Two Versions Of What Caused Our Global Financial Crisis

• Global Imbalances: People as diverse as Hank Paulson and Paul Krugman have pointed to distortions created by a glut of money from countries with high savings rates, such as China and the oil-producing states, flooding into America in search of yield. This allegedly kept interest rates low while fuelling a credit boom and booms in the housing and stock markets, the collapse of which both led directly into the financial crisis and the economic recession. Those holding this view typically conclude that a long-term fix will have to find a way to address these imbalances.

• Shadow Banking: Barack Obama has pointed to the alleged deregulation of the financial system while others say that the existing regulations were simply too old, too fractured, too ineffective and insufficiently global. A "shadow banking" system that grew up between the gaps in regulations–investment banks, hedge funds, mortgage lenders–operated outside the regulation developed for more traditional banks. They became "too interconnected to fail," building up huge systemic risk. Those holding this view typically conclude that what is needed is more and modernized global financial regulations.

This morning the IMF issued a report taking the Shadow Banking position. The Economist argues that this is a too convenient position for the IMF, and the IMF’s favored solution is too pat.

Yet there is an underlying inconsistency here. The IMF’s version of “how it all happened” is a classic example of institutions gaming the regulatory system. It is impossible to anticipate all the possible ways in which regulations can be evaded. And while the wisdom of hindsight may make it appear blindingly obvious that non-bank financial institutions could become large enough to pose a risk to the entire system, clearly this was not apparent to policymakers at the time. Increasing the scope of regulation may well prevent the precise problems that led to this crisis from recurring in the same way, but nothing stops financiers from finding ways to evade the plethora of regulations that the fund is proposing. It is hard to shoot a moving target.

My comment:  While it may be impossible to anticipate all ways in which regulations can be evaded, the Economist’s argument overlooks the gross lack of oversight, meaningful regulations lobbied away, and the failure to enforce rules that did exist.  And there was evidence all along the way.  So sure, it’s hard to shoot a moving target, especially when your eyes are blindfolded and you’re not trying.  The enforcement of intelligent regulations could have mitigated if not prevented the current financial disaster.  Moreover, as with an infection – bacteria mutate to evade the antibiotic of the day – ongoing surveillance and efforts to find more effective antibiotics should continue.  

And what about those pesky imbalances? The IMF’s view, broadly speaking, is that without excessive risk-taking by financial institutions, which was aided by the absence of regulation, imbalances would not by themselves have caused the meltdown. But equally, without the flood of money seeking returns, the risky financial instruments that the IMF is blaming for increasing systemic risk may not have grown and posed the risk that they did. Some blame the IMF’s policies during the Asian crisis for spurring countries in the region to build up enormous reserves. That may offer part of the explanation for why the Fund has come down so strongly on one side of the debate.

Dave’s comment:  I sense we would have done this to ourselves without cash from China and middle East.  I recall the words of the accurate doom-forecasting newsletters of 2006. They warned that the aggregate economic numbers showed enormous risks built up in the system – perhaps $1T worth of potential losses – but no one knew where the risks resided. They didn’t show up in the financial statements of all these huge financials that have failed or are failing.  The point was repeatedly made that enormous risks were hiding somewhere, but where?  We now know they were in loans to shadowbankers and hidden in off-balance sheet entities kept off-balance sheet by the credit default swaps they were hedged against. But the hedge funds failed. The counterparties to the credit default swaps (AIG) failed, forcing those entities back onto the balance sheet, destroying C’s and BAC’s balance sheets. The smartest, though too late, point made in recent congressional hearings is that we need(ed) systemic regulations. Looking at banks one-at-a-time didn’t reveal the problem.  The problem wasn’t that someone was hedging against AIG; it was that everyone was hedging against AIG. Off-balance sheet entities have to be  sharply curtailed.  Apparently we failed to learn that lesson from Enron. …and AIG (London) was a shadow banking entity regulated by no one.