The crisis raises vital questions about the intellectual assumptions behind previous regulatory approaches
I recently attended a lecture on ‘Financial regulation in light of the crisis’ by Dr Raghuram Rajan of the University of Chicago and the US’ National Bureau of Economic Research (NBER), arranged by the Reserve Bank of India. As one would have expected from him, it was a polished and a well-reasoned presentation on issues of great relevance to financial markets in general and banking in particular. Inasmuch as Dr Rajan is a policy adviser to the prime minister, and has authored a report on the financial system in India, his views are obviously of great importance.
Dr Rajan lists the ‘meta’ causes of the crisis as follows:
* Insufficient global demand,
* Emerging market focus on export-led growth,
* Excessive willingness of the US to stimulate.
Incidentally, the Governor of RBI, in his JRD Tata Memorial Lecture (July 31), also said he considered global imbalances as the starting point of the ‘chain of causation … to the financial crisis’. He too blamed the ‘large savings and current-account surpluses in China and much of Asia’ for the global imbalances.
To me, this view does seem a US-centric rationalisation of what has happened — it makes it look like as if the US was forced into over-consuming. Dr Rajan claims that the Asian export-led growth put “the burden of demand stimulus on industrial countries”. This too, is questionable unless, in the list of industrial countries, one includes only the US and the UK, excluding surplus countries like Germany and Japan. Coming to the third ‘meta’ cause listed above, Dr Rajan argues “US led the way in fiscal and monetary stimulus to boost economic growth in 2001-2004”. This seems to overlook many actual causes for the loose monetary and fiscal policies. The dotcom bubble which was blown up by financial market (another glaring example of market excesses and malpractices) burst in early 2000, leading to cuts in interest rates to avoid a recession. Further cuts were made in the wake of 9/11. As for the fiscal deficits, these were the result of tax cuts for the rich and the hugely costly military misadventures in Afghanitan and Iraq. Clearly, these policies were not aimed at accommodating, or provoked by, Asian savings habits, which are now being blamed for the crisis. The contribution of Asia was that it kept inflation at a low level.
However, the loose monetary policy led to a sharp increase in housing prices: In the three decades to 2000, average house prices in US had increased at a compound annual rate of 1.4 per cent. The rate jumped to 7.6 per cent per annum from 2000 to mid-2006, thanks to low interest rates. Lenders, apparently believing that house prices have only one way to go, were only too ready to give a second and even a third mortgage ‘home equity’ loans to borrowers, encouraging over-consumption. And, the ‘originate and sell’ model of housing finance through securitisation led to weaker lending standards. In fact, Nobel laureate Joseph Stiglitz had been cautioning about the risk in securitising mortgages since 1990. Interestingly, Dr Rajan himself had drawn attention to some of these risks in 2005 — and so had Dr Nouriel Roubini of New York University. (Dr Rajan had, at that time, also raised concerns about the compensation practices in the financial sector.) These, and the laissez faire regulatory stance that have been popular in the US and the UK since the Thatcher-Reagan era, were the real causes underlying the crisis: It is wrong to argue the Asian savings habits as were the starting point for what has happened.
The Turner Review (March 2009) published by the UK’s Financial Services Authority (FSA), discusses the fundamental theoretical issues raised by the crisis. It argues that “…the crisis also raises important questions about the intellectual assumptions on which previous regulatory approaches have largely been built.
At the core of these assumptions has been the theory of efficient and rational markets. Five propositions with implications for regulatory approach have followed:
(i) Market prices are good indicators of rationally-evaluated economic value.
(ii) The development of securitised credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability.
(iii) The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk.
(iv) Market discipline can be used as an effective tool in constraining harmful risk taking.
(v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added.
Each of these assumptions is now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities.”
Unless the issues are diagnosed correctly, and the necessary lessons drawn, we could end up reaching completely wrong conclusions. In particular, it is idle to maintain that markets are efficient and establish prices reflecting ‘rationally-evaluated economic value’. (Incidentally, I remain a firm believer in the corollary: Markets are inherently unpredictable.) This issue has great relevance to the advocacy of floating exchange rates, a point that came up in Dr Rajan’s presentation and to which I will revert.
