Is the Global Financial System in a “Doom Loop”?

MIT Sloan Professor Simon Johnson gave a talk here at MIT today — with the cheery title of “The Next Financial Crisis.” Johnson, a former IMF chief economist who blogs about the economy at the Baseline Scenario website, wasn’t referring to a specific crisis he sees brewing right at the moment so much as systemic problems with the financial system that make another financial crisis, in his view, inevitable at some point.

In particular, Johnson mentioned a recent paper by Andrew G. Haldane, Executive Director, Financial Stability, for the Bank of England. Haldane wrote about the idea of a  “doom loop” in the financial system. According to Johnson, the “doom loop” concept “is actually just another term for a cycle in which you have a boom, a bust and bailouts” — except the bailouts are done “in a sufficiently unconditional way” so that “the core structure of the financial system remains the same.”

The problem? Such a bailout may incentivize bankers to take excessive financial risks in the future. “State support,” Haldane writes, “stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits.”

And the risk, according to Johnston, is that a future financial crisis could lead to a second Great Depression.

Johnson’s advice? Make megabanks smaller. He drew an interesting analogy to the development of antitrust law; in 1890, Johnson said, the idea of proposing a cap on the size of private business would have seemed “ludicrous” in mainstream thinking. But then, over the next 20 years, Johnson argued, “we learned the hard way that having massive monopolies or trusts –as they were then called — develop was bad for society.”

Similarly, today, when it comes to the banking system, “I think we have to extend our thinking,” Johnson said.