View metadata, citation and similar papers at core.ac.uk

brought to you by

CORE

provided by Research Papers in Economics

CentrePiece Winter 2009/10

Over the last 30 years, we have built a financial
system that threatens to topple our global
economic order unless decisive measures aretaken. That is the contention of Peter Boone andSimon Johnson, who describe a ‘doomsday cycle’that could lead to economic disaster after thenext financial crisis.

The doomsday cycle
ver the last three
decades, the US financial
system has tripled in size,
as measured by total
credit relative to GDP(see Figure 1). Each time the system runs
into problems, the Federal Reserve quickly
lowers interest rates to revive it. Thesecrises appear to be getting worse andworse – and their impact is increasinglyO

global. Not only are interest rates nearzero around the world, but many
countries are on fiscal trajectories that
require major changes to avoid eventual
financial collapse.
What will happen when the next
shock hits? We believe we may benearing the stage where the answer will
be – just as it was in the Great Depression– a calamitous global collapse. The root

Figure 1:

Private sector credit/GDP just keeps growing, while
the Fed funds target rate is now near to zero
Source: Bloomberg, US Department of Commerce

400%

20%
18%

350%

16%

Fed funds target rate

250%

12%
Savings & loans crisis

10%

200%

8%

LTCM bailout

150%
Subprime
bubbleTech bubble

6%

100%
4%
50%

2%
00
1981

21983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Ratio of private sector credit to GDP

300%
14%

CentrePiece Winter 2009/10

problem is that we have let a ‘doomsday
cycle’ infiltrate our economic system (seeFigure 2).1
The doomsday cycle has several simple
stages. At the start, creditors anddepositors provide banks with cheap
funding in the expectation that if things
go very wrong, our central banks andfiscal authorities will bail them out. Bankssuch as Lehman Brothers – and manyothers in this past cycle – use the funds totake large risks, with the aim of providing
dividends and bonuses to shareholders
and management.
Through direct subsidies (such asdeposit insurance) and indirect support(such as central bank bailouts), weencourage our banking system to ignore
large, socially harmful ‘tail risks’ – thoserisks where there is a small chance of
calamitous collapse. As far as banks areconcerned, they can walk away and let
the state clean it up. Some bankers andpolicy-makers even do well during thecollapse that they helped to create.

Regulators are supposed to prevent
this dangerous risk-taking. Adair Turner,
chairman of the Financial Services
Authority, is calling for more radical
change than most regulators. But banks
wield substantial political and financial
power, and the system has become
remarkably complex, so eventuallyregulators become compromised.
The extent of regulatory failure aheadof the current crisis was mind-boggling.
Many banks, including Northern Rock,convinced regulators that they could holdjust 2% of capital against large and risky
asset portfolios. The whole banking
system built up many trillions of dollars in
exposures to derivatives. This meant thatwhen one large bank failed, it could bring
down the whole system.
Given the inability of our political andsocial systems to handle the hardship thatwould follow economic collapse, we rely
on our central banks to cut interest rates
and direct credits to bail out the lossmakers. While the faces tend to change,

Figure 2:

Stopping thedoomsday cycle
requires major
reform withpolicies
implemented
across the G-20
each central bank and government
operates similarly. This time, it was Mervyn
King, Gordon Brown, Tim Geithner and
Ben Bernanke who oversaw policy as thebubble was inflating – and are now
designing our rescue.
When the bailout is done, we start allover again. This has been the pattern inmany developed countries since the mid1970s – a date that coincides withsignificant macroeconomic and regulatory

Jamie Dimon

The doomsday cycle
Lloyd Blankfein

America's top ten bank CEOs

Dick Fuld,
Lehman Brothers

Explicit andimplict subsidies
encourage
excessive risk

Too manyloss making
bets

Ben Bernanke

Adair Turner

Regulation isaimed toprevent excess

Losses happen– we bail out
the system

Alistair Darling

Regulators
capturedby theindustry
Larry Summers
Tim Geithner
Mervyn King

1 Andrew Haldane, executive director for financial stability at the Bank of England,
has written an excellent paper describing a similar idea – the ‘doom loop’(http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf).

3

CentrePiece Winter 2009/10

change, including the end of the Bretton
Woods fixed exchange rate systems,
reduced capital controls in rich countries
and the beginning of 20 years ofregulatory easing.
The real danger is that as this cycle
continues, the scale of the problem isgetting bigger. If each cycle requires
greater and greater public intervention,
we will surely eventually collapse.

Stopping the doomsday cycle
To stop the doomsday cycle, we need far
greater reform than is currently underdiscussion. The headline-grabbing actionsof Gordon Brown and Alistair Darling,calling for financial transactions taxes anda one-year super tax on bonuses, have no
impact on the fundamental problems inour system. Indeed, they are potentiallyharmful to the extent that they mislead
taxpayers who want real solutions.
We need quite different and much
more focused policies. These policies must
be implemented across the G-20, withinternational coordination and monitoring.
Otherwise, financial services will move tothe least regulated parts of the world, andit will be much more difficult for eachcountry to maintain a tough stance.

4The best route tocreating a safer
financial system isto have very large
and robust capitalrequirements

CentrePiece Winter 2009/10

Tackling regulatory failure
So what should be done? First, consider
the regulatory problem: there are two
broad ways to view past regulatory failurethat has helped us arrive at this dangerous
point. One is to argue it is a mistake thatcan be corrected through better rules.
That has been the path of successive
Basel committees, which are now
designing comprehensive new rules toensure greater liquidity at banks and to
close past loopholes that permitted banks
to reduce their core capital. We both
worked for many years in formerly
communist countries, and this projectreminds us of central planners’ attempts
to rescue their systems with additional
regulations until it became all too
apparent that collapse was imminent.
In our view, the long-term failure ofregulation to check financial collapses
reflects deep political difficulties increating regulation. The banks have themoney, they have the best lawyers andthey have the funds to finance the politicalsystem. Politicians rarely want strong
regulators – except after a major collapse.
So politics rarely favours regulation.
There are also big operational
problems: how should regulators decide
the risk capital that should be allocated to
new and arcane derivatives, which banks
claim will reduce risk? When faced withrooms full of papers describing new
instruments, and their risk assessments,
regulators will always be at a disadvantage
compared with banks.
The operational difficulties are further
complicated by the intellectual
undercurrents: when the economy isbooming, driven by more leveraged bets,
there is a tendency for the academic world
to provide theories that justify status quo
policies. This is clear from the growth ofefficient markets theories, which infiltrated
regulators’ decision-making during theboom ahead of this crisis.
No wonder that Tim Geithner, while
president of the Federal Reserve Bank of
New York, or Alan Greenspan and Ben
Bernanke, as Fed chairman, did little toarrest the rapid growth of derivatives andoff-balance sheet assets.
It requires a strong leap of faith tobelieve that our regulatory system will
never again be captured or corrupted. The
fact that it has spectacularly failed to limit
costly risk should be no surprise. In ourview, the new regulations discussed inBasel 3 will fail, just as Basel 1 and Basel 2
have failed.
The proposals sound smart because
they are correcting egregious errors of thepast. But new errors will surface over thenext five to ten years, and these will be
precisely where loopholes remain, andwhere the system gradually becomes
corrupted, again.
We believe that the best route tocreating a safer system is to have verylarge and robust capital requirements,
which are legislated and difficult tocircumvent or revise. If we triple core
capital at major banks to 15-25% ofassets, and err on the side of requiring too
much capital for derivatives and othercomplicated financial structures, we will
create a much safer system with less scopefor ‘gaming’ the rules.
Once shareholders have a serious
amount of funds at risk, relative to thewinnings they would make fromgambling, they will be less likely togamble. This will make the job of
regulators far easier, and make it
more likely our current regulatory system
could work.

It is hard tobelieve that
regulatory
reform will
succeed thistime, when
it has failed soenormously –and repeatedly– in the past

Changing incentives
Second, we need to make the individuals
who are part of any failed system expect
large losses when their gambles fail andpublic money is required to bail out thesystem. While many executives at bailedout institutions lost large amounts ofmoney, they remain very wealthy.
Some people have clearly become
winners from the crisis. Alistair Darling
supported the appointment of Win
Bischoff, a top executive at Citigroup in
the run-up to its spectacular failure, to bechairman of Lloyds. Vikram Pandit sold hishedge fund to Citigroup, who then wrote
off most of the cost as a loss, but Pandit
was soon named their CEO.
Jamie Dimon and Lloyd Blankfein,
CEOs at JP Morgan and Goldman Sachs
respectively, are outright winners from thisprocess, despite the fact that each of theirbanks also received federal bailouts.
Goldman Sachs was lucky to gain accessto the Fed’s ‘discount window’, so
averting potential collapse.
We must stop sending the message toour bankers that they can win on the rise
and also survive the downside. Thisrequires legislation that recoups pastearnings and bonuses from employees ofbanks that require bailouts.

The role of policy-makers
Third, we need our leading fiscal andmonetary policy-makers to admit their rolein generating this doomsday cycle throughsuccessive bailouts. They need to develop
solutions so that their institutions cancredibly stop this cycle. The problem issimple: most financial institutions today
have now proven too big to fail, as ourpolicy-makers have bailed them all out.
The rules need to change so that creditors
do not expect another bailout when thenext crisis happens.
There is some encouraging progresswith plans for ‘living wills’ and measures
to reduce the interdependency of financial
institutions. But the litmus test for this will
be when our leading policy-makers startcalling for the break-up of large financial
institutions and permanent crude limits on
their size relative to the economy in thefuture.
Smaller institutions are naturally easier
5

CentrePiece Winter 2009/10

The failure of
regulation tocheck financial
collapsesreflects deep
political andoperationaldifficulties increating
regulation
to let fail, and this will make creditors
nervous when lending to them, so we canhave more confidence that creditors will
not lend to highly risky small institutions.
There are feasible ways of doing this: forexample, we could impose rising capitalrequirements on large institutions over the
next five years, thus encouraging them todevelop orderly plans to break up andshrink their banks.

Prospects for effective
reform
So where are we going with our current
reforms? It is now obvious that risk-taking
at banks will soon be larger than ever.
Central banks and governments aroundthe world have proved (once again) thatthey are willing to bail out banks atenormous public cost when things gowrong. Markets are now again providing
very cheap loans to banks, with thecomfort that the state will bail them out.
Today, Bank of America and the RoyalBank of Scotland are each priced to havejust 0.5% annual risk of default above
their sovereigns during the next five years
in credit markets. This is a remarkably low
implied risk considering that both banks
were near to collapse just a few months
ago. Creditors are clearly very confident
that they will be bailed out again if
necessary. Indeed, they are more
comfortable lending to large risky banks
than to many successful corporations.
There is no doubt that the regulatory
6environment is going to be tougher forthe next few years. But nothing haschanged to make us believe the regulatory
system will succeed this time, when it has
failed so enormously – and repeatedly – inthe recent past. To bring about thedramatic change that is needed also
requires international cooperation andconsistency.
Many of our current policy-makers –Ben Bernanke, Mervyn King, Alistair
Darling and Gordon Brown – are the sameones that inflated the last bubble. So weknow with great confidence that they are
the types that will bail us out each timethings go wrong. They are all currently oncourse for seeding our next rise andcollapse: cheap rates and credit, with large
moral hazard, are the initial stages of eachcycle. Very few of these people, apartfrom Mervyn King, appear prepared torecognise their past role in creating ourcurrent problems and then to discuss
resolutely how to change it.
The danger this system poses is clear,as Figure 1 shows. With our financial
system now well-oiled to take on verylarge risk once again, and to gamble
excessively, can we be sure that we cancontinue this cycle of bailing out eventualfailures? At what point will the costs be solarge that both fiscal and monetary
policies are simply incapable of stopping
the collapse?
Last year, we came remarkably close tocollapse. Next time, it may be worse. The
threat of the doomsday cycle remains
strong and growing.

Peter Boone is a research associate in CEP’sglobalisation programme and chairman ofEffective Intervention (http://www.effint.org),a charity based in Britain. He is also a
principal at Salute Capital Management.
Simon Johnson is a professor at MIT's Sloan
School of Management, a senior fellow at thePeterson Institute for International
Economics and a member of theCongressional Budget Office's Panel of
Economic Advisers.
They are co-founders of The Baseline
Scenario, a leading economics blog
(http://baselinescenario.com), and co-authorsof ‘Our Next Financial Crisis’, published in
The New Republic in September 2009(http://www.tnr.com/article/economy/
the-next-financial-crisis).

The rules needto change sothat creditors do
not expect
another bailout
when the nextcrisis happens