IRRATIONAL EXUBERANCE TO BUST: FINANCIAL BUBBLES DEMAND REGULATION

By KEMAL DERVIS

From YaleGlobal Online

The last 15 years have been characterized by rapid, accelerating world growth, with three interruptions: the Asian and then Russian financial crisis around 1997, the dot-com bubble burst around 2001, and most recently a financial crisis rooted in the U.S. sub-prime mortgages and securitized investment vehicles. In all three cases "irrational exuberance" as well as regulatory failures in the financial sector led to the shocks and growth slowdowns. The pattern suggests that there's a strong case for overhauling regulation of the financial sector.

The Asian crisis was caused by excessive private capital flows to the emerging markets with very open capital accounts and excessive appreciation of assets in or relating to these emerging markets. The ensuing capital-flow reversals and depreciations led to a growth collapse in these economies. The dot-com crisis was linked to excessive asset appreciation relating to high-tech start-up enterprises, mostly in the U.S. But the sectors affected represented only a small share of total asset values in the advanced economies. The new crisis hit in mid-2007 and is still unfolding. A good part of the liquidity that was provided to the world economy by the expansionary fiscal and monetary policies following the dot-com bubble burst went into the housing sector. The combination of liquidity, in part due to low interest rates in the U.S. and Japan, new complex investment instruments and serious regulatory failures with regard to the financial sector in the rich economies, allowed a new asset bubble, focused this time on the housing sector and associated financial instruments.

New economies of scale facilitated by the information revolution, global financial integration, regulatory changes in the U.S. allowing commercial banks to engage in investment banking and other previously restricted activities, the emergence of hedge funds and private equity all resulted in a dominant financial sector. In the early 1980s, the share of the financial sector in both corporate value added and profits in the U.S. was about 6 percent. The share of financials in corporate value added has steadily increased, reaching close to 10 percent in 2006-2007.

The share of corporate sector profits, however, climbed to an extraordinary 40 percent in 2007 -- all going to a sector that in itself does not "produce," as is the case for automobiles, clothing or machinery, but "intermediates and organizes" the resources that do produce. The super-bankers, hedge-fund managers and owners of private-equity firms have become the new "barons" of 21st-century capitalism in many countries.

Many believe that this much increased role of the financial sector works in favor of greater efficiency, forcing out lethargic managers, encouraging a relentless search for greater productivity, and allowing a constant restructuring that increases innovation throughout the economy. At the same time, immediate profits become a more important driver than long-term considerations. Projects that require long-term investments and substantial upfront costs, with benefits accruing over many years, are unlikely to receive sufficient support in this environment where short-term incentives dominate.

The drive for ever-greater profits, which propels the system, often reaches unreasonable dimensions. The rate of return on financial assets on average and over the long term must reflect the rate of return in the real economy. That rate of return can be higher than the real GDP growth rate, but it cannot be expected to be multiple times the real growth rate of GDP forever. If real growth in an economy is 3 percent, a rate that most analysts would say potential output cannot easily surpass in a sustained way in the most advanced economies, then it's unreasonable to insist on double-digit profit rates year after year.

Of course globalization means capital can escape domestic constraints. But then the real growth of the world economy sets long-term limits on what kind of return is feasible. The periodic asset bubbles may reflect an unreasonable pressure in the financial sector to promise returns that in the aggregate cannot be achieved. These promises keep being made, however, and asset bubbles keep emerging because the incentive structures in the financial sector are asymmetric: Managers reap great personal benefits from short term-profits, but pay comparatively little personal penalty when the bubble bursts.

Because asset-bubble bursts affect the entire economy, there's irresistible political pressure to socialize the losses when they become too threatening. This does not imply that expansionary fiscal and monetary policies should be avoided to forestall an even more dramatic slowdown in the U.S. and world economy. But socialization of large parts of the financial-sector losses may encourage the next asset price bubble.

To avoid constant repetition of the scenario, it's desirable to regulate the financial sector in a way that incentives become more symmetric, so that losses have serious financial consequences for those whose decisions cause them, and that rewards are tied to long-term success.

Regulation of the financial sector that encourages responsibility, a longer-term horizon and an evaluation of risk by managers, is both fair and in the long-term interest of a well-functioning market economy.

If we want to reap the benefits of global opportunities in a steady fashion, rather than being subjected to recurring shocks from the financial sector, it may be time to attack the root causes of these shocks in terms of financial-sector regulation that focuses on the nature of the structural problems in the sector, rather than using blunt macroeconomic instruments. Such tools may work in the short term by bailing everybody out, but often plant the seeds of the next financial storm.

All this matters to the developing world: Regulatory troubles may cause growth rates in India and China to decline significantly. They may rob Africa of the first real chance in decades to accelerate its progress.

Countries must engage in the overdue effort to build better, more equitable global governance, not least relating to the financial sector. This includes a reform of the United Nations and the Bretton Woods system, so that the interdependent world we live in is regulated in a manner allowing stronger participation by the emerging South and benefits accruing more equitably throughout the world economy.

Kemal Dervis is administrator of the United Nations Development Programme.