"Why the Next Financial Crisis Will Be Different"

From Knowledge@Wharton:

Major financial crises seem to rear their ugly head about every decade or so somewhere in the world, each different from the preceding one. 
 

While there has been a lot of research on the causes of the latest global financial crisis that began in 2008 — and how to prevent it happening again — many experts argue that any new crisis will be different. Like the old saw noting that “generals always fight the last war,” there have been questions raised about whether or not researchers have focused enough on what might cause a future financial crisis, particularly with regard to central bank behavior.

In an effort to avoid planning for the past when it comes to global financial crises, Wharton finance professor Franklin Allen has collaborated on a research paper titled “Financial Connections and Systemic Risk” with colleagues Ana Babus of the University of Cambridge and Elena Carletti of the European University Institute.

Allen spoke with Knowledge@Wharton about his paper and what regulators need to be concerned about in order to avoid future crises. 

An edited transcript of the conversation follows.  

On what the research is about:

The research I’m going to talk about is part of a long agenda. It has to do with the way that central banks and governments intervene in the economy.

For the last 20 or 30 years, central banks have, by and large, focused on fighting inflation. After we had the big shocks in the 1970s, that was the major problem, and that’s what they’ve spent their main efforts doing. Some of the central banks, like the Federal Reserve, have a dual mandate. In addition to worrying about inflation, they also have to worry about unemployment.

The way that this has been implemented in most countries, either explicitly or implicitly, is that the central bank has focused on inflation, and it’s usually granted formal independence from the government. The idea there is to stop it from lowering interest rates just before an election and making the economy boom, but then having inflation going up and so on. That was an idea that has been widely accepted for some time.

Financial stability was in the mix, but it was usually regarded as something that was secondary — so that was dealt with either by the central bank or in many countries, such as the U.K. or Japan, by a separate financial services authority or FSA. They would deal with problems to make sure that there were no difficulties in transmitting monetary policy because banks were having problems. The way they did that was to stop banks taking risks, one by one. They would look at each bank and make sure that they weren’t doing risky things. The idea was that would stop any problems in the financial system.

Fiscal policy was done separately by the treasury or the finance ministry, depending on the country. We could break up all these different parts of the way the government and central banks intervened, and they could all do their job separately. Now the problem is — what the crisis has shown — is that system didn’t work properly. What we need to do, I argue in this research, is to think carefully about how we should proceed going forward....MUCH MORE