Designing Economic Policy for a Second-Best World (Part II)

The third argument for the real cause of the current crisis points the finger at the extraordinary growth of financial derivatives and the emergence of very complex structured products.

These have posed problems at the most basic levels of record keeping, clearing, and settlement.

Whereas they were advertised to be spreading and reducing risk, they actually made it possible for risk-taking to multiply — sometimes in ways not understood by those doing the transactions — through heightened leverage and the absence of regulatory oversight.

Complex derivative trades are able to transform the risk characteristics of a portfolio in an instant, and make it impossible for the management of financial institutions to remain informed and in control. A firm can be fine one week — and insolvent the next.

Once again, the textbooks would praise these financial innovations as offering savers and investors new and more refined ways to manage risk in an uncertain world. Derivative products allow investors to separate different elements of risk and to trade and price them accordingly.

Although in 2002 Warren Buffet referred to derivatives as "time bombs" and "financial weapons of mass destruction," Chairman Greenspan presented strong counterarguments for the benefit of derivatives in speeches in 2003 and in 2005. In those remarks, he acknowledged risks posed by derivatives but concluded that the benefits outweigh the costs/risks.

The existence of additional choices cannot force any trader to take on risks or any borrower to overextend himself. Additional choices can only make markets more "complete" and hence better able to deliver good outcomes. Yet, radical changes in the prices of some derivatives caught major institutions by surprise and forced governments to put together rescue packages. The ability to trade in certain markets for structured products suddenly ceased.

A variety of entities now face costly calls for collateral and possible bankruptcy because of derivative trades that were supposed to lessen their costs and enhance their business prospects.

Are the derivatives and new products themselves to blame? Or is it the second-best world, where information is costly, not free, and where incentives are not always properly aligned between investors and their intermediaries — leading to results not foreseen in the textbooks? Does complexity introduce the possibility of actual fraud? Are some calculations of risk beyond our analytical capability?

My conclusion is that the debate about the causes of the current crisis should not be conducted in the abstract or set in the world of perfect textbook markets. The debate should be grounded in real world markets with their shortcomings and imperfections. Likewise, the debate about policy measures to resolve the crisis or to prevent future crises should be pragmatic and empirically based.

It seems obvious that one step we should take is to try to improve legal and regulatory structures in order to move us more in the direction of the textbook ideal where possible. But we need to remember that economic theory tells us little about the wisdom or effectiveness of partially correcting a market imperfection in a second best world.

Nevertheless, it seems reasonable that we should think hard about the ways in which corporate governance practices and compensation systems contributed to the current crisis, and seek to improve them. We should look for ways in which the current regulatory structure failed to provide for sufficient capital or to limit risky behaviors so that the financial system is resilient when shocks inevitably occur. However, we must realize that we shall still be in a second-best world. Monetary policy should reflect the absence of true market perfection in our financial system.

It is impossible to know for sure how much we need to compromise on first-best principles at this time. It seems unwise, and maybe futile, to go so far as to put absolute limits on cross-border financial flows for the sake of keeping down the size of a potential problem.

And if rules intended to limit the size of gross financial flows are not appropriate, surely such rules for net financial flows will make no sense. It seems too costly in terms of the benefits forgone to try to prevent further financial innovation or to force financial markets to become slower or less complex.

As we tackle the problem of reform and crisis prevention, two insights do emerge from this discussion. One, we must acknowledge the complications posed by global economic and financial integration. Therefore, we must approach reform with a view to achieving some necessary consistency across countries. Such an approach seems to be underway on the part of the United States and other G-20 countries as they hold meetings to address the crisis.

Second, we must also acknowledge that the pace of change in financial markets and products has been rapid and is likely to continue to be. Therefore, we need a regulatory framework that evolves over time and that has sufficient resources to cope with growing demands.

As they consider the course of regulatory reform for the U.S. financial sector, Secretary Timothy Geithner, the administration and Congress need to beware of regulatory approaches that are based on unrealistic assumptions about perfect markets. They need to formulate regulations suited for the real world.