Wednesday, July 16, 2014

A Systemic Explanation for The 2008 Financial Crisis

In September of 2013, Francis Breedon organized a Round Table discussion at the Money Macro Finance Conference held at Queen Mary College London. The session included myself, Chris Giles of the Financial Times and David Miles of the Monetary Policy Committee as speakers and Sushil Wadwhani as moderator.  Our topic: the Bank of England's remit.

Chris and David chose to speak about monetary policy and the role of the Monetary Policy Committee.  I chose, instead, to focus on the task that faces the newly formed Bank of England's  Financial Policy Committee.  This post will focus on one of the points I made in my talk, the distinction between what I call institutional and systemic explanations of the 2008 financial crisis.  My complete argument is published in a forthcoming paper "Financial Stability and the Role of the Financial Policy Committee", that will appear in The Manchester School.

Recent events have generated widespread consensus that the financial markets are not working as they should. But there is little agreement as to why. One explanation is that financial frictions can sometimes become more disruptive than usual and these frictions can be corrected by regulating financial institutions. An alternative explanation that I have promoted in my own work, is that financial markets do not allocate capital efficiently.  The failure of financial markets occurs because people who will be born in the future cannot trade in current markets. I call this the absence of prenatal financial markets.

The financial frictions view leads to an institutional explanation for financial crises. The absence of prenatal financial markets view leads to the systemic explanation. Quoting from my forthcoming paper...
Distinguishing the institutional from the systemic explanation of financial crises affects the way we respond. If the problem is institutional we should design regulations that help overcome the financial frictions that prevent our banks, insurance companies and pension funds from performing their appropriate roles as intermediaries. If the problem is systemic, the failure of institutions is a symptom and new regulations are analogous to putting an Elastoplast on a gunshot wound.
The consensus amongst economists in the U.K. and the U.S. is that the 2008 financial crisis that led to the Great Recession was an institutional failure. The response has been the passage of the Financial Services Act in the U.K. and the Dodd‐Frank Act in the U.S.; legislation that is designed to regulate the financial services industry. I believe that the consensus is mistaken; the problem is not institutional; it is systemic.
Let me be clear. I am not arguing that existing financial institutions were blameless. Nor am I arguing that the regulatory framework was effective. The crisis has taught us that the design of effective regulation matters: and it matters a lot. I agree wholeheartedly with Anat Admati and Martin Hellwig who argue forcefully that we need much higher capital requirements. Regulating existing institutions is necessary: but we can and should do much more. Quoting again from my forthcoming paper...
... If I am right, and the problem is systemic, regulating our existing institutions will not solve the problem [of preventing future financial crises]. It will lead to the creation of new institutions, shadow‐banks, shadow insurance companies and shadow pension funds; unregulated institutions that will be created to facilitate the trades that willing lenders and willing borrowers want to engage in. Dodd‐Frank and the Financial Services Act cannot prevent the next financial crisis any more than King Canute could prevent the movement of the tides.
...When the next financial crisis occurs, and it will occur, do not blame the members of the Financial Policy Committee. They are guard dogs without teeth. It’s time to move beyond empty rhetoric by giving to the FPC, the tools that will enable it to deliver what is requested of it. If we truly want financial stability; we must act to stabilise markets. 
If you want to read more, you will find a working paper version of the article here where I also explain what tools we should give to the FPC to maintain future financial stability.


  1. If preventing a crisis is like meteorologists trying to prevent a tornado, how would that fact be revealed in your institutional vs systemic analysis?

  2. A better analogy would be building a house in a flood plain. The institutional view is the belief that we can keep the house safe by asking a priest to bless the ground on which it is built. The systemic view would protect the house by building a dam upstream to regulate the flow of the river.

    1. It seems like another approach would be insurance, but not flood insurance w/ perverse incentives. Rather, universal basic income to protect everyone from inevitable floods.

  3. I think that it is too early to argue that more regulation would not be sufficient. Central banks have the potential to develop tools to rein in the worst of the financial markets if given the chance. Such moves would have to push passed obvious opposition from the finance sector who would fight any efforts to limit the scope of its actions. Perhaps a bigger obstacle would be what seems to be a desire by central bankers to be liked by investors and the public at large. I have argued that central banks need to develop more of a nasty side in imposing rules on the market rather than the current emphasis on helping out when times go bad. For more on this, see

    1. I agree that we should pursue the regulation path. But I don't think it will be enough.

    2. What is the empirical evidence that markets are sometimes stable and not subject to periodic crisis? What is the evidence that they are more like floods that can be dammed as opposed to hurricanes that should be prepared for?

    3. The working version of your paper is a classic false choice. Markets fail for one of two reasons: institutional or systemic. It's not the one, therefore it's the other. But there is no evidence that the cause of crisis must be one of the two you posit. The fact that they are the two posited by the rest of your profession is shaky ground, indeed.

      An equally plausible explanation is that the completeness of a market is not connected to it's stability. As we all know, Greenspan and Summers cheered the growth of various derivatives because every new kind of asset got us a more "complete" market. The crisis came anyway.

      Imagine if we thought that preventing hurricanes was a matter of cooling down the right location on Earth. How many different locations would we try to cool before we gave up? How many journals would we publish filled with abstract theorizing about why cooling Canada didn't work and we really should be trying to cool Thailand? Then, of course, the UofC crowd would say you never actually succeeded in cooling Canada, because fiscal policy is useless QED....

    4. Thornton

      "An equally plausible explanation is that the completeness of a market is not connected to it's stability."
      I agree with this wholeheartedly - at least if by 'market completeness' you mean the ability of people currently alive to contract on any observable contingency. The theme of my work is that this is NOT sufficient to guarantee financial stability precisely because the unborn cannot trade in markets that open before they are born. I have argued that government can potentially design an institution that makes those trades on behalf of the unborn. The word 'potentially' is important. Just because such an institution is feasible in theory does not mean that it is easy to make it work in practice.

    5. I saw that in the paper. It's certainly clever for many reasons, not least of which being the fact that no human society would ever construct such a thing so there are no examples of unstable markets that allow the unborn (or undead) to participate that a critic could point to.

  4. Frederick Soddy predicted the "systemic flaw": “The Role Of Money”
    (Entire book as a free download…
    Quote Soddy, “It was recognized in Athens and Sparta ten
    centuries before the birth of Christ that one of the most vital prerogatives
    of the State was the sole right to issue money. How curious that
    the unique quality of this prerogative is only now being re-discovered.”
    “… It is concerned less with the details of particular schemes
    of monetary reform that have been advocated than with the general principles to which, in the author’s opinion, every monetary system must at long last conform,
    if it is to fulfil its proper role as the distributive mechanism of society. To allow it to become a source of revenue to private issuers is to create, first, a secret and illicit arm of the government and, last, a rival power strong enough ultimately to overthrow all other forms of government.”
    To regulate this awesome power is really just about impossible since any conditions placed upon restricting the quality or quantity of the bank issuance is impossible because regardless of 'reserve' or 'capital ' requirements, these requirements are self-fulfilling after the fact of issuance. The issuance being as "good as the faith and credit of the sovereignty" is unconditionally guaranteed redeemable.
    As for the 2008 crisis there could have been a "systemic failure" because the Private For Profit Banks (PFPB) sold "future cash flow a/k/a interest income"
    and were not able to turn that over to the investors. Also after having paid for 'insurance against loss, it was discovered, the insurers as well lacked 'the good faith and credit to make good their warranties.
    If you can not trust the PFPB and the Insurers guaranteed redemption-the bubble surely would burst.

    “…but they can’t get the mortgage notes written down to affordable levels for contractual reasons….”
    Quote Sheila Bair (Former FDIC Chairman),”How could things have deteriorated so quickly…? In a word, securitization.
    …Working with a Wall Street investment bank, the issuer packages the mortgages together into ‘pools’ and divides the right to the cash flows of these mortgages into securities that are sold to investors…”
    THE KEY WORDS BEING, “…the right to the cash flows of these mortgages into securities that are sold to investors…”
    These contracts allowed the investors to take away the rights of the lenders to modify the mortgages: they sold “the cash flows” for cash .
    How could they get back the trillions of dollars they already spent so they could repurchase the MBSs ?
    The Fed would be able to “fix” the modification problem with a simple strokes on a computer: Allow all to stay at market value, with loans at 3% for 40 years,period. 85% would stay, the other 15% would become welcomed ‘short sales’. END OF CRISES, stabilizing the housing industry, saving millions of jobs and even creating more jobs.
    But if they were to reveal the banks made trillions of profit by selling-future interest income. The banks made a fatal error in that they turned over to the investors all control over the performance of the basic asset thereby making it impossible for the PFPB to make good on there “representations”. The only way available to the PFPB was to return the trillions they took since it was discovered that not only were they not of “good faith and credit” but also the insurers they paid were also not of “good faith and credit”. Has anyone asked ,why the Fed purchased almost $1 trillion of MBSs instead of the mortgages ? Would the Fed have exposed-we are in a system that is flawed and may result in catastrophic failure.

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    2. Yes -- existing financial institutions are not ideal. There are a number of reasons for this, including political pressure from the financial services industry. And the design of effective regulation is part of the solution. I would not go as far as abolishing private banks.

    3. " I would not go as far as abolishing private banks."
      Absolutely, as Soddy, and many economist agreed-Separation from government privileges could be a better solution, as for "capitalism"
      it would be even better than 'nationalization'.
      The message Soddy had was for the establishment of HONEST private for profit banks that earn their gain by services and investments.
      Fix the 'flaw' by no longer allowing the PFPB to issue currency as loans
      which allow the PFPB: " To allow it to become a source of revenue to private issuers is to create, first, a secret and illicit arm of the government and, last, a rival power strong enough ultimately to overthrow all other forms of government.”
      This fool begs a profound answer, knowing with due respect, a fool has no right to question.

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