Childish hope

When making coffee in my Bialetti Venus 4 I thought: the reason I have difficulty in writing that long article which includes the views of Triffin, Witteveen, D'Arista, Kenen, Williamson, Sheng, Persaud, Woo and others is that I realise too many written pieces are waiting to be read, and long articles will never be read seriously, I mean seriously by people who should read them as they are the ones taking decisions about the future course of the world economy.

I also thought: the plea, the longing in my post of yesterday is too idealist, too childish, because how can you expect or hope (esperar expresa ambas cosas) that we may live one day in a world where everybody has equal chances?

However, it is that hope or longing that inspires my work.

Is it too early?

Who has a vision of the future of global finance and the global economy? It seems that most social scientists and other thinkers are absorbed by crisis management.

Is it too early to think about a different world, a world where everybody is enjoying economic stability and the benefits of economic welfare?

Is it too early to envision the vision, the global institutions and the global and national institutional attitudes needed to realise such world?

My uncle Gino's advice

When I look at my face in the mirror while shaving my beard, I always think of my uncle Gino from Toronto, who used to give investment advice (he had his own investment letter for many years). One morning, the only morning I stayed at his home near Toronto, he told me that I did not need to hurry when shaving, as this would not finish the job more quickly. "Just do it quietly," he suggested.

This morning I had to think of my uncle Gino's advice when I was hurrying back to my computer to finish a post I've wanted to write for a long time, about visions of the future of finance in the global system. Why should I be in a hurry, I said to myself, if it won't speed the writing of a good piece?

The picture shows my uncle Gino in his youth, in the Netherlands. He died a couple of years ago, in Canada, the country that had become his new home when he emigrated in the late 1940s or early 1950s. I know him as one of my many uncles and aunts in Canada (my brother also lives in Canada). Gino was a successful investment adviser until he lost his money, not because of an international credit or debt crisis but because of something else.

PS: I see that the original date of drafting the first two paragraphs of this post appears as the date of this post. However, today it's 25 November 2008 and not 13 October 2008, so "normally" I would have felt that I should hurry to finally finish that post on visions of the future. But, listening to my uncle Gino's advice and seeing the speed of information and the speed of financial transactions as one of the problems of global finance and development, I know that slow writing (and slow financial transactions) may make a better contribution to world stability than all this frenzy chasing after financial news and financial opportunities.

Es esa locura de "breaking news" y "today's financial opportunities" (Act now!) en que vivimos que es una de las causas de la crisis... It is this madness of "breaking news" and "today's financial opportunities" in which we are living that is one of the origins of the crisis...

Solving the credit crisis: we need a visionary view

To understand the functioning of the global financial system, prevent its crises and propose a better system, is a tremendously challenging job. No economist alone or group of economists would be able to do that job. In order to do it properly, one needs an overview and comprehensiveness of knowledge (including that of the other social disciplines) that economists alone cannot possess. Thinkers from other disciplines are needed as well.

Most officials working at ministries of finance and central banks see it differently. They still think they can do the job. However, we do not only need technical expertise but also a broad and in-depth view that takes into account how the system works for all citizens, rich and poor.

OK, I agree, the most urgent job for officials is now to manage the crisis as good as they can, and make steps towards a better regulation of financial markets. But even accepting the adagio that “only small steps are possible”, we still need a broad, visionary view of the system.

Can we create such visionary view? How?

The last laugh

In the media and the bakery shop around the corner, I hear more and more people say that the global financial system is ludicrous. Yesterday, in my daily newspaper NRC Handelsblad Dutch writer Willem van Toorn said, "It is amusing for the outsider that the army of economists, who always have said to us with serious scientific economic faces that we should not stop growing, now do not seem to have any scientific text available and instead speak with deep concern about 'the emotion of the market'."

Willem van Toorn's concern (and amusement) with economists was shared the day before in the same NRC Handelsblad in a column by Jan Sampiemon, a former Chief Editor for Foreign Affairs and former Deputy Chief Editor of NRC Handelsblad. He said:

"European politics followed until the beginning of this week European business, which was captured by the new US managerial capitalism. … Among other things, you recognise an ideology by the commonness of opinion among nearly all those who are dealing with the issue as economist, politician, CEO or journalist. Relevant questions were not raised. 'Fundamentals' could not be debated and scientists who raised critical questions were turned to the corner where they could puzzle over their stalled career."

I circulated these two quotes among a number of economists of my FONDAD Network (the group is larger than the link indicates) and in response one of them sent me a nice video clip. I think it will make you either smile, burst out in laughter, or laugh like "een boer met kiespijn" (a farmer with toothache), as the Dutch expression goes. According to my dictionary the English would say, "laugh on the wrong side of your face (mouth)".

The Last Laugh - George Parr - Subprime - subtitulos
Cargado por erioluk

Fixing the financial crisis: an agenda for regulatory reform

I read a paper I like a lot. It has been written by Jane D’Arista and Stephany Griffith-Jones, two experts in international finance, both concerned with the functioning of the global financial system, its current crisis and its (likely) effects on people less fortunate than the rich.

The paper is called “Agenda and criteria for financial regulatory reform” -- a key issue that needs to be addressed urgently. In my view, all policymakers, officials, opinion-makers (any academic teaching or writing is an opinion-maker) or other person interested in the current financial crisis should read the paper and, if possible, do something with it.

The first introductory paragraph is worth quoting fully:

“The severe turmoil in the most “advanced” financial markets that started in the summer of 2007 follows many deep and costly financial crises in the developing economies during the last twenty five years. This more recent crisis, like previous ones, is the result of both:
(a) inherent flaws in the way financial markets operate – such as their tendency to boom-bust behaviour – and
(b) insufficient, incomplete and sometimes inappropriate regulation.
Financial crises tend to be very costly from a fiscal point of view (i.e., that of the taxpayer), from their impact on lost output and investment, and from their impact on people, many of whom are both innocent bystanders and poor.”

The second introductory paragraph is also worth quoting fully:

“It is therefore urgent and important to reform financial regulation, so that it makes financial crises less likely in the future. Those new systems of financial regulation should attempt to deal with the old unresolved problem of inherent pro-cyclicality of banking as well as financial markets. They should also deal with such new features as the growing scale and complexity of the financial sector, the emergence of new, as yet unregulated actors and instruments, as well as the increased globalization of financial markets. To do this adequately and to avoid regulatory arbitrage, regulation has to be comprehensive.”

As the remainder of the paper is 25 pages long, I cannot continue quoting every paragraph I like. So let me just highlight a few of the insights the paper provides.

“A key market failure in the financial system is the pro-cyclical behaviour of most financial actors, which leads to excessive risk-taking and financial activity in good times, followed by insufficient risk-taking and financial activity in bad times. As a consequence, a key principle and desirable feature for efficient regulation is that it is counter-cyclical, to compensate for the inherent pro-cyclical behavior of capital and banking markets.”

“After the eruption of the sub-prime mortgage crisis in the summer of 2007, criticisms of past and present policies of the Federal Reserve and other regulatory authorities became more frequent. (…)The Fed’s monetary influence weakened as it gave priority to deregulation and innovation and abandoned credit flows to the procyclical pressures of market forces, ignoring ways in which monetary policy itself had lost its ability to stabilize financial markets and the economy. It paid no attention to the way that foreign capital inflows drove up the supply of credit and failed to notice the explosion of debt that unchecked credit expansion produced. And, as debt soared, the Fed ignored the asset bubbles it fueled. (…). Together with its failure to criticize and curb abusive lending practices, the Fed’s passivity in responding to major changes in financial structure and regulation contributed to the prolonged and pervasive reach of the credit crunch that the sub-prime mortgage defaults unleashed.”

“Over the past 30 years, the US financial system has been transformed by a shift in household savings from banks to pension and mutual funds and other institutional investment pools. (…) The implications of these shifts in saving and credit flows have radically altered the way the financial sector functions, reducing the role of direct lending in favor of trading, investment and asset management.”

“At [a] 1993 conference, former Bundesbank Vice President Hans Tietmeyer’s … argued that, in a number of countries, deregulation and financial innovation had altered the transmission mechanisms for monetary policy to the real economy and had “generally made it more difficult for monetary policy makers to fulfill their stability mandate”.

Subsequent events have underscored the accuracy of these remarks. In the 15 years since they were made, however, the major central banks have taken no steps to improve the monetary transmission mechanism. On the contrary, they countenanced further innovation and deregulation and promoted the view that market-based solutions … could replace the quantity controls (reserve and liquidity requirements, lending limits and capital controls) that had been targeted for removal by the advocates of liberalization.”

When Jane and Stephany come, on page 12, to their criteria and principles for financial regulatory reform, the paper turns too detailed that it allows for quoting. You can read the full paper on the Fondad website, under “Other Publications”.

There is one concluding remark with which I like to finish this post:

“The discussion of a global financial regulator needs to be put urgently on the international agenda. In the meantime, efforts at increased co-ordination amongst national regulators requires top priority. It is also urgent that developing country regulators participate fully in key regulatory fora, such as the Basle Committee. Given their growing systemic importance, it is absurd and inefficient if they do not.”

Three schools of thought on crisis prevention

A few months ago Bill White, chief economist of the Bank for International Settlements (BIS), made an interesting speech stressing that "the first and crucial point" for proposing solutions to the credit crisis is "agreement on the nature of the problem". I think that the lack of such agreement is one of the reasons the credit crisis still lingers on. It also tells us that the risk is great the crisis will not be tackled in a fundamental way -- not even in the moderate way suggested by Bill White and some of his colleagues at BIS.

What are the underlying causes of the current financial turmoil? Bill White sees at least two schools of thought: one that asks itself "what is different", and the other, "what is the same". Most analysts follow the first school of thought, but Bill and some of his colleagues at BIS see more value in the second school. Why? Because the financial system "is inherently procyclical and thus chronically prone to bubble-like behaviour", argues Bill. To remedy this procyclicality we need a "new macrofinancial stability framework" (see also Bill's chapter in a recent Fondad book, "The Need for a Longer Policy Horizon: A Less Orthodox Approach").

Bill White observes that the school of "what is different" focuses on new developments in financial markets. Emphasis is put on the massive expansion of the subprime mortgage market in the United States, the growing use by banks of the originate and distribute model, the reliance on off-balance sheet vehicles, the development of new structured products, and the reliance on ratings agencies in marketing them.

"These new elements, originally thought likely to produce a welcome spreading and diversification of risk bearing," observes Bill White, "seem instead to have materially reduced the quality of credit assessments and also led to increased opacity. The result has been the generation of enormous uncertainty both about how large the prospective losses from defaults might be, and about where those losses might be concentrated. In this environment, everyone has become suspect, including the large banks at the heart of the financial system. Market liquidity and funding liquidity dried up, and the interbank term market effectively closed down. Moreover, there were significant knock-on effects, initially on other markets that rely on the interbank market for price fixing, but subsequently on a whole host of other markets where asset prices were considered to be richly valued."

"If it is these new market developments that have been responsible for the observed turmoil," says Bill, "then this suggests solutions that seek to preserve the benefits of the new products while reducing the unwelcome side effects. In the short term, this would imply injections of liquidity by central banks, and potentially other government agencies, to reliquify markets."

Bill's concern is that, in the aftermath of most historical bubbles, the focus of attention shifted to new instruments and techniques and the role they played in the process, while the key factor - leveraged speculation - was commonly ignored. "Evidently, it is more comfortable for all concerned to blame the essentially unpredictable side effects of new developments than to admit to having failed to see the build-up of all too traditional exposures."

Following the second school of thought Bill White asks himself what is the same about the current market turmoil compared to previous financial crises. His answer is "that in virtually every case, the crisis was preceded by very rapid credit expansion, which manifested itself in part in higher asset prices." These gains provided the collateral to justify even more lending and increased the appetite for risk-taking, on the side of both lenders and borrowers. As a result, leverage increased even as the general quality of credits deteriorated, and investment and consumption went beyond long-term trends. "At a certain point, usually when earlier expectations about profits or future income growth began to look unrealistic, this whole endogenous process went into reverse. In effect, boom turned to bust."

Based on the historical evidence Bill makes two observations. "The first is that the moment of change generally arrived completely unexpectedly, with the trigger for the event commonly being far too inconsequential to explain the resulting mayhem. This is precisely because a "trigger" is not the underlying "cause" of the problem. A second observation is that the turning point was almost never preceded by any significant degree of inflation. In particular, prices were falling in the United States in the late 1920s, were rising only very slowly in Japan in the late 1980s, and averaged only around 4% in Southeast Asia when that crisis hit in 1997."

What are the characteristics of the "new macrofinancial stability framework" suggested by Bill White?

"The first characteristic of such a framework would be a primary focus on systemic developments. In particular, attention would be paid to the dangers associated with many people and institutions having similar exposures to possible common shocks. The recognition of endogenous forces with potentially non-linear outcomes would be a further important theme. Evidently, this would not reduce the attention paid to the good health of individual institutions, but it would put such concerns into a broader context.

A second characteristic would be still closer cooperation between central bankers and regulators in assessing the build-up of systemic risks and in deciding what to do to mitigate them. What is needed is to find the point of optimal interaction between the more top-down approach of central bankers and the traditionally (though this is changing) more bottom-up approach of the regulators. Each perspective has much to offer. As an aside, such closer cooperation need not, though it could, imply a reversal of recent trends towards setting up independent regulatory agencies with responsibilities for both financial institutions and financial markets.

A third characteristic would be a much more "symmetrical" or countercyclical use of policy instruments. In this regard, the new framework would simply mirror the accepted wisdom for the conduct of fiscal policy: namely, that the good times should be used to prepare for the bad.

More specifically, monetary policy would lean against "booms" in the growth of credit and asset prices, particularly if accompanied by distorted spending patterns that opened up a real risk of subsequent reversal. This latter point is crucial if we are to distinguish between what is being recommended here and the quite different proposition of "targeting asset prices". Regulatory policy would have a similar bias, with risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being built up in good times and run down in bad."

Hervé Hannoun, the deputy general manager of BIS, added in a recent speech that there are three schools of thought on financial crisis prevention:

– The first school of thought considers that it is illusory to "lean against the wind". Asset price and credit booms are not preventable, and the real policy issue is to be ready to "clean up the mess" when the bubble bursts.
– The second school of thought considers that it is desirable to lean against the buildup of serious financial excesses. But monetary policy cannot deal with financial bubbles and asset price exuberance. Prudential and supervisory policy is instead the right tool for that.
– The third school considers that both monetary policy and macroprudential policy can and should be used to lean against the wind. A macrofinancial stability framework should be implemented to pre-empt financial excesses and "serial bubbles".

Hannoun emphasises that the third school of thought, the "macrofinancial stability framework" school, recommends leaning against the wind by making use of both monetary and supervisory instruments to pre-empt serious financial excesses.

"In this conception, macroprudential policy (the supervisory tool) has a crucial role to play in reducing the procyclicality in the financial system. But monetary policy also has a role to play in that respect. The recent financial turmoil suggests that monetary policy may have to counteract excessive credit expansion and asset price booms even if price stability were achieved. The key argument is that central banks should not rule out leaning against the wind by raising interest rates to stop asset price bubbles and credit booms from getting out ofhand: in other words, prevention is better than cure."

Bill White warns that the difficulties we face today in financial markets, with their potential to have significant effects on the real economy, indicate clearly that the costs of not having a new macrofinancial stability framework could be large.