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The crisis and slow recovery resulted from the combination of over-confident faith in free financial markets and from structural flaws in the eurozone. But underlying both was a failure to recognise the central importance to economic and financial stability of debt and leverage levels in general, and of the dynamics of bank credit creation in particular. Both the excesses of Anglo-Saxon finance capitalism and the flaws of the eurozone construct indeed reflected a failure to understand that financial and banking markets are different from other markets and that the general propositions in favour of market liberalisation - powerful in most sectors of the economy – are far less valid when it comes to finance. The flawed launch of the eurozone project indeed was in part based on the same over-confidence in the benefits of free financial markets and free capital flows that blinded us to the problems across the global financial system.
In particular I would like to pose five questions:
Financial markets link the present to the future in conditions of inherent irreducible uncertainty. They are populated by agents whose decision-making processes are part rational but part driven by emotional responses. As a result, they are subject to herd and momentum effects, to self-reinforcing surges of exuberance and then despair. The fundamental cause of the financial crisis of 2007 to 2008 was the build-up of excessive leverage in both the financial system (banks and shadow banks) and in the real economy. Increased leverage and rapid growth in leverage creates rigidities and financial stability risks.
Debt contracts play a valuable role in advanced economies, providing businesses and individuals with greater certainty over future income streams than would be delivered in a world where all contracts took an equity form. But the presence of debt contracts inevitably creates financial and stability risks.
The danger of excessive and volatile bank credit creation is still further exacerbated when credit is extended to finance the purchase of assets – in particular real estate – whose value is itself dependent on the level of debt financed demand. So too however, as we learnt before the crisis, can uncontrolled credit extension by chains of shadow banking entities which in aggregate perform credit intermediation with leverage and maturity transformation (the defining characteristic of banks but outside the scope of bank regulation).
It therefore seems at least possible that optimal bank capital ratios – taking into account both financial sector and real economy leverage effects – may be significantly above even Basel III standards. That does not mean it would be sensible to impose such higher standards in the near to medium term. The 2007 to 2008 crisis was caused by excess leverage, but deleveraging from those excess levels is a major threat to medium-term growth. The Basel III standards therefore represent a reasonable compromise between long-term optimality and the danger that too rapid progress to higher ratios would exacerbate that deleveraging, depressing economic activity. But we need to recognise that they are a compromise: and that in the long-term they might allow a return to harmful levels of leverage both within the financial system and the real economy. We therefore need to be able to offset any such future increase with other levers.
That focus on real economy leverage levels is not yet an accepted element within global or national regulatory regimes. Thus, for instance, the focus of the Basel III guidelines for the application of the countercyclical capital buffer (CCB) is on the rate of growth of credit, not the absolute level of leverage already achieved. The guidelines propose that there should be a presumption in favour of an increase in the CCB when credit growth is running above past trend. But if past trend growth has been faster than nominal GDP growth, growth in line with past trend will produce a steady increase in the level of leverage.
We cannot rely on free market forces to ensure that the level of leverage in the economy created by freely competitive banks is optimal. Nor can we assume that cross-border capital flows will always achieve the efficient allocation of capital to ‘viable’ business opportunities. Both our decisions on micro- and macro-prudential regulation, and on the design of the eurozone single currency and the eurozone single market, need to reflect, as they did not in the past, a fundamental reflection on the ways in which the impact of financial markets, debt contracts, fractional reserve banks, and short-term capital flows, diverge from that suggested by neoclassical assumptions of beneficial market completion.