By Peter Boone and  Simon Johnson

Over the last three decades, the US financial system has tripled in size, as measured by total credit relative to GDP. Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises appear to be getting worse and worse – and their impact is increasingly global. Not only are interest rates near zero around the world, but many countries are on fiscal trajectories that require major changes to avoid eventual financial collapse.

What will happen when the next shock hits? We believe we may be nearing the stage where the answer will be – just as it was in the Great Depression – a calamitous global collapse. The root problem is that we have let a ‘doomsday cycle’ infiltrate our economic system.

The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.

Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.

Regulators are supposed to prevent this dangerous risk taking. Adair Turner, chairman of the Financial Services Authority, is calling for more radical change than most regulators. But banks wield substantial political and financial power, and the system has become remarkably complex, so eventually regulators become compromised.

The extent of regulatory failure ahead of the current crisis was mind boggling. Many banks, including Northern Rock, convinced regulators that they could hold just 2% of capital against large and risky asset portfolios. The whole banking system built up many trillions of dollars in exposures to derivatives. This meant that when one large bank failed, it could bring down the whole system.

Given the inability of our political and social systems to handle the hardship that would follow economic collapse, we rely on our central banks to cut interest rates and direct credits to bail out the loss-makers. While the faces tend to change, each central bank and government operates similarly. This time, it was Mervyn King, Gordon Brown, Tim Geithner and Ben Bernanke who oversaw policy as the bubble was inflating – and are now designing our rescue.

When the bailout is done, we start all over again. This has been the pattern in many developed countries since the mid-1970s – a date that coincides with significant macroeconomic and regulatory change, including the end of the Bretton Woods fixed exchange rate systems, reduced capital controls in rich countries and the beginning of 20 years of regulatory easing.

The real danger is that as this cycle continues, the scale of the problem is getting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse.

WHATS THE ANSWER?  Read the paper

Source: VoxEU.org (full paper)