The age of financial instability

Economic crises, reinforced by volatility in international capital flows, are waning - but they will never be eliminated

12 June 2001

Severe financial crises have punctuated the progress of the last two decades. Without greater stability, many may conclude that toleration of a liberal internationally integrated financial system is a risk they can no longer afford.

The US, the UK, Finland, Norway, Sweden and Japan have all suffered significant financial crises since the early 1980s. As this year's annual report from the Bank for International Settlements (BIS) notes: "In many emerging markets, financial cycles have been particularly pronounced, typically being reinforced by large swings in the flow of international capital. The cost of these cycles has been high, with the direct cost of resolving bank crises often exceeding 10 per cent of gross domestic product and the indirect costs in terms of lost output higher still."

There are reasons for hoping that the worst may now be in the past.

First, monetary stability has returned after a prolonged era of high and variable inflation.

Second, liberalisation and international opening of financial sectors always create a shock of adjustment. Where regulation has been poor and liberalisation mishandled, severe crises have resulted. But those crises have taught lessons that should not need to be repeated.

Third, in 1996 net bank loans and portfolio investment in emerging markets ran at $97.1bn. Last year this was minus $9.9bn. Crises needs a preceding period of euphoria. In emerging economies, euphoria has fled.

Fourth, we know that the combination of capital market liberalisation with monetary autonomy and fixed exchange rates is unworkable. The International Monetary Fund's failure to say this loudly and often was its single greatest blunder of the past decade.

Finally, there have been big regulatory improvements at domestic and global levels. These include the establishment of the Financial Stability Forum and the new Basle capital accord, designed to relate capital requirements to risk more closely than before.

All these are reasons for optimism. Yet it would be wrong to expect an end to crises. One reason is that some important developing countries have still to join the global financial system, among them China and India. The deeper reason is that instability - defined as large swings in asset prices and distress of financial institutions - is inherent in any liberal system. Andrew Crockett, general manager of the BIS, suggested why in a splendid speech delivered last year.*

In answering the question why financial systems are prone to instability, he pointed to four unavoidable features.

• Fundamental value is extremely hard to assess. "We eagerly discount what is inconsistent with our theories or beat it into shape until it fits them."

• In the financial sector, excess supply does not lower prices and profits but raises them instead. Lending booms raise activity and asset prices, improving the perceived creditworthiness of borrowers and financial condition of lenders.

• The creation of liquidity, a core function of the financial sector, results in more fragile balance sheets.

• Ill-designed safety nets exacerbate instability.

And, argues Mr Crockett, developments of the past decade or two have exacerbated these failings.

One development is increased global competition and the consequent wave of what Joseph Schumpeter, the Austrian economist, once called "creative destruction". Another is increased liquidity, with the development of global markets and new instruments. Yet another is the increased value of public guarantees in a riskier environment. Globalisation has also tightened linkages across institutions, markets and countries. If one adds the liberalisation of repressed financial systems, it is no wonder that a wave of credit booms, asset bubbles and crises has emerged.

Between 1980 and 1990, the ratio of credit to GDP in the UK rose from less than 50 per cent to nearly 120 per cent. In Finland, it rose from 50 per cent to 90 per cent, before falling to just over 50 per cent in 1998. In Thailand, the ratio rose from 20 per cent in 1970 to 120 per cent just before the 1997 crisis.

These are extreme cases. But the cycle has been powerful almost everywhere. The spiral of good news to euphoria and back again does, alas, even capture regulators, central bankers and credit rating analysts. Not only is the market pro-cyclical, so are its guardians. Who then will guard the guardians?

Moreover, elimination of inflation is not enough to end such instability. It may even increase it. The BIS notes that "low inflation, particularly if accompanied by strong central bank credibility and robust economic growth, generates the very optimism that helps fuel credit booms and unsustainable increases in asset prices".

Mr Crockett argues that this is partly because modern fiat money (unbacked by gold or silver), combined with inflation targeting, separates monetary from financial stability more completely than did the old gold standard. Under the gold standard, credit expansion was limited by the monetary anchor. Under inflation targeting, there is no such anchor for credit.

What then is to be done?

The first answer is to recognise that a significant degree of instability is an ineradicable component of risk-taking financial systems, run and regulated by human beings. Boom and bust cannot be eliminated.

The second answer is to liberalise carefully.

The third is to eliminate unnecessary sources of instability, such as big swings in inflation, internally inconsistent exchange-rate regimes, 100 per cent deposit insurance and continued operation by bankrupt financial institutions.

The fourth is to align regulation with risk. This is the principal objective of the new rules on bank capital. But intermediaries can still subvert regulation, just as regulators are often seduced by the prevailing mood.

That leaves the final answer. This is to adjust monetary policy in the light of financial market conditions, not just the prospects for inflation. Soaring asset prices and rapid credit expansion should occasion tighter monetary policy, even if inflation is expected to meet its target within the forecasting horizon.

The good news is that the extraordinary instability of the past two decades ought now to diminish. The bad news is that it will never disappear. The world of low and stable inflation could even have increased instability, by encouraging optimism. There are no easy answers. The next few years will tell us how far we must review the questions.