The last financial crisis?
" The more actors there are who can read the signs of an approaching crisis, the less serious will be the consequences when the crisis breaks out."
The world's financial markets are going through a crisis that is rapidly developing into what seems to be the worst global economic crisis since the 1930s. Regulation enthusiasts have already stamped the crisis as ultimate proof that market deregulation is bad for humanity. - Cleaning up after the crash will no doubt be accompanied by loud demands for more regulation. It will be claimed that the state must prevent excesses similar to those that led to this crisis from taking place again.
It is perfectly acceptable that we try to learn from our mistakes and strive to correct the system in order to reduce the chances of similar problems occurring in the future. But that does not make it an easy task. The problem is that economic systems have an inborn tendency to generate crises. This tendency cannot be spirited away through regulation without choking business. All business activity is risk prone, and risks in different businesses are related. If things are going badly for one company they tend to go badly for others. If households cut their spending, all businesses will eventually be affected. In the opposite case, that is when households feel confident and increase their spending, most businesses will benefit.
The source of the next crisis will always exist in the fact that businesses that take big risks and bet heavily on economic growth are the ones that will profit most if growth continues. Money flows to the risk takers, who receive more money to invest. As long as things go well, the risk takers will become more dominant. Risk taking will gain an increasing role in the economy. This process continues until the risks materialise somewhere, for example in response to a break in the rising house price trend, as in the USA last year. As risks start to materialize, the businesses and investors that are most exposed to risk are quickly knocked out, creating a domino effect. While remaining risk takers' capital crumbles risk averse investors become even more careful.
Complete elimination of this cyclical process by regulation is impossible if we want to retain any kind of meaningful business activity. Even more frustrating is the fact that attempts at regulation tend to be counterproductive; if individual economic players are misled into believing that the regulation has reduced the risk of recession, their vigilance will decrease and their risk taking consequently increase. Regulation that creates a false sense of security will thus increase rather than reduce the risk of a financial crisis.
The somewhat paradoxical conclusion of this reasoning is that the best we can do is to keep the threat of a crisis alive. The more actors there are who can read the signs of an approaching crisis, the less serious will be the consequences when the crisis breaks out. Finland provides an excellent example. The fact that Finland has been doing relatively well in the present crisis can at least partially be explained by the deep crisis that the country experienced in the beginning of the 1990s.
Article published in Hufvudstadsbladet, Hbl, October 21, 2008.
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