Observations on the Evolution of Economic Policies

IMF Blog, March 25, 2011

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Guest post by Michael Spence, New York University, Professor Emeritus Stanford University, and co-host of the Conference on Macro and Growth Policies in the Wake of the Crisis.
Date: March 25, 2011.
Participated in an IMF conference devoted to rethinking policy frameworks in the wake of the crisis; reports "openness of the discussion, the range of views, the willingness to question orthodoxy, and the posture of humility."
Characterizes current phase as a path of rethinking conceptual frameworks and policy choices that "will contribute to the stability of the system."
Notes models and frameworks in finance and parts of macroeconomics are incomplete, requiring judgment, step-by-step evaluation, and occasional reversal of policy choices.

Core finding: "The dynamics of the risk characteristics of the financial system are not well understood by the participants or the regulators."
Challenge: understanding risk dynamics is "one of the hardest challenges in the area of economic and financial theory."
Observations:
- Investors are paying more attention to risk factors and liquidity costs/benefits, constantly adjusting investments and asset structures.
- Relationships between assets, prices and risk "may only remain stable for a few months at a time."
- The "old model with stable relationships, implemented through a largely fixed asset allocation framework is broken."
- Diversification remains relevant but must be implemented differently to be effective.
Policy implication: regulatory adjustments are necessary but not sufficient; better risk perception by participants and regulators, and effective defensive action by participants when risk is accurately perceived, are important.

Central claim: the "single target – single instrument approach to policy is not sufficient for achieving financial and macroeconomic stability."
Additional points:
- Policies focused solely on flows and prices are unlikely to be sufficient.
- Need to pay attention to balance sheet variables and micro–macro linkages.
- Expect "warning signs or puzzles" and the need to act on them without "air tight arguments"—moving away from a prior mindset favoring inaction absent clear intervention cases.
Policy recommendation: adopt a more balanced assessment of the benefits and risks of inaction versus action.

Observation: "The structure of all economies evolves in ways that affect the income distribution and employment opportunities."
Drivers: powerful market forces in the global economy; major technological innovations producing shifts in structure.
Notes:
- Emerging economies "only become big once."
- After structural changes, economies "don’t return to their previous average behavior."
- Need to institutionalize attention to structural evolution within longer term policy frameworks, supported by research.
Policy trade-off: addressing distributional and structural issues may risk dynamic efficiency at the global level, but ignoring them poses risks of harmful outcomes.
Recommendation: implement "more and less harmful ways to nudge structural evolution" rather than ignoring distributional and structural issues.

Recommendation: "I would ban high speed trading—the automated, computer-driven trading of large volumes of financial assets in a short timeframe—by introducing lags in the trading process or increasing capital requirements or both."
Rationale:
- Characterizes high speed trading as largely a zero-sum game, resource-using, and a contributor to potential market volatility.
- Concludes that economic benefits for pricing, capital allocation and risk spreading "seem negligible."

Broad assessment: financial regulation is a "huge subject" and needs substantial further work.
Key points and recommendations:
- Need to restrict excessive leverage at the macro level; same applies to banks.
- Regulating the shadow banking system is "crucial"—requires attention to ratings, capital requirements, incentives, and structures that allow efficient unwinding of securitized assets after shocks or crises.
- Procedures for dealing with underwater mortgages in trusts supporting securitized assets are described as "essentially broken," making recovery from crises and asset bubbles inefficient and lengthy.
- Current financial system structure features reduced separation of functions and is "shot through with actual and potential conflicts of interest," adversely affecting incentives, performance, and trust.
- Calls for regulatory action and stronger industry-side reforms; "There remains much more to be done, particularly on the industry side."

Source: Observations on the Evolution of Economic Policies, March 25, 2011.