Designing Economic Policy for a Second-Best World

Ever since the financial crisis began in the fall of 2007, three arguments concerning the causes of the problem have been made repeatedly and forcefully — although usually separately.

These arguments, which are not mutually inconsistent, can be summarized as:

First, monetary policy was too easy in the years 2004-2006. In particular, monetary policy should have responded to the emerging bubble in housing prices, to the rapid growth of credit and debt, and to the implausibly narrow risk premia on a range of financial assets. The excessive growth of household sector debt and the bubble in house prices inevitably collapsed, bringing on the crisis.

Second, the large external imbalances of the United States on the one hand — and China and other countries with high savings rates on the other — had as their necessary counterpart large, net, cross-border capital flows.

Capital from surplus countries in Asia and elsewhere flowed into the deficit country, the United States, further putting downward pressure on dollar interest rates and upward pressure on asset prices. These capital market developments added to the boom/bust experience of 2005-2008.

Third, the rapid growth of risky, new derivative instruments and the complexity of structured financial products were a “time bomb” destined to blow up our financial markets. These products could not be appropriately priced or managed, and have resulted in huge losses for key participants in our financial markets.

The pros and cons underlying these issues were debated widely as the economy expanded before the crisis hit. Academics and policy-makers (including at the Federal Reserve where I had the opportunity to participate as a staff member until my retirement in early 2008) looked to economic theory and past experience for answers and policy guidance.

In light of the severity of the crisis now confronting the global economy, we can see that the complexity of and distortions in real world markets often trump economic theory. The three arguments I have outlined share an implicit assumption that we are living in a second-best world — which means that the U.S. financial system and the entire global financial system operate in imperfect ways.

Economists use the term ‘second-best’ to capture the idea of an economic market or system that fails to meet all the assumptions of perfect competition laid out in textbooks. When those assumptions do not hold, we cannot be sure that the benefits of efficiency and stability promised by the textbooks for market outcomes will in fact occur.

From today’s perspective, it is not surprising to learn that our financial system did not meet the idealized assumptions of textbooks. This series seeks to explore what we can conclude from the three arguments above. In what sense do they provide insight into the causes behind the crisis or the policies we should adopt to resolve it?

The argument of too-easy monetary policy starts with the Fed keeping its short-term policy rate too low and hence keeping market interest rates lower than they should have been. Interest rates that are too low are the counterpart to asset prices that are too high. The low interest rates feed a credit cycle that leads to excessive borrowing by many. In this episode, these rates also led to the purchase of housing assets at prices that the borrower could not afford as time went on.

Monetary policy that is too easy helps create a boom that results in overly optimistic assessments of the creditworthiness of borrowers. Once prices reach a level new buyers cannot afford and/or the central bank begins to tighten policy, the bubble in prices pops, borrowers are forced to default on payments they cannot make, refinancing or selling of the assets becomes impossible, and a crisis for the banks and other lenders ensues.

This point of view is argued in a 2008 paper by Claudio Borio of the Bank for International Settlements (BIS) and in a 2008 speech by William R. White, formerly Economic Adviser and Head of Monetary and Economic Department of the BIS.

But, this argument leaves unanswered some important questions, such as how a central bank can know for certain that policy is too easy and a bubble is forming. If the central bank is otherwise meeting its objectives for price stability and appropriate full utilization of resources, are rising assets prices reason enough for it to tighten? And if it does then tighten some, will credit growth slow and the asset price bubble wind down without causing a crisis?

At the Federal Reserve, Chairman Alan Greenspan recommended in a 2005 speech against the use of monetary policy to correct misalignments in asset prices, as did Vice Chairman Donald Kohn in speeches in 2006 and 2008 .

Market participants clearly do not have perfect knowledge of whether asset prices have risen “too high,” but neither do central bankers. Here is where the “second-best” argument applies.

Financial institutions that are making decisions in an uncertain world can still be trusted to deliver efficient capital allocation if the following conditions are met: they are managed to maximize the risk-adjusted, long-term value of their asset portfolio; the compensation and incentives of traders and other employees result in focus on their part on the long-run performance of the firm rather than on short-run gains; risks are being evaluated objectively and the costs of mistakes are primarily borne by those who make them; and information is provided in a transparent way about the firm’s structure and objectives so that potential investors and counterparties can judge the wisdom of doing business with that firm.

We know from some spectacular examples that our markets did not meet these criteria.

The second argument points to the large net external imbalances of the United States (which runs a deficit) and the surplus countries, importantly China. Such large imbalances give rise to capital that flows from the surplus countries into the deficit country (i.e., the United States) and adds to the downward pressure on dollar interest rates, upward pressure on U.S. asset prices, excessive expansion of credit, and eventually a bust as asset prices become unreasonably high and credit quality problems emerge.

This perspective was argued in March 2009 by Mark Whitehouse in the Wall St. Journal. Ben Bernanke argued that a “global saving glut” was an important factor driving the widening imbalances in 2005. And as Federal Reserve Chairman, he linked these imbalances to the crisis in a speech last month.

Before commenting on how this relates to “second-best” issues, let me amend this argument in a way that is actually quite important. The net external imbalance of the United States, China, or other countries is not what flows across borders and must be intermediated by the global financial sector. It is the gross flows of capital that move across borders and through markets.

Indeed, it is the gross stocks of assets (far larger than any one year’s gross flow) that must be managed for risk. In 2007, the U.S. current account deficit was about $730 billion. So, the net inflow of financial funds from the rest of the world to the United States was about that large. But the gross inflow of financial capital to buy U.S. assets was about $2.1 trillion—nearly three times as large.

Of that amount, about $1.6 trillion were assets purchased by private foreign investors. These assets included a mix of foreign direct investment into the United States, purchases of U.S. Treasury securities, purchases of private stocks and bonds, flows of currency, and acquisition of claims on U.S. banks. All of these investments had to go through global financial markets and institutions.

During 2007, U.S. investors were also busy buying and selling a variety of claims on the rest of the world. The total net acquisition by U.S. investors was nearly $1.3 trillion, almost all of which was done by private investors.

The current account balance corresponds to the difference between the net foreign figure and the net U.S. figure. But that difference could be zero and the gross flows could still be very large. So let us keep our focus on the gross flows, not the net imbalance.

To understand whether and how these flows contributed to the current financial crisis, we have to recognize that an extraordinarily large number of investors had a role, and that the global financial sector has to handle an enormous variety of transactions.

The expansion of cross-border financial flows began well before the current credit boom and subsequent bust. Events that began in the 1990s have given rise to substantial changes in real and financial activity that increased the extent of economic integration across borders and the scale of cross-border transactions — what is generally referred to as globalization.
Financial globalization was spurred by the removal of barriers to cross-border financial transactions, by innovation and IT developments that made communication and information flow possible, by the creation of new financial instruments that facilitate trading of non-domestic assets, and by the expansion of major international financial institutions via foreign branches and subsidiaries.

In the textbook world, these developments would promote greater efficiency in the allocation of capital by spreading the best techniques for the allocation of saving throughout the global financial system. They would enhance competition in what had previously been small and isolated markets. And they would allow savers, wherever they might be, to achieve greater diversification and hence reduced risk in their investment portfolio.

Although these gains of increased gross cross-border financial flows may have been partly realized, it is all too apparent that risk management at many levels was not up to the task of handling a global range of assets and trading.

Information was not shared sufficiently, either among regulators of different countries or by those packaging and selling assets with their customers. Assets that were labeled as high quality and safe were not reliably so. Regulatory differences across countries were not fully understood by those participating in the now-globalized markets.

Financial globalization brought increased speed, lower transactions costs, and rapid innovation to a world that was clearly second-best.