“Can ‘It’ Happen Again?” Such was the title of a well-known paper written by economist Hyman Minsky in 1982. “It” referred to financial crises. His answer at the time was in the affirmative. And so it remains today.
The crisis that started in August 2007 has affected economies in different ways and in different degrees. It has seriously harmed most industrial economies: The U.S., the U.K. and peripheral economies in the eurozone have suffered the consequences of sudden stops in financial flows; others have been affected by recessions in the first group caused in the aftermath of housing bubbles.
Large emerging economies have been relatively immune to the financial turbulence, but have experienced a slowdown in exports. Policy responses have also varied: Aggressive monetary expansion by the Fed has made it possible for economic activity to recover relatively fast, while reliance on austerity policies has had the predictable effect of worsening the position of eurozone peripheral economies. So far it looks as though the worst may be over, but the near future remains full of risks, i.e., the consequences of the “tapering” of monetary expansion in the U.S., the danger of deflation in some eurozone economies, and the world-wide slowdown caused by so much turbulence.
To ask if there can be a repeat of a financial crisis amounts to asking if our financial system has become less vulnerable, for it is in the potential instability of the financial system that the root cause of financial crises lies. The answer cannot be in the affirmative for three main reasons.
- One source of instability lies in the existence of the “too-big-to-fail” (TBTF), also called systemic, banking institutions. These are prone to take excessive risks, since they know they will be bailed out if needed. All efforts to break up these systemic banks have so far failed.
- The main reason for bank vulnerability is insufficient capital; although the Basel Committee has made an effort to strengthen capital requirements, it has left an escape for those who want to soften them.
- The existence of a “shadow banking system,” made up of institutions such as hedge funds, which are sources of finance but effectively beyond the reach of supervisory authorities, is another acknowledged threat to financial stability.
The efforts to bring the shadow banking system – whose size is estimated to be as big as that of the formal system – to heel, to address the TBTF issue and to strengthen the financial structure of banks should and will continue. Meanwhile, luck will be needed and prudence is recommended. Borrower and saver beware.
