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Defining financial stability

July 8, 2009

By my count, the British government’s new paper setting out its plans for overhauling the banking industry mentions the words “financial stability” 141 times in its 147 pages. So it comes as some surprise that the document makes no attempt to define the phrase.

The paper talks at length about restoring, maintaining and protecting financial stability. Its main proposal is to create a Council for Financial Stability, to be chaired by the Chancellor. Meanwhile the Financial Services Authority is to be given explicit responsibility for maintaining the stability of the financial system rather than just regulating individual banks.

Bank of England already has a Financial Stability Objective, and has set up a Financial Stability Committee to worry about it. But at no point has anyone said what this actually means.

The Banking Act 2009, which passed into law earlier this year, is not much help. In a particularly fine example of circular bureaucratic logic, the description of the Financial Stability Objective says the Bank of England should “contribute to protecting and enhancing the stability of the financial systems of the United Kingdom”.

To be fair to the government, it acknowledges that it is much easier to define, say, targets for inflation. On page 47 it writes:

“By contrast, financial stability cannot be defined in any simple or straightforward manner; no single indicator can capture it; the actions of many players (in both the official and private sectors) have a major bearing on it and a wide range of policy instruments can be (and must be) deployed to deliver stability and prevent instability.”

This would be funny if it wasn’t so important. In principle, everyone agrees that a stable financial system is good. But there are degrees of stability.

In theory, the government could regulate the financial system so tightly that no financial institution ever failed. Leave aside the fact that the history of capitalism has been marked by periodic financial crises. But even if stability could be achieved, it would be extremely expensive and probably rule out any further innovation in financial services.

It is probably time for an open debate about how much stability we actually want in the financial system, and what we are prepared to give up in order to achieve it. Until then, the phrase financial stability should probably be used sparingly, if it all.

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