Economists' letter spells out what went wrong
Last Updated: 7:13PM BST 11 May 2009
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Dear Sir,
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.
2
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