Readers Question: Does it (financial crisis) have any possible positive effects for the future?
It is an opportunity to repair a broken financial system and put in safeguards to prevent future boom and busts.
For example, we could have policies which banks automatically hold more deposits during a boom to provide counter cyclical instruments.
We can have regulation to avoid mortgage products which have a high likelyhood of default.
It is another reminder of the fallibility of the free market and the psychology of booms and busts. Though this interesting book – This time is different – 800 years of financial crisis. Suggests it won’t be the last time, irrational exuberance will lead to market crisis.
A combination of factors made this crisis severe. It certainly provides an opportunity for reform of financial system, but, it is often harder in practise than principle. Markets have an ability to get around regulation. They still have political power in influencing government legislation. Also, the negative effects of the crisis will be felt for a considerable time. – Where did all the money go – article in Telegraph suggests bank lending is likely to remain constrained for a considerable time
Return to normal banking practises
Many banks in the UK had pursued high risk growth. Traditional bank models were ignored as money was borrowed on money markets to lend mortgages. Bank reserve ratios fell on the assumption of continued growth. The banking system only survived due to extensive public support, placing a large burden on taxpayers.
A new Era of Frugality?
Another potential benefit is that maybe consumers and society in general will be more thoughtful of the long term rather than short term consumption. A higher saving ratio may enable a higher investment rate and a more balanced economy. The UK and US economies were both geared towards consumer spending, partly financed through rising house prices. The recession may steer the economy in a different direction.
Better Macro economic policy
Policy makers are having to rethink the limitations of relying on a simple interest rate tool and 2% inflation target. Macro economics is more complicated than such a simplification. It was hoped controlling inflation would be sufficient to prevent a boom and bust. What this recession shows is how a bubble in asset prices (houses, and shares) can have a significant impact on macro economy.
Unfortunately, macro economics is much more complicated than just adjusting interest rates to keep inflation at 2%.
- Is inflation really so bad?
- What is the optimal inflation rate?