Keen – failure to control the financial sector

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Steve Keen gives reasons why it can be difficult to control the financial sector in this extract from pp.396-397 of Keen, S. (2011). Debunking economics : the naked emperor dethroned? (Rev. and expanded ed.). London; New York: Zed Books Ltd.

Fundamentally, reforms of the financial sector fail because they try to constrain the sector’s innate desire to create debt. They will work for a while in the aftermath to a crisis like the Great Depression or the Great Recession, where the carnage wreaked by a financial crisis is so great that the sector behaves prudently for a while. However, the incentives to create debt are so great for this sector that, over rime, a debt-driven culture will replace prudence.

Institutional control of finance is also flawed, for reasons that should be obvious from our current crisis: ‘regulatory capture.’ Not only are regulators slower to move than the organizations they are intended to control, they often become advocates rather than monitors of those organizations. There is little doubt that Greenspan’s actions in rescuing the financial sector from itself after numerous crises, in championing the development of financial assets now universally regarded as toxic, and in restricting the development of new regulations to control new financial instruments, turned a potentially garden-variety would-be depression in 1987 into the near-death experience of the Great Recession. The regulators, by delaying the inevitable for two decades, have made this crisis more intractable than it would have been without them.

Reforms also fail because they do not recognize that the financial system has what Kornai called a ‘soft budget constraint’ (Kornai, Maskin et al. 2003). A bank is not constrained in its lending by its reserves, but by the willingness of borrowers to take on additional debt (see Holmes 1969; Moore 1979). It therefore faces a ‘soft budget constraint’: to expand its operations, all it has to do is to persuade borrowers (firms and households) to borrow more money, and its income will grow — as will the level of debt.

This growth in bank income and debt is in turn dependent on the willingness of borrowers to incur debt. If this is based solely on their income, then the ‘hard budget constraint’ that households and firms face will put a limit on the amount of debt they will take on.

If, however, a Ponzi scheme develops in some asset class — so that people are willing to borrow money in the expectation of future capital gain — then the amount of borrowing will no longer be constrained by incomes. While capital gains are made, the borrowers also operate with a soft budget constraint: any deficiency of revenue over costs can be covered by selling an asset whose price has been inflated by the increase in leverage.

Initially banks — after they have forgotten the previous crisis — will be willing to fund this process, since it increases their incomes. But inevitably a crisis will result because the borrowing is adding to debt levels without increasing the capacity of the economy to service those debts.

Commentary added 16th October 2014