Paul Lachine

Completing the G-20’s Agenda

In calling for measures to “guard against systemic risk,” the G-20 summit recognized the need to regulate the entire financial system, not just individual institutions. Unfortunately, contemporary economic theory, which presumes perfect price discovery in asset markets, discourages policymakers from addressing the role of asset-price swings in managing systemic risk.

NEW YORK – The near-complete collapse of financial systems worldwide has exposed fundamental weaknesses in their architecture and in how they are regulated. In calling for measures to “guard against systemic risk,” the G-20 summit has begun the process of reconstruction by recognizing that the system in its entirety, not just individual institutions, must be regulated.

Unfortunately, the G-20 communiqué offers only more of the same prescriptions for managing systemic risk that the Financial Stability Forum (FSF), the United States Federal Reserve, and others have put forward. These proposals have focused on the problems caused by poor transparency, over-leveraging, outsized financial institutions, tax havens, bad incentives for financial bosses, and credit rating agencies’ conflicts of interest. All of these are important, but they miss a fundamental point.

No one now denies that the past year’s sharp downswings in housing and equity prices, which followed long upswings – far above historical benchmark levels – helped to trigger and fuel the crisis. As these downswings continue, there is a danger that they, too, may become excessive, dragging the financial system and the economy even deeper into crisis.

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