The Clare College distingished lecture in economics this year was given by Adair Turner, the chairman of the FSA. As I went to Clare College and as radical reform of finance is a topic close to my heart I wanted to give some comment on this.
Mr Turner starts by outlining three levels on which we should consider whether reforms have been radical enough:
1) The technical aspects of capital and solvency levels for banks
2) Whether finance has become too large a percentage of the economy, causing inequality of income
3) Whether our ideals and assumptions about the economy have been sufficiently restated
He makes the strong claim that the crisis requires reform on the 3rd and deepest of these levels. That this was fundamentally a crisis of our markets and systems, “that financial market instability and
inefficiency can arise not only because of poor incentives but also because
individuals do not always act in fully rational way”. Reforms to date have thus not been radical enough.
When discussing the technical treatment of bank capital, he introduces the Modigliani and Miller theorem. I think that this is central to the debate, because the interest tax shield on debt creates an incentive for pushing leverage as high as possible, reducing usage of equity finance. This creates a network externality as the social cost of the lower equity buffer is not borne by the institution. Perhaps one radical way to reduce economic instability is to get rid of the interest tax shield?
Slide 4 in his pack seems to illustrate this: increased leverage seems to always come after a period of real growth, not before. His key conclusion – that we will always have instability – is perhaps only true in a world where we always have leverage.
His discussion of inequality and bankers bonuses is interesting. He presents the case that while some of the increase in share of GDP from the FS industry may be justified, much of it is rent extraction in the form of tax avoidance, lack of transparency on pricing, monopolistic market spaces (eg market making) and inducement towards excess trading activities. He concludes that it is likely that financial services provides an increased propensity for rent-seeking activities.
His third section, on the failings of economic theory, essentially makes the point that classical economics, in which participants are rational, led to public policy decisions. What is interesting to me is how well known the limits to classical theory were, eg network externalities of pollution, and yet public policy makers still went down this route. This is a central problem where the ‘reasonably’ intelligent attempt to monitor and control the strongly intelligent, and shows how a little bit of knowledge can be a dangerous thing.
The full speech and his slides can be found here:
http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2011/0218_at.shtml
