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Wednesday, April 02, 2008

"Are We Having the Right Discussion about the Financial Crisis?"

Ricardo Hausmann is not a fan of the Taylor rule:

Are we having the right discussion about the financial crisis?. by Ricardo Hausmann: The discussion about avoiding a repetition of the current financial crisis has centered on the potential role of financial regulation. ... Many ... argue that if the Fed’s safety net is extended beyond commercial banks to other market participants, prudential regulation should also be extended to avoid moral hazard. Those that argue in this direction may have a point. But it is hard to see how the kind of financial regulation that would be called for would have avoided the current crisis. ... I believe that financial regulation is the wrong place to focus the policy discussion... It is macro policy, not financial policy that needs to be at center stage.

I propose we engage in the following counter-factual scenario. Let us suppose that more stringent financial regulations had been adopted in 2003 or some such date. Let us discuss two macroeconomic scenarios.

Consider first the case where the Fed would have set the same interest rates as we observe in the historical record. In this case, the new regulations would have lead to a smaller rate of credit expansion because the regulations would have meant that, for any interest rate set by the Fed, the market for credit would have been smaller. Presumably, there would have been less mortgage lending, fewer home equity loans and less junk mail offering zero percent loans on credit cards. Aggregate demand would have been lower and presumably so would have been the rate of growth, the level of employment, the inflation rate and the current account deficit.

Now, consider the alternative scenario in which the FOMC would have set interest rates following the way monetary policy is conducted, with the same inflation and employment targets. What would have been the consequences of this alternative and more plausible financial scenario?

Obviously, the Fed would have lowered interest rates until the amount of lending required by the inflation and employment targets had been achieved. The financial system would have been asked to find other ways to expand credit.

Maybe, that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But I am not so sure that this would have been the case. With the even lower level of real interest rates, the incentives for financial engineers to invent new instruments that could be placed in large numbers would have been enormous and many more bright minds would have been hard at work at circumventing the new regulations than those that had crafted them.

My bottom line is that it is impossible to discuss the lessons of this crisis without talking about macro policy. I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households.

In the end, it is hard to believe that a macro policy that overshoots the sustainable growth rate by encouraging millions of citizens to over-borrow is going to be made safe through financial regulation.

If I'm reading this correctly, the basic argument seems to be that effective regulation makes lending safer, but if you assume that regulation doesn't work, i.e. that regulations can be circumvented, then you find that regulation doesn't work:

...that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But...many more bright minds would have been hard at work at circumventing the new regulations...

So long as the regulation is effective, the problem would have been reduced, so the question is about the ability to implement effective regulation. Ricardo Hausmann is more pessimistic than I am about that, partly, perhaps, because I think much depends upon the attitude of those enforcing the regulations. I don't think a strong will to enforce existing regulations has been present among regulatory agencies, but I think that attitude will change due to current events in financial markets, and change even more when there is a change in the administration after the election. But I can't say I'm fully confident that attitudes will change as much as needed to bring about effective enforcement, or change enough to sustain the current desire to enact new legislation. [I'm short on time, so I'll just note that I disagree with blaming the Taylor rule for our current problems, and hope I can come back to this issue some other time.]

    Posted by on Wednesday, April 2, 2008 at 01:19 AM in Economics, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (22)


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