Preventing The Next Catastrophe: Where Do We Stand?
IMF Blog, May 3, 2013
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- Authors: David Romer
- Published: May 3, 2013
Introduction
- Author: David Romer
- Date: May 3, 2013
- Framing:
- Two perspectives on a conference: intellectual (provocative questions, stimulating discussion) and practical (averting another financial and macroeconomic disaster).
- Assessment: intellectually successful; practically inadequate—modest changes are helpful but unlikely to prevent future large financial shocks.
Financial sector as a continued source of shocks
- Key empirical claim:
- For the United States over the past thirty or so years, there have been "six distinct times" when financial developments posed important macroeconomic risks.
- Outcomes across those six episodes:
- In three of them, the risks were largely averted and the costs ended up being minor.
- In two, the costs were modest to moderate.
- In one, the damage was enormous.
- Illustrative episodes (as described):
- Volcker disinflation episode: severe recession + banks’ exposure to Latin American debt; last-minute policy turn and regulatory forbearance averted systemic collapse.
- 1987 stock market crash: rapid Fed responses prevented large damage.
- Savings and loan crisis (late 1980s/early 1990s): misallocation of investment, impaired lending, fiscal costs from bailout.
- 1998: Russian debt crisis and collapse of Long-Term Capital Management (LTCM); arranged rescue and lower rates preserved stability.
- Dot-com bubble and bust (late 1990s/early 2000s): misallocation of investment and recession.
- Recent housing-price collapse and financial meltdown: catastrophic effects.
- Cross-country examples and variety of shocks:
- Iceland and Cyprus: shocks from vastly expanded banking sectors with huge foreign deposits.
- Greece: disguised fiscal profligacy.
- Classic sudden stops.
- Conclusion on frequency and predictability:
- Financial shocks are likely to be both frequent and hard to predict — not just in timing but in form.
- Only two episodes on the illustrative list (dot-com and the recent crisis) are ex post reasonably called bubbles.
Small-scale solutions
- Two small-scale policy approaches evaluated:
- Using the short-term policy rate to address financial imbalances:
- Characterized as largely a "nonstarter."
- Reasons: policy rate is too crude, affects all markets, conflicts with other objectives, direction of adjustment often unclear.
- Potential benefit described as at best marginal.
- Macroprudential policies and capital account management ("wise central banker" or "Whac-a-Mole" strategy):
- Targeted regulations and interventions to address developing problems (e.g., targeted mortgage regulations in a city).
- Positive assessment: useful addition to the policy toolkit; examples cited include Israel, South Korea, and Brazil.
- Limitation: given the enormous range of potential shocks, relying on rapid, targeted policymaker interventions is "surely wishful thinking."
Deeper solutions on the financial side
- Goal: reform the financial system so shocks sent to the real economy are much smaller.
- Promising micro-regulation approaches mentioned:
- Stronger capital and liquidity requirements.
- Special rules for institutions that create more systemic risk.
- Restrictions on form or capabilities of financial institutions (examples: ring fencing in the United Kingdom; the Volcker rule in the United States).
- Limitations of modest reforms:
- Shadow financial institutions may escape rules.
- Rules can be gamed.
- Shocks can overwhelm moderate changes.
- Four examples of much larger reforms that received little serious consideration:
- Very large capital requirements:
- Historical note: Allan Meltzer mentioned that at one time "25 percent capital" was common for banks.
- Question posed: Should we be moving to such a system?
- Redesign of debt contracts:
- Amir Sufi and Adair Turner identified features of debt contracts that make them inherently prone to instability.
- Question posed: Should policy promote more indexation of debt contracts, more equity-like contracts, and so on?
- Simplification of the financial system:
- Observation: costs imposed by the modern financial system on the real economy may not be justified by benefits.
- Question posed: Might a much simpler, "1960s- or 1970s-style" financial system be preferable?
- Pigovian-style taxation of financial activity:
- Rationale: negative externalities from certain financial activities or structures.
- Question posed: Should there be substantial taxes on aspects of the financial system (options listed: debt, leverage, size, other indicators of systemic risk, a combination, or something else)?
- Author stance: does not claim answers but argues these ideas "deserve serious analysis"; notes radical redesign was largely missing from the conference.
Larger-scale solutions on the macroeconomic side
- Framing: make the macroeconomy more resilient to financial shocks; three policy areas discussed.
- Common currency area (eurozone focus):
- Concern: another large asymmetric financial shock in the eurozone could repeat recent painful dynamics.
- Assessment:
- Some improvement in short-term crisis management capacity.
- Little progress toward fundamental changes addressing country-level responsibility for bank insolvency vs. eurozone-level resolution.
- Minimal progress on fiscal union and mechanisms to handle large differences in competitiveness.
- Monetary policy:
- Observation: inflation targeting was effective for its first fifteen or twenty years but later proved "incapable of providing aggregate demand at the level ... needed."
- Suggestion: consider alternative frameworks (example mentioned: targeting a nominal GDP path).
- Status: idea mentioned intermittently but debate has not proceeded to serious quantitative analysis of costs and benefits.
- Other significant changes to the monetary policy framework have been discussed even less.
- Fiscal policy:
- Widely supported idea: desirability of more fiscal space.
- Challenge: difficulty of regaining pre-crisis fiscal space; progress has been minimal.
- Caveat: fiscal space is not a magic bullet—countries with responsible fiscal policies still suffered terribly in the crisis.
- Little discussion of larger fiscal framework changes:
- Strengthening automatic stabilizers (for example, macroeconomic triggers for changes in fiscal policy) was not mentioned.
- Fiscal rules or constraints:
- Possible models: constitutional rule, independent agency, or a combination enforcing responsible fiscal policy in good times and enabling credible temporary stimulus in downturns.
- Roberto Perotti and Avinash Dixit raised fiscal rules or councils briefly; idea did not advance further.
- Conclusion: limited progress on macro policy reforms strengthens the case for deeper financial reforms but also indicates need for broader macro thinking.
Conclusion and recommendations
- Overall diagnosis:
- After five years of catastrophic macroeconomic performance, "first steps and early lessons" are insufficient.
- Current reform focus is judged too small to prevent similar future crises.
- Recommended direction:
- Pursue more fundamental rethinking of:
- The design of the financial system (including consideration of very large capital requirements, structural limits, contract redesign, and Pigovian taxes).
- Frameworks for macroeconomic policy (including alternative monetary frameworks, stronger automatic stabilizers, and credible fiscal rules).
- Urgent call:
- Move beyond modest, incremental measures to serious analysis and consideration of larger-scale reforms that could substantially reduce the frequency and severity of future financial shocks.
Preventing The Next Catastrophe: Where Do We Stand? — David Romer, May 3, 2013
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