We are not macroprudentialists: a skeptical view of prudential regulation to deal with systemic externalities.

AuthorGlavan, Bogdan
PositionEssay

The aftermath of the 2008 global financial crisis has brought a revision of economic ideas, in particular a new wave of skepticism concerning financial markets' ability to function smoothly. (1) At the core of this skepticism is the idea that because of systemic externalities, a free market is exposed to episodes of boom and bust. As this market-failure argument goes, only by chance are the social benefits and costs of financing and investment decisions equal. Rational investors and financial institutions typically value risk and liquidity risk from their own "private" perspective, ignoring the larger social benefits of liquidity and the aggregate dimension of risk. As one advocate of this perspective aptly puts it,

The current financial crisis is a clear example of systemic failure. It illustrates-once again--the vulnerability of market capitalism to spectacular boom and bust cycles that can devastate the real economy. After decades of complacency about the ability of markets to correct themselves and the resiliency of the economy to financial and other shocks, we have experienced another spectacle of irrational herd behavior producing rapid increases in asset values, lax lending standards and over-borrowing, excessive risk taking, and out-sized profits in the financial sector. The boom was followed by a dramatic crash that spread rapidly through world financial markets, causing plummeting asset values, rapid deleveraging, risk aversion, and huge losses. (Rivlin 2009, 2)

Immediately after the onset of the crisis, a widespread consensus emerged among policymakers and academics that a new "macro" approach to prudential regulation, aimed at containing these externalities, is needed to stabilize the economy in the future. The dictum "We are all (to some extent) macroprudentialists now," coined by Claudio Borio (2003, 1), has gained momentum and justification in an avalanche of professional publications and public speeches.

In this article, we discuss the argument for prudential regulation from a skeptical perspective for two reasons. First, whereas readers can easily browse through a substantial body of literature justifying increased regulation, consistent critical works are considerably more difficult to find. We attempt to fill this gap and provide an opposing view. Second, troubled times give an inherent weight to state interventions and interventionist theories, as society asks or waits for the government to "do something." Therefore, we believe that in the current economic, social, and political context it is too easy for interventionist arguments to overshoot in the realm of decision making.

Our central claim is to show that the case for prudential regulation, notwithstanding its new theoretical rationale, is no better at present than it was before the crisis. We critically examine the idea that borrowing creates systemic externalities that give rise to herd behavior, catching the economy in a trap of multiple equilibria from which it can escape only with the help of a countercyclical prudential policy.

Systemic externalities, Systemic Risk, and Coordination Failures

The concept of systemic externallty purports to provide a solid ground for some sort of economic dirigisme. (2) Systemic externalities express the idea that individual behavior often entails a chain reaction or amplification effects that impact, positively or negatively, the whole market. Because of this phenomenon, the economy spirals up or down as investors' buying or selling stimulates third parties to imitate their behavior.

This idea's history can be traced back to the writings of authors such as Paul Rosenstein-Rodan (1943) and Ragnar Nurkse (1953), who explained underdevelopment as the natural result of a "vicious" network of interdependencies among economic agents and phenomena. After having fallen into oblivion for a while, the idea became fashionable again in the 1980s, when economists such as Douglas Diamond and Philip Dybvig (1983) and Kevin Murphy, Andrew Shleifer, and Robert Vishny (1989) began to use rational expectations models to elaborate multiple-equilibria theories in regard to bank runs, investment, and economic growth. Since then, economists have emphasized a number of situations in which the interdependence of private agents seems to produce welfare-inferior outcomes. In particular, since 2008 many theorists have appealed to systemic externalities in credit markets in connection with their considerations of policy responses to what they perceive as a clear market failure.

In relation to financial markets, the market-failure argument centers on the notion of systemic risk, a reflection of negative systemic externalities, which can be explained as follows. When deciding how much to borrow, private agents take into account only some of the benefits and costs of their financing and investment decisions, and they consider aggregate prices as given. But individual decisions concerning the magnitude of borrowing also have social effects. On the one hand, the more one borrows, the more one can invest and bid up asset prices. And the more asset prices increase, the more one can use the same collateral to obtain additional credit. On the other hand, increasing leverage comes at the price of increasing risk exposure. If all individuals pursue the same strategy and increase borrowing, then the overall situation will be worse for everybody. When market conditions turn negative, asset prices decline, so debtors will be forced to spend less, thereby depressing prices further and increasing the burden of debt for everybody.

The situation can be contemplated similarly from a lender's perspective. When judging the risk of an investment project, each individual lender takes asset prices as given. But asset prices are determined by lenders' aggregate behavior. When all banks increase lending, the effect is asset-price inflation and increased financial fragility. Each bank becomes more exposed to the systemic risk. If an adverse shock occurs, banks will be forced to liquidate their investments, which will deflate prices, thereby leading banks to liquidate further. "Hence, fire-sales by some institutions spill over, and adversely affect the balance sheet of others, causing a negative externality" (Brunnermeier et al. 2009, 22).

Financial fragility can be understood alternatively not as the consequence of a gap between private and social costs of borrowing, but as the effect of a wedge between private and social benefits of liquidity. Thus, the negative externalities of borrowing can be replaced in argumentation by "the other side of the coin"--namely, the positive externalities of holding cash. (3) In the boom, as asset values rise and mark-to-market risk is minor, investors underestimate the benefits of liquidity. Profit maximization consequently requires financial institutions to expand their balance sheets and increase leverage, often using short-term funding from the money markets. In the bust, market participants symmetrically rush to hoard liquid assets, deleveraging and reducing their exposure to (now overestimated) risky assets. Yet what seems reasonable from a single bank's perspective is bad in the aggregate: if many banks try to deleverage at the same time, they may cause a downward spiral of asset prices and a financial meltdown.

Theorists of systemic externalities claim that aggregate risk cannot be conceived as the sum of individual risk. Aggregate risk is endogenous, deriving from the banks' individually rational but collectively irrational behavior. Its magnitude depends on the size, degree of leverage, and interconnectedness of financial institutions. Thus, the proponents of macroprudential regulation provide an organic perspective on risk that is strongly anchored in the tradition of coordination-economics literature.

The economy is like an ecosystem, and Darwin was implicitly recognizing that ecosystems have multiple equilibria. Far more important in determining the evolution of the system than the fundamentals (the weather and geography) are the endogenous variables, the ecological environment (Hoff, 2000, 153).... In an ecosystem, a key factor determining how any individual will behave is his environment. One of the most important aspects of that environment is the behavior of others. Under some conditions, ecosystems have multiple equilibria, and individuals may fail to "coordinate" on the equilibrium that is preferred by everyone.... The basic mechanics of coordination failure are simple: An individual's behavior--for example, to produce or to prey on the production of others--creates externalities. The externalities affect not only the welfare of others, but also their decisions. The interaction of the slightly distorted behaviors of many different agents may produce very large distortions and can lead to the existence of multiple equilibria, some very good for every member of the economy, and some very undesirable. (Bowles, Durlauf, and Hoff 2006, 6-7)

From this mismatch between private and social valuations of liquidity results specifically a number of distortions: overborrowing, excessive risk taking, and excessive short-term debt, which may be seen as unintended harmful consequences of individual, fully rational behavior--a sort of tragedy of the commons. To put it differently, we confront a classical coordination problem (4) or "fallacy of compositions" (5) (den Butter 2010). The situation is, in Anton Korinek's opinion, similar to the problem of air pollution:

Financial fragility is an uninternalized by-product of external financing just as air pollution is an uninternalized by-product of driving. It is privately optimal for the drivers of cars to enjoy the benefits of their mobility while disregarding the pollution that they impose on the rest of society, since each driver knows that her individual contribution to air pollution is minuscule. In aggregate, however, there will be excessive...

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