On 10 April 2009, Professor Rajan published an article in The Economist.
Below is my full commentary:
Professor Raghuram Rajan argues for a regulatory system that is immune to boom and bust, the co-called “cycle-proof regulation”. This implies that he considers the current financial crisis as a typical cyclical boom-and-bust phenomenon and that existing regulatory system was incapable of preventing it.
Professor Rajan does not define in a strict way what he considers as the “current crisis”. However it is quite clear from his narrative that it is the current inability of banks and other financial institutions to perform the core of their business activities: inability of lending money to individuals, businesses and other banks due to the lack of liquidity. I.e. the banks ran out of cash to the extent that any further lending activities by many of the banks would jeopardise the access to funds by depositors.
This is not a typical characteristics of economic cycle referred to as boom-and-bust. This is a typical characteristics of criminal financial activities called pyramid scheme selling that the world witnessed not that long ago in Poland (in 1990) and in Albania (in 1996 – 1997). In this context the current Madoff’s case is not even a tip of the iceberg, but rather an epitome what the global financial system has become in reality in the recent years.
Professor Rajan does not describe the root cause (or the set of root causes) of the current crisis. In theory it is, of course, possible to prescribe a correct remedy without making a diagnosis. In practice however without it even the best of recommendations, and even if they were correct, are not presented in a credible way. Therefore even a theoretical statistical chance of correctness is destroyed by lack of credibility, as financial markets rely on credibility and confidence in its framework.
Professor Rajan begins with a rather trivial, albeit absolutely correct, observation: “(…) faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system.”
Then Professor Rajan goes on to offer his prescription. He seems to present it as if it was a panacea for any future threat of boom-and-bust cycle. Such approach seems to lack credibility due to its universality but looking in the context of the current financial crisis at his remedy, his proposed “three C’s” does not seem to be any better than the market already has. Indeed the mechanisms he proposes already exist and have already been used by financial institutions. For example, “contingent capital” is a form of derivative that is already wide-spread on the existing markets and is indeed at the heart of the cause of the crisis. Professor Rajan proposes different way of packaging and even further non-transparency. Similarly, buying “fully collateralised insurance policies (from unleveraged firms, foreigners [quite a bizarre proposal for global marketplace], or the government)” seems rather superfluous vis-à-vis capital requirements. Moreover there would hardly be a difference between the current government cash injection of, say, £90 billion and of policy payout of £100 billion (if bought for £10 billion premium). Indeed such arrangements would commercially incentivised financial institutions to engineer circumstances that would allow them to make claims. Not only would this be a way to recoup the premium, as otherwise it would have been lost, but it would also be a new way of making money!
The current financial crisis was caused by the fact that the financial institutions were giving out credit with loan-to-deposit ratio above 100%. Such phenomenon, by its very nature, transforms the financial system into a giant pyramid scheme. The spread between banks overblown and, in fact, bogus balance sheets and the cash on the market increases at exponential rate (i.e. dramatically fast). This is a counterpart of inflation on Zimbabwean scale where the spread between cash on the market and good available exploded to gargantuan proportions. There is no cure or regulation that would prevent such processes from leading to a sudden economic seizure and resulting crisis. That is why pyramid schemes have already been made illegal.
Therefore with respect of the causes of the current crisis, the existing regulations were already sufficient. Pyramid schemes have been illegal for some time. If the bankers had not breached this law, and/or regulators had prevented such breach and/or government agencies had supervised this properly the current crisis, which had been trivial to predict, would not have happened. This, alongside Professor Rajan’s point of possible over regulating, should be kept in mind in any discussion about introducing reforms to the financial industry.
However anti-pyramid scheme laws, sufficient for preventing the current crisis if they were administered properly, are not going to prevent cyclical problems of the economy. In this context Professor Rajan presents some noteworthy proposals, like limits on “too big to fail” institutions and, more concrete, “shelf-bankruptcy”. But interesting as they are (the latter actually quite ingenious), he seems to fall into a trap he is well aware of: the temptation to over-regulate. And in the presence of a pyramid scheme, like the one that caused the current crisis, they are irrelevant: even if they had delayed the collapse, the effect would have been ever more lethal. (Ironically this seems to have been a contribution to the current crisis of the existing derivatives and other financial instruments.)
To summarise, even assuming that Professor Rajan is correct on his cycle-proof regulation proposals, they are rather irrelevant to the current financial crisis. Is a time of collapse of the global pyramid scheme as the current crisis is, the right time to debate about cycle-proof regulation that would be immune to any hypothetical boom and bust? It appears to be an intellectual luxury quite detached from the financial reality on the ground. Or would it be more appropriate to recommend instructing law enforcement agencies to carry out investigations into criminal activities of global pyramid scheme selling and assets seizure from the perpetrators?
Below is my full commentary:
Professor Raghuram Rajan argues for a regulatory system that is immune to boom and bust, the co-called “cycle-proof regulation”. This implies that he considers the current financial crisis as a typical cyclical boom-and-bust phenomenon and that existing regulatory system was incapable of preventing it.
Professor Rajan does not define in a strict way what he considers as the “current crisis”. However it is quite clear from his narrative that it is the current inability of banks and other financial institutions to perform the core of their business activities: inability of lending money to individuals, businesses and other banks due to the lack of liquidity. I.e. the banks ran out of cash to the extent that any further lending activities by many of the banks would jeopardise the access to funds by depositors.
This is not a typical characteristics of economic cycle referred to as boom-and-bust. This is a typical characteristics of criminal financial activities called pyramid scheme selling that the world witnessed not that long ago in Poland (in 1990) and in Albania (in 1996 – 1997). In this context the current Madoff’s case is not even a tip of the iceberg, but rather an epitome what the global financial system has become in reality in the recent years.
Professor Rajan does not describe the root cause (or the set of root causes) of the current crisis. In theory it is, of course, possible to prescribe a correct remedy without making a diagnosis. In practice however without it even the best of recommendations, and even if they were correct, are not presented in a credible way. Therefore even a theoretical statistical chance of correctness is destroyed by lack of credibility, as financial markets rely on credibility and confidence in its framework.
Professor Rajan begins with a rather trivial, albeit absolutely correct, observation: “(…) faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system.”
Then Professor Rajan goes on to offer his prescription. He seems to present it as if it was a panacea for any future threat of boom-and-bust cycle. Such approach seems to lack credibility due to its universality but looking in the context of the current financial crisis at his remedy, his proposed “three C’s” does not seem to be any better than the market already has. Indeed the mechanisms he proposes already exist and have already been used by financial institutions. For example, “contingent capital” is a form of derivative that is already wide-spread on the existing markets and is indeed at the heart of the cause of the crisis. Professor Rajan proposes different way of packaging and even further non-transparency. Similarly, buying “fully collateralised insurance policies (from unleveraged firms, foreigners [quite a bizarre proposal for global marketplace], or the government)” seems rather superfluous vis-à-vis capital requirements. Moreover there would hardly be a difference between the current government cash injection of, say, £90 billion and of policy payout of £100 billion (if bought for £10 billion premium). Indeed such arrangements would commercially incentivised financial institutions to engineer circumstances that would allow them to make claims. Not only would this be a way to recoup the premium, as otherwise it would have been lost, but it would also be a new way of making money!
The current financial crisis was caused by the fact that the financial institutions were giving out credit with loan-to-deposit ratio above 100%. Such phenomenon, by its very nature, transforms the financial system into a giant pyramid scheme. The spread between banks overblown and, in fact, bogus balance sheets and the cash on the market increases at exponential rate (i.e. dramatically fast). This is a counterpart of inflation on Zimbabwean scale where the spread between cash on the market and good available exploded to gargantuan proportions. There is no cure or regulation that would prevent such processes from leading to a sudden economic seizure and resulting crisis. That is why pyramid schemes have already been made illegal.
Therefore with respect of the causes of the current crisis, the existing regulations were already sufficient. Pyramid schemes have been illegal for some time. If the bankers had not breached this law, and/or regulators had prevented such breach and/or government agencies had supervised this properly the current crisis, which had been trivial to predict, would not have happened. This, alongside Professor Rajan’s point of possible over regulating, should be kept in mind in any discussion about introducing reforms to the financial industry.
However anti-pyramid scheme laws, sufficient for preventing the current crisis if they were administered properly, are not going to prevent cyclical problems of the economy. In this context Professor Rajan presents some noteworthy proposals, like limits on “too big to fail” institutions and, more concrete, “shelf-bankruptcy”. But interesting as they are (the latter actually quite ingenious), he seems to fall into a trap he is well aware of: the temptation to over-regulate. And in the presence of a pyramid scheme, like the one that caused the current crisis, they are irrelevant: even if they had delayed the collapse, the effect would have been ever more lethal. (Ironically this seems to have been a contribution to the current crisis of the existing derivatives and other financial instruments.)
To summarise, even assuming that Professor Rajan is correct on his cycle-proof regulation proposals, they are rather irrelevant to the current financial crisis. Is a time of collapse of the global pyramid scheme as the current crisis is, the right time to debate about cycle-proof regulation that would be immune to any hypothetical boom and bust? It appears to be an intellectual luxury quite detached from the financial reality on the ground. Or would it be more appropriate to recommend instructing law enforcement agencies to carry out investigations into criminal activities of global pyramid scheme selling and assets seizure from the perpetrators?
You must thank Raghuram Rajan! His article in The Economist brought me to your blog... probably it also must have brought more readers from The Economist website to your blog.
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