The financial meltdown is now worldwide. Financial institutions have failed or are under severe pressure not only in the United States but in the United Kingdom, Belgium, the Netherlands, Germany, France, Italy, Ireland, Iceland, Russia, China, India, and still other nations. The turmoil began with falling prices for housing and for securities and derivatives backed by mortgages. But it is increasingly unanchored from those original causes. Herd behavior and self-fulfilling expectations are now threatening even healthy, adequately capitalized institutions. It is unhelpful to label such herd behavior “irrational.” In intense financial crises, individual actors behaving rationally, each trying to protect their own interests, can nonetheless generate a wretched collective outcome.
Because the crisis is worldwide, vigorous international cooperation is necessary to restore the normal operation of financial markets. Yet government officials and parliaments may not be able to act promptly (witness the difficulty in the United States of getting rescue legislation though the Congress). The burden of cooperative actions in the short run may therefore continue to fall on central banks. So far, central banks have consulted closely and acted aggressively to supply liquidity to the financial markets (backed up by increases in their swap lines with each other). That commendable and reassuring collaboration will have to be continued, even enhanced.
The turmoil in asset values could spread to exchange markets. Sudden, disorderly changes in exchange rates have not yet been observed on a significant scale. But central banks should have contingency plans for coping with such disorder if it were to occur. In normal times central banks are reluctant, correctly so, to engage in massive intervention in exchange markets. If contagion were to inflame the exchange markets and put severe pressure on individual currencies, however, central banks might be compelled to take aggressive action there too. Such cooperative intervention would entail central banks buying a currency judged to be under unwarranted attack, preventing its disruptive decline.
As the financial crisis has spread in Europe and Asia, the U.S. dollar has recently strengthened, not weakened, against the euro, the British pound, and the Japanese yen. Market transactions have been skittish but not disruptive. However, a further meltdown of American financial institutions and a surge of bearish expectations about American political and economic developments could conceivably turn market sentiment against the U.S. dollar, causing sudden selloffs of dollar-denominated assets by private foreigners. In the worst case, declines in confidence in the American economy could even intensify pessimistic judgments about the continued sustainability of the U.S. dollar’s use as a reserve currency. A sharply falling dollar, were it to happen, would sorely test central bank cooperation. Moreover, such cooperation might have to include not only those central banks who have already been supplying massive amounts of liquidity to financial markets but even the central banks of nations such as China, Russia, India, and Brazil that hold large amounts of dollar-denominated assets in their reserves. Judgments about exchange-market intervention – when might a currency be experiencing “unwarranted” attack? how to estimate an appropriate post-crisis valuation of the U.S. dollar against foreign currencies? – would be difficult and controversial. With luck, cooperating central banks will not need to make those judgments. But precautionary contingency planning is certainly in order.
Contingency consultations about coordinated reductions in policy-determined short-term interest rates should also be considered. Domestic goals and needs differ across the major countries. Given cross-border contagion and disruptive herd behavior, however, consultations among central banks leading to mutually-timed announcements of monetary-policy actions could help to restore confidence.
For the longer run, to reduce the probability of future crises, governments and central banks need jointly to improve world standards for prudential supervision and regulation of financial institutions. And greater cooperation will be needed to monitor and enforce those standards. Improvements will be slow. Yet genuine progress over the longer run is essential to achieve a healthier and more stable evolution of the world’s financial markets.
It is no more reasonable for nations to act independently in stemming financial crises and in prudentially supervising their financial institutions than it would be for one nation’s signalling codes at sea and in airspace to take no account of the signalling codes of other nations. International cooperation is an increasingly vital underpinning for nations’ economic activity and political governance.