Too big to fail
Singapore Straits Times, 18 August 2012
Over the past few years, substantial financial and economic costs have been generated by financial institutions that were ‘too big to fail’ due to their systemic importance. Because these large institutions benefited from implicit government support, they did not internalise the full costs of the risks they were taking. This was not good for the economy or for the government – and is increasingly seen as not good for the financial institutions concerned.
In response, many proposals have been made to constrain the too big to fail financial institutions. For example: tighter regulation; requirements for large institutions to hold more capital; and the separation of investment banking from retail and commercial banking. And there are also calls to break up large financial institutions; some argue that banks that are too big to fail are by definition too big to exist.
So why is a different logic applied to global economic policy debates? Although there is broad consensus about the need to constrain too big to fail financial institutions, there is less concern about finding ways to constrain the risk profile of systemically important large economies. This is unfortunate because there are important parallels between the too big to fail financial institutions and policy settings in large economies. As is the case with large financial institutions, large economies do not internalise the full costs of their decision-making on others (such as loose monetary policy that has an impact on other economies); are somewhat insulated from market pressures (the US is regarded as a safe haven despite its public debt load); and are likely to receive official support when they encounter problems (e.g. the IMF in the Eurozone).
And, as with large financial institutions, the challenge is to balance the risks associated with being too big to fail with the valuable contributions that large economies play in supporting the global economy. Large economies provide an engine of demand, as the largest spenders in the global economy, and provide liquidity through issuing reserve currencies. At times, large economies – the US, Japan, and Europe – have undertaken international policy coordination to ensure stable growth for the global economy. The G20 crisis meeting in late 2008 was the most recent example of large economies providing this valuable stabilising function (although there is little prospect of sustained policy coordination now).
But in general, this is not self-sacrificing behaviour. It has been in the domestic interests of large countries to provide an expansionary impetus to the global economy. And although it may be an exaggeration to describe the reserve currency status of the US as an ‘exorbitant privilege’, as a French Minister did in the 1960s, it is true that large economies have a greater degree of policy autonomy than others. Large economies are able to design policy to suit their objectives with less consideration for others.
However, substantial global risk exposures can be created if relatively unconstrained large economies are able to pursue unsustainable policies. Although large economies can play a valuable stabilising and expansionary role in the global economy, this can be pushed too far. And my sense is that we are moving from a situation in which large economies provided ballast in the global economy, stabilising it and managing risks, to a situation in which this weight is breaking loose and is acting as a destabilising force.
Large advanced economies comprise a smaller share of global GDP than 20 years ago, but the world is much more connected and shocks radiate through the system with greater force and speed. There is much concern, for example, about the spill-over effects of the Eurozone crisis, the short-term fiscal cliff and structural fiscal imbalances in the US, and the pressures caused by the aggressive monetary easing in the core on other parts of the world. Large economies are increasingly a source of systemic risk, which may compromise the performance of the global economy. Problems in smaller economies – such as Greece – can also have out-sized effects because of contagion, but these costs are likely to be of a different order of magnitude than shocks generated by large economies.
So given the parallels with too big to fail financial institutions, the thinking about how to constrain these institutions may be instructive to economic policy-makers. Of course, proposals to reduce the scale of large financial institutions do not apply to countries; large countries will not break themselves up into smaller political entities for this reason. But the proposals that focus on constraining the risk profile of systemically important financial institutions are relevant. In an uncertain, deeply connected global economy, it is appropriate to build in some redundancy through more prudent policy settings in the systemically important large economies. The current approach – of aggressive fiscal and monetary policy, with relatively little attempt to address structural imbalances and pressures – is not a sensible way to manage the global economy.
Over the past decade, various proposals have been made to constrain the size of current account surpluses that countries can run. The thinking is to place the burden of adjustment on surplus countries, to ensure there is an expansionary bias in the system. But given the distribution of systemic risks in the global economy, the burden of adjustment should be more symmetrical. The focus should be on limiting the extent to which large economies can generate major systemic shocks, whether they are running large current account surpluses or deficits. Large economies should face an expectation that they reduce – not increase – systemic risks in the global economy; their role extends beyond being the consumer of last resort. As with financial institutions, such constraints may slow economic activity for a time – but will strengthen the resilience of the system and reduce the chance of costly blow-ups.
Exactly how to do this is a matter of judgement, and a prescriptive, rules-based approach is not appropriate. And of course, large economies tend to resist the establishment of constraints. But despite these difficulties, the scale of the systemic risks means that starting a conversation about guidelines on the appropriate risk profile of large economies is important. These guidelines could cover measures such as the public debt level, the current account deficit, and the nature of monetary policy. Such guidelines would be applied to systemically important economies, such as the US, Europe, and China – or potentially to the full membership of the G20.
Global economic policy-makers should carefully consider how best to reduce the risk profile of systemically important large economies, learning from the costs of neglecting to deal with the too big to fail financial institutions. It seems unlikely that large economies will pick this issue up, so the intellectual and policy leadership may need to come from outside the G20. But either way, serious efforts need to be made to address the building systemic risks in the global economy – and soon.