December, 2008. Evolving Changes to the Financial Architecture. In order to overcome not only the ongoing global financial crisis but such future experiences, it is necessary for economists and policymakers to discuss possibilities for reconstructing our global financial system. This has been done to some extent, but due to the all-consuming nature of the crisis, which originated in the world’s most powerful country, previous recommendations for a new financial architecture, and far-sighted considerations for a better system, have been somewhat overlooked as scholars and politicians alike attempt to interrupt the panic and stabilize the global economy. This article seeks to outline an agenda for further discussion.
As Federal Reserve Board Governor Kevin Warsh pointed out in his speech to an NYU audience in November, we in the United States have already begun constructing a new financial architecture, with the abrupt weakening of and government involvement in the largest investment banks and bank holding companies.
Thus far, in response to the threat of a massive banking system failure, the main changes in the US consist of increasing FDIC insurance, using government funds to shore up Fannie Mae, Freddie Mac, Citigroup, AIG, and over thirty other banks, setting up special investment vehicles financed mainly by the Federal Reserve to improve liquidity in short-term financial markets (i.e., for money market mutual funds), and greatly expanding operations of the Federal Reserve. Both Goldman Sachs and American Express successfully sought to become bank holding companies, in order to qualify for FDIC insurance and additional types of funding. Firms’ acceptance of government funds means, in the case of Fannie Mae and Freddie Mac, that the government has a large degree of financial control, and in the case of Citigroup, AIG and other banks, that the government holds equity in the firms. Hence the most significant feature of the new financial architecture in the US, at least, is greatly increased government ownership.
This is an important point to consider when we think about changing the institutional and regulatory structure of the financial sector. This is not something that free-market economists and policymakers ever dreamed would happen, but it was necessary to stop the crisis from burrowing deeper into the global economic foundation. In the face of a sudden halt in the financial sector of the economy, both the private and the public sector have had to alter the status quo. But the changes do yet not appear to address the underlying systemic flaws in the global financial structure.
Systemic flaws are evidenced by the rise of the crisis itself, due to flaws in regulation and risk assessment programs, as well as in the near-immediate flight of the Japanese yen from the carry trade and other short-term capital flow reversals, and by the inability of Hungary, Ukraine and Iceland to prop up their financial systems during the credit crisis, resulting in the rescue of the countries by the IMF. Changes to the financial regulatory structure are in the works, but larger fundamental changes that may help control the creation and spread of crisis have not been discussed as much. Here we examine the issues that must be addressed and call for further discussion of a better financial architecture.
Fundamental Imbalances. Two fundamental imbalances in the global economy must be addressed. The first large imbalance can be traced to the procyclical behavior of finance. That the decline in housing prices and subsequent failure of collateralized debt obligations and other mortgage-backed securities created a global crisis as monumental as this one is testament to the prodigious amplification of downturns and upturns that finance is prone to creating. This is not to say that some amplification of business cycles is bad; indeed, it is the existence of credit and innovations in finance that have, in large part, led to a great growth in potential GDP. However, when expansions are allowed to grow unchecked, creating asset price bubbles, it can be expected that contractions will be particularly painful.
The solution to this problem is not to quash financial innovation, but to monitor the growth rate of asset prices, as well as to monitor the value of underlying securitized assets. The source of the problem that caused the subprime housing crisis was a lack of oversight of the quality of the subprime mortgages themselves after they were bundled and sold off as securities. Since these mortgages were held off banks’ balance sheets, with the fair value of the securitized investments the only figure actually seen on the banks’ balance sheets, they were overlooked by bank auditors, and the riskiness of underlying assets in these new types of securities was not caught by SEC officials. Along with soaring home prices, the scene was ripe for disaster. As housing prices deteriorated, the fair value of the new mortgage-backed securities also deteriorated, leaving investors, which included other financial institutions in the US and abroad, with mounting losses.
Eatwell (2002) also points out that risk has been heightened by the increasing homogeneity of investor behavior and by the manifestation of systemic risk in the macroeconomy. These are aspects of the current financial architecture that make the procyclicality of finance particularly threatening if improperly regulated. Investors today have much of the same access to information, utilize financial professionals who seek the same goal of short-term gains, and operate across non-segmented, or homogenized, markets. This greatly increases firms’ financial risks.
Linked to firms’ financial risks is macroeconomic risk. Interest or exchange rate policies can create or prevent the manifestation of systemic risk. Interest rate policies can spread risk when interest rates are raised in the face of a credit crunch. Very low interest rates can prompt markets to allocate financing to poorer credit risks. Portending recession at home or abroad can cause foreign investors to pull out short-term capital that, if denominated in foreign currency, can suddenly devalue the domestic currency. This is the danger of a strong carry trade, which places foreign currency loans mainly in emerging markets, where interest rates are higher. When interest rates fall, foreign currency swiftly exits domestic capital markets. These characteristics of the global economy contributed to both the Asian financial crisis as well as the current crisis. Interest and exchange rate policies can prevent the spread of systemic risk by counteracting the general direction of these movements.
Widely suggested in response to this crisis is the implementation of additional macroeconomic and microeconomic financial regulations, which would prevent asset price bubbles from wiping out extensive pools of wealth. Within this broad proposition are a variety of ideas, some of which would directly address this type of problem, and others which would address a broader set of potential dangers, including that of homogeneity and the linkage between micro and macroeconomic risk. They are as follows:
· restrict off balance sheet vehicles to increase accountability—in other words, ensure that risky investments that are currently not fully audited along traditional means should be both audited and required to have sufficient capital to back them (Crotty and Epstein 2008). These vehicles may be moved back onto the balance sheet (Alexander et al 2007);
· improve valuation standards and transparency on structured financial products (Crotty and Epstein 2008, Blundell-Wignall 2008; Kregel 2008);
· implement some countercyclical measures in Basel II standards, which, as they stand, give rise to herd behavior, since banks all use the same risk models that indicate lower risk during an expansion and higher risk during a contraction (Persaud 2000; Alexander et al 2007), and also encourage the type of originate-and-distribute model that caused the crisis in order to strengthen the appearance of banks’ balance sheets (Risk.net Winter 2008);
· monitor asset prices for bubbles—companies with asset prices greater than a certain threshold should be audited. A baseline stress test should be performed on all banks so that regulators can monitor for future risk where necessary (Alexander et al 2007);
· implement macroeconomic controls that increase costs of short-term capital inflows, such as capital controls in order to “price in” risk (Eatwell 2002).
Some or all of these measures should be imposed at once, since both monitoring and regulation are necessary. Many of them are very technical and will require a team of talented banking, finance, and regulatory experts to draw up proper rules and procedures. But luckily, most everyone agrees that better monitoring and regulation are essential, so politically there is support for at least some restructuring in these areas.
Secondly, and less likely to be addressed, are economic imbalances caused by dependency on the world’s three largest currencies: the dollar, the euro, and the yen. The dominance of these currencies and their relationship to developing countries’ economies have helped spread financial contagion.
Most significant is the large instability created by the debt position of the United States versus its trading partners. This is in large part because the US dollar is the primary global reserve currency, and other countries are willing to export goods to the US in exchange for holding dollars, building up the US current account deficit, and to invest in the US on the assumption that the dollar will continue to hold its value, effectively also supporting a current account deficit in the US by increasing funds to the capital account.
In a crisis such as this one, which originated in the US, countries such as China and India, which export goods and services to the US, suffer greatly with a sharp drop in production and employment, and in turn, countries that are heavily invested in such countries also face negative returns on investment. The US as consumer of last resort, due to the powerful position of the dollar, has created a situation in which the US economy must be sustained in order to maintain growth in developing regions.
A new problem has also been created by the increasing power of the euro, with the near-collapse of the Hungarian, Ukrainian, and Icelandic economies. The financial crisis spread to Hungary due to withdrawal of short-term foreign capital denominated in Euros, while in Ukraine crisis arose as demand for its primary export, steel, was hit hard by the slowdown in the EU economy. Icelandic banks faced difficulties in financing short term foreign (mainly EU) debt, leading to a severe credit crisis and then into a further devaluation of the krona. The crisis quickly devastated these economies as production and investment by the EU suddenly slowed.
Some of the reversal of short-term finance was due to a sharp decline in the yen carry trade, which has been a facet of global finance for years. Overseas borrowers, zparticularly hedge funds, were glad to obtain yen-denominated capital, and Japanese investors enjoyed higher interest rates in other markets. However, beginning in mid-2007, with the onset of the credit crisis, the yen carry trade began to unwind, as yen returned to Japan when interest rates elsewhere fell. And as yen returned to Japan, exchange rates elsewhere began to depreciate.
There have been proposed changes to the current global currency regime, including a global reserve currency promoted by well-known economists from Keynes to Stiglitz. These changes have a great deal of merit, but are politically charged, and therefore more likely to derail a conversation on reducing currency dependencies. At the minimum, within the existing configuration, something must be done to stem short-term capital flow reversals out of emerging economies and to decrease the large US current account deficit. Economists have offered various justifications for fixed or floating exchange rate regimes in developing countries, but there is such conflict of both opinion and evidence that this is not something we believe should be sifted through at the international level. Economies with both fixed (or managed) and floating regimes were subject to the present crisis. In response, there have been recommendations to change the existing regimes, which may or may not be optimal.
The US current account deficit is a major issue, since if it becomes unsustainable, developing countries will suffer great economic losses due to declining trade. D’Arista and Griffith-Jones (2006) also point out that the current account deficit is financed by private capital flows that have increased the amount of US domestic debt held, to finance both the current account deficit and the national debt. Foreign capital inflows have helped support the large credit expansion in the US after the 2001 bursting of the “dot-com” bubble. In addition, assets held in the form of US Treasuries build on global business cycles following fluctuations in US Federal Reserve policy, and can in response undercut initiatives by the Fed through changes in security holdings.
Strangely, during the course of this crisis, foreign investors fled toward, not away from, dollar holdings, which were considered safer. However, the continuing dominance of the dollar actually contributes to global imbalances, and the transmission of crisis more readily occurs because of this. With the increasing power of the euro, there is the opposite danger that the dollar may experience a sharp depreciation as investors transfer holdings to the euro. With so much riding on the dollar, neither of these scenarios contributes to sustainable growth.
This imbalance needs direly to be addressed, although it is requires particularly careful treatment. A reduction in the US current account deficit, whether trade led or investment led, would be painful for both trading partners and investors. A clear government policy to decrease the current account deficit, as well as the national debt (the latter not immediately in the face of the crisis, but in the long run), is likely the best policy, since this would allow investors and producers time to change their expectations. However, there must be an agreement among the most developed countries, i.e. the US, Japan, and the EU, not to propagate the same imbalance in another currency. Much more discussion on this topic is needed.
Short-term capital flow reversals are a danger to emerging economies that consequently face sharp currency devaluations and a sudden credit crisis. It has been recommended that developing countries buffer their economies with countercyclical fiscal policies, in which government surpluses are built up during expansions to protect these economies in the case of a crisis. However, this may not be sufficient in the face of very large capital flow reversals, particularly when the economy is already small, as in the case of Iceland. Capital controls are controversial since they may prevent current or future investment, although Chilean capital control policies, through the tax or encaje on short-term capital, have been lauded for their effectiveness in stemming capital inflows.
This is a difficult subject since emerging economies need finance, especially when financial resources are used for investment rather than consumption. In this case, a higher authority or “watchdog” must monitor the stability of the global economy to warn emerging economies of potential capital flow reversals (confidentially, not publicly, so that investors do not react by withdrawing capital at once). The IMF and World Bank jointly set up the Financial Sector Assessment Program after the Asian Financial Crisis to do just this, but because the scope of risk assessment has been too narrow its effectiveness has been limited. This is something that must be changed immediately, as EU leaders are well aware.
There are additional problems with the financial architecture that must also be broached.
The first is the issue of the bailout strategy: when finance fails, taxpayers end up paying for it. This is, of course, a last resort, but there are currently few alternatives. Both economists and the public have suggested that firms within the financial sector pay into a large fund that can be used in case a bailout is necessary. This would be a more just way of dealing with crises, although it may slow growth to some extent.
Accompanying this issue is the question pertaining to the European Union over governance of emergency liquidity. Currently, the lender of last resort function is allocated to the member states. It has been suggested that the EU and the ESCB draw up a contingency plan for dealing with economic crises in advance. This plan would clarify which party would take responsibility for particular aspects of a crisis (Alexander et al 2007).
Another issue to consider is the future role of the IMF, which was initially created at Bretton Woods in 1944 in order to handle macroeconomic issues between nations, such as balance of payments account imbalances. French Prime Minister Nicholas Sarkozy and others have called for the IMF to become a global lender of last resort (an international central bank), although this proposal has been tabled due to its challenge to implement, politically. Widely agreed upon is that the IMF should better reflect the composition of its members (RTE Business, November 4, 2008). As discussed above, the IMF must also greatly strengthen its “watchdog” duties currently assumed by the Financial Sector Assessment Program.
And finally, there is the not-so-small matter of how to deal with bad assets already on banking books. Banks have not coped well with a sharp decline in asset values, and have required capital injections by the Federal Reserve. Although the Fed initially intended to purchase banks’ bad assets in the initial $700 billion bailout plan, this plan was abandoned when the scope of financial troubles widened. But these bad assets must be dealt with, either by banks themselves or by a new entity. Davidson (2008) recommends creation of an organization to recover funds from the bad assets, as was done by the US after the savings and loans crisis, and as other countries have also implemented. Something like the Resolution Trust Corporation could be revived by the government in order to remove non-performing loans from banks’ balance sheets. These types of asset management companies have had mixed levels of success in various contexts, but this is a matter to reconsider in order to improve the health of the financial sector.
Before there can be a global adoption of a new financial architecture, significantly more dialogue about an improved system must take place. The two primary areas of concern regard the instabilities created by the procyclical nature of finance and the currency imbalances in the global economy. But the proverbial devil is in the details, and working out a widely accepted solution to these instabilities requires a great deal of consideration among economists and policymakers that is not taking place.
President Obama is scheduled to attend the next G-20 economic summit on April 30, 2009, and many policy proposals are on the table for building a new financial architecture. It has been noted, both in the media and at the last G-20 meeting on November 15, 2008, that preparation for such a change takes time and thought. There is time, presently, for discussion; proposals for a new financial architecture should be circulated as widely as possible.
We hope that economists will have opportunity to discuss and perhaps revisit these wider issues. There are many venues for discussion, including higher-level meetings, conferences, seminars, op-ed columns, and web blogs. Hence the beginning of a conversation has begun, but it has tended to pertain only to ways of reregulating finance, rather than to global imbalances that help cause and spread crisis. Reregulation of finance is a critical piece in constructing the new financial architecture, but it is not the only piece. In order to prevent future crises, a solid monitoring, regulatory, and policy framework must be created in an atmosphere of global cooperation. There can be no better time: the world is listening intently to the wisdom of economists.
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