While it will probably take a few years for the economy to fully recover from the recession of 2008-9, the financial crisis that deepened it and threatened another great depression has passed. With the benefit of hindsight we now have a clearer picture of its causes. Inappropriate government policies and regulations incented and permitted economic agents to undertake too much risk with borrowed money. Following is a big picture overview of what happened and how to “fix it”.
Macro Factors – Global Imbalances
For a variety of reasons, many countries chose to keep their
exchange rates low enough relative to the U.S. dollar to facilitate the growth
of their export sectors or to accumulate larger foreign exchange reserves (the
foreign currency assets owned by central banks with which they can finance
temporary external deficits and defend the external value of their currency).
Many developing countries following the earlier example of Japan have adopted
an export lead strategy for development. For some this strategy took the
healthy form of removing trade restrictions that allowed the growth of both
imports and exports subjecting their economies to greater competition and
promoting greater efficiency and productivity. But some, such as China,
promoted exports at the expense of imports. These countries set their exchange
rates (explicitly or via foreign exchange market intervention by their central
banks) below levels that would produce balance between imports and exports.
To prevent the resulting inflow of surplus dollars from depreciating their
currency’s exchange rate in the market, the central banks of these countries
intervened to buy the excess dollars (often sterilizing the domestic monetary
consequences of such intervention to prevent inflation). The result was an
increase, and often a very large increase, the foreign exchange reserves
(ownership of U.S. dollar assets) of these countries.
In some cases, countries wished to increase their foreign
exchange reserves for sound prudential reasons. Following the Asian financial
crisis of 1997, many Asian countries thought that the conditions imposed by the
IMF for its temporary balance of payments financial assistant were too harsh.
In order to avoid them, they determined to increase their reserves to levels
that would avoid the need to borrow from the IMF when their exchange rates were
For these and other reasons many countries ran international
trade surpluses that greatly increased their foreign exchange reserves. The
surpluses of some countries must be matched by the deficits of others. Thus the
result of the build up of reserves (largely investments in the United
States—largely U.S. government securities) in China and other surplus countries
has been an inflow of capital into the deficit countries (largely the U.S.). 
Under the gold standard, the international reserve asset was
supplied by nature. Under our
current system the U.S. dollar is the dominant reserve currency and it is
supplied at the discretion of the Federal Reserve, America’s central bank. For
other countries to obtain dollars on net the U.S. must have a balance of
payments deficit. Under the gold standard, increases in the world’s demand for
reserve assets (gold) would increase the price of gold (as its supply is
limited by nature) and would produce worldwide deflation.
Under the current dollar standard, the world’s trade surpluses are invested
(largely) in the U.S. The U.S. money supply is not affected, but the demand for
U.S. securities is increased lowering interest rates in the U.S. If surplus
countries have fixed or targeted exchange rates, their central bank must buy
the surplus dollars thus increasing their domestic money supplies. Sterilized
intervention to defend exchange rates is very expensive.
Large global trade imbalances of recent years have lowered interest rates in
deficit countries and when combined with the Federal Reserve’s policy of
domestic price stability in the U.S. (avoiding deflation as well as inflation)
have flooded the world with liquidity. Very low interest rates and excessive
liquidity fueled asset price bubbles, including the real estate bubbles in the
U.S., U.K., Spain, and a number of other countries.
This is the macro environment that fueled other factors that facilitated
excessive risk taking by banks and other financial institutions.
Micro Factors—Excessive Leverage
After centuries of little change, commercial banks have
changed dramatically over the last three decades. Traditionally banks took
deposits from the public, provided payment services for their depositors using
those deposits, and made loans financed by those deposits. Over the last few
decades, banks increasingly financed loans with borrowed funds, replaced liquid
and safe government securities with riskier assets on their balance sheets, and
undertook other speculative (trading) activities. They also moved their
riskiest assets off their balance sheets into special purpose vehicles and
other structured finance products. In short, banks enormously increased their
leverage and significantly increased the riskiness of the assets and positions
they held on and off their balance sheets. Why did this happen?
Several factors combined to shift the balance of risk and
return sought by many but not all banks in the U.S. and in many other
countries. Adrian Blundell-Wignall and Paul Atkinson, in a very insightful
article in the Journal of Asian Economics
set out four primary factors: “(i) capital rules and tax wedges set up clear
arbitrage opportunities for financial firms over an extended period—these were
policy parameters that could not be competed away as they were exploited.
Instead they could be levered indefinitely until the whole system collapsed;
(ii) regulatory change permitted leverage to accelerate explosively from 2004;
(iii) systemically important firms in banking with an equity culture emerged;
and (iv) cumbersome regulatory structures with a poor allocation of
responsibilities to oversee new activities in the financial sector were in
The complex and badly flawed U.S. tax code, with different
rates for different people and circumstances, created the possibility to reduce
taxation on a given underlying income stream (e.g. a mortgage) by shifting it
to investors and/or forms that received more favorable tax treatment through
the construction of complex financial derivatives. The tax saving was largely
enjoyed by the financial engineers creating these complex financial
instruments, with little to no gain for the economy. Modern computers
significantly lowered the cost of constructing and monitoring these complex
financial instruments, further increasing their attractiveness.
Basel II permitted reductions in capital for mortgage
related investments while closing some regulatory holes created by off balance
sheet activities of covered banks. Anticipating these changes many banks
effectively reduced capital charges to their future Basel II levels by moving
them off balance sheet starting in 2004. Some ill advised regulatory changes by
the SEC in the U.S. allowed American banks to greatly increase leverage toward
the more lax European levels. When combined with accelerating real estate
prices in the U.S., and some other countries, some banks increased their
leverage and the riskiness of the assets they held significantly. The question
remains, why bank shareholders and management accepted to do so.
For the United States, a major factor was the increased
dominance of the “equity culture” over the “credit culture” in banks, following
the adoption of the Gramm-Leach-Bliley Act of 1999, which allowed the merging
of investment banks with commercial banks.
Banks’ deposit customers want a safe place to keep their
money and convenient ways to settle (pay) financial obligations with that money.
Small savers want safe term deposits with modest, risk free interest rates that
can be easily withdrawn when needed. Bank’s accommodated those preferences by
lending modest amounts to its depositors or to credit worthy businesses with
good track records or collateral. For centuries, bank owners understood the
nature of the banking business in this way and expected modest but steady
returns on their investment. Blundell-Wignall and Atkinson refer to this as the
Investment banking has a very different culture. Investment
banks earn fees for facilitating complex financial deals and for managing
customer funds who generally have a much higher risk tolerance than do typical
bank depositors. Investment banks also trade and invest their own fund. The
risk preferences of investment banks and their customers tend to be high in
pursuit of high returns. While the repeal of the depression era Glass-Steagall
Act, removed some harmful restrictions, such as the prohibition against
interstate banking, it also removed the barrier between investment banking,
commercial banking and insurance. As the risk taking equity culture of
investment banking mingled with the conservative credit culture of traditional
bankers, risk preferences and standards in many banks shifted toward the equity
culture. Conversations with Citibank employees confirm a dramatic change in the
institution’s attitude toward risk taking over the last decade as its
management was taken over by investment bankers.
The extensive use of bonuses in preference for higher
salaries is also more typical of the equity-investment banking culture in which
the risks and rewards of performance are shared with employees. From an
investment banking perspective, the tax and regulatory arbitrage opportunities
of poorly designed tax laws and regulations called for and justified as much
leverage as they could get away with. The risks seemed small and the return
large if highly leveraged as long as real estate prices kept rising.
Reliance on functional regulation, which certainly has its
merits, left cross-functional risks uncovered. ‘‘Multiple specialized
regulators bring critical skills to bear in their areas of expertise but have
difficulty seeing the total risk exposure at large conglomerate firms or
identifying and preemptively responding to risks that cross industry lines.’’ Market self-regulation was weakened by the lax enforcement
of underwriting standards by agents and brokers who earn fees for concluding
deals but have no skin in the game (no financial stake in the ultimate outcome
– repayment—of deals). Compliance with already low underwriting standards was
sometimes fraudulently ignored or misreported. But the combination of these
weaknesses with the presumption of many players that because the government was
promoting increased home ownership and the lower mortgage underwriting
standards needed to qualify more marginal borrowers, the government would stand
behind its policies and bailout participants if they incurred losses. The
expectation of many that they could keep large profits from risk taking and
pass on the losses to tax payers proved all to true in the end. Obviously,
greater risks were logical in this environment.
The way forward
Economic fluctuations and bubbles have always existed and
will continue to exist. However, greater central bank sensitivity to its
contribution to asset price bubbles should be able to avoid bubbles as large as
the recent real estate bubble. Beyond that, excessive risk taking can be
reduced in the future by removing the tax and regulatory arbitrage
opportunities that reward it
and by strengthening corporate governance so that bank owners have more control
over the salaries of and risks taken by management. Filling some of the
regulatory gaps will also help. The moral hazard impetus to excessive risk
taking exacerbated by government bailouts over the past two years will be difficult
to overcome but extending the failing bank resolution powers the FDIC now has
for banks (bank bankruptcy laws) to a broader range of financial institutions
and requiring firms to develop resolution plans in advance will help. Similarly
removing artificially low costs of funds to firms viewed as “too big to fail”
with appropriately higher capital requirements will also help restore market
discipline of excessive leverage and risk taking. Blundell-Wignall and Atkinson
provide an excellent summary of an exit strategy and reformed system needed in
the future. I want to focus, however, on the nature and scope of commercial
The fractional reserve banking system, which allows banks to
lend the money deposited with them, provides commercial banks with their great
efficiency as well as fragility and potential instability via bank runs. It has
long been the source of much discussion. Strangely perhaps, some strong free
market advocates have proposed extreme regulation of commercial banks in the form
of drastically limiting what they may do with deposits. Narrow banking, for
example, would forbid banks to lend, limiting them to investing depositor’s
money in liquid and safe bonds or bills (e.g. marketable government debt). The
deposits of cash with mobile phone companies in Kenya and Afghanistan that can
be transferred to other mobile phone customers as a convenient, low cast way to
pay bills or transfer cash have a similar restriction. One hundred percent of
the deposits with the phone company must be deposited by the phone company with
banks. Credit Unions operate under somewhat less strict regulations that allow
them to lend to their own, member depositors. Others have advocated what might
be called mutual fund banking (as opposed to the “par value” banking we now
have), in which depositors acquire a share in the bank’s assets rather than the
right to withdraw the amount they deposited.
In that regard it is like a normal mutual fund against which checks may be
written for whatever the current value of the depositor’s share of the bank’s
assets are. Mutual funds can lose money but cannot go bankrupt (unless they are
allowed to leverage investments). The severity of these regulatory restrictions
is accepted by their advocates in the interest of clear, rule-based arrangements
within which the banks could operate freely and safely.
While these proposals have some merit, they are extreme and
in my opinion unnecessarily restrictive. A more moderate proposal is to restore
some version of the separation between commercial banks and other forms of
financial services contained in the Glass Steagall Act.
Mervyn King, Governor of the Bank of England, stated the
problem recently as follows: “Why were banks willing to take risks
that proved so damaging both to themselves and the rest of the economy? One of
the key reasons – mentioned by market participants in conversations before the
crisis hit – is that the incentives to manage risk and to increase leverage
were distorted by the implicit support or guarantee provided by government to creditors
of banks that were seen as “too important to fail”. Such banks could raise
funding more cheaply and expand faster than other institutions. They had less
incentive than others to guard against tail risk. Banks and their creditors
knew that if they were sufficiently important to the economy or the rest of the
financial system, and things went wrong, the government would always stand
behind them. And they were right…. It is hard to see how the existence of
institutions that are “too important to fail” is consistent with their being in
the private sector….
“The banking system provides two
crucial services to the rest of the economy: providing companies and households
a ready means by which they can make payments for goods and services and
intermediating flows of savings to finance investment. Those are the utility
aspects of banking where we all have a common interest in ensuring continuity
of service. And for this reason they are quite different in nature from some of
the riskier financial activities that banks undertake, such as proprietary
trading. In other industries we separate those functions that are utility in
nature – and are regulated – from those that can safely be left to the
discipline of the market….
“There are those who claim that such proposals
are impractical. It is hard to see why. Anyone who proposed giving government
guarantees to retail depositors and other creditors, and then suggested that
such funding could be used to finance highly risky and speculative activities,
would be thought rather unworldly. But that is where we now are.”
Some refer to these
reserves as the domestic currencies “backing.”
 Reducing the exchange rate,
reduces the cost of exports to foreign buyers and increases the cost of imports
to domestic purchasers.
 “The U.S. net international
investment position at yearend 2008 was -$3,469.2 billion….” U.S. entities
owned assets abroad valued at $19,888.2 billion and foreigners owned assets in
the U.S. valued at $23,357.4 billion. The
U.S. current account deficit peaked at $804 billion in 2006 dropping back
somewhat to $706 billion in 2008. (U.S. Bureau of Economic Analysis)
Until its collapse in
1971, the gold standard had evolved into a “gold exchange standard” as part of
the Bretton Woods agreements that created the International Monetary Fund.
Under the gold exchange standard, gold backed the system once removed.
Countries held U.S. dollars, which the U.S. was committed to exchange for gold
at its fixed price on demand.
 Trade imbalances (e.g. U.S.
deficits) would produce gold related monetary flows. Interest rates would
increase in the U.S. as the market’s response to the falling supply of currency
and produce domestic deflation in the U.S. in order to rebalance the real
exchange rate (terms of trade—inflation adjusted nominal exchange rates). This
was the self-correcting trade imbalance mechanism of the gold standard.
 “Sterilized intervention”
refers to central bank sales of their domestic assets to reabsorb their
currency injected into their economies when they intervened in their foreign
exchange market to buy U.S. dollars (or any other foreign currency).
 Low interest rates increase
the present (capitalized) value of given income streams. Thus with lower
interest rates homeowners can buy larger homes for the same monthly payments
and more renters can afford to become homeowners. The result in the U.S. was a
surge in new home construction (ultimately over building) and, where zoning
laws restricted the market’s supply response, price bubbles for existing
 Adrian Blundell-Wignall and
Paul Atkinson, “Origins of the financial
crisis and requirements for reform” Journal
of Asian Economics, Volume 20, Issue 5, September 2009, Pages 536-548.
 Government Accountability
Office (2005, p. 28).
 This shares some features
of Islamic banking.
 Mervyn King, Speech to
Scottish business organizations, Edinburgh, October 20, 2009.