Welfare and economic growth in modern economies is intimately linked to the workings of the financial sector that is expected to facilitate accurate price discovery, allocate resources efficiently, enable risk sharing and act as a shock absorber for the real economy. While the financial crisis was a wake-up call that something was seriously amiss in the financial sector, serious problems with the performance of the financial system in discharging fundamental functions expected of it have been manifest much earlier.
However, the European Union is suffering from crisis-driven myopia where the dominant paradigm of how to prevent another crisis has crowded out the more important question of how to make the financial sector function better. It would not be too unfair to say that the primary, if not the sole focus of the extensive regulatory reform agenda in the EU is crisis avoidance. We have catalogued the various causes of the crisis on a piecemeal basis and are trying to use a tick-mark approach to ensure that these are addressed.
But we have embarked upon this ambitious program of reform of the financial sector without having ever asked basic questions such as 1) what the financial sector is meant to do 2) whether it was doing this job well and 3) and if this were not the case then what corrective measures could be applied using the window of opportunity provided by the crisis. We have not paused to map out what the supposedly well-functioning financial sector that should emerge from this reform process ought to look like.
The implicit underpinning of this approach is that all was well before the crisis. That if only we are able to prevent the recurrence of another crisis, finance would do its job.
The problem is that crisis prevention alone does not a good financial system make. The real long-term costs of a malfunctioning financial system have arisen not during war-time (the financial crash) but during peace time when the financial sector was apparently working well. These costs are far bigger and far more serious than even the high end estimates of the costs of the present crisis.
These costs arise when the financial sector fails in its assigned role of supporting real sustainable growth in the economy through 1) facilitating price discovery 2) ensuring the efficient mobilization and allocation of resources 3) providing opportunities for effective risk sharing 4) acting as a shock absorber for the real economy 5) and the provision of access to suitable credit, savings and investment products for economic actors.
For example, a financial system that impeded proper price discovery can send erroneous price signals to the economy and lead to suboptimal investments. These have a large opportunity cost. Problems with short-termism and misaligned incentives can cause the financial sector to misallocate resources away from high return investments into wasteful investments that have a lower economic return.
The financial sector can and does, often as a result of implicit public subsidy and the asymmetry of information, push risk away from entities most competent to handle and absorb it towards public entities as well as unsophisticated economic actors least capable of managing and absorbing such risks.
The real economy is cyclical and has strong inertia so the virtual financial sector which can at least on paper adjust faster has a higher shock absorption capacity. At least that is the theory. In reality, the financial sector has often acted as an amplifier and even a source of shocks to the real economy imposing significant economic costs.
The financial sector is supposed to increase welfare through improving access to credit, savings and investment products for economic actors. However, the financial market remains far from complete, many economic actors still lack access to financial services and appropriate products are often not matched with the users. All of these reduce potential economic welfare.
Most of the time, a sub-optimal financial system will simply chug along imposing large opportunity costs on the economy without necessarily blowing up. That is why, while addressing the flaws in the financial system, stability is not enough of a consideration and attention must be paid to principles such as transparency, efficiency and equity, amongst others.
Instead of waiting for the financial sector to blow up again, we urgently need to use the current spate of financial sector reforms and regulations being enacted in the EU to redesign the financial system so it fulfils the tasks expected of it and to improve its functioning. The political window of opportunity for financial reform will close soon again. Moreover, it is also not clear whether the current spate of reforms will even fulfil the narrow stabilization role ascribed to them. The EU needs a positive vision for what its reformed financial system looks like and how it can best serve the real economy and citizens.