These are the glory days of the financial markets. They are bigger, richer and more powerful than they have ever been.
Yet it is that very position at the heart of global economic life that makes this year's credit squeeze a threat. Already, fairly or unfairly, a pantomime cast of predatory lenders, bankrupt bankers and teenage money managers has been lined up to take the blame. There are calls - some justified - for stricter regulation of financial markets. But before writing new rules, we should remember the financial world of 40 years ago, and where liberalisation has got us.
In the US 40 years ago, commercial banking and securities trading were strictly separated by the Glass-Steagall Act, and banks were unable to expand across state boundaries. On Wall Street and in the City of London, there were fixed commissions for share trades, and a closed circle of underwriting banks. Home mortgages came from building societies or a savings and loan and there was little competition on interest rates. Banks held a lot of reserves, but before the first Basel agreement on capital adequacy, reserves often bore little relation to a bank's risk. Exchange rates were fixed under the Bretton Woods regime and the international mobility of capital was restricted.
The liberalisation of these restrictions, mainly in the 1970s and 1980s, brought great benefits. The deregulation of financial markets led to a surge of competition and innovation. The cost of trading securities has collapsed. Banks have become bigger - and so in one sense more secure - and brought the techniques of the securities business to bear on banking. As a result of liberalisation, financial intermediation is cheaper, and we have a more complete and efficient set of markets.
Whereas 40 years ago many millions of young people may have wanted to borrow against their future income, in order to go to university or to buy a home, they struggled to do so. The liberalisation of consumer finance has eased credit constraints on many.
With the free international movement of capital has come a surge in direct and portfolio investment across borders. Not only has capital been allocated more efficiently as a result, but foreign investment has been a channel for the transfer of technology and management skills, and so increased growth. The wave of globalisation in recent decades would have travelled more slowly without financial liberalisation.
But for all this gain, there is a cost. Any relaxation in controls on banks' capital and activities makes it easier for them to take risks - and so increase profit - in the knowledge that the state cannot afford to let them fail. There is no simple answer, but a system of bank rescues in which shareholders lose all of their money creates the right incentives. Shareholders walked away from this year's bailouts of Northern Rock and Germany's IKB.
Consumer credit liberalisation also leads to a trade-off. Subprime mortgages made home ownership possible for hundreds of thousands of people who would otherwise have been tenants. Yet incompetent and fraudulent misuse of subprime mortgages has caused tens of thousands of those people to lose their homes as well as a shock to the financial markets. Regulation should be directed at the misuse and mis-selling of these products and not at the products themselves.
The greatest effect of financial liberalisation, however, has been to bind markets more closely together. A shock in the US mortgage market really can affect the availability of credit for a European consumer. To those consumers this is hard to explain, and feels like a threat, yet while the scope for financial shocks is now greater, there is little evidence that they have increased in frequency or in magnitude. Financial regulation, especially on bank liquidity and consumer lending, should be tweaked in response to the credit squeeze. But its liberal direction, which has brought great benefits, must remain.
Yet it is that very position at the heart of global economic life that makes this year's credit squeeze a threat. Already, fairly or unfairly, a pantomime cast of predatory lenders, bankrupt bankers and teenage money managers has been lined up to take the blame. There are calls - some justified - for stricter regulation of financial markets. But before writing new rules, we should remember the financial world of 40 years ago, and where liberalisation has got us.
In the US 40 years ago, commercial banking and securities trading were strictly separated by the Glass-Steagall Act, and banks were unable to expand across state boundaries. On Wall Street and in the City of London, there were fixed commissions for share trades, and a closed circle of underwriting banks. Home mortgages came from building societies or a savings and loan and there was little competition on interest rates. Banks held a lot of reserves, but before the first Basel agreement on capital adequacy, reserves often bore little relation to a bank's risk. Exchange rates were fixed under the Bretton Woods regime and the international mobility of capital was restricted.
The liberalisation of these restrictions, mainly in the 1970s and 1980s, brought great benefits. The deregulation of financial markets led to a surge of competition and innovation. The cost of trading securities has collapsed. Banks have become bigger - and so in one sense more secure - and brought the techniques of the securities business to bear on banking. As a result of liberalisation, financial intermediation is cheaper, and we have a more complete and efficient set of markets.
Whereas 40 years ago many millions of young people may have wanted to borrow against their future income, in order to go to university or to buy a home, they struggled to do so. The liberalisation of consumer finance has eased credit constraints on many.
With the free international movement of capital has come a surge in direct and portfolio investment across borders. Not only has capital been allocated more efficiently as a result, but foreign investment has been a channel for the transfer of technology and management skills, and so increased growth. The wave of globalisation in recent decades would have travelled more slowly without financial liberalisation.
But for all this gain, there is a cost. Any relaxation in controls on banks' capital and activities makes it easier for them to take risks - and so increase profit - in the knowledge that the state cannot afford to let them fail. There is no simple answer, but a system of bank rescues in which shareholders lose all of their money creates the right incentives. Shareholders walked away from this year's bailouts of Northern Rock and Germany's IKB.
Consumer credit liberalisation also leads to a trade-off. Subprime mortgages made home ownership possible for hundreds of thousands of people who would otherwise have been tenants. Yet incompetent and fraudulent misuse of subprime mortgages has caused tens of thousands of those people to lose their homes as well as a shock to the financial markets. Regulation should be directed at the misuse and mis-selling of these products and not at the products themselves.
The greatest effect of financial liberalisation, however, has been to bind markets more closely together. A shock in the US mortgage market really can affect the availability of credit for a European consumer. To those consumers this is hard to explain, and feels like a threat, yet while the scope for financial shocks is now greater, there is little evidence that they have increased in frequency or in magnitude. Financial regulation, especially on bank liquidity and consumer lending, should be tweaked in response to the credit squeeze. But its liberal direction, which has brought great benefits, must remain.
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