Participant Opinion Piece: Cynthia Williams on the political and technical challenges of creating productive financial markets

"Two quite interesting papers have recently been published, related to the questions at the core of NSFM’s inquiry: what causes financial instability, and what can be done to address it, both as a regulatory matter and as a matter of behavioral change.  The first paper, entitled "Too Much Finance", is by three IMF economists, Jean-Louis Arcan, Enrico Berkes and Ugo Panizza.

This analysis shows that up to a certain point the existence of ‘financial depth,” defined as the extension of credit to the private sector, leads to increasing economic growth, especially in low- and middle-income countries.  But past a certain point, roughly 100% of GDP, extra finance slows down growth, both by increasing economic volatility and increasing banking crises, but also by “draining” talent into the financial sector from the productive sectors.

The second paper, entitled "Systemic Financial Risk", analyzes the results of repeated simulations using an agent model of financial markets to show how excessive levels of leverage can lead to a systemic crash.  Contrary to prior “representative agent” models that assume homogeneous rational actors in general equilibrium models, this analysis uses agent based models that simulates interactions between non-representative agents (noise traders, hedge funds, investors in investment funds, banks, and regulators).  The paper shows the particular systemic danger of agents using high amounts of leverage to fund speculative investments, while also demonstrating that moderate levels of leverage can have stabilizing effects.  While the focus on leverage certainly gives scope for informed policy reform, the report also recognizes the importance of further understanding the social dynamics within financial institutions in order to more fully address systemic financial risk.

While both of these reports offer important insights into the technical challenges of creating productive financial markets, the political challenges remain central: how to introduce the structural reforms that are necessary, given the power of finance; and perhaps more important, how to change the cultures within the largest financial institutions and amongst its networks of actors."

Cynthia Williams is a Professor at the University of Illinois, School of Law and a Director of the Board of NSFM.

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