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I. Introduction
It is challenging to lay out in 10–15 minutes what can be done to improve the current international financial and monetary system. I am reminded of the story of the woman who was drafting an obituary after her 80-year-old husband passed away. In her draft, she mentioned all his major accomplishments, the surviving family members, and the time and place of the funeral. She then sent her draft to the local newspaper. They phoned her back and told her that since the obituary was 500 words long and since they charge three dollars per word, it would cost $1,500. After some reflection, she opted for a shorter, three-word version: “Max Schwartz died.” The paper then informed her that they had a six-word minimum. She revised again. In the end, she chose: “Max Schwartz died. Oldsmobile for sale.” I will give you the six-word version of my reform suggestions.
When pondering desirable reforms, I prefer to think about both the international financial system and the international monetary system because as this global crisis demonstrates so vividly, the root causes can come from both the financial and the monetary spheres and they can interact in a variety of ways. On the financial side, I want to emphasize two problems: pricking asset price bubbles before they get too large, and confronting “too big to fail.” On the monetary side, I want to concentrate on what can be done to discourage “beggar-thy-neighbor” exchange rate policies.
II. Reforming the International Financial System
Any credible story about the origins of this crisis has to give a role to easy credit conditions, a rapid run-up in housing and equity prices, and broad mispricing of risk. Recall, however, that the precrisis orthodoxy, at least in central banks, was that it was unwise and unnecessary to ask central banks to attempt to prick asset price bubbles—on at least three counts. First, they have no reliable methodology for, or comparative advantage in, identifying such bubbles. Second, even if they could identify such bubbles, the short-term interest rate was not a good instrument for pricking such bubbles: after all, small increases in rates would have little effect and large increases would generate too much collateral damage to the economy as a whole. Third, preemptive action was unnecessary because once such bubbles burst on their own, the mess could be cleaned up at relatively low cost by engineering a swift and sizeable decline in policy interest rates.
How has the crisis altered that orthodoxy? Clearly, the we-can-clean-it-up-cheaply-after-the-bubblebursts- with-low-interest-rates argument can be discarded (at least for cases where the buildup of the bubble involves significant leverage). Challenges to the we-can’t-identify- bubbles-beforehand argument have also been given some increased support from the crisis. Reflecting research done at both the Bank for International Settlements and the International Monetary Fund (IMF), twin threshold early-warning models of banking crises that identify tail observations on both excess credit growth and increases in housing and/or equity prices—as well as studies that examine the relationship between indices of financial stress and economic downturns—look more relevant and promising than before the crisis (see Borio and Drehmann 2009 and Lall, Cardarelli, and Elekdag 2008). If it remains difficult to identify bubbles before they get too large, the message now to both central banks and regulatory authorities is: “I know, but try much harder.”
Last but not least, the crisis should prompt us to consider a better bubble-busting tool kit. As my Peterson colleague Adam Posen (2009) put it in a recent paper, if one is faced with a leaky showerhead but has only a hammer, you are in a fix: small taps will do nothing, while a strong rap may break the pipe. What you need is duct tape for small leaks and a wrench for large ones. But what will serve as the duct tape and the wrench? I would say that the gathering consensus is that the duct tape and the wrench should be countercyclical changes in some combination of regulatory capital (risk weighted and unweighted) and regulatory liquidity requirements, margin requirements, loan-to-value ratios on residential and commercial mortgages, and lending standards. In a recent report of the Pew Task Force on financial regulatory reform (Pew 2009)—of which I am a member and signatory—the decision of when to activate such macroprudential instruments and which combination to use would be made (in the United States’ case) by a systemic risk oversight council composed of the central bank, the Treasury, and the leading regulatory authorities; it would then be implemented by the regulatory authorities. In some cases, the central bank would also “lean against the wind” by raising interest rates; in other cases, it might not. Yes, such macroprudential actions run the risk of killing off some expansions too soon, but they also hold the promise of avoiding severe collapses like the present one. I think it’s well worth a try.
Commentary Type