Changes in policy thinking forced by the crisis

Martin Redrado, Governor of the Central Bank of Argentina spoke on 'Where is global finance heading?Status of the international monetary system and the stake of emerging economies'.

Some interesting points made by him :

* For the first time in recent decades, the emerging world is not at the epicenter of a financial crisis. We, developing economies, were “learners of first resort” that financial stability is a prominent goal for central banks. And, what is most important on the way forward, we are meant to be both the engine of the world economy but also to share the driver’s seat, which is a bigger role that comes with bigger responsibilities.

* Latin America is also playing a growing role in the world economy by being a factor of stability as opposed to what happened in other times in history. Definitely, the region has been better prepared to face this crisis both when comparing with history and with the way other emerging markets are being affected.

* Speaking about financial stability, in my opinion, one of the key structural changes in economic policy is that financial stability is now ranking higher on every central bank goals worldwide. ... ..

* In this regard, the economic literature is lagging behind. If the relationship between economic theory and policy recommendations is reasonably well defined during “normal” times, in times of turmoil, this relationship becomes much weaker. We have reached a point in which economic theory is having a hard time keeping up with praxis. Literature has shown results that are ambiguous or contrary to those produced by the usual “technology”, especially in relation to the approach that relies on the interest rate as the single instrument. Same applies to managed floating exchange rate regimes. Recent empirical papers that refined the analysis started by several academics argue against sharp fluctuations in the domestic currency. Instead, mitigating excessive volatility, especially in developing countries with rather shallow capital markets and limited access to hedging, seems to be an appropriate policy.

This kind of monetary and financial framework that ensures systemic stability has been my main task during the last years. This means giving priority to avoiding "the next crisis" and building buffers to minimize the effects of disruptions. In my country, the decades of macroeconomic instability and recurrent crises were not harmless in terms of welfare.

RBI fans

Reserve Bank of India has come out vindicated in its 'conservative' approach during the boom years. Remembered that again today with the Business Standard's piece by Jamal Mecklai on the coming of age of the Indian rupee.

Here are a couple of links in praise of the RBI and former Governor Reddy.

This one by TCA Srinivasa Raghavan when the Turner Report came out

and this one in the New York Times last December on How India avoided a crisis

Both go to show how context matters in policy and regulation.

I had also written a piece in Financial Express a couple of months back explaining the foreign bank branch licencing policy as well, main conclusion being:

... is the branch authorisation policy really liberal or is RBI being a stick in the mud? The answer lies in the emphasis on ‘reciprocity’. According to the US 2009 National Trade Estimate Report of Foreign Trade Barriers, “Under India’s branch authorisation policy, foreign banks are required to submit their internal branch expansion plans on an annual basis, but their ability to expand is severely limited by nontransparent quotas on branch office expansion.’

However, in a speech to the Bankers Conference in 2007, RBI deputy governor, V Leeladhar stated that between 2003 and 2007, 75 branch licences had been given to foreign banks, out of which 19 were for US-based banks. Yet, during the same period, the US had not authorised any expansion of Indian banks, despite requests for 3 branches, 2 subsidiaries and 9 representative offices, some of which were pending for more than 5 years.

This tu tu main main is a hallmark of reciprocal access negotiations, but just goes to show that there are ample grey areas, even in something that may seem so simple as branch authorisation.

Curbing instability

Another insightful piece by Axel Leijonhufvud, available at CEPR

Titled Curbing Instability: Policy and Regulation, it begins with pointing out the crux of the problem:

...modern macroeconomics presumes that the economybehaves like a stable general equilibrium system. If problems arise in such a system it can only be due to ‘frictions’ or ‘imperfections’ of the sort just mentioned. Once these issues are analyzed, therefore, the macroeconomist would have nothing to add.

This modern macroeconomics is wrong. If it were even roughly right, none of the desperate, improvised ‘non-standard measures’ by treasuries and central banks aimed at preventing unstable processes from overwhelming the markets would have been needed. All traditions of central banking have been abandoned and every line of demarcation between central banks and treasuries transgressed in the last 20 months. It is not to overcome ‘frictions’ that the authorities have been pouring trillions of dollars, pounds and euros into the world economy.

Axel's paper takes on a very different macroeconomic perspective and focuses on the instabilities of the system that the crisis has revealed.

There are Three points of instability:

1. Potential instability of the price level under present arrangements.
2. Instability of system-wide leverage.
3. Increased global connectivity of the system and the lack of any clear boundary for the responsibilities of central banks.

Once this is understood the prescriptions become clearer, though may not be palatable to the finance guys.

Economists of Tomorrow

Very good paper by Alan Freeman, read it here : Titled the Economists of Tomorrow, it talks of what kind of ideas do we want to spread in our economics courses and departments – The Abstract: It argues that a pluralist subject benchmark, derived from a pluralist code of conduct, is a prerequisite for the reform of the profession. Critical, pluralistic and independent thinking should be the primary requirement good economic practice, and specific provisions should be made to recognize, promote, defend and guarantee this good practice in teaching and assessment alike. This is needed because of what Colander et al (2008) term the “systemic failure” of economics –the profession’s inability, taken as a whole, to anticipate and understand the financial crash and recession of 2008. This exposes a deep-seated weakness in economics: systemic failure requires a systemic solution. The paper explains how the built-in tendency of the economic profession to select for conformity has led to its regulatory capture. Existing UK benchmarks have substituted peer-ranking – the appointment of judges selected for conformity – for collaborative peer review – the pluralistic integration of the strengths of the academic community. This past practice has become institutionalized at every level. The profoundly non-scientific practice of simply reproducing a politically acceptable consensus has thereby replaced the independent and critical pursuit of knowledge as the primary peer-recognized hallmark of quality. Tomorrow’s economists need to be defended against the systemic failure of the economics of today. This requires a conscious regulatory intervention – benchmarking for pluralism.

Parts of the paper that I liked best: The “good economist” of the future must do the diametric opposite of what her or his teachers have done. She or he must accept, entertain, and encourage difference and controversy; jettisoning the simple repetition of canon or doctrine in favour of critical independence which challenges and questions all received wisdom. Such capacities will develop only if the starting point is a recognition which economics has yet to achieve – that it contains more than one approach, more than one theory, and more than one proposed solution, to every problem it faces. Pluralism is the recognition of this fact. Pluralism draws on a lost economic tradition: controversy. The fertile currents which renew it flow both from the theoretical legacy of economic thought, and from the new and creative ideas, on such issues as feminist economics, sustainable economics, cultural economics, behavioural economics, financialisation, new trade theory and new labour market theory, which have emerged over the past forty years. Such thinking has matured, gaining vitality and confidence, in proportion to its marginalisation by the mainstream. Pluralism’s sweep extends to the beginning of economics, including both thinkers once lionised and since discarded, and also numerous thinkers whose ideas were rejected before being claimed as seminal. It includes intellectual giants, in a spectrum from left to right, whose work even when invoked is cited with zero regard for what was actually said, and including, for example, Friedrich Hayek, John Maynard Keynes, Rosa Luxemburg, Karl Marx, Carl Menger, Hyman Minsky, Karl Polanyi, Joseph Schumpeter, and Thorstein Veblen. How are these alternatives to be placed at the disposal of tomorrow’s economists? Not, we insist, by replacing the present canon with any one of them. Economics over the decades has become used to the idea that progress consists simply of replacing one canon with another. Pluralism is a break with the entire conception that the state of economic knowledge at any given time may be encompassed in a single canon, doctrine, or dogma. It defines economics – in line with the other social sciences – as the co-existence of multiple theories, none of which is taken to be definitively true or false until, and unless, the evidence has accumulated to prove or disprove it.