Fighting the Next Global Financial Crisis

NEW HAVEN – What do people mean when they criticize generals for “fighting the last war”? It’s not that generals ever think they will face the same weapon systems and the same battlefields. They certainly know better. The error, to the extent that the generals make it, must operate at a more subtle level. Generals are sometimes slow to get around to developing plans and ordnance for those new weapon systems and battlefields. And, just as important, they sometimes assume that the public psychology and narratives that influence their soldiers' morale are the same as in the last war.

That is also true for regulators whose job is to prevent financial crises. For the same reasons, they may be slow to change in response to new situations. They tend to adapt only gradually to changing public psychology. The need for regulation depends on public perceptions of the last crisis, and, as George Akerlof and I argued in Animal Spirits, these perceptions depend heavily on changing popular narratives.

The latest progress reports from the Financial Stability Board (FSB) in Basel outline definite improvements in stability-enhancing financial regulations in 24 of the world’s largest economies. Their “Dashboard” tabulates progress in 14 different regulatory areas. For example, the FSB gives high marks for all 24 countries in implementing the Basel III risk-based capital requirements.

But the situation is not altogether reassuring. These risk-based capital requirements may not be high enough, as Anat Admati and Martin Hellwig argued in their influential book The Bankers New Clothes. And there has been much less progress in a dozen other regulatory areas that the FSB tabulates.