Monday, March 31, 2008

Ricardo Hausmann, Martin Wolf, Guillermo Calvo, debate on rescue of Bear Stearns

From FT, the top macro-economists debate;

In his column last week Martin Wolf argued that it was intellectually untenable for Wall Street to resist more onerous regulation of capital requirements or liquidity. Moral hazard is already visible, he wrote, in the jump of investment banks’ share prices since the Bear Stearns rescue.

Ricardo Hausmann argues that tighter regulation during the past few years would not necessarily have led to better pricing of risk. He would put the blame on “a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment”.

Robert Wade points out that a “new financial architecture” was discussed after the financial crises in in Mexico (1994–5) and East Asia/Brazil/Russia (1997–8) — but by 2000, when these crises appeared limited to the emerging markets, “discussion petered out”.

Just when you thought things could not get much worse, Guillermo Calvo warns that the current financial crisis could be distracting us from another problem: a reduction in central banks’ ability to anchor nominal prices. “In the short run this may be less noticeable in broad price indexes like the CPI but, in my view, it is already being reflected in, for instance, the dollar/euro exchange rate,” Calvo argues. This could have a deleterious effect on trade, he says, because while public policy can respond to trading partners’ technical superiority, for example — it is difficult to effectively reform against arbitrary swings in exchange rates.

Adam Posen echoes Martin’s fears that the current crisis will be interpreted by countries such as China and India as a strike against free market liberalisation. But he fears the misinterpretation will go further. “Life is complicated, so events get overdetermined.” The outcome could be an even deeper rejection of liberalisation, as the entire “anglo-saxon model” is blamed for what Posen calls a “regulatory ankle-sprain”.

Ricardo Hausmann: Martin makes an interesting point. If the Fed’s safety net is extended beyond commercial banks to other market participants, prudential regulation should also be extended to avoid moral hazard. Martin may have a point, but I believe he may be focusing the policy discussion in the wrong place. It is macro policy, not financial policy that needs to be at center stage.

I propose we engage in the following counter-factual scenario. Let us suppose that more stringent financial regulations had been adopted in 2003 or some such date. Let us discuss two macroeconomic scenarios.

Consider first the case where the Fed would have set the same interest rates as we observe in the historical record. In this case, the new regulations would have lead to a smaller rate of credit expansion because the regulations would have meant that, for any interest rate set by the Fed, the market for credit would have been smaller. Presumably, there would have been less mortgage lending, fewer home equity loans and less junk mail offering zero percent loans on credit cards. Aggregate demand would have been lower and presumably so would have been the rate of growth, the level of employment, the inflation
rate and the current account deficit.

Now, consider the alternative scenario in which the FOMC would have set interest rates following the way monetary policy is conducted, with the same inflation and employment targets. What would have been the consequences of this alternative and more plausible financial scenario?

Obviously, the Fed would have lowered interest rates until the amount of lending required by the inflation and employment targets had been achieved. The financial system would have been asked to find other ways to expand credit.

Maybe, that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But I am not so sure that this would have been the case. With the even lower level of real interest rates, the incentives for financial engineers to invent new instruments that could be placed in large numbers would have been enormous and many more bright minds would have been hard at work at circumventing the new regulations than those that had crafted them.

My bottom line is that it is impossible to discuss the lessons of this crisis without talking about macro policy. I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households.

In the end, a macro policy that overshoots the sustainable growth rate by encouraging millions of citizens to over-borrow is not going to be made safe through financial regulation.

Guillermo Calvo: Martin Wolf is right that the current arrangement in financial markets needs to be revised. How to do that is a much larger issue, and I agree with Ricardo Hausmann that one cannot tackle the financial system in isolation of other macro policies and, in particular, monetary policy. The financial system is much like the nervous system: it is in contact with the whole body. Important as those issues are, however, there is the risk that financial distress may be distracting us from the recent surge of another type of vulnerability, namely, much poorer price and exchange rate anchoring—a weakness that, if left unattended, may result in a new type of crisis.

The period of so-called Great Moderation spanning from the 1980s until now has given central banks the illusion that they can implement an incredibly clever nominal anchoring system by appropriately manipulating a reference interest rate (Taylor’s rule is an example), to such an extent that it is safe to let the exchange rate and the stock of money (whatever its definition) be fully determined by market forces. This arrangement could work under highly demanding rationality conditions, but even if the latter are satisfied one can find examples in which nominal anchoring requires some kind of fiscal anchoring along the way (see, for example, John Cochrane, “Inflation Determination with Taylor Rules: A Critical Review” NBER Working Paper 13409, September 2007). Thus, even under this narrow perspective, the present situation suggests that central banks may be about to lose the awesome power that they enjoyed during the Great Moderation. The reason is that central banks are beginning to venture into areas that go beyond standard liquidity management by acquiring assets, some of which could be insolvent or require major rescheduling. These are fiscal operations that might tend to deteriorate the already weak US fiscal stance, for instance. In other words, the fiscal anchor may become much weaker than it used to be, bringing about the specter of “fiscal dominance,” a phenomenon that has wreaked havoc in several developing economies. (There are even more relevant considerations that may contribute to making nominal anchoring tricky, like dumping of international reserves by Sovereign Wealth Funds while central banks peg their nominal interest rates; but this is not the place to expand on that.)

Consequently, one of the casualties of poor financial regulation may be a weakening of the central banks’ ability to anchor nominal prices. In the short run this may be less noticeable in broad price indexes like the CPI but, in my view, it is already being reflected in, for instance, the dollar/euro exchange rate. Under weak nominal anchoring, market-determined exchange rates could become highly volatile because slight changes in moods or expectations may cause them to veer into wildly different directions. And the solution cannot be found in more sophisticated or better regulated derivatives. Derivatives, if anything, make nominal anchoring even more difficult to achieve.

Weak nominal anchoring could have deleterious effects on international trade. Losing international competitiveness due to your trading partners’ technical superiority is something politicians can deal with in a sound way by, for instance, speeding up the pace of reform. But if the cause is an arbitrary swing in exchange rates, reform could actually be counterproductive, appreciating their currencies even further. Paradoxically, the “solution” could be found in crazy policies, a very dangerous path for the world economy to follow!

This is not the place to offer alternatives (although I believe that some kind of exchange rate coordination merits serious attention). My main point is that the world may be on the brink of a new regime in which exchange rates’ volatility increase the complexity of current problems by involving vital areas like world trade. I think it is time for the international community to urgently address those issues head on. Complacency got us into the subprime mess; let’s not do the same with monetary policy. Maybe my concerns are overblown, but it is always better to prevent than to cure.

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