To address bubbles and financial crises, one of the most important projects is to develop countercyclical factors to offset, at least in part, the excesses induced by the procyclical ones.
Cycles in economics and finance are inevitable. The dream that they could be prevented by macroeconomic "fine tuning" by governments, guided by the wise advice of learned economists, was given up long ago. How quaint now seems the title of a 1960s book, Is the Business Cycle Obsolete?-- although not more quaint than the celebrated 21st century assertion that economics and central banking had achieved "The Great Moderation."
Many factors are procyclical. (That is why we have cycles.) These include the crowd psychology of confidence vs. fear, of optimistic leveraging in the boom vs. the panicked scramble for cash in the bust. The ability of great numbers of people to make a lot of money from asset bubbles while they last, which may be for many years, is key to understanding their historical recurrence.
In the housing bubble of which we are still living in the wake, for example, the ever-rising asset prices seemed to be confirmed by success on all sides. As long as house prices were rising, everybody--borrowers and lenders, brokers and investors, speculators and house flippers, home builders and home buyers, bond rating agencies and bond salesmen, realtors and municipalities, politicians promoting increased home ownership and regulators announcing there were no bank failures--all seemed to be winning.
"All people are most credulous when they are most happy," wrote the great banking thinker Walter Bagehot 138 years ago. "When much money has just been made, when some people are really making it, when most people think they are making it…almost everything will be believed." There's a challenge for countercyclical strategies!
When things cease to be believed, the reaction of great numbers of people to losing vast amounts of money with great rapidity is procyclical. "Fair value" accounting is procyclical. The policies governing loan loss reserves are procyclical. Stock buybacks are procyclical. Political retribution is procyclical.
Of the procyclical forces, one of the most important is financial regulation--a problem well known to theoreticians of banking and regulation. This is true in the up cycle, marked by cognitive herding concerning, for example, a great moderation, a global liquidity glut, the power of financial models, the theories imbedded in "Basel II" capital requirements, and the "strong capital ratios" created by the profits of the bubble.
But it is even more true in the down cycle and the bust. Reflecting the losses and recriminations of the bust, regulators are afraid of being criticized themselves, afraid of making further mistakes, and trying to rebuild their deposit insurance fund which has shrunk to negative net worth. Reacting to the painful mistakes already made, they clamp down forcefully. This contracts credit further than the crisis already has. As one leading banking lawyer and former regulator summarized it, "Regulators are now, as usual, tightening the noose." In addition, we now have the Dodd-Frank Act, best characterized as the "faith in bureaucracy act," which looks to be strengthening the procyclical forces.
In short, procyclical regulation can help exaggerate both the ups and the downs. Can countercyclical regulatory factors be introduced to help instead moderate the cycles?
Fortunately, Bill Longbrake and Cliff Rossi show that the answer is Yes. In this instructive monograph, they take up in detail the procyclical problems and potential countercyclical improvements in the key regulatory areas of capital requirements, government deposit insurance, accounting, loan loss reserve policy and practice, and liquidity rules.
To make financial markets less vulnerable to their inevitable cycles, it is an essential responsibility of both private financial actors and government officials to study, develop and implement countercyclical approaches. This will, if achieved, limit the excesses of the next boom, and moderate the pain of the next bust.Alex J. Pollock is a resident fellow at AEI