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Commentary: A global fix for the next financial panic

  • Story Highlights
  • Robert Bruner: 1907 panic led to the founding of the Federal Reserve Bank
  • Every crisis produces changes to help avoid future problems, Bruner says
  • G20 policymakers should promote transparency and insurance for risk, he says
  • A larger reserve institution than the IMF is likely, Bruner says
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By Robert F. Bruner
Special to CNN
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Editor's note: Robert F. Bruner is dean of the Darden Business School at the University of Virginia and co-author of a recent book on financial crises, "The Panic of 1907."

Robert F. Bruner says the financial panic of 2008 has exposed the need for sweeping global reforms.

CHARLOTTESVILLE, Virginia (CNN) -- When financier J.P. Morgan saved the New York financial community from the Panic of 1907, the U.S. finally awakened to the need for a strong central banker: one who could marshal resources, organize bankers and galvanize society to fight the crisis.

The "Panic" consisted of the desperate withdrawal of cash by bank depositors, so sudden that it threatened the stability of the financial system.

The run began when failed stock market speculation bankrupted two brokerage firms. But actually, the deteriorating financial conditions began 18 months earlier with the San Francisco earthquake of 1906, which sucked capital from all over the world and started a liquidity crunch

The U.S. had no central bank in 1907 and had resisted the notion since the days of President Andrew Jackson. But the growing financial demands of modern society changed the minds of consumers, businesspeople and eventually Congress.

Virtually every financial crisis in the past 100 years has been followed by hearings, civil and criminal litigation, and ultimately, new laws and regulations. Each new crisis reveals new challenges to the public welfare.

This crisis will be no different. Leaders from the G20, a group representing the world's largest economies, will meet November 15 to design new global regulations to forestall future financial crises. But what will the leaders regulate that hasn't been regulated before? How should they do it? And what should they avoid?

The current crisis overshadows previous crises in four key ways: complexity, inflexibility, speed and scale. Complexity appears in the exotic securities, the complicated financial institutions and the innumerable linkages among firms and markets; all of these make it very difficult for decision-makers to know what is going on.

Inflexibility is reflected in the historically low reserves and high borrowing of American firms and individuals in early 2007. The economy had relatively less capacity to absorb economic shocks.

Speed appears in our ability to get news and transfer funds at the speed of light; this means trouble can travel rapidly.

Scale is evident in the massive losses on subprime loans and other debt. For instance, government commitments to stanch these losses are estimated at $1 trillion to $2 trillion.

The leaders should address these four novelties as they design the new global financial system.

The antidote to complexity is transparency. Complexity can hide the reality about financial conditions. This leads to greater uncertainty in the minds of investors and can cause aberrant and even irrational behavior among players in the markets.

Runs on solvent banks arise where depositors cannot tell the difference between those banks that can meet their financial obligations and those that cannot. The first remedy to future crises to which the leaders should rise is greater transparency, in the form of stronger reporting requirements to the public.

The antidote to inflexibility is insurance. Firms and individuals who want to borrow should be required to purchase "shock absorbers" with which to withstand a loss of income, natural disaster or default. The most basic kind is a "rainy day account," a reserve fund of cash that a firm or individual could use in case of adversity.

The Basel Accords reached by 11 leading industrial nations (1988 and 2004) have dictated an international standard of the minimum amount of capital banks should have. Plainly, the leaders should evaluate the standard in light of recent experience with the risky assets (such as subprime loans) in which banks can invest.

But shock absorbers could also exist in the form of insurance policies that would protect the mortgage lender against a decline in a homeowner's creditworthiness. Robert Shiller has sketched a range of such possible insurance policies in his new book, "The Subprime Solution."

The antidote to speed is a coordinated braking mechanism. Trading in markets can be suspended, as can cross-border capital flows. The theory is that suspensions can provide a "cooling off" period in which news and information can disperse, allowing panicked players to assess the situation more fully.

In other market situations (such as currency markets), governments have actually entered as traders to counterbalance the pell-mell selling. The brakes need to be applied infrequently and carefully. If players in the market can correctly anticipate a reaction by governments, the players will begin to game the system. If you accurately anticipate how governments will intervene in markets, then a bet against the government is a sure thing.

The word "coordinated" deserves special consideration by the leaders: it makes no sense for the New York market to suspend trading when many of the same securities can be traded in London or Tokyo.

In this era of global financial markets, players can simply end-run the interventions of any one country by moving their trading to another venue. We will probably see greater coordination among countries in the future.

The antidote to the massive scale of losses will be the creation of larger reserve institutions. The International Monetary Fund was created in 1944 to be the lender of last resort to countries experiencing financial crises. But the capital base of the IMF today is only $265 billion. This is insufficient to make a dent in the scope of America's financial crisis. The leaders seem likely to create a more muscular multilateral institution.

No matter what the leaders decide, caution is warranted. These antidotes are not panaceas; they can only influence the occurrence and severity of future crises; they cannot prevent them. Worse, over-exuberant regulation in any of these areas could have costly side-effects on economic growth, innovation and global trade.

No doubt, there will be more aggressive proposals, such as a global currency, wealth redistribution schemes, or tariffs on foreign trade. Finally, though the sense of urgency is laudable, to start tinkering in the depths of a crisis seems hasty. As the saying goes, the road to hell is paved with good intentions.

The opinions expressed in this commentary are solely those of Robert F. Bruner.

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