"The power to become habituated to his surroundings is a marked characteristic of mankind....We assume some of the most peculiar and temporary of our late advantages as natural, permanent, and to be depended on, and we lay our plans accordingly. On this sandy and false foundation we scheme for social improvement and dress our political platforms." – J. M. Keynes, The Economic Consequences of the Peace
Keynes wrote prophetically of the economic consequences of the Treaty of Versailles. Could the same be said of current financial reforms? Are policy-makers taking for granted the essential role performed by finance in a vain pursuit of its risk-proofing? Do we assume that our "late advantage" of an open, global capital market and trade environment is a "natural, permanent" feature of the economic landscape?
Or is the other extreme possible? Are we being too timid? Consider the jaded attitudes of the bank CEO who recounted: "My daughter called me from school one day, and said, 'Dad, what's a financial crisis?' And, without trying to be funny, I said, 'This type of thing happens every five to seven years.'"1
Should we be content with a dreary cycle of upheaval?
Such resignation would be costly. Even after heroic efforts to limit its impact on the real economy, the global financial crisis left a legacy of foregone output, lost jobs, and enormous fiscal deficits. As is typically the case, much of the cost has been borne by countries, businesses, and individuals who did not directly contribute to the fiasco.
If what's past is prologue, growth will be lower and unemployment higher for years to come. The Bank of Canada forecasts that, as a result of the crisis, cumulative foregone economic output from 2009 to 2012 will be 16 per cent of GDP in Europe and 9 per cent of GDP in Canada (see Appendix, Chart 1). Over the longer term, we estimate that these shortfalls could grow to about 40 per cent and 30 per cent of respective GDP. Given the synchronous nature of this global crisis, there are reasons to fear such severe outcomes.
Surely, and contrary to what some in the industry would have you believe, there is some price worth paying to reduce such tail risks in the future. This past weekend's historic Basel III agreement strikes exactly the right balance.
In my remarks today, I will focus on the costs and benefits of financial sector reform. I will argue that the economic case is compelling and the basic stakes enormous. Financial crises are normally followed by financial repression; economic downturns, by increased protectionism. Without credible, coordinated financial reforms, we risk losing the open trading and financial system that has underpinned the economic miracle of recent times.
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