The economist and former professor at the University of Chicago Booth School of Business will examine the lessons of the 2008 financial crisis and how, unless we reform our banking system, further crises are inevitable. In identifying a potential cause of the next crisis, Cochrane sees sovereign debt as the main weak point in the current financial system:
“I don’t think expansions end on their own. There has to be a shock or a spark. Clearly, the world and the market are nervous about what the next one will be! I still see sovereign debt as the biggest problem, but that too needs a spark. Like Greece did, sovereigns can paper things over in good times, and the unpayable debt and phoney accounting shows up in bad times. So what will be the spark? I’m more worried about geopolitical than economic events right now.”
Lost decade
In addition to a decade of elevated unemployment, Cochrane estimates that the 2008 financial crisis cost the US almost 10 percentage points of GDP and that 10 years later, it has still not recovered to the previous trend. With hindsight, he believes that more banks should have been allowed to fail during the last financial crisis but they aren’t the root cause of the problem:
“We should be less willing to bail them out next time but that’s not the key. Once a crisis is on, governments really do have to stop the crisis, and that generally means bailing out creditors so they don’t run. Only by fixing the system so there aren’t runs in the first place will we stop bailouts.”
Cochrane, similarly doesn’t believe that making bankers personally accountable or criminally liable for future failures from excessive risk-taking is necessarily a good idea:
“There was a run. Ninety-nine percent of the 2008 crisis did not involve anyone doing anything illegal. Going after bankers would just lead to more show trials and scapegoats being hurried off to prison.”
Worst of both worlds
Cochrane, who blogs as the Grumpy Economist, believes that the next crisis could be even worse than 2008 and argues that to avoid a perfect storm of government debt defaults, global economic recession, budget and pension deficits, we must act now. The key to averting potential banking system failure and therefore financial crises, according to Cochrane, is more capital:
“The problem is that the ex-post bailout leads to ex-ante risk taking, and markets pretty much expect that in a big crisis all the big banks will be bailed out once again. Governments would like do the opposite – to convince everyone you won’t bail them out, so people manage their own risks, and then bail out after the fact to stop crises. I worry we are in the opposite world, in which everyone expects a bailout but in fact governments will not do it, for legal limitations, political reasons, or because they reach their fiscal limits. That’s the worst of both worlds.”
Cochrane is sceptical that the slew of regulation and stress tests introduced following the previous crisis will help and believes that the financial and monetary system must change. He argues that banks should be funded largely by equity, rather than a reliance on borrowing, to prevent future runs and ensuing financial crises:
“The way you stop crises is to not let them start. That means that banks and others must finance their risky investments with a lot more equity. Leaving a lot of debt on the table and then promising not to bail out is like playing a game of chicken – driving cars at each other at 90 mph and seeing who will swerve first.”