March 26, 2008
The rescue of Bear Stearns marks liberalisation’s limit
By Martin Wolf
Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.
Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.
Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.
The remainder of this column can be read here. Debate from our panel of economists appears below.
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.
Posted by: Ricardo Hausmann | March 26th, 2008 at 3:51 pm | Report this commentRobert Wade: First, a comment on Martin’s proposition: “Until recently, it was possible to tell the Chinese, the Indians or those who suffered significant financial crises in the past two decades that there existed a financial system both free and robust. That is the case no longer. It will be hard, indeed, to persuade such countries that the market failures revealed in the US and other high-income countries are not a dire warning.”
This lesson should have been abundantly clear in the wake of the Asian crisis 10 years ago. At that time the standard advice was (and remains) that developing countries should liberalize and open to the world economy at the same time as they strengthened financial regulation. The problem then, and now, is that we do not have robust indicators of the “strength” or “soundness” of systems of financial regulation. A good example of our inability to judge is the World Bank’s report, Private Capital Flows to Developing Countries, published in April 1997, a few months before the onset of the East Asian crisis. It said:
“Developing countries show considerable variation in the capital market attributes needed for financial integration. The most dynamic emerging markets, where progress has been particularly intense during the last five years, include most of high-growth Asia (Korea, Malaysia, and Thailand, with Indonesia and the Philippines not far behind) and two markets in Latin America (Chile and Mexico, with Brazil also ranking well)…. The lagging emerging markets … are in South Asia (India, Pakistan, and Sri Lanka) and China.” [1]
Second, a comment on Martin’s argument that, on the one hand, there is now a strong intellectual case for tighter financial deregulation; but “The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity, after this crisis is over. They may succeed.” Again, it is worth remembering what happened ten years ago. Following the financial crises in Mexico (1994–5) and East Asia/Brazil/Russia (1997–8) there was an upsurge of discussion about the need for not just more regulation but a whole “new international financial architecture” (NIFA). On the table were proposals for a number of new organizations, such as a global financial regulator, a sovereign bankruptcy court, an international deposit insurance corporation, and the like; and for expanded powers for the IMF, including to support standstills and even capital controls, so as to give countries better protection against creditor panics.
But, after 2000, as the “emerging markets” crisis remained confined to emerging markets and did not hit the Atlantic heartlands, discussion petered out. Not much has been done in the meantime to strengthen international financial regulation, and Basel 2 and International Accounting Standard 39 (”fair value”) arguably make things worse. In the follow-on from the current crisis a more determined effort will have to be made to curb the tendency of banks to be reckless with their capital and to mislead consumers, against the anti-regulation drive of Wall Street and City lobbies.
Posted by: Robert Wade | March 26th, 2008 at 4:31 pm | Report this commentGuillermo 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.
Posted by: Guillermo Calvo | March 27th, 2008 at 1:39 am | Report this commentAdam Posen: The issue politically - be it in what is said to the Chinese or Indians, or what is said at the OECD, or in intra-European debates - will alas not be limited to whether we need more regulation. As was the case mistakenly with the Asian financial crisis for the “East Asian model”, this will be considered a test of the broader “Anglo-Saxon Model”, especially since that model was assumed to be based on finance. And it will come up as a barrier to liberalization more generally. And this is very bad.
Life is complicated, so events get overdetermined. The Asian financial crisis was not in fact an overall verdict on the multiple economic systems there - as the variety of crisis recovery experiences bore out - but in reality did show the problems with overinvestment by cronies (in short). Similarly this financial turmoil in the US shows that if one allows under-provisioning by banks, does not prevent fraud, and institutionalizes useless “AAA” ratings (in short), bad things happen.
It does not show anything about the worth or validity of the arms-length approach to business or of the preference for securitization over relationship-lending. Yet that is where the discussion is heading in Europe and Asia: to argue that relationship based lending and insider/stakeholder corporate governance are not actually harmful, and that the opposite “American way” is unstable. This is demonstrably false, and the US productivity growth of the last 15 years bears this out. But that will now get lost.
If life was neat and symmetrical - or at least monocausal - one could find a way to torture events to show, no, what happened here was actually insider lending akin to Asia, et al,. But life is not that neat. One can be a marathon runner with a great cardiovascular system and still get felled by a twisted ankle when careless. So we have to be prepared to fight the battle over the systems politically, even when what felled us was a regulatory ankle sprain. (The tripping to cause the sprain was due to ideological blinders against reasonable regulation, but again that’s for another day).
So Martin may well be right that this is a turning point, a local maximum, for “free-market capitalism”, but the danger to it comes from a different angle than he expresses.
Posted by: Adam Posen | March 27th, 2008 at 8:22 pm | Report this commentMartin Wolf: I would like to thank the participants in this debate.
I think Ricardo has made an enormously important point, with which I fully agree. Indeed, I have a book, which should be published this summer, that makes much the same argument.
My difference with Ricardo, I think, is that it was largely the policies of other countries that drove the monetary policies of the US. Thus, in a nutshell, given the real exchange rate set largely by foreign desire to purchase US assets (in part as a by-product of their desire to sustain export competitiveness), internal balance could be achieved only with a large excess of US demand over GDP (i.e. a big current account deficit). This necessitated debt accumulation inside the US, with the consequences we see. Indeed, I have written many columns pointing to the link between the external imbalance and the internal financial imbalances. Since Ricardo believes there are no external imbalances (because of “dark matter”), this argument will not appeal to him. But, naturally, it persuades me.
The question, then, is whether alternative policies would have made a difference. Suppose the Federal Reserve had pursued a less aggressive policy. Then demand would have been weaker and both the external deficit and GDP lower. One possible response might have been a more aggressive US fiscal policy. That could well have been a superior alternative to what has happened. Another possibility is that the rest of the world would itself have pursued more expansionary policies, thereby reducing the need for the Fed to be so expansionary.
Alternatively, if regulation had been tighter, Fed policy might have had to be still more aggressive, as Ricardo notes. An interesting question is whether there was a set of regulations and interest rates that would have encouraged the corporate sector to borrow more for investment. That would probably have been a better alternative.
Anyway, I agree on the big point. The macroeconomic environment made it very difficult to manage the financial system. I would add that the global macroeconomic environment also made it very difficult to manage US monetary policy in a sensible way.
I find myself in the disturbing position of agreeing with Robert Wade. A first for both of us, probably!
Guillermo’s point is subtle and very important. As I understand it he is arguing that with fiscal policy possibly burdened by the need to take over bad private debt, the ability of the central banks to anchor nominal expectations may collapse. The same thing may apply if the dollar collapsed under the pressure of selling by sovereigns. This could make it difficult to manage interest rates in a stable manner.
Finally, Adam is clearly right that this will be considered a test of the broader “Anglo-Saxon model”. I don’t see how it could not be. But I disagree with Adam on whether this crisis shows something important about securitisation, as opposed to relationship lending. It seems rather clear, at least to me, that it has shown serious problems with securitisation, at least as practiced. I am not saying that these difficulties cannot be fixed. But clearly the long chain of irresponsible agents created huge and ongoing difficulties. Fixing this will take quite a bit of thought and care.
Adam suggests that US productivity performance demonstrates the superiority of arm-length finance. Does it? I am agnostic about this. It seems clear that arms-length finance, in the form of venture capital, has been very helpful. But would we not argue that many other aspects of the US economy have been as important, if not more so, in explaining the productivity improvement - the openness to innovation and competition, the import of skilled and motivated people and the scale of the economy?
In any case, we both agree that this episode is very damaging to the cause of liberalisation across the globe.
Posted by: Martin Wolf | March 29th, 2008 at 6:11 pm | Report this comment