Unregulated Financial Systems Make Unstable Economies

Many have written about the mistakes that were made but also about the challenges and the reforms needed to sustain the global economic system.

One of these voices is Martin Wolf. In The Occupy Handbook published recently, Financial Times columnist Wolf explained what he sees as the biggest challenges to the current economic system.

In an interview with IMF Survey, Wolf presented a blueprint for the reform of the economic system.

IMF Survey: What is the biggest challenge to the current economic system?

Wolf: One of the biggest issues, really for centuries, but certainly over the last 80 years or so, in economics has been stabilizing the economy itself. How do you stabilize the economy? That was the main issue in the ’30s, then it became a huge issue again in the ’70s, and economists have given a number of answers to that.

I think this recent experience has underlined the thesis that there are deep, inherent instabilities in a market economy with an open, unregulated financial system. At the level of straight macroeconomic policy, the experience has made it very clear that we need a very full weaponry of stabilization policy.

The crisis has meant quite extraordinary monetary policy actions but it is absolutely clear to my mind that in circumstances like this one needs to use fiscal policy as well, very aggressively.

In addition to the fact that although the financial sector and its inherent fragility is crucial—both at the macroeconomic and the microeconomic levels—without a more stable financial system, it is basically impossible to achieve a greater stability in the economy as a whole.

The consensus that was reached in the last 20 years—that one just lets monetary policies stabilize inflation, does not need to use fiscal policy at all—has turned out to be really quite profoundly false.

IMF Survey: Despite its flaws, the financial system is an essential part of the market economy. What kind of policies would you advocate for its fixing?

Wolf: Most economies look at these questions in terms of incentives and, when something goes wrong, they immediately say it is because of perverse incentives of some kind.

There’s no doubt in the case of our financial sector they’re extremely perverse incentives. They come from the role of limited liability companies with very, very high leverage and with management rewarded for raising the returns on equity, which they can achieve by taking risks and by, among other things, by leveraging their banks...