Since mid-2007 the world has been wrapped up in a financial crisis, the likes of which virtually no-one has seen in their lifetime. Although the worst of the crisis, which occurred in 2008, is now well behind us, New Zealand and the entire world continue to struggle with weak economic growth and high unemployment. This raises some important questions, namely: what happened, and what can we do to make matters better in the future?

When Lehman Brothers failed in September 2008, the global economy experienced its worst financial crisis since the Great Depression. This crisis has been termed the Global Financial Crisis (GFC) by commentators. For 70 years there was no financial crisis of true global significance, and that had created a situation where policy makers, and the economists advising them, thought such crises were unlikely to ever happen again.

There is no denying that mainstream economists were overconfident that a full-blown global financial crisis would never occur. Such overconfidence showed a general unwillingness to look at the period before the Great Depression when it came to specifically discussing how the finance industry should be regulated.

Before and during the Great Depression, financial crises were a central part of what happened in the global economy. As globalisation increased, so did the complexity of the financial system, and so did the transmission between bank failures in one country and another. By the late-19th century, arguably the first true international financial crisis occurred with the Panic of 1873 and the following Long Depression.

Banking crises, from the mid-19th century through until the Great Depression, all seemed to be the result of the same underlying factors – depositors would lose faith in banks and cause a run on institutions that would otherwise be solvent. Deep down, human nature makes us cautious of schemes that take our liquid assets (cash) and transform them into risky illiquid assets with an uncertain return (the factories etc that borrowers invest in). As a result, whenever there was bad news about the economy, a run on banks was almost expected.

Financial institutions learnt to protect themselves from these runs, but the sharp tightening in lending standards that would occur during these runs had a real economic impact – pushing down output, and leading to significant numbers of people being out of work. The Great Depression was the largest version of this, but with a twist – at first depositors and financial institutions expected the Federal Reserve to protect them, and once it was clear the Fed would not, all hell broke loose.

There was a belief among economists (myself included) that this outcome would not happen again, as policy makers had discovered a “sweet spot” in terms of financial regulation. By making central banks responsible for deposit guarantees while also regulating banks’ functions and bank licensing, the periodic bank runs that occurred prior to and during the Great Depression seemed to be a thing of the past.

But the regulations were not perfect, and over time they were adjusted to try and better represent the trade-offs that policy makers and economists believed existed.

Furthermore, as is often the case with regulation, the world changed, and some of the lessons that were learnt during historic crises were misunderstood or forgotten. Overtime, a shadow banking system in wholesale financial markets developed. This shadow banking system was outside many of the direct bank regulations and, as a result, was not protected from the risk of “bank” runs.

This lack of regulatory protection proved to be the ultimate downfall of the shadow banking system. As trust broke down between market participants, the issue of asymmetric and imperfect information between borrowers and lenders came to the forefront. The result was a huge bank run in wholesale financial markets, as it was unclear to those with liquidity which assets were good and which were bad.

While governments and central banks spotted what was going on in wholesale markets eventually, and worked to steady the ship in the financial sector, the damage was already done. The drop in credit availability for producers and exporters led to a sharp decline in world trade and a global recession.

Contrary to what is often suggested, this way of viewing the financial crisis is consistent with the economic mainstream. However, it illustrates some of the areas that were missed or downplayed in the lead-up to the crisis – specifically the development of the shadow banking sector. Framing the crisis in the same way that economists had previously understood the Great Depression, and understood the financial crisis prior to this period, means that we can also use economic theory to tell us how we can improve matters.

As was shown during the GFC, in the worst-case scenario, governments will bail out banks. This decision isn’t an issue of banks being “too big to fail” – during the Great Depression deposit guarantees schemes were justified on banks being “too small”. The justification here was that too many small banks would be just treated the same way by depositors, leading to runs on banks whose underlying balance sheet was healthy during a panic.

We can argue about whether this policy is right or fair, but in truth we have to accept that deposit insurance is here to stay. As a result, regulation needs to be set with the recognition that bail-outs will occur during a crisis – and that financial firms themselves recognise this.

The benefit of deposit insurance is that you don’t get bank runs. The issue with deposit insurance is that people are effectively willing to lend as if it is riskless. As we do not live in a riskless world, this lending behaviour is a form of moral hazard.

By viewing this deposit guarantee as a form of insurance by government, it raises the question why the financial firms aren’t they paying an insurance premium. It is this sort of question that may justify a tax on depositors, or the Reserve Bank’s push for their Open Bank Resolution (OBR) regulation.

We also need to ask how the shadow banking sector appeared. The shadow banking sector came about because costly regulation of banks and other financial institutions made them search for a way to get around the regulation. Whenever we introduce policies to reduce risk, we need to keep in mind that, the more cost you put on individual banks or lenders, the greater the cost they will be willing to expend to get around the regulation.

While this description gives us an idea of how the crisis started, and how we can minimise the chances of another crisis occurring in the future, it does not tell us why the current financial crisis has continued for so long. We will discuss that in an upcoming article.