Finance is hopelessly prone to wild cycles. When an economy is purring, profits go up, as do asset values. When credit is easier to obtain, spending goes up and the boom intensifies. Eventually perceptions of risk shift, and tales of a "new normal" gain credence: new technologies mean profits can grow forever, or financial innovation makes credit risk a thing of the past. But as asset prices fall, banks grow stingier with their loans. Firms feel the pinch from falling sales, get behind on their debts and workers, who get behind on theirs. The desperate sell what they can, so asset prices tumble, worsening the crash.

Regulation is often "procyclical": it adds fuel to the fire. In the decade up to the global financial crisis America rolled back Depression-era bank regulations, protected liberal trading rules for derivatives, presided over a wave of banking-industry consolidation and tolerated a dangerous drop in mortgage-lending standards. The ensuing crisis prompted a wave of new financial regulation, but these rules are now being weakened, even as exuberance returns.
America’s Congress is expected to tweak the Dodd-Frank Act in coming months to limit the application of some rules to the largest banks. The Federal Reserve is drafting plans to reduce bank-capital requirements. (Post-crisis revisions to the Basel bank-capital standards for global banks encouraged regulators to set a countercyclical capital buffer, which should rise with financial excess; the Fed’s is currently set at zero).

Technical defaults

One reason is that regulators are, like everyone else, too eager to conclude that this time is different. Many proposed post-crisis reforms offered technical solutions to the industry’s problems, such as better measures of financial instability or reforms to CEO pay to improve bank behavior (and reduce the need for robust regulation). Yet in finance, as in much of economic policy, problems that look technical are in fact political.

As deregulation proceeds, politicians’ electoral hopes – and, sometimes, their own financial interests – rely on the burgeoning booms. So they become more sympathetic to financial interests. Crises are usually followed by a political backlash, which sweeps in new leadership with a mandate to regulate.

Is there any hope of escaping such cycles? Central-bank independence helped depoliticise business-cycle management. Giving central banks more regulatory responsibility, as many countries did after the crisis, might therefore help (though it might also encourage politicians to meddle more with central banks). Curbing the power of the financial industry might prove more effective.

The original article is here.

Information is taken from the Economist’s site.