Avoiding the Next Financial Crisis
In the Sunday NYT Alan S. Blinder, writes about a 10-step recovery from the financial collapse. He outlines the ten steps, which he calls commandments.
I have no issue with the commandments as such and I even agree with his main point that people are forgetting the lessons of the financial crisis. What is unclear who exactly are these commandments for? Is it the banks or is it the government regulators or is it investors or tax payers or consumers? For any and all of his commandments to be obeyed we need a tougher regulatory regime than the one currently in place.
There are two things we need to prevent a replay of the 2008-09 crisis. First and foremost is regulation with teeth. Self regulating markets, especially capital markets are a myth. Consumers and tax-payers need to be protected from the “innovations” in finance. The rest of the economy is still hobbling back, but the banks and financial institutions which were responsible for the collapse have made out like bandits. We need to regulate banks and bank like institutions, because failing banks, especially large ones, have the potential to crash the entire economy. For starters,
- Regulate the over-the-counter derivative trading
- Form regulatory body that tests the “innovations” of financial institutions, an NHTSA for the capital markets. We crash test dummies to see whether cars are safe. We need to do the same with new financial products. So called “black swan events” seem to occur with alarming frequency, so we need to test just how robust these innovations are, under unexpected circumstances. Like testing structural integrity of tall buildings or bridges in case of an earthquake. If they are too dangerous or too opaque to be understood they should not be be traded.
Secondly we need an overhaul of conventional wisdom in finance in particular and economics in general. We need to understand what we seek to change. Current theories are inadequate to the task, more on that later.