Now that it is close to three years since the demise of Lehman Brothers and the onset of the 2008 global financial crash, senior figures in the central banking community are starting to think beyond “mere” regulatory issues, to consider what kind of financial system we need in the 21st Century. At the end of June 2011, Andrew Crockett, the special advisor to the Chairman at JP Morgan Chase, delivering the Bank of International Settlements (BIS) Per Jacobsson Memorial Lecture, made this his theme.
He posed both himself and his audience the question: “What principles should underpin the financial system for the medium- and longer-term future.” What is it, in other words, that we expect an efficient and stable financial system to do? What basic functions should it perform? How should it set about adding value to the real economy? By holding prices steady? By creating some growth through the judicious printing of money when the economy nose-dives? By enabling easy credit through “loose for longer” monetary policies? By being vigilant about “leaning against” booms and emphasising counter cyclical measures? The options are many and various.
Then there are all those questions about how best to regulate such a system once you have agreement as to what its basic functions and goals should be.
As easy as 1, 2, 3
Crockett’s starting point is an excellent broad brush analysis of what goes to make up the global financial system. He boils its basic constituents down to three core elements: the intermediaries (banks and insurance companies which act as the principals in assuming liabilities and acquiring claims), markets (the forums in which claims are exchanged), and infrastructure (payment and settlement systems, exchanges, but also all the “mechanisms” which provide contractual certainty, such as ratings agencies, accountants, auditors and analysts).
All three elements, he notes, are “inextricably intertwined” and they all work together to one glorious end, namely to both enable transactions and to improve the information available to all the participants. And the ultimate end or goal of the whole process, at the global level, is to guide the allocation of resources. Booms on this analysis are caused when too much resource is attracted in an unsustainable way to certain economic activities. Busts are the correction of this malinvestment, itself caused by faulty information flows (El Dorado is this-a-way people! – only it’s not).
Looked at like this, what you, I or anyone else would want from a 21st Century financial system is pretty straightforward. You want a way of “cleaning” the information flows so that people do not go haring off after super profits down unsustainable channels (tulips in 17th Century Holland, real estate in the US in the 1980s and the “noughties”), but instead proceed sensibly so that only the minimal amount of malinvestment takes place. Which would be a neat trick if anyone could pull it off. Better risk analysis (which is what regulation is all about, after all) seems to be the direction to go in here.
“High-quality information is the raw material for directing resources to their most efficient use, facilitating intertemporal contracts, and thus strengthening growth potential. Financial sector reform, to be of greatest service to users of financial services, should protect and enhance the capacity of the system to generate such information.”
Crockett turns the current analysis of the global financial system on its head. Instead of following the current trend, which is dead set on analysing the system’s ability “to impose negative externalities”, in central banker speak – you and I would talk about its ability to go off the tracks and create an almighty train wreck – Crockett wants to talk about how the system adds value. Not surprisingly, for him, in the final analysis, this all comes down to the system’s ability to improve the quality of information flows in order to best guide the allocation of resources.
How the results of any “allocation of resources” are distributed is, in current mainstream economic thinking, a separate conversation. That conversation takes place in the socio-political realm. Interestingly, Austrian school economics, following Mises and Hayek, does not make this same separation. Since private property is the central plank in Austrian school thinking (any state interference with private property distorts incentives and so distorts the pricing mechanism that underpins markets) political programmes founded on redistribution of wealth are contra-indicated, as the military like to say.
This leaves the Austrian school with a problem when the global starting point is massive inequality with starvation at one end of the spectrum and massive hoarding of wealth at the other. Since this is clearly a mis-allocation of resources if ever there was one, considered from the perspective of the human race as a whole, some kind of redistribution would seem to be essential.
Mining the potential
Of course, you could assume, as is tacitly or explicitly done in the more theoretical reaches of Austrian school thinking, that every person is at bedrock a skilled entrepreneur just raring to use pricing information to turn a profit.
Indeed, this may actually be the case with anyone in good health and in full possession of their wits – who knows? If one assumes this, then all that is necessary for redistribution is for the state to protect and enable fledgeling entrepreneurial activity – actually not a bad idea, put like that… on the assumption that entrepreneurial activity would then snowball (with few malinvestments, since the financial system would, supposedly, be producing “clean” information). Utopia would then not be far off, presumably…
The lesson to take away here, in the context of Crockett’s thinking on the global financial system, is that where he talks about the goal of the financial system being to allow markets (and countries) to achieve their potential, it may be that an endemic part of the muddle we are in (see Greece, see the US debt saga, see rising inflation in emerging markets) is that our understanding of what constitutes “potential”, is still in its infancy…
Further reading on global financial systems, malinvestment and financial regulation:
- Prophet of Instability by David Smith
- A One-in-Fifty-Year Event by Leigh Skene
- What Would a New Bretton Woods Mean for the IMF? by Augusto Lopez-Claros
Tags: Andrew Crockett , Austrian School of Economics , Bank of International Settlements , BIS , central banks , credit rating agencies , financial regulation , financial sector reform , global financial system , Greece , Greek debt , Greek economy , Hayek , JP Morgan Chase , Lehman Brothers , malinvestment , Mises , Per Jacobsson Memorial Lecture , regulation , risk analysis , US debt , US deficit , US economy