Professor Joachim Voth has written a fascinating public paper for the UBS International Center of Economics in Society. Entitled “Fear, Folly, and Financial Crises”, Joachim draws lessons from history to argue that appropriate regulation can curb the frequency of financial crises. Crises are not, as is commonly thought, the inevitable result of everyone becoming irrational every few years. The key points are:
(1) Financial repression through regulation can prevent crises, but this comes at the cost of low growth.
(2) Therefore having no financial crises is not a good thing. The optimal number of crises is not zero.
(3) Lessons from history can help policy-makers deal with crises (e.g. the response after the 2007/08 crisis was guided by the lessons learnt when analysing the mistakes made by policy-makers in the 1930s).
(4) The severity of sovereign debt crises can be reduced by lowering banks’ exposure to sovereign debt, making risk transfers effective, and by writing contingency debt contracts (which would reduce the pro-cyclical nature of fiscal policy during crises).
(5) The frequency and size of bubbles can be reduced by avoiding short-selling restrictions, only allowing shares to come to market when the company is mature, and allowing large numbers of shares to be traded with ease.