Financial crises keep happening.
In the 21st century, surrounded by powerful computers, huge databases, mathematical models and internationally agreed-upon capital standards, we have experienced another great bubble and bust, based, as often in the past, on leveraged real estate.
"Waiting to be solved … lurks the great question of banking reform," said Woodrow Wilson in 1912. Halfway through 2009, the "great question of banking reform" is yet again lurking. There is an overpowering desire by politicians to show that they can Do Something: like create a "systemic risk regulator."
It is essential to distinguish between a systemic risk regulator, a bad idea, and a systemic risk adviser, a reasonable idea.
"Everybody knows Santayana's line that those who fail to study the past are condemned to repeat it. When it comes to financial history, those who do study it are condemned to recognize the patterns they see developing, and then repeat them anyway!" Why this witty statement from the banking expert George Kaufman is true is a disturbing and profound question. Why do crises keep happening? Part of the answer is that the force of the government, including particularly the Federal Reserve, is itself a key source of systemic risk.
Any meaningful systemic risk adviser has to be distant enough from the government and central bank power structures to be able to speak freely and forcefully about the systemic risk that the government's actions may be creating. That is why, even if one correctly prefers an adviser to a regulator, a council of government agency heads is not the answer.
What hope is there that a systemic risk regulator could operate successfully? "Economic forecasting was invented to make astrology look respectable," John Kenneth Galbraith is said to have remarked.
To forecast the financial future correctly — let alone to control it! — is impossible. This is because of Uncertainty, which means, according to the classic discussion by Frank Knight, that not only do you not know the odds of events, you cannot know the odds. This in turn is partially because beliefs about the odds by market actors, central bankers and regulators change the odds.
As Sir Isaac Newton wrote in disgust after investing in the South Sea Bubble, "I can calculate the motions of the heavenly bodies, but not the madness of people." Using Newton's laws, the courses of the planets can be predicted with accuracy and complete agreement among experts hundreds of years into the future, but the course of financial markets cannot be reliably predicted for the next six, or even three, months. And financial forecasts always display marked disagreement among experts.
What we need to deal with systemic risk is much less models than memory.
As for the Federal Reserve, its history has been marked by policies that have subsequently been revealed as deflationary or inflationary blunders — well-meaning mistakes, subject to huge uncertainty as decisions were made in the midst of complexity and crisis. Among these mistakes were the Great Inflation and stagflation of the 1970s. Now with the 21st century bubble turned to bust, we have another instance in which the Fed is again perceived to have made big mistakes.
An additional assignment as the systemic risk regulator would make the Fed too conflicted when combined with its role as monetary manager — indeed history does not make us too confident even about the Fed's performance as the latter.
Why would we reward with even more power the same agency whose monetary policy stoked the housing excesses in the first place? To paraphrase Sen. Jim Bunning, R-Ky., at a congressional hearing last year: How can you regulate systemic risk when you are the systemic risk?
So: (1) Should there be a systemic risk regulator? No. (2) If there is one anyway, should it be the Federal Reserve? No.
Instead, I favor creating a very senior systemic risk advisory function, which would supply institutional memory of the outcomes of past financial patterns. This advisory body should have a heavyweight board, an insightful and articulate executive director and a small staff of top talent. It must be free to speak its mind to Congress; the administration; foreign official bodies; and financial actors, domestic and international. It must be free to address the government's contribution to systemic risk, in addition to that of private actors.
The systemic risk adviser should look first of all for the buildup of leverage, hidden as well as stated. Its purview should be global. Its thinking and analysis should be deeply informed by the financial mistakes and travails, private and governmental, of recent years, decades and centuries.
The advisory body should be skeptical about "new era" rationalizations, but aware of its own limitations in the face of fundamental Uncertainty. It should remember that losses often turn out to be, as they have been in the current bubble and bust, vastly greater than anyone thought possible; it should also remember that risk taking is essential and that the failure of individual firms is not only necessary, but, in the systemic sense, desirable.
Even the best adviser will not foresee all future problems or prevent all future bubbles and busts.
Everybody — no matter how intelligent, diligent and knowledgeable; no matter how many economists and computers are employed — makes mistakes when it comes to predicting the future, including the future results of their own actions. Because Uncertainty is fundamental in financial markets, entrepreneurs, borrowers, central bankers, government agencies, speculators and politicians alike will continue to make mistakes.
Nonetheless, a systemic risk adviser is distinctly worth a try, and, if it is properly structured, we should try it.
