By Jon Danielsson and Jean-Pierre Zigrand, London School Of Economics:
So what led to the most recent build-up of systemic risk and the resulting Global Crisis, an outcome that seemed to catch almost everybody by surprise? One explanation is that the relative absence of crises over the past few decades lulled policymakers, financial institutions and researchers into complacency. Central bankers mostly focused on fighting inflation while regulators tended to neglect the system as a whole, instead aiming to ensure that each individual financial institution was well regulated – through so-called prudential regulations.
The latest crisis has demonstrated the folly of such thinking, which assumes that as long as each component of the system is safe, the whole system must be safe as well. This assumption carries the danger of policy authorities falling victim to the ‘fallacy of composition’ prefigured by Milton Friedman (1980):
“The great mistake everyone makes is to confuse what is true for the individual with what is true for society as a whole. This is the most fascinating thing about economics. In a way, economics is the most trivial subject in the world, and yet it is so hard for people to understand.
“Why? I believe a major reason is because almost any interesting economic problem has the following characteristic: what is true for the individual is the opposite of what is true for everybody together”.
With financial market regulation, the fallacy of composition has serious consequences – attempting to ensure the safety of each part of the financial system independently can lead, perversely, to the system as a whole becoming more unstable. Trying to make every market participant behave prudently destabilises the financial system.
Both regulators and institutions place constraints on how market participants are supposed to behave. Those rules are often motivated by ‘microprudential’ or internal considerations, such as moral hazard or adverse selection. For example, there is a wide range of constraints on the amount of risk an institution can hold, how it can refinance itself and on the collateral it must hold.
Unfortunately, in the spirit of the fallacy of composition, while these rules are meant to guarantee sound microprudential behaviour, they can create dangerous positive (reinforcing) feedback loops. One example would be cases where a fall in asset prices triggers an obligation to raise cash by selling more assets, which pushes prices down further.
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