might not be allowed to accept deposits from households and, possibly, non-bank businesses.
By focusing regulation on deposit-taking banks, all other financial institutions – including hedge funds, private equity funds, and other sources of risk capital that underpin economic dynamism – could bear the risk of bad decisions, without much regulation or potential cost to taxpayers (though with supervision to avoid systemic risk). Narrow banks could restart effective intermediation and ensure that consumers and employment-creating small and medium-size enterprises are adequately financed and can contribute to the reactivation of the economy.
Moreover, the demise of banking conglomerates during the crisis offers an opportunity to devote at least the part of the public resources that have been earmarked for restructuring existing banks to the creation of a new class of banks. The new institutions will catalyze the reorientation of the financial sector toward serving the business sector by financing long-term investment and innovative projects.
At the same time, countries ranging from France and the Netherlands to Singapore and Chile are adopting subsidies to companies for ongoing employment of low-wage workers. A development bank – specializing in project finance for infrastructure development, new technologies, and investing in the working poor, the environment, and other capital projects – could be the ideal institution to channel and monitor this type of subsidy.
The crisis also appears to provide an opportunity to develop more inclusive financial markets. The new regulatory framework should aim to “democratize finance” by redressing asymmetries in information, mainly stemming from informational the gap between sophisticated institutional market players and retail customers. This would enable households to expand their risk management through futures markets, home equity insurance, and continuous workout mortgages.
Finally, the new regulatory framework must address excessive swings in equity, housing, and other asset prices. It was the sharp reversal of upswings in equity and housing prices far above historical benchmark levels that helped to trigger – and continue to fuel – the financial crisis. As the downswings continue, there is a real danger that they may also become excessive and drag the economy and the financial system into an even deeper crisis.
A new conceptual framework – Imperfect Knowledge Economics (IKE) – provides the rationale for policy intervention in asset markets, and also has important implications for how regulators should measure and manage systemic financial risk.
IKE acknowledges that, within a reasonable range, the market does a far better (though not perfect) job in setting prices than regulators can. But it also recognizes that price swings can become excessive, imposing high social costs. IKE suggests a panoply of novel measures, including “guidance ranges” for asset prices and targeted variation of margin and capital requirements, to help dampen such excessive movements.
One of this framework’s important policy conclusions is that wholesale restrictions on short‐selling (and other such measures that pay no regard to whether an asset is over- or undervalued) could actually lead to greater instability. Yet improving the ability of financial markets to self‐correct to sustainable values is the entire point of prudential regulation. Rules that are beneficial in some circumstances may become counterproductive in others. The prevailing view that policymakers should be bound by fixed rules will not do.
Edmund S. Phelps, the recipient of the 2006 Nobel Prize in Economics, is the Director of the Center on Capitalism and Society at Columbia University. More information about the Center can be found at http://capitalism.columbia.edu.