Can We Regulate Systemic Risk?

MILAN – In the past two years, two dangerous episodes of financial instability and sudden changes in market dynamics have hit the world economy. More are likely, because the global economy is out of balance in several respects as it emerges from the crisis, particularly in terms of sovereign debt and the structure of global demand.

Systemic risks drive most crises, and pose a challenge for several reasons. First, they are not easy to detect with confidence, and are even more difficult to prove. Second, predicting the exact timing of a break point (when bubbles burst, markets lock up, and credit freezes) is, and will likely remain, beyond our ability. Finally, crises are highly non-linear events, which means that they occur without much warning.

Periodic outbreaks of instability impose high social costs on those who had the least to do with causing them. If repeated, this pattern may erode confidence in financial markets and regulators, which could well lead to heavy-handed regulation, the expansion of the state, and retrenchment from globalization.

But the problem is even more serious. The financial and economic crisis is morphing into a sovereign debt crisis in advanced countries. Financial and economic imbalance can lead to dangerous fiscal imbalance, as tax revenues plunge and social insurance and bailout expenditures rise. The International Monetary Fund suggests that as much as 75% of the “fiscal stimulus” in the advanced countries comprises non-discretionary counter-cyclical measures.