“After the Crises: Assessing the Costs and Benefits of Financial Liberalisation” - આરબીઆઈ - Reserve Bank of India
“After the Crises: Assessing the Costs and Benefits of Financial Liberalisation”
Lord Adair Turner, Chairman, Financial Services Authority, United Kingdom
delivered-on ફેબ્રુ 15, 2010
Mr Governor, ladies and gentlemen, it is a great honour to have been invited to give the 14th Chintaman Deshmukh memorial lecture, and a great pleasure to be with you here in Mumbai. The Reserve Bank of India has a high reputation as a centre of thoughtful analysis of the important issues of financial stability and optimal policy which concern policy makers throughout the world, and a high reputation for having helped steer India through the recent financial turmoil. It is about the origins of that turmoil and how we respond to it that I will talk tonight. In Autumn 2008, the world financial system suffered a huge crisis which imposed great harm on the world economy, and thus on the employment, wealth and welfare of many people throughout the world. In its wake, there is strong determination to learn the lessons of what went wrong and to build a more stable global financial system for the future. This has involved a new institutional structure, with the creation of the international Financial Stability Board, bringing together developed and emerging market central bankers, regulators and financial ministers. We are striving to ensure a strong and globally agreed response. But we have been here before. Indeed, only 11 years before 2008, in Summer 1997, the global financial system had also been rocked by an enormous financial crisis – the emerging market and primarily Asian crisis of 1997-98. And after that crisis there was a determination to learn lessons, to improve the quality of regulation. And there were new institutional structures: the Financial Stability Forum, which was the direct pre-cursor of the Financial Stability Board, was established in 1998, to ensure better surveillance of emerging risks, and identification of the policy responses needed to avoid future crises. Sadly that institutional response was ineffective. In part that is because the latest crisis came from a quite different direction. And just as many generals are said to have a tendency to fight the last war, so regulators and central bankers may have a tendency to address the problems revealed by the latest crisis. We must avoid that mistake. And one way to avoid that mistake is to draw lessons not just from the latest crisis but from previous crises as well, identifying the general factors underlying both this latest manifestation of financial instability and crises that went before. So my aim this evening is to ask what common lessons we can learn both from the Asian crisis of the 1990’s and the latest developed world crisis. And India is a very pertinent country in which to attempt that analysis, since India managed in both crises to escape with relatively little financial instability and relatively slight economic harm. There are of course important differences between the two crises. 1997 was essentially a crisis of emerging markets and a crisis in which instability of cross border capital flows played a crucial role. Swings in nominal and real exchange rates, first rising to unsustainably high levels and then crashing dramatically, played a key role. And the sudden depreciations produced inflationary pressures and capital flight, for which the prescribed medicine was tighter fiscal and monetary policies. By contrast, 2008 was in its origins a crisis of the US and European financial systems: rooted in over-exuberant credit extension in developed markets, and in the development of complex and opaque forms of securitised credit and of new and risky forms of maturity transformation. Exchange rate movements and international capital flows played only an incidental role: capital flows to emerging markets did turn volatile in late 2008 but only in response to the crisis, having played no fundamental causative role. And the consequences of the crash were deflationary rather than inflationary, in price as well as in output terms – so that the prescribed medicine has been fiscal and monetary loosening. But despite these major differences, the two crises also have strong common features, and in particular both were rooted in, or at least followed after, sustained increases in the relative importance of financial activity relative to real non-financial economic activity, an increasing “financialisation” of the economy. The Asian crisis came after a strong upsurge in the scale of financial capital flows to and from emerging countries: an upsurge which was seen in equity portfolio flows, debt security flows, and cross border bank capital flows (Exhibit 1). This upsurge was also matched by a longer term growth of financial capital flows between developed nations (Exhibit 2). And after the setback of the 1997 crisis, these capital flows, both between developed countries and between developed and emerging countries, have resumed an even stronger upward path (Exhibit 3). Finally this upsurge has been accompanied over the last 30 years by a quite striking increase in the volume of foreign exchange trading activity relative to global GDP and trade. (Exhibit 4). The crisis of 2008, meanwhile, came after several decades in which financial activity within developed economies – whether measured by total bank assets to GDP, or by the scale of credit and derivatives trading, or the scale of interest rate derivatives trading, had increased dramatically (Exhibit 5). On a whole series of measures, therefore, the sheer scale of financial activity has increased dramatically both in absolute terms and relative to real economic variables such as GDP, over the last 30 years. This followed several decades in which no such trend had been apparent. Of course, that increasing scale of financial activity reflects in part the globalisation of world trade and long term capital flows, and the world of floating exchange rates which followed the breakdown of the Bretton Wood system in the early 1970’s. But it has also been deliberately fostered by policies of financial liberalisation, with the size and sophistication of financial sectors seen by an increasingly dominant conventional wisdom – the Washington Consensus as it was labelled – as important positive drivers of national and global growth. The crucial issue which we now need to address, after two terrible crashes in just 12 years, is whether this increasing scale of financial activity truly has been beneficial, which elements are beneficial and which harmful, and what trade-offs are required in public policy between any benefits of increased financial liberalisation and sophistication and the instability which seems at times to accompany it. It is useful to begin that analysis by looking at the most macro and long-term indicators. Is there in economic history a clear correlation between the financial intensity of an economy – measured in all the different possible ways – and the overall rate of economic growth? The answer is that at this macro level there is no clear and universal positive relationship. Carmen Reinhart and Ken Rogoff in their recently published and excellent survey of eight centuries of financial folly, crashes and debt defaults (“This Time it’s Different”), identify the period 1945 to the early 1970’s as one of “financial repression” in which the role of the financial system was subdued in many countries.1 And in some countries, for instance one might argue in India, that “financial repression” probably was one among a package of market restrictive policies which hampered economic growth. But equally there were countries which in that period achieved historically rapid growth with fairly “repressed” financial systems (for instance Korea), and in the developed economies – the US, Europe, and Japan – this period of financial repression was one of significant and relatively stable growth, comparing fairly well with the subsequent 30 years of increased financial activity and financial liberalisation. And there does not appear to be any compelling proof that increased financial innovation over the last 30 years in the developed world has had a beneficial effect on output growth. Indeed a recent paper by Moritz Shularick and Alan Taylor documents the growth of leverage and credit extension which liberalisation and innovation has helped facilitate, but finds little empirical support for the proposition that this liberalisation and innovation has led to a corresponding increase in trend growth rates for the countries in their sample.2 So the broad historical macro facts do not provide compelling evidence that an increase in the financial intensity of market economies is necessarily and always and limitlessly beneficial for growth or welfare. To progress beyond this very general conclusion, however, we need to consider both the economic theory of why, and under what circumstances, financial liberalisation might deliver economic benefit, and to consider the specific categories of financial activity which played important roles in, first, the crisis of 1997 and then the developed world crisis of 2007 to 2009. This lecture is therefore structured in five sections:
The predominant neoclassical school of economics has perceived increased financial activity – greater market liquidity, more active trading, and financial innovation – as a broadly positive development.3 This is because extensive financial activity is essential to complete markets. The first fundamental theorem of welfare economics, demonstrated mathematically by Kenneth Arrow and Gerard Debreu, 4 illustrates that a competitive equilibrium is efficient. But this is only true if markets are complete i.e. if there are markets in which to strike all possible desired contracts, including insurance contracts and investment contacts linking the present and the future, as well as markets for current goods, services and labour. Therefore the more liquid are financial markets and the more extensive is financial innovation, the more efficient the economy will be. Thus :
Moreover, these advantages of financial markets apply not merely within an economy, but between countries. The less restricted and the deeper the markets for capital flows between countries, the more efficient will be the international allocation of capital, with globalisation and financial liberalisation therefore naturally and beneficially linked. Of course, these propositions do not mean that there is no role for regulation of financial services and financial markets. Neoclassical theory specifically identifies that competitive equilibrium conditions can be prevented by the existence of market imperfections, and recognises, as per the Lancaster- Lipsey conditions, that if a specific market is imperfect, liberalisation of other markets might be suboptimal 6. But the neoclassical approach does tend to dictate a particular regulatory philosophy, in which policymakers ideally seek to identify the specific market imperfections preventing the attainment of complete and efficient markets, and in which regulatory intervention should ideally be focussed, not on banning products or dampening down the volatility of markets, but on disclosure and transparency requirements which will ensure that markets are as efficient as possible.These propositions, and the strongly free market implications drawn from them, have played a somewhat dominant role in academic economics over the last several decades, though with dissenting voices always present. But they have been even more dominant among policymakers in some of the finance ministries, central banks and regulators of the developed world. Keynes famously suggested that “practical men, who believe themselves quite exempt from any intellectual influences, are normally the slaves of some defunct economist”. But the bigger danger may be that the reasonably intellectual men and women who play key policy- making roles, are often the slaves to a simplified version of the predominant conventional wisdom of the current generation of academic economists. Certainly in the case of the UK Financial Services Authority, the idea that greater market liquidity is in almost all cases beneficial, that financially innovation was to be encouraged because it was likely to expand investor and issuer choice, and that regulatory interventions have to be specifically justified by reference to the specific market imperfections which they are designed to overcome, formed key elements in our institutional DNA in the years ahead of the crisis. And the predominant tendency of the International Monetary Fund, both at the time of the Asian crisis and in the run up to 2007-09, was to stress the advantages of free capital flows and financial innovation, making reference to theories of market completion and allocative efficiency. However, this benign view of limitless financial deepening - of increased trading activity and innovation - is rejected by the Keynes/Minsky school of thought. Keynes, most famously in Chapter 12 of The General Theory, argued that liquid financial markets did not ensure allocative efficiency through the attainment of a rational competitive equilibrium, but were instead subject, for inherent and unavoidable reasons, to self-reinforcing herd/momentum effects. Professional investment was, he famously said, like a “pick the prettiest girl photo competition”, in which the successful competitor was the one who correctly and most rapidly predicted the preferences of the other competitors. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees”.7 Keynes therefore believed that the professional investor or trader, be it in equity markets, currency markets, or, he would have said today, the CDS market, is “forced to concern himself with the anticipation of impending changes, in the news and in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced”. And he argued that pure speculation, unattached to fundamentals, could drive self-reinforcing bubbles, which not only served no useful allocative role, but which produced important destabilising effects. Keynes’s argument received strong empirical support from Charles Kindelberger’s analysis of market manias, panics, and crashes through the ages.8 Hyman Minsky developed a theory of the dynamics of the capitalist economy and of its financial institutions, in which sustained good economic times were likely to produce a shift in the relative balance of financial activity away from hedging and rational allocative activities towards purely speculative activities, which in turn could lead to sudden collapses in values, debt deflation traps and major real economic disruption.9 And indeed some of the world’s most successful financial speculators – in particular George Soros – have themselves argued that major liquid financial markets are not driven to equilibrium by fundamental factors, but are subject to endlessly reflexive disequilibrium dynamics.10There are different ways of explaining these disequilibrium dynamics:
It is therefore notable that the school of thought which we can broadly label as Keynes/ Minsky is not characterised by a single unifying theory equivalent to that of neoclassical equilibrium. As a result, as I will discuss in Sections 4 and 5, it is not easy to derive from this way of seeing the world a simple and universally applicable set of criteria for deciding appropriate regulatory intervention, such as can be derived from the neoclassical approach. But I will argue in Section 5 that it is better to live in the real world of complexities imperfectly understood, than to construct for ourselves an intellectually elegant set of assumptions which do not fit real world phenomena. And the evidence of the crises of 1997 and of 2007-09 to which I will now turn, suggest that we should be highly sceptical of the benefits of general and limitless financial liberalisation. 2. THE ASIAN CRISIS OF 1997 In respect to the 1997 crisis, the crucial contested issue in economics is the benefits and disadvantages of short term financial capital flows. As already shown, these flows increased dramatically in the decade running up to the 1997 crisis and the dominant conventional wisdom of the time – as expressed for instance in the attitude of the IMF – was that these flows were positive. This was based on the neoclassical argument that capital flows in general (including short term portfolio flows as well as long term direct investment ) help achieve a more efficient global allocation of capital, linking savers to business investments in a more efficient fashion13. Indeed it was right in the middle of the Asian crisis – at its Hong Kong meeting in September 1997 – that the IMF proposed that capital account liberalisation should be made a binding commitment of IMF membership, going beyond the commitment to current account convertibility included within the IMF’s original founding articles. But while this was the conventional wisdom, a wide variety of studies have cast doubt on whether free movement of capital, and in particular of short term capital, is at all positive for growth.The challenge has been launched on both empirical and theoretical grounds.
These arguments together make a compelling case for: i) Believing that the positive benefits of short term capital flows may be very slight even in the absence of shocks. ii) Believing that these benefits can be significantly outweighed by the adverse impact of financial shocks. Against this criticism, the counter defense of capital flow liberalization has not sought to deny the reality of potentially volatile capital flows, but has argued that this potential arises only because of fundamental deficiencies in, for instance, the credibility of government’s fiscal and monetary policy, or the quality of domestic financial system regulation and governance. These arguments recognise – in line with the Lancaster and Lipsey second best theory – that market liberalisation can be harmful if applied in a context where many other market imperfections and distortions exist. But this insight is then used to support the argument that capital flow liberalisation can be a good thing, provided that appropriate supplementary reforms are made, and in the appropriate sequence. An argument which enables believers in the free market creed to hold that the faults in the system revealed by 1997 ultimately lay not in too much market liberalisation, nor in the inherent instability of markets, but in inadequately complete application of good free market precepts. This argument between those who believe that the potentially harmful volatility of financial markets is inherent and unfixable, and those who believe that it can be fixed if credible policies are in place and well communicated, is an old one. In 1943, in a paper which input to the Bretton Woods deliberations, the economist Ragnar Nurkse reviewed the floating exchange rate regimes of the early 1920s, and concluded in particular that movements in the French franc exchange rate between 1924 and 1926 illustrated “the dangers of cumulative and self- aggravating movements… (which)… instead of promoting adjustments in the balance of payments, are apt to intensify any natural disequilibrium and to produce what may be termed “explosive” conditions of instability.” But Nurkse’s account was met by the counter-argument of Friedman et al, that this apparently self-fulfilling unstable speculation was a rational response to the uncertainties of French policy, and that the key lesson therefore is the need for policy to be appropriate, well communicated and credible17. Faced with these alternative arguments it becomes impossible, as Barry Eichengreen has noted, ever to prove which argument is correct except if we were able to look directly into the minds of financial speculators and possibly not even then. But while proof is ultimately unattainable there are three compelling arguments for not seeing the “conditions and sequencing” argument as at all conclusive:
Overall, therefore, I believe that the case that short term capital flow liberalisation is beneficial is, as Jagdish Bhagwati argued in his famous 1998 article “The Capital Myth: The Difference between Trade and Widgets and Dollars” based more on ideology and argument by axiom than on any empirical evidence. Though also undoubtedly, as Bhagwati argued, based on interests. For what we saw in respect to capital flow liberalisation in the 1990’s (as in respect to domestic financial liberalisation in developed countries) was the assertion of a self-confident ideology which also happened to be in the direct commercial interest of major financial services firms with powerful political influence in the major and developed economies and in particular in the US. That combination of ideology and interests has proposed an over-simplistic conventional wisdom of self-equilibrating exchange rates and optimal capital flows. Instead we need to recognise that in global short-term capital and related FX markets we face the risk of potential instability and overshoot. What we should do about that is less obvious. It does not necessarily follow that comprehensive capital flow controls are the required answer: there is a reasonable argument that while the theoretical and empirical case against constraints on short-term capital flows is quite poor, the pragmatic case against them (or at least against their comprehensive application) is quite strong, simply because they may be unenforceable and tend to produce other distortions18. But I will return to that issue in Section 4, simply arguing for now that foreign exchange markets and short term capital flows are not self-equilibrating, but at times subject to inherent and self reinforcing instability.3. THE DEVELOPED ECONOMIES’ FINANCIAL CRASH OF 2007-09
As with the growth of international capital flows and of related Forex trading, so with a whole series of other financial activities, the last two decades has thus seen a dramatic increase in the scale of financial activity relative to the real economy, accompanied by a wave of complex financial innovation.
In this confidence in the benefits of financial liberalisation, the IMF was not alone. There were of course some economists who raised fundamental objections to the conventional wisdom – Nouriel Roubini and Robert Shiller in particular – and specific concerns were often expressed, including within the IMF GSFR from which I have quoted, about developments in particular credit markets and about the capacity of risk management systems always to cope with increased complexity. But the predominant view in policy-making circles was not only sanguine about increased financial intensity and financial innovation but positive. And the dominant intellectual ideology of the day was largely embraced by regulators who as a result were highly susceptible to the argument that if a particular regulation threatened financial innovation or market liquidity it was by definition inappropriate. An argument often reinforced of course by the influence of self-interested political lobbying: Bhagwati’s combination of “ideology and interests” was clearly influential in relation to some key measures of domestic financial liberalisation, (such as the removal of leverage restrictions on investment banks in the US), as well as in its assertion of the benefits of short term capital flows. Finding a solution to the “too big to fail” problem is therefore a vitally important part of the international regulatory agenda, and a key priority of the Financial Stability Board and in particular of its Standing Committee on Regulatory and Supervisory Cooperation which I chair. The options under consideration include capital surcharges for large systemically important banks to reduce the probability of failure; the development of contingent capital instruments which would automatically convert to loss-absorbing equity well before failure; and the development of recovery and resolution plans (“living wills”) which require banks to be internally organised in a fashion which would make it possible for the authorities to execute options other than the rescue of the entire group as a single entity. An important related set of policy options are those which might limit the extent to which deposit-taking banks are involved in risky propriety trading activities, an area where the Obama administration has recently brought forward proposals These policies to restrict or more efficiently manage the risks created by size or breadth of activities are rightly seen as means by which to protect taxpayers against the risk that they will in future have to repeat the expensive rescue operations of the last two years. They are a necessary part of the regulatory response. But they are not a sufficient response to the crisis for four reasons:
As a result, while the “too big to fail” agenda is extremely important, we should be very wary of assuming that it will in itself solve the problems of financial instability. Indeed, any idea that it is a sufficient response rests on strong confidence in the neoclassical proposition that financial markets can be made self-equilibrating if only we can discover and correct the crucial imperfections which prevent the attainment of the Arrow-Debreu nirvana – in this case the poor incentives and lack of market discipline created by “too big to fail” banks. If instead we believe – in line with the Keynes/Minsky school – that financial systems and markets are inherently subject to self-reinforcing herd and momentum effects which create instability, then we will need to combine the “too big to fail” agenda with other policy responses. Constraint will therefore almost certainly require the development of new macro-prudential tools, new mechanisms to take away the punch bowl before the party gets out of hand. These could include discretionary variation of capital requirements through the cycle, either across the board or in relation to specific sectors such as commercial real estate. Or new regulations which seek directly to influence borrower as well as lender behaviour, such as limitations on allowable loan-to-value ratios: new tools which entail moving away from the belief that a stable equilibrium will be delivered if only markets are efficient and classic monetary policy tools appropriately aligned.21 But while I say “new” tools, they are of course not new in India, and you have been using them recently and very effectively. Nor are they entirely new to developed countries. Rather they were tools we used to have 30 to 40 years ago, but rejected as old-fashioned and unneeded in our over-confident embrace of neoclassical propositions. (iii) A balanced approach to market liquidity Alongside these tools of macro-prudential management, we also need a more open mind about the benefits and the potential downside of increased market liquidity, and a more balanced regulatory approach. For many years, the benefits of increased market liquidity have been an article of faith, frequently deployed to argue against tighter regulation. And increasing liquidity clearly is valuable up to a point. It widens the set of contractual options available to individuals and Corporates. In current or close to current markets such as Forex and commodities spot and forward, it reduces the cost of operations for end-users in the market. In markets which form part of the capital allocation mechanism, linking savers to investments (e.g. via equities and bonds), it provides a wider set of options for investors, enabling them to provide funds which are long term contractually committed to issuers, while allowing them the option of only holding for a short period of time. This in theory has a direct welfare benefit (by providing a closer matching of available options to investor preferences), and may under some circumstances foster a higher rate of savings and investment than would otherwise result. And we need to recognise honestly that more liquid markets require speculators – traders taking positions specifically in order to make trading profit, and these speculators may under some conditions be well informed, provide market discipline and help generate prices which inform efficient decisions. But Keynes believed that “Of the maxims of orthodox finance, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of institutional investors to concentrate their resources upon the holding of “liquid” securities”22. And scepticism about the limitless benefits of market liquidity and of the speculation required to make it possible, is justified on two grounds:
Our mental model of the benefits of extra liquidity should therefore not be one in which more liquidity is always beneficial, but perhaps as shown on this chart (Exhibit 13) one in which the benefits are subject to diminishing marginal utility and in which there is an offsetting and rising danger of a negative effect arising from the potential for destabilising speculative activity - but with the severe complication that the point of optimal benefit is impossibly difficult to define with any precision, that it varies by market and over time, and that we have highly imperfect instruments through which to gain the benefits without the disadvantages. There is, for instance, no economic value that I can discern from the operation of speculation in currency “carry trades” which are among purest examples of what Professor John Kay labels “tailgating strategies” – riding an unsustainable trend in the hope that you will be clever enough to get out just ahead of the crash.23 But there may be no instruments which can eliminate carry trade activities without undermining useful Forex market liquidity of value to nonfinancial corporations.
5. FINANCIAL DEEPENING AND LIBERALISATION: AN OVERALL APPROACH We do not know for sure and the truth is likely to differ between different markets. The problem for regulators and central bankers is that this conclusion does not provide us with nice easy answers on which to base policy. It might be optimal simultaneously to seek to make one market (say spot equities) more liquid and more efficient in a technical sense, while in another market (eg, complex bi-lateral CDS contracts) to be indifferent if capital requirements and collateral management rules result in the market dwindling in size. Such a complex conclusion will make many people uneasy. It is much easier to proceed in life on the basis of a clearly defined and simple credo which provides the answer to all specific issues. But it is more likely to produce good results if we live in the real world of complex trade-offs and of relationships which are true up to a point. 1 C. Reinhart and K. Rogoff This time its different: Eight centuries of financial folly, Princeton , 2009 2M. Schularick and A.M. Taylor : Credit booms gone bust: Monetary policy , leverage cycles and financial crises 1870-2008 ,NBER Working Paper No15512, November 2009 3 I am indebted to Jonathan Portes , Chief Economist at the UK Cabinet Office for sharing with me an unpublished article which provides a particularly clear description of the differences between the Neoclassical and Keynes / Minsky approaches 7 John Maynard Keynes , The General Theory of Employment , Interets and Money , 1936 , Chapter 12 9Hyman Minsky, Stabilising an Unstable Economy , 1986 13 See Stanley Fischer Capital account liberalisation and the role of the IMF in Should the IMF pursue capital accounting convertibility, Essays in International Finance, Princeton 1998. 14Capital flows and emerging market economies , CGFS Papers No 33, January 2009 17 See Barry Eichengreen Globalising Capital, Princeton 2008 page 49-55 for discussion of this debate. 18See Richard Cooper, “ Should capital-account convertibility be a world objective?”, in “Should the IMF Pursue capital account convertibility?”, Princeton 1998, for a discussion of this argument . 19 Benjamin Friedman , Overmighty finance levies a tithe on growth, Financial Times , 26th August 2009 20 These dynamics are described here only at a very high level but will be addressed in much greater detail in a lecture to Cass Business School , London on March 17th 2010 , entitled “ What do banks do, what should they do?” 21 The case for such tools and the complexities involved in their application are discussed in a Bank of England Discussion Paper “The role of macroprudential policy”, November 2009 23 See John Kay , “Tailgating blights markets and motorways”, Financial Times, January 19th , 2010 24 L.H Summers and V.P. Summers , Journal of Financial Service Research , 1989 |