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Monday, April 13, 2015

'The Mythic Quest for Early Warnings'

Cecchetti & Schoenholtz:

The mythic quest for early warnings: Economists and policymakers are on a quest. They are looking for the elixir that will protect their economies from financial crises. Their strategy is to find an indicator that provides an early warning of collapse, and then respond with preventative measures.
We think the approach of waiting for warnings is seriously flawed. The necessary information may never be in our grasp. And even if it were, our ability to respond rapidly and effectively is far from clear. Rather than treating the symptoms of illness after they start to develop, we believe the better strategy is early immunization: the more resilient the financial system, the less reliance we will have on faulty or nonexistent warnings.
To back up a bit, there are now an abundance of indices designed to measure financial system stress. ... [reviews work on scores of indicators] These findings are compelling. They tell us that forecasting systemic stress is extremely difficult and that ordinary financial market indicators efficiently summarize what information there is. ...
We do not mean to strike too harsh a tone. Having accurate measures of where we stand is extremely useful. ...
Will researchers eventually develop measures that tell us not just where we stand, but where we are going? Is the quest for early warning indicators destined to succeed? It’s possible that with more detailed data on what is going on in both financial institutions and financial markets that we will be able to anticipate big risks on the horizon. We hope so, but shouldn’t plan on it: there are important grounds for skepticism. ...
Where does this leave us?  Our answer is that we have yet another reason to be skeptical of time-varying, discretionary regulatory policy. In an earlier post, we noted that the combination of high information requirements, long transmission lags and significant political resistance made it unlikely time-varying capital requirements will be effective in reducing financial vulnerabilities. Our conclusion then, which we reiterate now, is that the solution is to build a financial system that is safe and resilient all of the time, since we really never know what is coming. That means a regulatory system based on economic function, not legal form, with sufficient capital buffers to guard against all but the very worst possibilities.
In the end, a financial system that relies on an early warning indicator of imminent financial collapse seems destined to fail.

I don't think we should stop trying to find indicators that would be useful to regulators (and neither do they), just because we haven't found them yet doesn't mean no such indicators exist -- they may. But I fully agree that regulation should be based upon the state of the art, and presently we haven't found reliable indicators of forthcoming problems in financial markets.

    Posted by on Monday, April 13, 2015 at 06:30 AM in Economics, Financial System, Regulation | Permalink  Comments (16)


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