Ending The Doomsday Cycle

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Interesting article by ex-IMF supremo Simon Johnson and Peter Boone on how to correct a severe systemic fault in our economic system they believe could cause complete financial meltdown / economic collapse.

The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.
Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.
Regulators are supposed to prevent this dangerous risk taking. Adair Turner, chairman of the Financial Services Authority, is calling for more radical change than most regulators. But banks wield substantial political and financial power, and the system has become remarkably complex, so eventually regulators become compromised.

The extent of regulatory failure ahead of the current crisis was mind boggling. Many banks, including Northern Rock, convinced regulators that they could hold just 2% of capital against large and risky asset portfolios. The whole banking system built up many trillions of dollars in exposures to derivatives. This meant that when one large bank failed, it could bring down the whole system.

Given the inability of our political and social systems to handle the hardship that would follow economic collapse, we rely on our central banks to cut interest rates and direct credits to bail out the loss-makers. While the faces tend to change, each central bank and government operates similarly. This time, it was Mervyn King, Gordon Brown, Tim Geithner and Ben Bernanke who oversaw policy as the bubble was inflating – and are now designing our rescue.

When the bailout is done, we start all over again…

The real danger is that as this cycle continues, the scale of the problem is getting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse.

Link to read the full article – The Doomsday Cycle .

Johnson and Boone believe that as the regulatory system is prone to capture (the Banks have the most money & the best lawyers) regulation alone is not the answer. Their solutions are briefly presented beneath the fold.
And the solutions, they propose three steps –

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We believe that the best route to creating a safer system is to have very large and robust capital requirements, which are legislated and difficult to circumvent or revise. If we triple core capital at major banks to 15-25% of assets, and err on the side of requiring too much capital for derivatives and other complicated financial structures, we will create a much safer system with less scope for “gaming” the rules.

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Second, we need to make the individuals who are part of any failed system expect large losses when their gambles fail and public money is required to bail out the system. While many executives at bailed-out institutions lost large amounts of money, they remain very wealthy.

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Third, we need our leading fiscal and monetary policymakers to admit their role in generating this doomsday cycle through successive bailouts. They need to develop solutions so that their institutions can credibly stop this cycle. The problem is simple: most financial institutions today have now proven too big to fail, as our policy-makers have bailed them all out. The rules need to change so that creditors do not expect another bailout when the next crisis happens.

No bio, some books worth reading – The Rational Optimist: How Prosperity Evolves – Matt Ridley .

Crisis Economics: A Crash Course in the Future of Finance -Nouriel Roubini, Stephen Mihm