Is the Financial System Fit for Purpose?
Mainstream macroeconomics has neglected some important aspects of finance. Understanding and incorporating these would enrich the ability of economics to help guide policy and benefit economic performance.
The main function of financial systems is to facilitate the allocation of economic resources across time and space. While the main benefits of finance are indirect, its services are related to almost every economic transaction. This places finance centre to macroeconomic performance. People benefit from finance indirectly through the services provided. These include enabling payments, managing risk, and using some people’s savings to fund other people’s borrowing. How well financial institutions meet the demands of people can be viewed as its ‘functional efficiency.’
The structure of financial institutions is an appropriate part of financial policy. Yet there are almost no public discussions of alternative institutional arrangements. Some of these institutional structures matter greatly to citizens, but are not the focus of financial institutions; for example, the supply of housing finance, student loans and stability of banks. The continued increased in the frequency and severity of financial crises for decades now questions the stability of finance. The loss in GDP of the 2008 crisis was greater than what economic at the time would suggest. Whilst progress has been made in light of the crisis, many important issues remain.
Crises are often treated as unforeseeable shocks to the economic system that are unrelated to market fundamentals. Yet the fall in house prices from the 2008 crisis was caused by endogenous factors. The financial system itself creates types of risk, and not including this could lead to inadequate policy responses by failing to address the initial causes of financial instability. We still don’t fully understand all the consequences of the quantitative easing experiment. When it was introduced, the distributional consequences were not considered. The Bank of England now owns one-third of government debt, increasing the exposure to losses, which would involve tax payers’ money.
The enormous increase in bank reserves has coincided with a sharp fall in the money multiplier. While many suggest that this is based on an antiquated view of money creation, are we confident that the break-down is permanent? The view of money creation whereby loans create the money supply suggests that central banks have little monetary control. Given the historical correlation between money and inflation, this breakdown is not well understood and at odds with central bank control. In what ways could central bank independence and the activities of the central bank in the private sector change the effectiveness of the financial system? What are the exact influences of the central bank on the functioning of the financial sector? How do we reconsider models of financial markets to include central banking to closer describe observation and the behaviour of central banks?
The enormous increase in cross border claims and financial flows appears to have created a global credit cycle with highly correlated returns across national markets. The international connectivity was probably the defining feature of the 2008 crisis. To prevent global crises, international regulations have been attempted, but getting countries to agree on the right regulation often proves difficult. Technology is obscuring national boundaries and making it harder to know where transactions are coming from. Unconventional methods such as cryptocurrencies may pose new challenges to how we understand international finance. What new challenges does an increasingly interconnected global financial system pose for understanding how it functions?
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