In a paper published at VOXeu.com, two economists assert that substantial reform of the global financial industry is necessary to avoid successively greater economic collapses which they have termed a “doomsday cycle.”

Economists Peter Boone, Research Associate, Centre for Economic Performance, LSE, and Simon Johnson, Professor of Entrepreneurship, Sloan School of Management, MIT and CEPR Research Fellow, note that, since 1980, the U.S. and other countries have experienced several financial shocks that have been treated by government spending without resolving the underlying causes.  Thus, once the crisis has passed, banks resume risky behavior, and each time a crisis ensues, it is worse than the last.  As countries continue to bailout banks to a greater degree as each crisis comes and goes, the ability of central banks and federal governments to combat the next crisis becomes weaker.  Therefore, in the future, there may be a financial collapse so large, and with governments handcuffed by ballooning deficits from previous bailouts, a “calamitous global collapse” will follow on the scale of the Great Depression.

Boone and Johnson point out, “The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.”

But as the crisis eases, and the economy improves, no steps are taken to prevent future excessive risk-taking.  To the contrary, the economists observe that the system encourages banks to take risks. “Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.”

The economists recommend major financial reform across three broad areas to be implemented as uniformly as possible across the G-20 nations:

1. Dealing with regulatory failure – new rules and regulators will not account for the fact that the financial industry has a powerful lobby and the tendency for regulators to come from and flow to the industry being regulated – thus, the best reform is simply to have large and robust capital requirements generally, and, specifically, additional capital requirements for complex financial instruments;
2. Adjust executive and trader compensation to adjust for long-term risk – bank executives and the traders under them benefited personally by having the banks take on outsized risk, and, although they lost a lot of money in the collapse, that amount paled in comparison to what they earned prior to the collapse – thus, the best reform here is to require “clawback” provisions in compensation contracts that that recoups past earnings and bonuses from employees of banks that require bailouts; and
3. Tackle the “too big to fail” problem – larger institutions that are more interconnected with financial markets practically required a federal bailout, while smaller institutions were left to fail – this not only puts pressure on taxpayers to foot the bill of a financial collapse, but it also discourages creditors and investors from providing capital to smaller financial institutions – rather than set a hard limit on how large a financial institution can be, it would be better practice to impose rising capital requirements on large institutions over the next five years, which would encourage them (as opposed to ordering them) to develop orderly plans to break up and shrink their banks.

These are reasonable proposals that would not be very complicated to implement.  However, if history is a guide, even if some financial reform is enacted as has been proposed, the underlying causes of the “doomsday cycle” will not be addressed, and we will be left looking for the next calamity to strike.

To view Boone and Johnson’s column at VOXeu.com, please click on the following link: The Doomsday Cycle.