July 2, 2008
Lessons to be learnt from the financial crisis
By Martin Wolf
“We told you so.” The Bank for International Settlements has long warned of the dangers of unrestrained credit growth and asset price inflation. In this year’s annual report, the last to be prepared under the direction of William White, its long-serving Canadian economic adviser, it felt free to point out how right it had been. But it did so with restraint: “Rather than seeking to apportion blame,” it says, “thoughtful reactions must be the first priority.”
The report provides just such reactions. But it also describes the mess created by those who ignored its earlier warnings. “The current market turmoil in the world’s main financial centres is,” it claims, “without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless.”
As readers of BIS annual reports would expect, this one gives good answers to four big questions.
The remainder of this column can be read here. Debate from our expert panel appears below.
Lewis Alexander: I enjoyed your piece on the BIS Annual Report. The Annual Report is always worth a read, but I have a somewhat different reaction to this report, and to some of their previous work.
In the run up to the current crisis, some at the BIS argued that key central banks were underestimating how stimulative policy was because policymakers did not take into account signals coming from the financial sector. The BIS analysis focused on quantity measures, such as rapid credit growth. I believe that other indicators - such as the level of long-term interest rates and of credit spreads - were more meaningful, but the basic point about excessive stimulus still stands. To me, the most telling point was Chairman Greenspan’s testimony in February 2005, when he described the low level of long-term interest rates as a “conundrum”. Essentially Chairman Greenspan was saying that financial conditions had not tightened although the Federal Reserve had been raising policy rates for more than six months. With 20-20 hindsight, I would argue that the FMOC should have put more weight on the market signals that their policy actions were having little impact on financial conditions and the economy.
I suspect that the BIS is now making a similar mistake in reverse. Monetary policy should always be consistent with the objective of maintaining long-term price stability and stable inflation expectations. But the signals coming from financial markets suggest that the effective stance of monetary policy in key countries now is restrictive. In the United States, for example, financial conditions are as adverse today as they have been at any time since this crisis began, with the exception of the worst days of the Bear Stearns episode. The same analytic approach that viewed credit spreads as too narrow before the current crisis now would say that credit spreads are too wide. Moreover, credit growth has decelerated if one takes into account the collapse of various channels of the so-called “shadow banking system”, such as asset-backed commercial paper. Of course, policymakers in many countries, particularly those that are benefiting from strong terms of trade and rapidly growing emerging economies, need to tighten policy to contain domestically-propelled overheating. But I think the Fed, ECB, and the Bank of England face a very different set of risks.
Another theme in the BIS Annual Report is the need for a greater focus on the financial system as a whole, as opposed to individual institutions, in promoting stability. I certainly agree that the events of the past year suggest that policymakers need to think more about policies that will secure systemic stability. But policymakers should be careful about any co-mingling of monetary policy and prudential regulatory issues. Monetary policy needs to take into account the state of financial conditions to achieve price stability. But monetary policy is no substitute for effective prudential regulation in containing systemic risks.
This year’s BIS Annual Report argues that policymakers should not focus narrowly on the very specific problems that caused the current crisis, but on more general factors that drive financial cycles. I agree. But to understand why crises recur, policymakers need to think about how financial markets deal with innovation. In important ways, every cycle is different, even though there are common patterns. Behavioral finance teaches us that people to tend to overreact to small amounts of information. This lesson may help to explain how financial innovations that are initially sensible and successful are often pushed beyond reasonable bounds. Experience suggests that big problems do not arise at the early stages of innovation, but rather after financial institutions (and regulators and supervisors) have had some experience with new products and/or markets. Initial success appears to breed complacency that subsequently leads to collective mistakes. Addressing such complacency to contain systemic threats is predominantly the responsibility of prudential, not monetary, policy.
Posted by: Lewis Alexander | July 6th, 2008 at 12:57 pm | Report this commentMartin Wolf: I appreciate Lewis Alexander’s thoughtful comments. Let me take up his principal points.
Lewis agrees with the BIS that the Federal Reserve underestimated how stimulative its monetary policy was in the run up to the crisis. But, he argues, the BIS does not understand how contractionary the situation in the high-income countries has now become. For this reason, the BIS is too critical of the recent easing, particularly in the US. Lewis has an important point here. The fundamental issue is the difficulty of working out what the right policy is today. But my own guess is that the Fed has eased too much, particularly given the dependence of the US on foreign confidence in the long-erm value of the dollar. But I agree that it is hard to be sure of this in the current difficult circumstances.
The other big issue Lewis raises is the balance between monetary and prudential policies. I agree that monetary policy is no a substitute for prudential regulation. But it should be a complement to it. In easy times, when asset prices are exploding upwards, monetary policy should tighten more than is thought to be necessary to hit a precise inflation target. This is “leaning against the wind”. Inflation will then fall a little below target and, when (if) the bubble bursts, the central bank will be in a position to ease more aggressively than if it had not acted in this way. Over time inflation will oscillate a little more around the target, but bubbles will also be a bit smaller and the ability to offset the impact of booms and busts on the economy should also be a bit bigger. This seems s good bargain to me.
Of course, this does not mean that prudential policy does not matter, as well. It does. But it is very difficult to implement successfully, partly for the reasons Lewis mentions - in particular, the tendency towards complacency in the boom phase.
Posted by: Martin Wolf | July 18th, 2008 at 6:34 pm | Report this comment