The doomsday cycle turns: Who’s next?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander also lectures at NYU and SunySB)

Industrialized countries today face serious risks – for their financial sectors, for their public finances, and for their growth prospects. The authors explain through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and yet inherently difficult to regulate and control.

There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque. Bailouts encourage reckless behavior in the financial sector, which builds up further risks – and often lead to another round of shocks, collapses, and bailouts.

This is called the ‘doomsday cycle’ and is described in a short communique titled The doomsday cycle turns: Who’s next? (Simon Johnson & Peter Boone, VOXEU, September 21^st).  The cycle originates when the financial system is allowed to grow creating excessive borrowing and leverage, but is hidden by the complexity and opaqueness.

The problem is that the modern financial infrastructure makes it possible to borrow a great deal relative to the size of an economy – and far more than is sustainable relative to growth prospects. The expectation of bailouts has become built into the system, in terms of government and central bank support. But this expectation is also faulty because, at times, the claims on the system are more than can ultimately be paid.

This system distorts incentives and that may result in unforeseen consequences.  For politicians, this is a great opportunity to buy favor and win re-election while delaying unpopular decisions.  For bankers and financiers of all kinds, this is easy money and the opportunity to earn an outlandish bonus.  For the broader public, none of this is clear – until it is too late.  The regulated financial sector has little interest in speaking truth to authority; that would just undercut their business. Banks that are ‘too big to fail’ benefit from giant, hidden and very dangerous government subsidies. Yet despite repeated failures, many top officials pretend that ‘the market’ or ‘smart regulators’ can take care of this problem.

The complexity and scale of modern finance make it easy to hide what is going on. The issues are abstract and lack the personal drama that grabs headlines. The policy community does not understand the issues or becomes complicit in the schemes of politicians and big banks. The true costs of bailouts are disguised and not broadly understood. Millions of jobs are lost, lives ruined, fiscal balance sheets damaged – and for what, exactly?

The question is: Who will be hurt next by this structure?  There are three prominent candidates are Europe, Japan and the US.  In Europe, the crisis originated from a flawed design of the euro and shows little sign of emerging from the crisis any time soon.  In the US, excessive private sector borrowing is showing some signs of improvement as the economy continue to delever.  While Japan, faces the impact from an aging population and economic stagnation. 

Through our financial systems, we have created enormous, complex financial structures that can inflict tragic consequences with failure and are difficult to regulate and control.  The lesson from all these troubles is clear: the relatively recent rise of the institutions of complex financial markets, around the world, has permitted the growth of large, unsustainable finance. We rely on our political systems to check these dangers, but instead the politicians naturally develop symbiotic relationships that encourage irresponsible growth. The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and is still growing. There are more crises to come and they are likely to be worse than the last one.

www.voxeu.org/article/doomsday-cycle-turns-who-s-next -