American foreign policy chief Henry Kissinger had once asked Chinese leader Zhou Enlai what impact he thought the French Revolution had on the world. Zhou’s answer was memorable: “It is too early to tell.”
So it is with the global credit crisis. July 2007 was the final moment of calm before the storm that has shaken and stirred many boats. As with the French Revolution, initial attention was restricted to the body count. But later, fond beliefs on economics, finance and regulation will be shattered. What will these be? As Zhou would have said—it is too early to tell.
But there should be no doubt that there will be deep and significant lessons to be learnt. America in the 1930s, Japan in the 1990s and Asia in 1997— each financial crisis led to a whole new way of looking at economies and public policy. Here is a random list of some very preliminary lessons of the past 12 months, culled from the work of select economists and practitioners.
First, this period marked the end of financial arrogance. The fond hope that computer models could make the economy predictable ignored the fundamentally uncertain nature of the modern market economy. There is a world of difference between models and markets. Complicated derivatives dreamed up by investment banks and priced according to fancy models proved to be essentially worthless.
Nobel economist Edmund S. Phelps wrote in The Wall Street Journal in March that economists are mistaken in the belief that the economy is essentially predictable and understandable. He termed this “conceit in the financial industries and central banking” and added that “considering uncertain knowledge to be certain knowledge, (is) taking us in a hazardous direction”. Scathing stuff.
Rather than admit its mistakes, the financial industry pretended to be surprised by what happened. Goldman Sachs CFO David Viniar famously said in August 2007: “We were seeing things that were 25-standard deviation moves, several days in a row.” A 25-standard deviation event is a very, very rare one. How rare? As economist Brad de Long was quick to point out, “The universe isn’t old enough for even one sixteen-standard-deviation event to have ever happened.” We know for sure that financial crises happen more often than that.
Second, some of the basic assumptions about modern central banking have been overturned, especially the belief that central banks should have a single-minded focus on inflation, ignoring other parameters such as financial stability. “Under certain conditions, concentrating on year-to-year monetary stability, in the sense of keeping of a CPI inflation target, can lead you to follow policies that are inimical to financial stability in the long run,” wrote economist Axel Leijonhufvud in October 2007.
He said low inflation lulled the US Fed into keeping interest rates too low for too long. Alan Greenspan did not worry as long as inflation was low. He was not too concerned about what was happening in the financial system. But Leijonhufvud said US inflation was low thanks to cheap Chinese imports. So, the flood of money did not at first show in the inflation numbers; but it led to excessive risk taking in the financial sector. “Inflation targeting might mislead you into pursuing a policy that is actively damaging to financial stability,” he wrote.
Third, the lessons on financial sector regulation. The credit crisis has shown that the economic cycle is at the heart of financial instability. (Or is it the other way round?) Why did banks take so many risks? Charles Goodhart and Avinash Persaud have argued quite convincingly that the capital which banks need to put aside should not be a static number. Rather, it should change with the state of the economic cycle. They have proposed contra-cyclical charges—“capital charges that rise as the market price of risk falls as measured by financial market prices”. That would work as an automatic and built-in stabilizer.
There is another issue that regulators are struggling with—what should they regulate? Central banks have traditionally regulated institutions that accept deposits from the public, since financial crises usually started with runs on banks, as depositors lined up to withdraw their money. The bank topples over and pulls down the rest of the financial system.
But what happened at Bear Stearns changes all that. Bear Stearns did not accept deposits from the public. Yet, its collapse could have pulled down the entire US financial system. In an unprecedented move, the Fed helped arrange the firesale of a financial institution that does not take public deposits. At one stroke, a century and more of central banking convention was dumped. The so-called “boundaries of regulation” expanded. From here, it is not hard for regulators to argue that all financial creatures that could seek help from them should first come under the regulatory scan.
And the lessons will mount as the crisis deepens.
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