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March 30, 2009

Economist's View - 6 new articles

Rodrik: Simon Johnson's Morality tale

Dani Rodrik responds to Simon Johnson:

Simon Johnson's morality tale, by Dani Rodrik: Simon Johnson tells a simple and compelling story: the U.S. has been afflicted by a version of the crony capitalism that has been the scourge of so many emerging markets, except that Wall Street has bought its influence and power not by bribery but by shaping the ideology of our times...

The solution, to Simon, is equally clear. Finance needs to be cut down to size. What the U.S. needs is what the IMF would have told any country...

As with any story built around clear villains easy solutions, there is something in this account that is quite unsatisfying. For one thing, I think it puts the blame too narrowly on the bankers. Yes, there can be little doubt that banks badly misjudged the risks they were taking on. But they were aided in all this by the broader economics and policymaking community--not because the latter thought the policies in question were good for bankers, but because they thought these would be good for the economy. Simon himself says as much. So why pick on the bankers? Surely the blame must be spread much more widely.

And I find it astonishing that Simon would present the IMF as the voice of wisdom on these matters--the same IMF which until recently advocated capital-account liberalization for some of the poorest countries in the world and which was totally tone deaf when it came to the cost of fiscal stringency in countries going through similar upheavals (as during the Asian financial crisis).

Simon's account is based on a very simple, and I believe misguided, theory of politics and economics. It is an odd marriage of populist and technocratic visions. Countries fail because political elites always end up in bed with economic elites. The solution, apparently, is to let the technocrats (read the IMF) run your affairs.

Among the many lessons from the crisis we should have learned is that economists and policy advisors need greater humility. Too many of us thought we had the right model when it turned out that we didn't. We pushed certain policies with much greater confidence than we should have. Over-confidence bred hubris (and the other way around).

Do we really want to exhibit the same self-confidence and assurance now, as we struggle to devise solutions to the crisis caused by our own hubris?

[Dani is generally opposed to a global financial authority. He says "the logic of global financial regulation is flawed." See his article and the discussion at the Rodrik Roundtable.]

Rogoff: Brave New Financial World

Like Edmund Phelps, Kenneth Rogoff is also worried about regulatory overreach in response to the crisis:

Brave New Financial World, by Kenneth Rogoff, Commentary, Project Syndicate: A huge struggle is brewing within the G-20 over the future of the global financial system. ... In all likelihood, we will see huge changes in the next few years, quite possibly in the form of an international financial regulator or treaty. ...

The United States and Britain naturally want a system conducive to extending their hegemony..., other countries would like to see more fundamental reform. Russia and China are questioning the dollar as the pillar of the international system. ... These are the calmer critics. ...Czech Prime Minister Miroslav Topolanek, openly voiced the angry mood of many European leaders when he described America's profligate approach to fiscal policy as "the road to hell." He could just as well have said the same thing about European views on U.S. financial leadership.

The stakes in the debate over international financial reform are huge. The dollar's role at the center of the global financial system gives the U.S. the ability to raise vast sums of capital without unduly perturbing its economy. ...

More fundamentally, the U.S. role at the center of the global financial system gives tremendous power to U.S. courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the U.S. financial system has helped to fuel such a deep global recession. ...

Fear of crises is understandable, yet without these new, creative approaches to financing, Silicon Valley might never have been born. Where does the balance between risk and creativity lie?

Although much of the G-20 debate has concerned issues such as global fiscal stimulus, the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

If our leaders cannot find a new approach, there is every chance that financial globalization will shift quickly into reverse, making it all the more difficult to escape the current morass.

As I said here in response to an op-ed by Becker and Murphy where they also express concerns about regulatory overreach, my fear is the opposite, that powerful interests will prevent us from taking the steps we need to take:

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and [anti-regulation] Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and give us the time to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

I was talking about the U.S., but the same is true at an international level where change is even harder to coordinate, and the danger that compromise to please all will produce reform that does little to restrict behavior is even greater.

Phelps: Financing Dynamism and Inclusion

I was asked to post this abridged version of a letter from Edmund Phelps to G-20 leaders:

Financing Dynamism and Inclusion, by Edmund S. Phelps: This commentary is based on an open letter sent to Prime Minister Gordon Brown and other leaders of the G-20 ahead of their summit in London on April 2, 2009. The unabridged version of the letter is published here. The letter sums up the main recommendations presented in New York City on February 20 at a conference at Columbia University's Center on Capitalism and Society. The conference,"Emerging from the Financial Crisis," brought together distinguished policymakers, bankers, regulators, journalists, and scholars. The list of conference panelists, video excerpts, including Paul Volcker's luncheon speech, can be found here. Participants' presentations, elaborating the conceptual foundations and policy recommendations put forth at the conference, are here.

When the G-20 leaders convene in London next week to propose measures to address the global economic crisis, re-regulation of the financial sector will be high on the agenda.

Although the need for re-regulation is clear, the key issue is how to design regulation without discouraging funding for investment in innovation in the non-financial business sector. In regulators' understandable desire to rein in the financial sector's excesses, there is the danger that policymakers – often pushed by the public – will adopt rules that dampen incentives and competition to the point that the sources of dynamism in the economy are weakened.

The need to encourage entrepreneurship and ensure that young people have the opportunity to start new businesses is acute. Even in the usually innovative American economy, dynamism has declined over the current decade, with economic inclusion – high employment rates and careers permitting ordinary people throughout society to flourish – also decreasing.

The housing boom, of course, masked this decline in economic dynamism and inclusion. Now that the boom has ended, it is clear that a durable return to a normal degree of prosperity and inclusion will not take place until the financial sector is reoriented away from mortgage lending and reshaped to serve first and foremost the business sector.

A new regulatory framework must be internationally consistent, particularly in areas such as capital adequacy, liquidity management, and financial reporting standards for financial and non-financial corporations. The "non-cooperating centers" must also be regulated on a global and consistent basis. And new international arrangements should address the devastating impact of financial contagion from advanced countries on many emerging markets, in part by providing additional resources to multilateral lenders.

At the same time, several key areas should be on the reform agenda. The first concerns regulating the scope of activities of banks, which, since the extreme dismantling of the regulatory framework in the late 1990's and early 2000's, have engaged in highly speculative and leveraged trading activities.

Since the costs of financial conglomeration are not offset by its informational advantages, some have called for a return to "narrow banking." Commercial banks would use their deposits to make loans to consumers and small and medium-sized businesses, which would also facilitate risk management by re-personalizing relationships between bankers and their clients. Investment banks might not be allowed to accept deposits from households and, possibly, non-bank businesses.

By focusing regulation on deposit-taking banks, all other financial institutions – including hedge funds, private equity funds, and other sources of risk capital that underpin economic dynamism – could bear the risk of bad decisions, without much regulation or potential cost to taxpayers (though with supervision to avoid systemic risk). Narrow banks could restart effective intermediation and ensure that consumers and employment-creating small and medium-size enterprises are adequately financed and can contribute to the reactivation of the economy.

Moreover, the demise of banking conglomerates during the crisis offers an opportunity to devote at least the part of the public resources that have been earmarked for restructuring existing banks to the creation of a new class of banks. The new institutions will catalyze the reorientation of the financial sector toward serving the business sector by financing long-term investment and innovative projects.

At the same time, countries ranging from France and the Netherlands to Singapore and Chile are adopting subsidies to companies for ongoing employment of low-wage workers. A development bank – specializing in project finance for infrastructure development, new technologies, and investing in the working poor, the environment, and other capital projects – could be the ideal institution to channel and monitor this type of subsidy.

The crisis also appears to provide an opportunity to develop more inclusive financial markets. The new regulatory framework should aim to "democratize finance" by redressing asymmetries in information, mainly stemming from informational the gap between sophisticated institutional market players and retail customers. This would enable households to expand their risk management through futures markets, home equity insurance, and continuous workout mortgages.

Finally, the new regulatory framework must address excessive swings in equity, housing, and other asset prices. It was the sharp reversal of upswings in equity and housing prices far above historical benchmark levels that helped to trigger – and continue to fuel – the financial crisis. As the downswings continue, there is a real danger that they may also become excessive and drag the economy and the financial system into an even deeper crisis.

A new conceptual framework – Imperfect Knowledge Economics (IKE) – provides the rationale for policy intervention in asset markets, and also has important implications for how regulators should measure and manage systemic financial risk.

IKE acknowledges that, within a reasonable range, the market does a far better (though not perfect) job in setting prices than regulators can. But it also recognizes that price swings can become excessive, imposing high social costs. IKE suggests a panoply of novel measures, including "guidance ranges" for asset prices and targeted variation of margin and capital requirements, to help dampen such excessive movements.

One of this framework's important policy conclusions is that wholesale restrictions on short-selling (and other such measures that pay no regard to whether an asset is over- or undervalued) could actually lead to greater instability. Yet improving the ability of financial markets to self-correct to sustainable values is the entire point of prudential regulation. Rules that are beneficial in some circumstances may become counterproductive in others. The prevailing view that policymakers should be bound by fixed rules will not do.

Paul Volcker on the Financial Crisis

Paul Volcker at the "Emerging from the Financial Crisis" Conference More video from the conference

Paul Krugman: America the Tarnished

The financial crisis has damaged our global authority, credibility, and leadership, and that will make it much harder for the world to accomplish the essential task of coordinating a common response:

America the Tarnished, by Paul Krugman, Commentary, NY Times: Ten years ago the cover of Time magazine featured Robert Rubin,... Alan Greenspan,... and Lawrence Summers... Time dubbed the three "the committee to save the world," crediting them with leading the global financial system through a crisis..., although it was a small blip compared with what we're going through now.

All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. ... The United States, everyone thought, was the country that knew how to do finance right.

How times have changed..., ... our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow.

Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. ...

Simon Johnson..., who served as the chief economist at the IMF..., declares that America's current difficulties are "shockingly reminiscent" of crises in places like Russia and Argentina — including the key role played by crony capitalists.

In America as in the third world, he writes, "elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive."

It's no wonder, then, that an article in yesterday's Times about the response President Obama will receive in Europe was titled "English-Speaking Capitalism on Trial."

Now, in fairness ... the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent's economic and financial troubles, which arguably run as deep as our own... Still, it's a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead.

And that's a very bad thing... I've been revisiting the Great Depression,... one thing that stands out ... is the extent to which the world's response to crisis was crippled by the inability of the world's major economies to cooperate.

The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: "All of us are going to have to take steps in order to lift the economy. We don't want a situation in which some countries are making extraordinary efforts and other countries aren't."

Yet that is exactly the situation we're in. I don't believe that even America's economic efforts are adequate, but they're far more than most other wealthy countries have been willing to undertake. And by rights this week's G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight.

But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right.

The financial crisis has had many costs. And one of those costs is the damage to America's reputation, an asset we've lost just when we, and the world, need it most.

links for 2009-03-30

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