Government failure caused the financial crisis
12 May 2009
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Society and Culture
11 May 2009
Government and Institutions
14 May 2009
Tax and Fiscal Policy
19 November 2024
In a statement published today in the Daily Telegraph and reproduced below, fourteen leading economists – authors of the comprehensive new IEA study, Verdict on the Crash – explain how government failure caused the financial crisis and why politicians’ calls for tighter regulation are misconceived.
The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.
● Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk.
● US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac (which had explicit government targets of providing over 50pc of mortgage finance to poor households) and through the Community Reinvestment Act and related regulations.
● Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely.
● Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to “maintain market confidence”.
● The tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system.
● Financial institutions that have made mistakes have lost the majority of their value. On the other hand, regulators are being rewarded for failure by an extension of their size and powers.
● Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions.
As such, no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens.
A revolution in financial regulation is needed. The proposals of the G20 governments and the EU are wholly misconceived. Specific and targeted laws and regulations could restore market discipline.
These should include:
● Making bank depositors prior creditors. This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely.
● Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail.
● Enhancing market disclosure by ensuring that banks report relevant information to shareholders.
This should be reinforced with central bank action to ensure that:
● Proper use is made of lender-of-last-resort facilities to deal with illiquid banks.
● The growth of broad money is monitored together with the build-up of wider inflationary risks.
Yours faithfully,
Dr James Alexander, Head of Equity Research, M&G; Prof Michael Beenstock, Professor of Economics, Hebrew University of Jerusalem; Prof Philip Booth, Professor of Insurance and Risk Management, Cass Business School; Dr Eamonn Butler, Director, Adam Smith Institute; Prof Tim Congdon, Founder, Lombard Street Research; Prof Laurence Copeland, Professor of Finance, Cardiff Business School; Prof Kevin Dowd, Professor of Financial Risk Management, Nottingham University Business School; Dr John Greenwood, Chief Economist, Invesco; Dr Samuel Gregg, Research Director, Acton Institute; Prof John Kay, St John’s College, Oxford; Prof David Llewellyn, Professor of Money and Banking, Loughborough University; Prof Alan Morrison, Professor of Finance, University of Oxford; Prof D R Myddelton, Emeritus Professor of Finance and Accounting, Cranfield University; Prof Geoffrey Wood, Professor of Economics, Cass Business School.
Click here to download Verdict on the Crash.
The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.
● Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk.
● US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac (which had explicit government targets of providing over 50pc of mortgage finance to poor households) and through the Community Reinvestment Act and related regulations.
● Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely.
● Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to “maintain market confidence”.
● The tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system.
● Financial institutions that have made mistakes have lost the majority of their value. On the other hand, regulators are being rewarded for failure by an extension of their size and powers.
● Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions.
As such, no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens.
A revolution in financial regulation is needed. The proposals of the G20 governments and the EU are wholly misconceived. Specific and targeted laws and regulations could restore market discipline.
These should include:
● Making bank depositors prior creditors. This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely.
● Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail.
● Enhancing market disclosure by ensuring that banks report relevant information to shareholders.
This should be reinforced with central bank action to ensure that:
● Proper use is made of lender-of-last-resort facilities to deal with illiquid banks.
● The growth of broad money is monitored together with the build-up of wider inflationary risks.
Yours faithfully,
Dr James Alexander, Head of Equity Research, M&G; Prof Michael Beenstock, Professor of Economics, Hebrew University of Jerusalem; Prof Philip Booth, Professor of Insurance and Risk Management, Cass Business School; Dr Eamonn Butler, Director, Adam Smith Institute; Prof Tim Congdon, Founder, Lombard Street Research; Prof Laurence Copeland, Professor of Finance, Cardiff Business School; Prof Kevin Dowd, Professor of Financial Risk Management, Nottingham University Business School; Dr John Greenwood, Chief Economist, Invesco; Dr Samuel Gregg, Research Director, Acton Institute; Prof John Kay, St John’s College, Oxford; Prof David Llewellyn, Professor of Money and Banking, Loughborough University; Prof Alan Morrison, Professor of Finance, University of Oxford; Prof D R Myddelton, Emeritus Professor of Finance and Accounting, Cranfield University; Prof Geoffrey Wood, Professor of Economics, Cass Business School.
Click here to download Verdict on the Crash.
10 thoughts on “Government failure caused the financial crisis”
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Your sentiment is right but the order is wrong. Point 3 is the most important, followed by points 4 & 5, then point 2, then points 6 & 7, and finally point 1. I am unconvinced by the idea that central banks could have prevented the build up in debt through tighter monetary policy. It was the failure by those in authority, i.e. regulators, to recognize the risks of excessive debt that was the root cause of the problem. Talk of overly loose monetary policy dilutes the force of this argument.
Your sentiment is right but the order is wrong. Point 3 is the most important, followed by points 4 & 5, then point 2, then points 6 & 7, and finally point 1. I am unconvinced by the idea that central banks could have prevented the build up in debt through tighter monetary policy. It was the failure by those in authority, i.e. regulators, to recognize the risks of excessive debt that was the root cause of the problem. Talk of overly loose monetary policy dilutes the force of this argument.
Yes, the politicians turned a blind eye/encouraged a credit bubble.
But do not overlook the flipside of the credit bubble, in other words the asset price bubble. Buying off voters, most of whom are home-owners, with a house price bubble is the oldest trick in the book, which Labour copied off the Tories, but took it to extremes (the same goes for governments in other bubble countries).
Yes, the politicians turned a blind eye/encouraged a credit bubble.
But do not overlook the flipside of the credit bubble, in other words the asset price bubble. Buying off voters, most of whom are home-owners, with a house price bubble is the oldest trick in the book, which Labour copied off the Tories, but took it to extremes (the same goes for governments in other bubble countries).
We have spoken on the crash many times, and my point of view in respect of yours is common only generally.
1. Obviously, US has started the financial crisis, so we are to find what initiated it in the US. Bubble of the house prices etc. are the reasons – but all staying behind one and main point – very high share of the US annual warfare expenditures (20-25%). Why? Imagine you have a business with a cash of say 100000, which produces earnings at 15-20% rate. According to compound interest formula, your initial injected capital will build up every year – all know about it. The US has eaten up all the earnings by spending on warfare, instead of economic development.
We have spoken on the crash many times, and my point of view in respect of yours is common only generally.
1. Obviously, US has started the financial crisis, so we are to find what initiated it in the US. Bubble of the house prices etc. are the reasons – but all staying behind one and main point – very high share of the US annual warfare expenditures (20-25%). Why? Imagine you have a business with a cash of say 100000, which produces earnings at 15-20% rate. According to compound interest formula, your initial injected capital will build up every year – all know about it. The US has eaten up all the earnings by spending on warfare, instead of economic development.
It is especially obvious since the rate of growth of the US economy is much less then its war expenses. On the contrary, Canada which has open border with the US and much-much less warfare expenditurees, has higher growth.
2. Global financial system needs changes – same as in times of F.D.Roosevelt, but on the global scale. Having the EU Central Bank as possible scenario and invention of euro to the market – but on global scale. Fundamental bottom line of this stays on the need for global economic integration, at least for major players – are they ready for this? Almost, just to remind of EAFTA, NAFTA, SACU, EU, EurAzEC, AFTA, EU-US FTA etc. – these are all in place.
It is especially obvious since the rate of growth of the US economy is much less then its war expenses. On the contrary, Canada which has open border with the US and much-much less warfare expenditurees, has higher growth.
2. Global financial system needs changes – same as in times of F.D.Roosevelt, but on the global scale. Having the EU Central Bank as possible scenario and invention of euro to the market – but on global scale. Fundamental bottom line of this stays on the need for global economic integration, at least for major players – are they ready for this? Almost, just to remind of EAFTA, NAFTA, SACU, EU, EurAzEC, AFTA, EU-US FTA etc. – these are all in place.
What confronts them as major obstacle is political will of the people in power, and cultural differences. Israel and Arabs, US and Russia, India and Pakistan – they all say, but not doing much, although being a step from integration in respective and prospective economic unions.
3. The measures you propose to do it or not – in market sense, like more regulation of the markets, they are to be discussed since they will lead to better functioning, to even more perfection of existing system.
Banks allowed for falling down, will cause default of businesses, and not insured deposits of the citizen. So may be, you are cautiously right.
What confronts them as major obstacle is political will of the people in power, and cultural differences. Israel and Arabs, US and Russia, India and Pakistan – they all say, but not doing much, although being a step from integration in respective and prospective economic unions.
3. The measures you propose to do it or not – in market sense, like more regulation of the markets, they are to be discussed since they will lead to better functioning, to even more perfection of existing system.
Banks allowed for falling down, will cause default of businesses, and not insured deposits of the citizen. So may be, you are cautiously right.