Afternoon Must-Read: Martin Wolf: Financial Reform: Call to Arms

Martin Wolf: Financial reform: Call to arms: “The financial crises and the years of economic malaise…

…that followed represent profound failures of the economy and of policy. Above all, they were failures of understanding…. In retrospect, the insouciance of policy makers about the risks being run seems terrifying. But this also raises a big question now: have they learnt the right lessons for the future?… The target of monetary policy is to keep inflation low and stable, though some central banks (notably the Fed) explain that the aim is the highest level of activity subject to hitting its inflation target…. The financial sector is also to remain broadly the same as before, albeit vastly more tightly regulated and with somewhat higher capital requirements. There is also to be enhanced oversight of the systemic fragility of the financial system under the rubric of macroprudential policy.

This new orthodoxy is merely a chastened version of the old. But is it workable?… There are a number of reasons for believing the answer is no First, policy makers rely overwhelmingly on monetary policy as the stabilisation instrument of choice. But monetary policy works via asset prices and credit expansion. This combination certainly risks a repeat of crises…. Second, experience shows that the low inflation targets to which policy makers are committed are not high enough to ensure short-term interest rates can remain above zero in all circumstances…. Third, potential exists for conflict between monetary policy on the one hand and macroprudential policy on the other….

The new regulatory regime is an astonishingly complex response to the failures of this model. But ‘keep it simple, stupid’ is as good a rule in regulation as it is in life. The sensible solution seems clear: force banks to fund themselves with equity…. A shift away from over-reliance on inflexible debt contracts, with all the fragility they create in the economy, would require complementary policy changes. The existing favourable tax treatment of debt needs to be ended…. The pre-crisis orthodoxy proved defective. The new orthodoxy is an improvement. But it is open to question in important respects. The financial system remains fragile. The risks of further crises are not small. Far greater ambition is needed.