Academic journal article Independent Review

We Are Not Macroprudentialists: A Skeptical View of Prudential Regulation to Deal with Systemic Externalities

Academic journal article Independent Review

We Are Not Macroprudentialists: A Skeptical View of Prudential Regulation to Deal with Systemic Externalities

Article excerpt

The aftermath of the 2008 global financial crisis has brought a revision of economic ideas, in particular a new wave of skepticism concerning financial markets' ability to function smoothly. (1) At the core of this skepticism is the idea that because of systemic externalities, a free market is exposed to episodes of boom and bust. As this market-failure argument goes, only by chance are the social benefits and costs of financing and investment decisions equal. Rational investors and financial institutions typically value risk and liquidity risk from their own "private" perspective, ignoring the larger social benefits of liquidity and the aggregate dimension of risk. As one advocate of this perspective aptly puts it,

The current financial crisis is a clear example of systemic failure. It illustrates-once again--the vulnerability of market capitalism to spectacular boom and bust cycles that can devastate the real economy. After decades of complacency about the ability of markets to correct themselves and the resiliency of the economy to financial and other shocks, we have experienced another spectacle of irrational herd behavior producing rapid increases in asset values, lax lending standards and over-borrowing, excessive risk taking, and out-sized profits in the financial sector. The boom was followed by a dramatic crash that spread rapidly through world financial markets, causing plummeting asset values, rapid deleveraging, risk aversion, and huge losses. (Rivlin 2009, 2)

Immediately after the onset of the crisis, a widespread consensus emerged among policymakers and academics that a new "macro" approach to prudential regulation, aimed at containing these externalities, is needed to stabilize the economy in the future. The dictum "We are all (to some extent) macroprudentialists now," coined by Claudio Borio (2003, 1), has gained momentum and justification in an avalanche of professional publications and public speeches.

In this article, we discuss the argument for prudential regulation from a skeptical perspective for two reasons. First, whereas readers can easily browse through a substantial body of literature justifying increased regulation, consistent critical works are considerably more difficult to find. We attempt to fill this gap and provide an opposing view. Second, troubled times give an inherent weight to state interventions and interventionist theories, as society asks or waits for the government to "do something." Therefore, we believe that in the current economic, social, and political context it is too easy for interventionist arguments to overshoot in the realm of decision making.

Our central claim is to show that the case for prudential regulation, notwithstanding its new theoretical rationale, is no better at present than it was before the crisis. We critically examine the idea that borrowing creates systemic externalities that give rise to herd behavior, catching the economy in a trap of multiple equilibria from which it can escape only with the help of a countercyclical prudential policy.

Systemic externalities, Systemic Risk, and Coordination Failures

The concept of systemic externallty purports to provide a solid ground for some sort of economic dirigisme. (2) Systemic externalities express the idea that individual behavior often entails a chain reaction or amplification effects that impact, positively or negatively, the whole market. Because of this phenomenon, the economy spirals up or down as investors' buying or selling stimulates third parties to imitate their behavior.

This idea's history can be traced back to the writings of authors such as Paul Rosenstein-Rodan (1943) and Ragnar Nurkse (1953), who explained underdevelopment as the natural result of a "vicious" network of interdependencies among economic agents and phenomena. After having fallen into oblivion for a while, the idea became fashionable again in the 1980s, when economists such as Douglas Diamond and Philip Dybvig (1983) and Kevin Murphy, Andrew Shleifer, and Robert Vishny (1989) began to use rational expectations models to elaborate multiple-equilibria theories in regard to bank runs, investment, and economic growth. …

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