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This guest blog is by Mick Moran, WJM MacKenzie Professor  of Government, University of Manchester and is an edited text of the keynote address to the Biennial Conference of the European Consortium for Political Research Standing Group on Regulatory Governance,  and was presented at University College Dublin, 18 June 2010.

Regulation and the Financial Crisis

The mess we are in.

Four quotations aptly summarise the mess we are in, and the way we got there.

‘Complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.’ (Alan Greenspan 2002)

‘In addressing the challenges and risks that financial innovation may create, we should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it is most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks’ (Ben Bernanke May 2007)

‘the current economic situation is better than what we have experienced in years. Our central forecast remains quite benign: In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.’ (OECD Economic Outlook 2007)

These first three quotations sum up ‘the Great Complacency’ –  the delusion that led so many economists and economic policy makers to announce that the last bubble was ‘the Great Moderation’ – a new utopian age when all the fundamental problems of a market economy had been solved.

And the fourth quotation sums up the sort of intellectual mess that the financial crash left behind.  Buiter puts it with characteristic Dutch bluntness:

‘The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard.  A drastic but chaotic re-education took place and is continuing.’ (Wilhem Buiter 2009).

What went wrong with economic understanding? 

 The problems with the discipline of economics are surely threefold:

·        It became corporatised: both as to education (especially in the Business Schools) and in practice (economists in financial institutions).  The economist in the study was transformed into the economist broadcasting from the dealing room, laying down the law about what markets would and would not tolerate.

·        It became organised into a conventional academic hierarchy.  What we can learn from the recent fate of economics is that the worst thing that can happen to a social science discipline is that it gets  access to a Nobel Prize

·        It became professionalized: it developed a recursive world of professional economics that heightened the danger of succumbing to groupthink.  Algebra is not substitute for observation.

 

But while economists were cheerleaders during the ‘Great Complacency’ they were not the only culprits. Hardly anybody – not policy makers, not academic students of regulation – foresaw what was coming.  We all have lessons to learn.  Here are three that we must urgently take on board.

Democracy matters: the end of the ‘Great Moderation’ was also the end of  a ‘Great Experiment’ lasting more than 30 years: the experiment was designed to insulate regulation from democratic  politics.  Hence  the rise of central bank independence and the spread of independent regulatory agencies.  We saw the realisation of Majone’s theory of the regulatory state: a theory that asserted that majoritarian democracy could not cope with the complexity of modern market management.  The Great Experiment proved to be a disaster.  It led us to the catastrophe of 2008; and rescuing the financial system was only possible by turning to those despised figures, elected politicians, who it turned out were the only ones able to mobilise the cash and legitimacy to put the financial system on something like an even keel.

Ideology matters: the core of the crisis was due to the naturalisation of markets: an exercise in ideological hegemony that pictured them as subject to quasi-scientific determined laws.  They need to be denaturalised both to understand the crisis and to avert future disaster. Markets are social institutions to be understood by observation not algebra.

Interests matter: Many of our standard notions in explaining regulatory catastrophe – Groupthink, coordination problems – work contingently to explain things – see my opening three quotes.  But why was something like groupthink so prevalent?  It was linked to three developments

1.     The astonishing rise of a new Anglo-American plutocracy in the markets: the era of the Great Moderation was also the greatest era of plutocratic enrichment since the age of the Robber Barons.  But unlike the Robber Barons these new plutocrats did not practice the engineering of steel of railways; they practised the smoke and mirrors of financial engineering.

2.     The fantastic wealth of the financial sector on both sides of the Atlantic bought an equally fantastic amount of lobbying muscle.

3.     This converted into the kind of hegemony that lay behind my opening quotes: the stories of regulation before the crisis – in the UK, in the US, even in a smaller case like Ireland –are of timidity and subordination on the part of public regulators.

We have to fashion a new ideology of public interest regulation, and a new confidence in that regulation: it existed when the American  New Deal institutions found their feet; it must be rediscovered.  And, as the forces of financial power might regroup, it must be rediscovered in the face of the lobbying machines of the financial markets.

 

 

David McWilliams mentioned the decline in the Baltic Dry Index in his column last Sunday: there is more on the topic here.

Paul Krugman takes the cases of Ireland and Spain to address this question here.

Paul Krugman has a post this morning pointing out that in a standard Mundell-Fleming model, a fiscal contraction in Europe will have a negative effect on its trading partners in a floating rate environment: it not only lowers total European demand, but also leads to a weakening euro. Now, the latter effect is driven by lower European interest rates, and as Krugman acknowledges this channel won’t be working in a textbook manner in a world where European interest rates are almost (if not quite) at the zero bound; but the euro is indeed weakening as we speak, and Americans are getting worried.

There is broader point here. In a Mundell-Fleming world, with floating exchange rates, fiscal expansion is good for one’s trading partners: it involves a positive externality. Whenever you have positive externalities, there is a risk that not enough of whatever produces those externalities will be provided. Thus, in 2009, when fiscal policy was on the agenda, an important role of international coordination was to ensure that nations not try to free ride off each other’s stimulus packages. Cooperation was relatively easy to sustain: the world economy faced a clear and present danger, and nations benefitted from each other’s programmes.

In 2010 things look very different. Fiscal policy has gone into reverse in several countries, and so the focus will presumably shift to monetary and currency policy. But while fiscal stimulus helps a county’s trading partners, currency depreciation hurts them. (More generally, in a Mundell-Fleming floating rate world, expansionary monetary policy in one country hurts other countries — though again the fact that interest rates are almost at zero complicates the analysis.) So, we have moved from a world where macroeconomic policy involved positive spillovers to one where it is likely to involve negative spillovers — a much more ‘beggar-thy-neighbour’ world.

Expect lots of protectionist rhetoric in the months ahead.