The Need for Regulation to Prevent Future Financial Crises

Bill Hibbard

Submitted as an Op-Ed to the New York Times, 26 March 2008

The current credit crisis is a warning that the combination of financial deregulation and the increasing complexity of our economy creates instability. If we want to avoid future crises and the possibility of ruinous inflation or deflation, we need to adopt regulations that force financial institutions to limit their leverage and follow stricter accounting standards.

In a 16 March 2008 comment in the Financial Times, Alan Greenspan lays much of the blame for this crisis on the fact that econometric models do not yet adequately represent the full complexity of the economy, particularly the human nature motivating economic decisions. However, the largest economic decisions are made by institutions using their own econometric models. Thus it is hopeless for any model to ever adequately model the economy, since the complexity of the economy increases with the complexity of models. In fact, the increasing complexity of the economy means that the human ability to understand it is decreasing. This is illustrated by the degree to which the current crisis surprised economists. It is futile to try to prevent future crises by improving the accuracy of econometric models, since all major market players use similar models. Our economic future will include a series of increasingly severe crises unless we adopt regulations that damp the amplitude of economic shocks.

A major cause of economic instability is leverage. If an institution invests 100 borrowed dollars for each of its own dollars in mortgage securities, then even a small rise in foreclosures will wipe out its capital. Institutions are encouraged to take such risks by the expectation that the government will bail them out with loans in order to prevent their bankruptcy. And institutions become overconfident in the accuracy of their models when they lead to successful decisions over a few calm years. It is a classic case of failing to appreciate their own ignorance. An economy driven by a large number of similar but competing models simply defies modeling or human understanding. The combination of unlimited leverage, faith in government rescue and incomprehensible complexity will inevitably lead to a series of crises.

The government mandates cash reserve requirements for commercial banks, limiting the amount of leverage they can employ, and in return promises to provide liquidity to prevent runs on those banks. It is time to mandate limits on leverage for all financial institutions whose size would require a government bail out, and mandate strict accounting standards to prevent institutions from hiding leverage off their balance sheets.