Debt and systemic risk: the contribution of fiscal and monetary policy.

• Author: Steil, Benn
• Position: Essay

The story of the financial crisis will be retold endlessly as one of widespread corruption and incompetence, enabled by a policy agenda fixated on deregulation. But to accept this story, one would have to believe that if the marketplace had been confined to ethical and informed individuals, and if their activities had been carefully scrutinized by diligent regulators, we would have avoided a major financial boom and bust.

While we cannot rule out such a proposition a priori, we can state with overwhelming empirical support that the history of financial crises teaches us either that it is not so or that we are, in any case, incapable of imposing such structures on anything approximating a free society. The historical evidence has been meticulously compiled, filtered, and explicated in Carmen Reinhart and Ken Rogoff's new study This Time Is Different: Eight Centuries of Financial Folly (Reinhart and Rogoff 2009).

Excessive Debt

The heart of the problem, in Reinhart and Rogoff's analysis, is "excessive debt accumulation." That such debt accumulation was a feature of the current crisis is beyond doubt. That it pervaded so many sectors of the economy and underpinned so many asset classes is also beyond doubt. That its most damaging manifestation, in the real estate market, was fuelled and fated by policymakers who supported, as a general principle, more regulation as well as those supporting less regulation, is further beyond doubt. Therefore, any sound attempt at reconstituting regulatory structures in the wake of the crisis must focus directly on restraining excessive debt accumulation.

The first and most essential step in such a process should be applying a"do no harm" test on the current structures. That is, rather than simply assuming that excessive debt is the result of individuals and institutions having a natural predilection for debt which must be restrained by government, we need to consider whether government policy is actually encouraging individuals and institutions to take on more debt than they would in the absence of such policy. We do not have to look far to find compelling evidence that it is: fiscal and monetary policies provide plenty.

Fiscal Policy

With regard to fiscal policy, reform of the tax code should be a priority. At the household level, full mortgage interest deductibility gives Americans an enormous incentive to leverage the purchase of larger homes than they need, and home equity loan interest deductibility then gives them the incentive to leverage consumption by reducing equity in their homes and raising their default risk. Although these phenomena are fairly well known, much less discussed are the problems at the level of corporate taxation. A recent cross-country...