Beyond Pangloss: financial sector origins of inefficient economic booms

What is this research about and why did you do it?

In the wake of the Global Financial Crises (GFC), the GDP of most countries failed to recover and catch up with its previous trend. The bulk of the literature focuses on ex-post weaknesses. Instead, we study the cause of the boom that preceded the crisis and ask whether it was sustainable, or even desirable in the first place.  

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How did you answer this question?

We built a theoretical macroeconomic model to study the distortion created by government guarantees to banks and other financial institutions. In particular, we focus on how the implicit subsidy attached to such guarantees affects real investment decisions. Financial institutions have an incentive to extract the maximum benefit from this subsidy thereby taking on excessive risks. Financial regulation aims at mitigating such risks. We model how financial engineering allows banks to circumvent regulation. We also show how granting negative net present value loans can be beneficial for banks because they can be used as collateral and boost trading book profits.  

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What did you find?

Our central finding is that, beyond the existence of government guarantees, what really matters is the extent to which they can be exploited.  As economies deregulate their financial sectors and financial institutions innovate and become better able to circumvent what regulation is left, real economic distortions can become substantial. This resonates with developments prior to the GFC. But since the GFC was followed by a regulatory crackdown, which reduced the ability for banks to exploit the guarantees, a new hypothesis arises: the Great Recession may have been the reversing of a Great Distortion that was itself due to increased opportunities for exploiting government guarantees.  

Illustrative calculation of the distortion, as well as the upper and lower bounds that come from using different data sources, different assumptions on confounding variables, and alternative detrending approaches. Based on the estimates, the distortion before the GFC is between 3% and 8% of GDP. This is sizeable given recessions typically give rise to a negative output gap of 1-3%.

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What implications does this have for the research on wealth concentration or economic inequality?

These questions are important because, while it is typically a small elite who benefits from the excesses of a financial boom, it is the taxpayer at large who is on the hook once government decides to socialise the losses. Furthermore, aggressive lending expansions (think of the subprime lending episode in the US prior to the financial crisis) could be predatory and entail massive, long lasting welfare costs to borrowers.  

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What are the next steps in your agenda?

One can think of financial regulation as a cat-and-mouse game. Banks dedicate huge resources to lobby against regulation, and to minimise its impact on their activities. Regulators need tools and frameworks to increase the chance that they “get it right”. Ramifications that need more research and that we are interested in include: international collaboration of regulators, credible resolution mechanisms for large banks, and robust measures of systemic risk building.  

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Citation and related resources

This paper can be cited as: Malherbe, F. and McMahon, M. 2021. 'Beyond Pangloss: Financial sector origins of inefficient economic booms.' CEPR DP15180.

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Related resource:

• CORE Insight Too big to fail