Saturday, April 12, 2008

Explaining the crisis (3)

In the draft version of my previous post, I had written that Andrew Sheng absolved central bankers from blame for the international credit crisis.

Asking Andrew if he agreed with my judgment of his paper, Andrew replied that he thought the word “absolved” was too strong. “Regulators do share some of the blame,” he said, “but they were neither equipped nor structured to deal with a macro crisis, because they are fettered in silos. The real problem lies in mindsets. The market knows best mindset does not mean that the market is always right. Triffin is right. Who wants to go against the crowd in a feeding frenzy and take away the punchbowl? Central banking and regulation are not in the popularity business. When they are, or when they are captured by the vested interests (who may prefer that they are in silos) then the collective action of private greed at public cost must inevitably lead to crisis. The self-organized and reflexive nature of markets mean that central bankers and regulators must lean against the wind. They may not be able to stop the tide, but they would be doing their jobs.”

In a subsequent exchange of emails, John Williamson replied that he was not suggesting that the regulators could be expected to deal with a financial crisis, “but that if they had acted differently we would not have had a crisis at all. Admittedly it is not unambiguous where regulation ends and central banking begins, but the ‘financial authorities’ encouraged the trends that culminated in the crisis instead of leaning against them. And such leaning would have involved different regulation rather than higher interest rates. That is what I meant.”

John’s reply prompted Andrew to observe, “I recognize that it is difficult to separate completely where central banking ends and where supervision or regulation begins. The real issue is the mindset – are you liberal on market entry and financial innovation, and where do you begin to tighten regulation when you think that the financial institutions are skating on thin ice?”

Andrew continued: “The mindset of ‘market knows best’ is that you allow liberal financial innovation, without checking, since the prime brokers are supposed to look after their own money well. Greenspan explained that house-owning democracy is good (per his biography) and did not look into the quality of the lending nor the due diligence. By refusing to lean against the wind at the central bank level, he allowed the bubble to form. He could have tackled the excess leverage through imposing higher margins, but he refused to do so in 2000 and also the 2004/2006 mortgage excesses. He also allowed interest rates to go too low.

Using the present structured examination techniques, the bank regulators in US,. UK and EU were not able to detect these excesses. Everyone worried at the macro level, and no one did the forensic examination at the micro-level. So, if you do not think there is a problem at the macro-level, and do not do enough examination at the micro-level, how can the regulators have "leant against the wind"? Worse, there are so many silos in the regulatory structure (which Paulsen is trying to consolidate) that no individual regulatory authority could have leant. The last time CFTC tried to impose some restraints on derivative trading, it was beaten back by Congress.

The point I was trying to make is that the central bank is in charge of overall monetary policy and systemic financial stability. Greenspan was at the helm in charge of bank examination also. There is no excuse for him, to blame the lack of judgement on whether a bubble exists, nor on the inadequacy of risk management tools. The central bank is paid to make these judgements. If monetary policy denies that core inflation should include asset prices, then monetary policy was in fairy land.

I recognize that there is a problem with the techniques that regulators use to try to stop market excesses. But if the overall philosophy is to allow the market to take care of itself, then the regulators on their own, in their silos, cannot do that much. The fact is that no one wants to stop a bubble on the way up, but everyone wants to blame the regulators after the bubble implodes.”

John Williamson responded: “Andrew, I was not attempting to defend Alan Greenspan, who (as you point out) was also a principal regulator. It is in the latter capacity that I would mainly criticize him. Yes, certainly one wants someone to think about “whether a bubble exists” (the idea that central bankers should not try to identify bubbles because they cannot be 100% certain is dreadful). But having reached that conclusion one does not break a bubble by raising interest rates (since by definition a bubble is a price rise that is not explained by things like interest rates), but by telling people to stop doing certain things. I call that regulation (though it may be supplemented by things like raising margin requirements, even if this probably would have been ineffective). Yes, it involves recognizing that the market does not always know best, because they go on dancing until the music stops. In economist’s language, this is to acknowledge there may be differences between private and social costs.

The job of regulators is surely to do well-directed forensic examinations at the micro level. I agree that you cannot blame individual low-level regulators who are not well directed. I hope no one thinks I suggested otherwise.”

John’s clarification prompted Andrew to add, “I don't think we disagree. Leaving interest rates too long was a problem, and raising margin rates would have helped, as long as someone cried Cassandra. Unfortunately few did. Makes me think that the self-organized nature of markets and incentives are such that the cycle of boom bust is inevitable. I think Greenspan has been chastized enough by the media to remind all leaders to do what they feel is right.”

(to be continued)

On the picture you see the Amsterdam office of FONDAD. I feel privileged that I can work now all days (and nights) from home rather than commuting daily between Amsterdam and The Hague, as I did during 21 years. The address is Nieuwendammerdijk 421, 1023 BM Amsterdam. The house stands on a dike and at the back slowly sinks in peat-soil. It has a garden and you are most welcome to drink a cup of tea or glass of wine in the garden if the weather permits. Behind the shop window was a vegetable shop; now it is crowded with books. I'm afraid I won't have the time to read them all (again). Never mind, life is beautiful and I do read a book picked from the shelves every now and then. "Economics in Perspective: A Critical History" (1987) by John Kenneth Galbraith is one of the books waiting to be taken from the shelves. I think Andrew recently read it (again). Who of you has read it? What did you think of it? Another book waiting to be taken from the shelves is "History of Economic Analysis" by Schumpeter. I'd like to reread the chapter on Money, Credit, and Cycles (pp. 1074-1135 in my edition of 1967, printed in Japan). Robert Triffin was a student of Schumpeter. Triffin told me, “The great thing is not to choose a topic at the university but to choose a man. At that time at Harvard the greatest man undoubtedly was Joseph Schumpeter and I learned my economics from Schumpeter.”

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