If improved financial regulations wont prevent crashes, what is the point of them?

The background to this column is that I am greatly influenced by Joseph Schumpeter (1883-1950) who saw innovation at the heart  of capitalism. Sometimes the risks taken to innovate go belly-up and firms crash; with knock-on effects. Those crashes are therefore an integral part of the innovation which goes with the rising level of material production and capitalism.

Perhaps the greatest – certainly the most rapid – innovations of contemporary times are in the financial sector, so we should expect financial crashes in due course. A Schumpeterian thinks in terms of when, not if.

There is quite a lot of noise at the moment predicting a financial crash. The noise tends to get magnified because it makes good media headlines. Should we take it seriously?

Since there is going to be a crash some time, the doomsayers are bound to get it right some time. This year? Moreover, the size of the crash may matter. For instance, a number of New Zealand construction firms have fallen over recently – enough of them to suggest there is some underlying problem. Thus far the effects have been locally disastrous especially to the subcontractors, but you can imagine scenarios in which the whole economy might suffer.

There is some evidence of much of the world economy going into a cyclical downturn. It is usually attributed to Trump’s trade war with China compounded by US business getting increasingly uneasy with his erratic anti-business behaviour; both will have knock-on effects to other countries.

Moreover, world interest rates seem to be rising from their current low levels, especially as the US Fed attempts to mop up excessive liquidity from the quantitative easing used to cushion the 2008 Global Financial Crisis and the US huge, unfunded, tax cuts.

In any case, we haven’t had a decent international financial crisis for a decade; isn’t one about due?

Two serious contributions to the concern have come from the IMF and the Bank of International Settlements. Let me set this issue out in my terms.

There is an awful lot of liquidity in the international economy. Much is held by the rich who have little need to spend a large portion of it. But returns on investment are low. So they look for innovations which give them high-risk financial returns. Such innovations can evolve into gambling as they did in the run up to 2008. It is argued that such innovation/gambling is again rapidly evolving.

We start to go through the Minsky cycle. Hyman Minsky (1919-1996) – a student of Schumpeter but also greatly influenced by Keynes – saw a sequence in which investors went from hedging, to speculation, to Ponzi strategies and thence to the ‘Minsky moment’, when the resulting financial instability collapses into a financial crash.

Hedging involves debt payments (covering interest and principal) from current cash flows from investments. During the speculation phase the cash flow from investments can service the debt, that is, cover interest, but the borrower must regularly roll over (re-borrow) the principal. The ‘Ponzi’ phase (named after Charles Ponzi who famously ran a fraudulent scheme) occurs when it is believed that the appreciation of the value of the asset will be sufficient to refinance the debt. The cash flow from investment is insufficient. Instead the Ponzi investors keep borrowing, secured against the appreciating asset value. .

But the price – the asset value – cannot keep rising forever. When it doesn’t – when the ability to borrow stops – the Minsky moment occurs.

Notice a key element in this cycle is that the investors have been borrowing from others, Their trick is to leverage, to borrow some of the investment at a low return and invest it at a higher return adding the gains to their equity return. (This is exactly what you try to do, when you borrow on mortgage to finance your house purchase.) Using ‘someone else’s money’ exposes the someone to a loss when the crash occurs, even though they may be unaware their money is being used this way. At which point the crash gets messy – as it did during the GFC.

One further complication is that the intermediary between the ultimate lender and the ultimate borrower takes a cut from the apparent profits. If the investment is in the Ponzi part of the cycle there is no long term return. Even so the intermediary will have taken their cut and almost certainly insulated themselves from paying anything back in the crash. So those exposed lose even more.

Gee, it is getting complicated. Let us leave the intricacies aside and ask what can be done, especially as Schumpeter and Minsky say you cannot stop financial crashes. It is not if, but when.

I was at a really good seminar recently, in which the overseas speaker pointed out that none of the changes in financial regulation would have prevented the Global Financial Crisis. The audience gasped, except we Schumpeterians – of course.

Why then bother with financial regulations? Well, they might be able to moderate the severity of the crash and improve post-crash resilience – the ability to recover from the negative impacts of external economic shocks.

Another common objective is to ensure that the costs of a financial crash will be shared more fairly than they have been in the past. That includes those who will suffer collateral damage – a particular problem for the New Zealand economy during an international financial crisis.

For example, the Reserve Bank is proposing that our trading banks have larger capital buffers to give greater protection to depositors and taxpayers during a financial crisis, with shareholders taking more of the downside (as well as the profit during good years).

These are all worth doing, even if they reduce the opportunities for financial innovation a little. But they leave a Schumpeterian a little troubled when we pretend that they will prevent the next crash. Some people seem to even believe it.

Yet all investors need some assurance that they will not be robbed at the next financial fallout. Such trust is critical for a modern economy. We walk a narrow path between the promotion of trust and the reality that crashes are integral. One answer is to ignore what Schumpeter and Minsky taught us; a foolish answer but one acceptable to too many people.