The perceived wisdom maintains that systemic risk was much higher in 2008 than it is today. I am not so sure.
I did a Vox talk podcast the other day and made the claim that systemic risk might be higher now than in 2008, catching some flak for saying so. After all, four years ago, Mark Carney, then the Chairman of the Financial Stability Board and Governor of the Bank of England, confidently claimed that:
But why might systemic risk have increased since then?
Systemic risk is the likelihood we may suffer a severe financial crisis that then might cause an economic recession.
It is a probability that an extreme event may happen, so even if systemic risk is relatively high, it is pretty unlikely we will suffer a crisis. But some of us did get hit by one in 2008, so systemic risk must have been quite high then?
Not necessarily. To begin with, only a handful of countries did actually suffer a systemic event, like Iceland and Ireland. Some countries certainly experienced significant turmoil, but averted a crisis by prompt intervention, and most of the world didn't even experience much turmoil. So, the actual crisis event was contained.
The concept of systemic risk embeds the ability of the sovereign to react to it. So an event where the government has the means to respond without too much cost does not come with a lot of systemic risk.
But have the postcrisis reforms reduced systemic risk, as Mark Carney maintains? I don't think so.
Since then, the thrust of Macro Pru has been to reduce risks that proved important in 2008. Perversely, however, this could easily make the next crisis worse by inducing overconfidence and focussing regulatory attention on fighting the last war.
After all, it is axiomatic that we will suffer another crisis where it will not take place where the last one happened.
Has systemic risk increased? It isn't easy to verify. After all, as I said in my last post, systemic risk cannot be measured because we are trying to use day-to-day data to forecast the risk of events that, by definition, are not in our data sample.
But three factors make it likely that systemic risk has increased.
The first is that the thrust of financial regulations has, since 2008, been to harmonise beliefs in believes and action — force the institutions of the financial system to see risk in increasingly similar ways and react to it in similar ways. Of course, that is then procyclical, amplifying booms and busts.
But, as I argue in my Illusion of Control book, diversity is the best way to get financial stability. And financial policies since 2008 have been anti-diversity.
The second factor is that the fiscal space for addressing a crisis is much smaller now than then. Both because governments are more indebted and also since inflation is so high, rendering it much harder to monetise interventions.
And finally, recent interventions have raised moral hazard.
So, the case for systemic risk being higher now than in 2008 is quite solid.