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'Systemic risk' theory gains in stature as way to prevent the next bubble

Overheated markets for real estate and other assets could face closer scrutiny from regulators. For instance, some analysts say China's property market has the hallmarks of a bubble.
Overheated markets for real estate and other assets could face closer scrutiny from regulators. For instance, some analysts say China's property market has the hallmarks of a bubble. (Nelson Ching/bloomberg News)
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"I think there has been a massive change in the debate," said Andrew Smithers, founder of the London-based Smithers & Co. economic consultancy. "Simply ignoring asset prices is so demonstrably silly that it will not carry on either side of the Atlantic."

Although Fed Chairman Ben S. Bernanke and others speak warily about using interest rates or the other "very blunt" tools of the central bank to address problems in specific parts of the economy, he also has said he remains "open-minded" to the idea.

Other ideas under discussion include imposing higher capital requirements on banks under certain conditions to slow lending, as well as steps such as forcing potential home buyers to make larger down payments -- familiar to Asian regulators who have had to cope with rapid increases in real estate values.

A new bureaucracy

Overheated markets or dangerous levels of credit and borrowing are hardly pressing issues in the current climate, in which concern is centered on keeping a shaky recovery on track in the United States and Europe. But the attention given systemic risk is apparent in the new bureaucracy growing up around it.

The legislation signed into law last week by President Obama includes a Financial Stability Oversight Council, with powers to study and move against possible sources of systemic risk in the United States.

Europe is establishing a European Systemic Risk Board; the BIS has set up a Financial Stability Board to study and make recommendations about the issue; and the IMF has proposed a central role for itself in monitoring systemic risk on a global scale.

In recent papers, both the IMF and the BIS discussed the chance that a wrong policy choice might slow otherwise healthy economic growth. But they also said the depth of the recent downturn showed that central banks and other government agencies need to expand their traditional focus on such issues as inflation and employment, and to be more attuned to controlling systemic risk and ensuring general financial stability.

Central banks in the developed world have learned how to keep prices stable, but "there was a gaping hole in the system," which ignored financial stability concerns, IMF financial counselor Jose Vinals wrote in a recent essay. Although he said central banks need to keep inflation as their chief focus on monetary policy, he also called for "more 'leaning' in good times and the need for 'less cleaning' in bad times once bubbles explode."


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