Our most recent financial crisis has brought the way in which the banks and financial markets operate into sharp relief. Perhaps more significant is the amount of money it has cost to bail out the banks, as UK taxpayers underwrite levels of national debt which – depending on the election -could herald a new era of sluggish UK growth & relative decline, and strengthen the case for joining the Euro.
Many commentators have squarely laid blame at the door of financial innovation. But financial disasters are nothing new and they are not caused by a single event. They repeat with astonishing regularity, and often radiate from the center through commodity prices, capital flows, interest rates, and shocks to investor confidence. This time round, cataclysm was closely linked to a series of economic circumstances – strong growth, low inflation and the increased flow of international trade and finance. And although the global financial crisis was not caused by these factors per se, they highlighted the vulnerabilities in the financial and regulatory systems of the UK and US – fundamental weaknesses that were exposed because they combined with a number of unsustainable trends such as rapidly rising property values, high levels of consumer debt and untrammelled bank leverage.
While financial innovation may have a role to play in fomenting disaster, it is likely to occur in combination with other systemic factors. Bankers are incentivised to penalise risks that can be seen and measured, but this time round they invented new and sophisticated financial products which generated added value and high profit, but which carried risk they did not see – or perhaps chose to ignore.
In good times, the City attracts wealth, generates economic wellbeing and creates employment. In bad times, it can put our AAA credit rating at risk and prolong recession by limiting the flow of credit in the financial system. Still, financial services are crucial to the allocation of resources in a modern economy. We would be wise to realise it will be impossible to prevent future calamity – that is simply the inherent nature of the capital markets. By implementing a combination of regulatory and systemic changes, the UK may seek to retain its position as a leading global financial market. A successful outcome will depend largely on the appetite of the State to do battle with the bankers, and the motivation of investors to think intelligently about financial innovation.