Is Another Financial Crisis Inevitable?

Fed Flash
Diane Swonk, Chief Economist

Oct. 28, 2009 – 7:00 a.m. CT

Is Another Financial Crisis Inevitable?

One of the true benefits of my job is that I get feedback on what I have written, almost on a real-time basis. Hence, my comments today. A colleague called me yesterday to say that apparently her people and her clients read everything in my September issue of Themes on the Economy, right down to the last line, which read:

"Another financial crisis is not only possible, but probable."

My own, more humble suspicion is that many people (who are time-strapped like me) skipped to the end, and then found themselves gasping for air.

I spent much of the last five months talking with the Fed, Treasury, economists, and – to a lesser extent – Congress, trying to make sense of the crisis and how to prevent such a disaster going forward:

Executive compensation played a minor role in causing the crisis, but is an easy scapegoat for Congress – especially against a backdrop of rising income inequalities and high unemployment. This is despite the fact that those who lead the companies that failed or were bailed out were largely wiped out themselves.

A larger but harder problem to tackle is company structure. Partnerships and privately held companies tend to better align the incentives of the most highly compensated individuals by creating incentives throughout the company – not just at the upper echelon – to take a longer-term view of the risks that they are taking. The companies we are now examining, however, gave up their partnership structure – which helped them survive the Great Depression – for public offerings – which proved to be their undoing in this "Great Recession."

Financial deregulation, in and of itself, was a good thing, fueling innovation and jobs across the board for more than two decades. Deregulation without transparency and enforcement of the existing regulations, coupled with globalization of credit markets and the ability of firms to arbitrage regulations to find the easiest regulator – both within and across country borders – however, was a disaster. These not only allowed units of firms to act independently and take even greater risks than senior managers realized, but allowed unscrupulous investors to game the system (the worst case to date being Bernie Madoff).

Efforts to identify and more effectively liquidate financial entities that are taking excess risks sounds noble, but are inherently difficult, especially now that we have a panel of regulators (with all the turf battles that go along with it) charged with finding the worst violators. The idea of the Fed as some sort of "Regulator of Last Resort" has been sidelined because of the inherent risks such a regime might create in terms of limiting the Fed's independence from Congress.

The push to make the universe of large firms pay should a violator need to be bailed out is a good idea in theory, as it should incent the largest firms to better self regulate and ask more questions of the counter-party risk they hold. It will also incent some of the largest firms to downsize in order to avoid the rule, which is good if it limits systemic risk, but bad if it is just another way to fly under the radar of regulators.

Those pushing hardest for financial reforms (the Fed and Treasury) are intentionally slowing the process. They legitimately want to avoid over-regulation, especially so close to the crisis and in an election year like 2010. Moreover, there is a concerted effort to coordinate reforms across country borders, which will not only take time, but may not be achievable. The result is a series of piecemeal reforms which will inhibit innovation and limit growth as long as it persists.

Finally, and perhaps most importantly, financial bubbles are natural and predictable phenomena. It is in our nature to overshoot. Classroom studies show that the most informed investors, when told where the price of a particular asset will end up, will overshoot time and time again. Some believe humans are hardwired that way.

Indeed, some level of financial instability is not only inevitable but DESIRABLE. We can't grow and innovate unless we take some risks. That said, however, we can attempt to limit the frequency and depth of financial crises going forward, and it is those efforts that keep me bullish over the longer haul on investing in equities, particularly in the U.S.

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