New Economy in Progress

A better financial system needs to counter herding, booms and busts and the inherent tendency towards instability.


New research shows the costs of financial crises and that excessive credit growth produces financial instability. The idea that an ever-larger financial sector increases society’s well-being is now very much in doubt. Indeed, recent academic work indicates that the reverse may be true. A smaller, more regulated financial sector might be better in terms of financial stability and overall economic performance. How can this research help us to build a more resilient financial system?

From a policy perspective, the crash of 2008 revealed that microprudential regulation of individual banks was not enough. Financial regulation and risk management could no longer rely on the market being the main disciplining device, as had been the case before the Great Financial Crisis. If market prices are periodically driven away from their fundamental values, market-based measures can be misleading (Yellen, 2017). Events such as the housing bubble of the 2000s show that prices can diverge from fundamentals for prolonged periods of time. In this case, the banking system as a whole lacked the capacity to absorb the correction in prices when it eventually came.

As a result, economists have therefore agreed on the need for macroprudential management. Since 2008 the discussion has evolved towards higher capital requirements for financial institutions; many economists from across the political spectrum now favor higher capital ratios (see e.g. Admati and Hellwig, 2014). Although some authors have questioned whether higher capital ratios reduce the probability of crisis ex ante, the empirical evidence suggests that higher capital ratios reduce the cost of crises because recovery from a financial crisis is much faster (Jordà ,Schularick & Taylor, 2017). However, we observe not only excess credit growth during economic expansions, but also excessive credit contraction during downturns. The new paradigm for the financial system needs to acknowledge this procyclicality of the financial system. One idea that is being discussed in Germany and other countries concerns countercyclical capital buffers. When times are good, banks build up a capital cushion that they can employ during an economic downturn to absorb losses (BIS, 2010; Bundesbank, 2015).

Another policy tool that has gained increasing traction since 2008 is the idea of a financial transaction tax (FTT). Intellectually, the idea can be traced back to Keynes (1936) and Tobin (1974) and was supposed to “throw grains into the wheels of the [foreign exchange] market.” If more financial transactions create financial instability, less trade may be a stabilizing factor. Today, a tax on financial transactions could be justified on the grounds that it would curtail transactions that have a negative social impact and which contribute to system-wide instability; reducing the volume of transactions via a tax might be an option for Zsolt Darvas and Jakob von Weizsäcker (2010).

Finally, since 2008 economists and politicians have discussed the need for a new global financial architecture. Some have called for a new version of the Bretton Woods System, which shaped the post-war era. Such a system would learn from the mistakes of the past, for example by developing an international reserve currency and managing the procyclicality of international capital flows (Stiglitz, 2010). However, the design, structure and implementation of such a system is still subject to debate. Critics have pointed out that focusing on a new Bretton Woods System ignores the importance of large private multinational corporations that transcend national boundaries (Tooze, 2019).

Whatever is agreed, the new paradigm may need to ensure a more transparent financial system, especially regarding so-called shadow banking, and to democratize the interwoven relationship between business and state authority as well as the role of central bankers.


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