In Can Financial Markets Be Controlled?, Howard Davies demonstrates his long experience in, and careful thinking about, the instabilities of financial systems.
Possible reforms are weighed sensibly and realistically in this short (109 pages) and substantive book. The author displays a refreshing humility about what the human mind is capable of when faced by the uncertainty of the financial future. He points out that “few anticipated the crisis” that began in 2007, and that the “judgments and forecasts” of economists, regulators, and central bankers, “widely shared at the time,” turned out to have been “catastrophically wrong.”
Whose fault was it all? Who was guilty? Davies considers the “outpouring of academic and popular literature attempting to explain the origins of the crisis” and the many and conflicting theories. A commonly proposed cause: “an excess of deregulation, itself animated by a naïve and ideological belief in the primacy and superiority of markets.” As he correctly says, with that thesis, “those on the left found their prejudices and beliefs comfortingly reinforced.”
Less comforting for them is the fact that “the number of regulatory staff, on both sides of the Atlantic, grew rapidly in the decade leading up to the crisis.” The ranks of the regulators in the United Kingdom, for example, went from “a little over 200 at the end of the 1980s to 2,600 just before the crisis.”
A specific mistaken deregulation, allegedly, was ending the 1933 Glass-Steagall separation of investment from commercial banking in the United States. But as Davies points out, the Europeans had no such separation in the first place, so in their case it couldn’t be ended. Moreover, “some of the most stable institutions throughout the crisis, like JP Morgan, were among the biggest and most diversified.” We may add that the financial system that performed best of all, Canada’s, was and is primarily composed of big banks that combine commercial and investment banking.
Accurate or not, the “excess of deregulation” theory has had major effects in the wake of the crisis: huge increases in regulation, growing rapidly. Banks now have “big teams of regulators . . . permanently on the premises.” In Britain, “supervision teams have grown, and extensive use is made of costly external consultants.” This means that regulators “are aware that they are more and more closely implicated in management decisions and are fearful of the risks they run,” and “only a vanishingly small number of people can explain the rules to which they are now subject.”
“If financial stability were correlated with the costs of regulation,” Davies skeptically writes, “the system would be safer than ever.” A big “if.” Has the regulatory efflorescence made the system safer? When the next crisis arrives, we will know the answer.
In Davies’ view, there are no excuses for the many big mistakes made by private financial actors. Many firms’ managers and boards of directors “failed signally in the crisis.” Given that fact, the costly expansion of government regulation in response to the crisis was, if not optimal, at least 100 percent predictable. In that sense, “Boards can hardly complain.”
But governments themselves were guilty, as emphasized by a competing thesis “developed on the right, centering on state interference in the financial markets.” That there was plenty of such interference leading up to the crisis—and that such interference continues—is beyond doubt. In Washington, administration after administration wanted to stimulate the housing market, which “distorted credit allocation, encouraging non-creditworthy borrowers to take on unsustainable debt.” Moreover, government-supported Fannie Mae and Freddie Mac “were at the heart of the problem” as they pursued “an essentially political agenda.”
On the other side of the Atlantic, some of the most enthusiastic investors in disastrous bubble assets were state-owned German banks whose boards of directors were “weighed down with politicians.” So governments “were uncomfortably aware that they themselves enjoyed the party while it lasted.” In particular, governments had “basked in the feel-good mood created by a rising property market fueled by the easy availability of cheap credit.”
That brings us to another guilty party: the Federal Reserve, accused of being “complicit in a massive expansion of the money supply.” Why, Davies asks, did “central banks do so little to rein in what can now be seen to have been an extreme example of irrational exuberance?” Because they did not see it then, of course. Like others, the Fed utterly failed to anticipate the coming disaster it helped create. But central banks “have a well-developed resistance to accepting responsibility,” Davies sardonically observes, “because much of their influence depends on the appearance of infallibility.” An accurate indictment—but what a silly idea it is that central banks are any less fallible than anybody else.
The “feel-good mood created by a rising property market” seduced the lenders, borrowers, investors, regulators, governments, and central banks that together make up the financial system. Every financial system, appropriating Walter Bagehot’s words from 1873, “will have been unusually fortunate if during the period of rising prices it has not made great mistakes.” In the 21st century’s rising property prices, as Bagehot would have expected, it once again made great mistakes.
On the most fundamental level, “extravagant credit creation was at the heart of the crisis.” Davies boils it down to one simple word: leverage. This is surely right. “The credit cycle,” he writes, “is as regular as the business cycle, but typically its amplitude is twice as big.” In other words, finance exaggerates the volatility. But if you want regulation to moderate these cycles, you have to answer a hard question: How will the authorities know when credit growth is excessive? This is especially problematic, Davies points out, if the authorities are themselves pushing to expand credit in the real-estate market.
They are already at it again in both the United States and the United Kingdom. We may be scandalized by this, but we should not be surprised.
On the macro level, Davies wonders how to address “the dangerous tendency of developed economies to accumulate debt.” A logical question, and a difficult one. He suggests correcting the bias in favor of debt that is embedded in current tax systems. As good an idea as this is, it’s unlikely to happen. He rightly wants to reexamine the international monetary system. Without doubt, the post-Bretton Woods world of pure fiat currencies and floating exchange rates has proved over four decades—that is, from its beginning—to be crisis-prone.
Davies also wants to escalate financial stability regulation to a supra-national level, governed by an international treaty. This is the only major point in the book with which I find myself in entire disagreement. To believe that an international, even more complex bureaucracy would do any better than the national ones we’ve already got requires a remarkable leap of faith, especially when, as Davies argues, “detailed intrusive regulation is doomed to fail.”
Reforms are made more difficult because “the debate about whether the crisis was the result of too much or too little state intervention has not been resolved.” Since debate over what caused the 1930s crisis has not yet been resolved, 80 years later, we had better not plan on reaching a consensus about the recent one. Still, we can work to achieve two strategic goals that Davies convincingly sets out:
- “The long-term aim of regulation should be to strengthen the control mechanisms within firms, rather than to replace them”; and
- Governments “should in particular eschew efforts to manipulate property prices for political ends.”
This sober, knowledgeable, and balanced book does not try to sell its readers the snake oil of simple solutions to inherently complex problems characterized by high uncertainty.