A system overwhelmed by innovation

By Clive Crook 2008-10-20

The stunning scale of the interventions under way in financial markets - barely imaginable just weeks ago - make it seem that nothing will ever be the same. A crisis so grave, so weighted with ideological implications, must point to a grand political realignment, with much of what we thought we knew about the role of governments and markets overthrown. So it is argued, and so many people hope.
It is possible. It happened after the Great Depression. But I doubt that this crisis will change the world anything like as profoundly. In the end, I doubt it will even overthrow much of the conventional wisdom about states and markets.
In thinking through the parallel with the 1930s, the important question is how far the financial emergency will infect the rest of the economy. The Depression changed the US and the world because it wrecked the lives of countless millions of people.

The US and many other countries face a bad recession - but surely nothing to compare with that sustained catastrophe. Ragged as the response to this emergency seems, we will look back and say that, compared with previous crises, the remedies were both prompt and massive. Notwithstanding the past few weeks' arguments about how to stabilise the situation, we will also say that consensus was achieved with surprising speed - and that the willingness to support it with sufficient resources (meaning without limit) was never really in question. In short, the mistakes of the 1930s are not being repeated.
Sorting out the details of the response will be messy but the principles are now clear and policy is forming around them. First, address illiquidity in the market for mortgage-backed securities. Second, inject public capital on a huge scale, drawing in new private capital at the same time. Third, revive the inter-bank market with temporary guarantees. Fourth, especially in the US, step up efforts to slow mortgage foreclosures, to relieve the distress and stop house prices undershooting.
Britain was first to put most of these elements in place. It helps to have an impotent legislature. The US administration has to ask Congress first, so these things take a little longer. Washington will argue about whether the rescue package, together with the Federal Reserve's existing powers, leave enough wiggle room for all of the above. But Hank Paulson, reeling from this week's turmoil on Wall Street, is on board. Those four complementary parts, backed before this is over with a trillion or two of taxpayers' money in the US alone, have every chance of limiting the damage to the real economy to a bad recession, as opposed to a new Depression.
One can also predict the central feature of the post-crisis regulatory regime. It was suggested on this page on January 31 by Charles Goodhart and Avinash Persaud: contra-cyclical capital requirements. The basic idea is simple: force banks to build up capital faster when their lending is expanding most rapidly. Financial busts almost always follow credit booms. Contra-cyclical capital requirements tax the expansion of credit and build a bigger cushion for any bust.
Very many other issues will need to be addressed, of course, including the meaning of the term "bank" for these purposes (it will have to be widened); regulation of derivatives; regulation of mortgages; and opportunities for international regulatory arbitrage (which put a premium on, at a minimum, closer co-operation among national regulators). Still, when all is said and done, contra-cyclical capital will be the central idea.
Suppose that the US and the world escape with a bad recession but no worse, and that a new regulatory system - one that shackles lenders more tightly in good times - is put in place. Where would this leave the underlying argument about state and market, and the prospects for government intervention in other parts of the economy?
My guess is: rhetorically adjusted, about where it was before the crisis. This is because countervailing forces are in play, limiting any net effect.
The intellectual climate has already moved decisively in favour of market-sceptics. Until further notice, pro-market triumphalism is over. In the US, most likely, Barack Obama will be elected - not just because of the crisis, though it helps - and he will have big Democratic majorities in Congress to help him govern. His stump speech ties the emergency to deregulation and "trickle-down economics", the outgoing doctrines. All that is history, he says.
We shall see. Mr Obama's laudable ambitions to extend health insurance to all Americans, to refurbish the country's failing infrastructure, to make a college education affordable and to cut nearly everybody's taxes will run up against the amazing demands that the rescue will place on present and future taxpayers. The fiscal mess left behind by the Bush administration makes the problem much worse. Supposing he wins, the intellectual climate will be strongly on Mr Obama's side; the fiscal climate, and taxpayers watching these bills fall due, will not. Circumstances will force the next president to be a fiscal conservative on matters other than temporary stimulus and financial stability.

There is a broader point. The financial crisis was indeed a failure of regulation. The system was overwhelmed by innovation. Regulators are going to have to catch up and, you could say, try to hold innovation back. But finance is not a normal industry. The question to ponder is this: in which other industries will curbing innovation - also known as market forces - strike governments or voters, in the US or anywhere else, as a good idea?