On the Record

The Stability of Global Financial Markets

Lex Rieffel

Q. It is a troubling time for the global economy. Financial markets are on edge and experts are talking about recession in the U.S. economy. What are the biggest threats right now?

A. The biggest threat is fear of the unknown. We are coming out of a period of exceptional global economic expansion. Just when we were getting used to the idea that it could continue forever, things started going wrong. Now all bets are off. One day it looks like the worst is behind us and the next day another piece of news sends markets into a tailspin.

Three major uncertainties are the losses yet to come in the financial system, inflation, and the U.S. election.

The wizards in the world’s leading banks and nonbank financial institutions got carried away with their magic. Not just bankers, but also lawyers and accountants and fund managers. Ordinary people are also to blame for believing the magic, for forgetting the age-old wisdom of “caveat emptor.” Just look at the label “subprime mortgage;” it advertises a borrower who is not creditworthy. As always happens, there is now an over-reaction. Nobody wants to lend to anybody. The people with money are waiting for prices to drop further. There are no good precedents for what is happening now, because it is such a global phenomenon. But there are good reasons for expecting a sense of stability in the international financial system to return toward the end of this year.

Inflation is washing over the world and stopping it will not be easy or pretty. It has multiple causes, including rapid economic growth in countries with large populations such as China and India. The classic method of stopping inflation is to discourage consumption and investment by raising interest rates so households and businesses save more and spend less. But this is an indirect and rather unpredictable process, especially when there is as much turmoil in the financial system as we have now. An earlier and deeper recession would cure inflation faster, but the political forces this time appear to favor a shallow recession and more inflation.

The media are devoting a lot of attention to the presidential election campaign in the United States but few commentators have highlighted the link between this campaign and the global economy. Without question it is an important factor in market psychology everywhere. All market participants expect significant policy changes in January 2009: on the wars in Iraq and Afghanistan, on global warming, on regulating financial institutions, and so much more. As soon as the Democratic nominee has been selected, a major uncertainty will be removed. As Election Day in November approaches, polls will point to the likely winner and the policies of the next president will start coming into focus. The stabilizing impact of the election, especially if the winner gets a strong mandate, should not be discounted.

Q. How did the mess in the financial markets happen? Aren’t supervisors like the Federal Reserve supposed to be protecting our country from disasters like the S&L crisis at the end of the 1980s? Will this one be bigger?

A. Last summer’s crisis, sadly, had much in common with other crises. A kind of race was going on. One team consisted of banks and nonbank financial institutions selling innovative products to investors who accepted the claims that the risks were low and the rewards high. The other team consisted of the financial sector regulators. In some countries, like the U.K., there is one regulator for the whole financial system. In the United States, for historic reasons, we have an exceptionally large number of separate agencies regulating and supervising the financial sector. The regulators lost the race; the financial hucksters ran right over the edge of a cliff.

The United States strengthened financial sector regulation and supervision substantially after the S&L crisis, but the United States also “liberalized” the sector so that it could be competitive globally. The center of the financial world was starting to move away from New York and toward Europe, especially London, because banks abroad had more scope to innovate. There were compelling reasons for the United States to give up the restraints on banking that were imposed in the Great Depression. It was the right policy choice. Moreover, the Federal Reserve and the Treasury Department understood that regulation and supervision would have to be strengthened and believed they were staying on top of the situation.

Author

Financial sector regulation and supervision is extremely difficult to do well, however. It requires a very delicate balance. Risk-taking by financial firms is absolutely critical to the process of economic growth in the modern world. Excessive regulation and supervision can clearly be an impediment to growth. The hard part is adapting regulation and supervision to the rapid changes taking place in every sector.

The current crisis has exposed the weakness of the framework of financial sector regulation and supervision that exists in the United States. The case for consolidating some of the disparate agencies, as proposed by the Treasury Department, is solid. The devil, as always, is in the details. And there is no “right” or “perfect” solution.

Regulation and supervision of the insurance sector will be one of the hardest to get right. Currently it is a state responsibility, not a federal one. We have 50 insurance regulators. There are solid constitutional arguments for this arrangement, but there are equally strong efficiency arguments for a single nation-wide framework for regulating and supervising the insurance business.

Unfortunately, the current crisis shows every sign of being bigger than the S&L crisis, and one of the lessons of past crises is that the losses almost always end up being larger than the initial estimates. It would be a mistake, however, to hastily impose sweeping restrictions on financial firms. It would be like closing the barn doors after the cows have escaped.

Q. Are there any global economic issues that you believe are being over-hyped?

A. Yes. Sovereign wealth funds, but a better term for this class of funds would be “sovereign investment funds.” They are not a major threat for two reasons. First, the most prominent of these funds, such as those of China and Russia, are closely linked to the very large global payment imbalances that now exist. These imbalances are not sustainable. As the balance-of-payment surpluses of these countries come down, and as they stop intervening to prevent their currencies from appreciating, the flow of cash into the sovereign wealth funds will diminish. This process could happen quite rapidly and at some point within the next five years could even reverse. Second, the term masks a great variety of institutional arrangements. In the long term, the most important variety is likely to be government-controlled pension funds. For obvious reasons, the managers of pension funds will be relatively risk-averse, which means they will have to place a substantial fraction of their portfolios in low-risk assets such as long-term government bonds and highly-rated corporate bonds. Over time, the weight of pension funds controlled by governments around the world in the universe of so-called sovereign wealth funds will increase and eventually dominate. The weight of what might better be called “sovereign slush funds”, seeking high yields by accepting high risks and sometimes being guided by political criteria, will decline.

Q. What has led to the rise in commodity prices, including food, and will the impact on developing countries be different from the impact on developed countries?

A. An overly simplistic answer is that rising fuel prices prompted farmers to shift production out of food grains into biofuel crops, which led to a shortage of staples such as rice and wheat and corn. A fuller explanation would have to address why fuel production has not risen enough to meet demand, the extent to which government subsidies are contributing to the shift into biofuel crops, and how rising incomes in big emerging market countries like China and India are associated with rising meat consumption.

The competition between food grains and biofuel crops is likely to remain intense for another generation or two. Political pressures will undoubtedly favor food grain production but probably not enough to bring food prices down to the levels enjoyed during the past 10-20 years.

The developed (mature market) countries have three large advantages in the meeting the food needs of their populations: their populations are growing more slowly, they have better land and water resources, and food is a much smaller portion of household expenditures. The developing (emerging market) countries will face great policy challenges in this area, especially as their political systems become more democratic and therefore more subject to consumer pressures.

For non-food commodities, especially oil and gas and metals, the emerging market countries appear to have an advantage over the mature market countries that they will be able to maintain for many years. The size of the advantage will depend greatly on the pace of technological change.

In both areas, however, the openness of the global trading system will be a critical factor. The present degree of openness provides substantial benefits to all participants. Greater openness is probably not necessary to support well-distributed global growth in the medium-term. However, further steps to restrict trade, such as the limits on food exports recently imposed by a number of countries, could become a serious threat to growth in both emerging market and mature market countries.