Systemic instability and failure

One of the distinguishing features of globalisation and liberalisation of financial markets over the past decade and a half has been the frequency with which financial crises at both the national and international levels have occurred. National financial crises have all too often spread like wildfire across the globe threatening to bring systemic failure and the breakdown of the entire global structure of private financial markets. There is abundant evidence in this experience to convince us that there is an inherent vulnerability of private financial markets to systemic instability and failure.

Why is this the case? The major reasons I have identified in the recent US experience centre on the chicanery, deliberate fraud, inadequate oversight, and conspiracies among investment analysts, auditors, financial officers, and politicians to cut corners and operate illegally if necessary. Certainly all these elements have been exposed with the Enron, WorldCom, Qwest, Tyco and similar scandals. There are nevertheless, other reasons for systemic instability and failure. Financial markets are places where information flows are crucial but these are both limited and unequally distributed. There is no free and equal access to information with the result that, in terms of efficient market theory, financial markets are intrinsically imperfect. This imperfect condition creates the predisposition for their failure and collapse. As a consequence of this, even under the most pro-capitalistic free market political regimes, financial regulation and supervision occur with the government and other public authorities (for example, central banks) taking the lead.

Financial repression

In learning from the US experience we need to bear in mind that for most of the period since Independence regional governments have followed policies which can be described as ‘financial repression.’ Financial repression was the very antithesis of the financial liberalisation widely practised today. The main pillars of financial repression were 1) fixing interest rates below market levels 2) directive control of the allocation of credit by governments 3) discouraging and/or limiting the domestic presence of foreign financial enterprises (sometimes by way of nationalisation) and 4) governmental directives to force private financial institutions to hold an ‘excessive’ portfolio of government securities. The adverse consequences of this period were many, and the gains few. Thus low negative real interest rates (that is interest rates adjusted for inflation) discouraged domestic savings and encouraged individuals and firms to send their savings abroad. This situation played a major role in the widespread capital flight at that time. These rates of interest also ensured that an efficient allocation of resources did not take place, because the cost of financing was being artificially restricted. In the case of nationalised banks, loans were directed to political favourites, who in turn had a low, if indeed any, motivation to repay. Low repayment rates led in many instances to effective bank failure but, in order to avoid wider systemic failure and also to cover for the political fallout of bank collapse, budgetary bailouts were provided to depositors and creditors at taxpayers expense.

Further, deliberate efforts were made to conceal these funds from the public with the result that they were misdirected away from the bank re-organisation they were intended to serve to the outright subsidisation of more of the same. Inevitably the cycle of bad loans therefore continued.

In these countries macroeconomic performance rapidly deteriorated, economic growth was impeded, and inefficiency thrived. Regrettably, the costs of these bad policies were carried disproportionately by the poor. The irony, however, is that the original motivation for these policies was guided by distributional concerns, that is, the need to make regional financial systems serve the needs of the poor. The practice became different, because in the end political priorities led all others and the poor’s welfare was sacrificed at the altar of politics.