Robert Shiller, like Alan Greenspan, says we need a "well-articulated policy" to manage the next financial crisis. In particular, we need to update our laws and institutions - he says bankruptcy law is good place to start - to handle the complexities inherent in modern financial markets, and to recognize systemic risk:
Crisis Averted. What of the Next One?, by Robert Shiller, Economic View, NY Times: ...Given the threats posed by the financial crisis, a better framework for dealing with systemic crises is urgently needed. The policies recently instituted by the Treasury and the Federal Reserve to deal with financial crises seem improvised, rather than part of a consistent, well-articulated policy.
There is still a risk that financial dominoes will begin to fall. ...[T]his ... is worth some careful thought. If the Bear Stearns crisis had such a potential for disaster, what will we do if a major hedge fund fails or if several crises happen at once? ... What if the next case is worse? No one in government seems to feel a responsibility for warning about such possibilities and formulating a detailed policy for dealing with them.
Bankruptcy law is a good place to start. After all, the dreaded financial meltdown would amount to a wave of bankruptcies.
Preventing Bear Stearns from becoming the responsibility of the bankruptcy courts was one reason the Fed felt that it had to act so quickly. Current bankruptcy law was not written with the perspective of systemic risk in mind. There is a big problem — a discontinuity in macroeconomic outcomes — when large financial institutions are at the margin between solvency and insolvency. The formal declaration that an important financial institution is insolvent could threaten the whole economy...
Jay L. Westbrook, a bankruptcy scholar ... at the University of Texas School of Law, has called for extensive study of the systemic financial issues related to bankruptcy law. He said the law might be changed in innovative ways so that in times of financial crisis, when more is at stake than the fate of individual companies and their stakeholders, troubled companies could be kept functioning longer. A subsidized system of triage would be needed to identify which companies should be saved, with the main criterion being the possible economic impact of their liquidation.
In this country, we seem to get things right eventually. ... We learned how to deal with the systemic effects of bank runs — but it took a couple of hundred years. In the 19th century, periodic banking crises were the major cause of economic crises. By the 1930s, we had a four-pronged approach to deal with the banking variety: regulation, direct discount-window lending by the Fed, deposit insurance and processes for orderly resolution of insolvencies.
Now the financial system is much more complex. It includes a variety of entities that resemble banks in their vulnerability to panics, though we don’t fully understand the crisis potential. Hedge funds, for example, do not need to disclose much about what they are doing, yet they are starting to play a role in our economy that resembles that of 19th-century banks.
What would happen to the economy if hedge funds had to liquidate, one after another, in a financial crisis? We need to rethink the theory and practice of bankruptcy, given the new complexities.
Current bankruptcy law, and the system of bankruptcy courts, were put in place by Congress with the help of organizations like the American Bankruptcy Institute, the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association. It’s not shocking that these groups seem to have approached the problem of bankruptcies largely as narrow specialists, thinking mostly of the interests of their clients, rather than of the economy as a whole. We can’t expect securities lawyers to focus on issues like threats to consumer confidence or, for that matter, disruptions in the labor market.
But someone needs to do it.