Revisiting the ‘GFC’: what went wrong?

One of my favourite bloggers, Oxford economist Simon Wren-Lewis, has drawn attention to a new book that revisits the ‘global financial crisis’ or GFC as it is widely known. There is, of course, a voluminous literature on the topic, but this contribution by Tamim Bayoumi – a senior IMF official – offers some fresh insights. A summary of his arguments can be found here, while a succinct review is available here.

To start with, Bayoumi gives the GFC a new name with a strong geographic complexion. Instead of the GFC, we now have ‘NAC’ – or the North Atlantic crisis. The idea is that the financial crisis that eventually paved the way for the Great Recession of 2008-2009 was not merely US-centric. Europe also played a significant role – a view that is not widely noted.

Bayoumi traces the NAC to ‘…serial but different regulatory mistakes in Europe and the US starting in 1980. By 2002 …the elements that drove the crisis were already in place.’ It appears that a crisis that erupts seemingly out of nowhere can actually germinate and fester for decades. It is indeed noteworthy that the roots of the NAC lie in the much-noted era of the Great Moderation.

One of the culprits behind the NAC was the rapid expansion of Northern European ‘universal’ banks that grew out of ‘(r)egulatory changes in the mid-1980s’. Such changes ‘…merged commercial banking (loans to clients) with investment banking (buying and selling of assets)’. These merged entities also relied heavily on ‘internal risk models’ that were paradoxically enabled by ill-thought changes to international rules. These internal models encouraged rather risky expansions beyond national borders at the expense of prudent commercial decisions.

In the US, similar developments took place in the mid-1980s.  Regulatory changes encouraged switching of deposits and loans from ‘…sound commercial banks to more fragile investment banks that formed the core of the shadow banking system’. Further regulatory changes in 2003 and 2005 ‘helped to parasitically intertwine the…fragile US and European banking booms’.

Bayoumi goes on to highlight the collective follies – or ‘intellectual blinkers’ as he calls them – of regulators and policy-makers on both sides of the Atlantic that constrained them from identifying the dire consequences that would follow from unsustainable banking booms. These included: (a) the Basle Committee’s switch to internal risk models; (b) the undue faith of central bankers on monetary policy that led them to focus primarily on inflation rather than financial stability; (c) the belief that international spill overs were insignificant in scope and scale; (d) the inadequate mechanisms of the Eurozone to support member states when they encounter difficulties with respect to debt servicing.

What I liked most about Bayoumi’s analysis is his concern that the ‘macroeconomics profession is …slowly adapting to the lessons of the crisis’. There is still a lingering commitment in ‘standard macroeconomic models’ to the efficacy of financial markets, an enduring confidence in the ability of central bankers to cope with business cycles and the persistence of the view that international spill overs are not significant. Only time will tell whether Bayoumi’s concerns are valid.

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