By Lawrence Summers
Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican administration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable.
Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spillovers and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead.
However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible. Read more
The US retains the capacity to disrupt the world economy which it has possessed since at least the 1920s. Accordingly, the struggle between the deleveraging of high-income countries and the growth momentum of emerging economies is ending, alas, in a decisive victory for the former. Read more
By Michael Bordo and Harold James
The chaotic, costly and ineffective international response to the current financial disorder has prompted French president Nicolas Sarkozy, British prime minister Gordon Brown and German president Horst Köhler, a former head of the International Monetary Fund, to call for a new Bretton Woods conference to design a new global financial system. Read more
Will the UK government’s scheme for rescuing the financial system work? The answer to this question depends on the meaning of the word “work”. I can identify three issues: will the scheme rescue banking? Will it cost too much? Will it prevent a recession?
First, though, what is the scheme? Read more
In the last week the world has seen the UK’s “good Gordon” in action. Confronted by the implosion of the country’s financial system, Gordon Brown, the British prime minister, acted. The plan his government came up with is comprehensive and bold. It will also be expensive. But the cost will be much less than the alternative – a depression – would have been. Read more
By Maurice Obstfeld, Jay C. Shambaugh and Alan M. Taylor
Since the early 1990s, central banks in many emerging markets and developing countries have accumulated foreign reserves at an unprecedented rate. The macroeconomic impact of these official flows has been profound and they have contributed significantly to global imbalances. Providing an explanation for these trends remains a major puzzle in international macroeconomics, and prevailing theories based on trade or debt deliver poor empirical performance. We argue that part of this great reserve accumulation is a response to the threat of financial instability in the context of rapidly expanding financial systems, increasingly mobile capital, and exchange rate objectives. The recent turbulence in global financial markets supports this view. Read more
by Robert Wade
With headlines blaring that as much as £10bn of UK savings are at risk in the collapse of Iceland’s banking system, the question arises as to why the finance directors of UK companies, local government authorities, charities and police left their assets with Icelandic banks during the first half of 2008? Why did they run the risks in return for an only slightly higher rate of interest? The same can be asked of the finance directors of German, Danish and Dutch organizations which stand to lose from the Icelandic collapse. Why did their respective national financial regulators not rein them in? Read more
by Tito Boeri
The leaders of the eurozone finally agreed on a plan. It is a very ambitious rescue plan, as it should be, to stop the self-fulfilling prophecies that brought us to the brink of another Great Depression. But the plan should now be made acceptable also to European citizens.
In the next couple of weeks we shall see how effective these extreme measures are in reducing the spread between Euribor and the ECB refinancing rate. If they are successful, there will be no need to implement these measures. If they are not, public debts in the eurozone are bound to skyrocket. If they only partly succeed in reassuring markets, there will be sizeable outlays to the banking sector. The insurance on the interbank market is potentially very costly – before the crisis the overnight volumes in many Euro countries were of the order of 1-2 per cent of gross domestic product – while the bank recapitalization plans commit so far up to 20 per cent of the eurozone GDP and this share is bound to increase further as national plans are unveiled and countries are forced to raise capital to match the core tier one levels of UK banks (too bad that there was no cross-country co-ordination in this respect!).
Is public opinion in the EU ready to accept such potentially massive transfers of resources from the taxpayer to the banking sector? True, it is mainly gross debt that will increase. By selling assets later on, net public debts may actually go down when the crisis is over. It is also true that in saving the banking system we ultimately save our economies and million of jobs. Nonetheless, there is a non-negligible risk that plans committing large resources to bank rescues will find strong opposition in national parliaments. Read more
by Christopher Carroll
In the past decade or so, an economist asked to tell a horror story over toasted marshmallows at a cookout would not have conjured up empty McMansions haunted by sub-prime ghosts (though in retrospect that would have been a pretty good tale). Instead, among friends, if the mood was right, we might say to each other in a spooky voice “think what will happen if the baby-boomers all decide to cash in their stock investments at the same time!” Followed by nervous laughter and a quick change of subject.
At first blush, it seems that we were barking up the wrong tree. Today’s global conflagration originated in the market for sub-prime mortgage securities, which has little evident connection to boomer retirement investment decisions. It is easy to follow a direct chain of links from the sub-prime sparks that first flared in the spring of 2007 all the way through to last week’s stunning losses in stock markets around the world. Read more
By Viral V. Acharya
The G7 and Eurozone meetings have raised hopes of expedient recapitalization of several banking sectors with the use of public funds. Such recapitalization is rightly aimed at shoring up equity base of the highly leveraged banks whose capital is essentially eroded, and of better-capitalized banks whose equity base has suffered too due to a spillover from adverse news about the highly leveraged ones. In light of this much-needed response to the global financial crisis, it is important to remember that following the first round of recapitalizations, regulators should and will look for ways to “clean up” the system. To this end, well-capitalized banks and financial institutions need to be given incentives to acquire weak banks sooner rather than later. Read more