Financial Crises and Market Regulation

By Jordan, Jerry L. | Economic Commentary (Cleveland), October 1, 1999 | Go to article overview
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Financial Crises and Market Regulation

Jordan, Jerry L., Economic Commentary (Cleveland)

Financial crises are inevitable. Both government intervention and market innovations can influence the frequency and severity of these episodes, but they cannot eliminate them. Evolution toward stronger political and economic institutions is a discovery process, and the sometimes dramatic financial market adjustments labeled "crises" are an unavoidable part of that process.

Government intrusions into financial markets typically make financial crises more serious. For the most part, official programs seem designed to act as sponges for absorbing risk exposures from particular groups of economic agents. This can lead market participants astray. Unless the resulting incentive to overinvest in risky projects is offset by an effective program of supervision, agents are likely to misallocate resources. Moreover, especially before a crisis, a government may act as though the capacity of its risk sponge is unlimited. Only when that capacity is testedby calls on foreign exchange reserves, by demands on taxpayers through the budget-does information about limits emerge. Crisis ensues.

Financial crises are not predictable. If they were, actions would be taken to alter the predicted event, and the crisis would be avoided. It is the surprise contained in new, unexpected information that sets off these episodes. If there were no surprise, there would be no basis for the sudden and substantial changes in market prices of financial instruments that are characteristic of crises.

The Element of Risk

and the Lessons of Failure

Financial outcomes always have an element of uncertainty as well as an element of risk. I choose the words uncertainty and risk deliberately.1 They describe two different kinds of exposure to chance events. Uncertainty is impossible to describe probabilistically because the distribution of possible outcomes essentially is unknown. Therefore, exposure to uncertainty cannot be hedged or insured against. Gains and losses from uncertain events are pure economic rents. They are either home by those exposed to them or socialized in an act of community greed-such as a steeply progressive tax -or in an act of community compassion -such as Red Cross, Federal Emergency Management Agency, or Marshall Plan assistance. We cannot help but be surprised by the occurrence of uncertain events. This is why crises are unpredictable.2

Risk, on the other hand, is used for exposure to the other kind of outcome. This exposure can be described probabilistically, typically by using a model of some sort to filter past experience. Exposure to losses from risky events can be bought and sold in the marketplace. An insurance company will assume your exposure to loss from the death of a partner in return for an insurance premium. Financial institutions accept exposure to the bankruptcy of debtors in return for a sufficiently large risk premium.

The existence of risky situations is not a source of crises, for rational economic agents will have incorporated calculations about potential outcomes into their decision-making. Instead, crises typically result from risk mismanagement.

Risks can be transferred from one party to another, but they cannot be eliminated. Exposure to loss from a partner's death can be shifted through an insurance company to a diversified set of policyholders. Exposure to loss from lending can be shifted through a bank and the FDIC to all insured depositors or general taxpayers. Exposure to exchange-rate changes can be shifted to someone else through the organized exchanges or an over-the-counter transaction or by government to general taxpayers.

While individual parties can take actions to reduce, minimize, or avoid their own risk exposure, they can do so only when another party is willing and able to bear such risks. This is where government behavior can become a problem. Usually, with the most sincere and honorable of intentions, governments seek to reduce, minimize, or eliminate the exposure to risk of some constituent.

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