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Saturday, November 24, 2012

Interview with Reinhart and Rogoff

Found this interview of Reinhart and Rogoff via Barry Ritholtz (I had to search the title in Google to get past the paywall):

Top Culprit in the Financial Crisis: Human Nature, by Lawrence Strauss: ... What are your thoughts about the steps taken to foster fiscal and monetary policy?

Reinhart: We can always go back and figure out a way in which the fiscal and monetary policy could have been made sharper, to do more. But the thrust in a deep financial crisis, when you throw in both monetary and fiscal stimulus, is to come up with something that helps raise the floor. That's why the decline wasn't 10% or 12%. However, one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish.
Rogoff: ... Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine." ...
Is there a regulatory framework that would prevent severe financial crises?
Reinhart: Of course there is. But can we get there?
Rogoff: And stay there?
Reinhart: That's the question. Getting there is one thing, staying there is a different matter. And that's where the memory, or the dissolution of memory, kicks in. This comes out very clearly in our chapter in the book about banking crises. Devastated by what happened in the 1930s, the architects of the Bretton Woods System at the end of World War II, including John Maynard Keynes, were very leery of financial markets. This was an era of financial repression. Trade boomed. Not trade in finance, but trade in goods and services. And this very tight system, with all its distortions and problems, still delivered decade after decade of no systemic crisis. Between 1945 and 1980, it was an unusually quiet period. But then, by the late-1990s, the regulations seemed passé. The financial system found ways of circumventing regulation. It was outmoded. It was discarded, and we started anew.
Rogoff: It's important to channel some financing into safer instruments. If banks were to finance themselves like normal firms by raising a significant share of their lendable capital through issuing equity or retained earnings, we would have much, much safer financial system. So that's a very simple change. ...
Reinhart: You go through history and, in good times, the tendency is to liberalize. Then a crisis happens, and you retrench. But the retrenchment lasts only as long as your memory does, and memory is not that great. Not the memory of the policy makers and not the memory of the markets. So as you start putting time in between where you are now and your last crisis, complacency sets in, and you begin to be more cavalier about what your indicators or warning signals are showing. That's the essence of the this-time-is-different syndrome. The debt ratios are X, but we really don't have to worry about that; the price-earnings ratios are Y, but that's not a concern.
And so, given that this is so grounded in human nature, I'm extremely skeptical that we will overcome financial crises in any definitive way. We may have longer stretches [without a major crisis], as we did after World War II during the era of financial repression, which grew out of the crisis of the early 1930s. Back then, you had a lot more regulation and clamps on risk-taking, both domestically and cross-border. But then we outgrew it. It was passé. Who needed Glass-Steagall? ...

I mostly agree with what they say in the interview, but they are still too hawkish on short-run fiscal policy for my taste. I believe their work and statements in interviews such as this helped to drive the harmful austerity movement in Europe and that should at least bring caution. Reinhart's argument was that yes, immediate austerity makes things worse. But the failure to invoke immediate austerity brings about even bigger problems down the road, so big that the pain now is worth it. She has backed off a bit relative to where she was a few years ago, but as the following quote shows Reinhart will only say "the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle" -- notice that she doesn't say it is the wrong policy for a country line the U.S.:

this is not the time to be an inflation hawk. I would rather see the margin of error favor easing too much, rather than too little, for many reasons. The frailty of the recovery is still an issue. The amount of debt that is still out there for households, the financial industry, and the government is still large.
The fiscal side is more complicated, because the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle. However, over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing.

The last statement is annoying. It's health care costs, not unfunded pension liabilities that is the problem for the long-run federal budget. Maybe she has unfunded state and local pension liabilities in mind as well, don't know, but a bit more care when making these kinds of statements would be helpful since this will be interpreted by most as a call for big cuts in Social Security. It was enough to aid and abet the failed austerity movement, do they want to similarly aid and abet the dismantling of Social Security with careless statements such as this?

    Posted by on Saturday, November 24, 2012 at 11:40 AM Permalink  Comments (26)


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