Archive for August 26th, 2008

Blinder’s Dutch boy story retold

August 26, 2008

Kansas Fed Symposium papers have been put on the website. The conference going by its tradition has led to couple of superb papers. The paper which has led to most controversy is the one by Willem Buiter (a 141 page paper!!) and the discussion of the paper by Alan Blinder. Buiter thrashes Fed and Blinder defends it. I haven’t read Buiter’s paper (of course) and just read Blinder’s paper.

In this post, I would like to restate Blinder’s story of the Dutch Boy. Blinder’s version is:

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

Perhaps, You’ve have heard Fed’s an alternative version of this story. In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.

Here is my version of the story:

The little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. 

Meanwhile as the help too time to arrive, he remembered and wondered why such dikes keep being built. He had heard stories of such dikes being made time and time again and someone finding it and sticking his finger. Sometime the dikes were quite weak and the finger didn’t work and drowned everybody despite the best effort.  He had also heard the persons who built the dikes did not usually suffer as they had received the money and were building dikes elsewhere or enjoying the pay-offs (building their own castles away from the dikes).  He had even heard that if the flow of water was very strong it could destroy other dikes as well leading to big deluge. This made him nervous and wanting to withdraw the finger.

Then he also remebered, the dikes that were stronger and the finger helped, the person was hailed as a hero. So he just stuck it on hoping his dike is stronger.

Despite all this confusion, he kept thinking why the dikes kept on being built in such a manner….. He then related the problem to his school and realised that whenever he (or orhers) was punished he did not make the same mistake (or atleast tried his best to aviod it). So why did the dike buuilders not get punshed enough not to repeat the mistake again?

While thinking all this, the dike turned out to be weaker than expected….


Bernanke gives a reality check on systemwide regulation

August 26, 2008

Bernanke in his speech at Kansas Fed Symposium raises number of issues on financial stability and regulation. It is a pretty good speech highlighting issues related to the subject.

First, Fed’s response to the crisis:

The Federal Reserve’s response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year.

The second element of our response has been to offer liquidity support to the financial markets through a variety of collateralized lending program

The third element of our strategy encompasses a range of activities and initiatives undertaken in our role as financial regulator and supervisor

As first two have been discussed at numerous forums, Bernanke focuses on third as that is also the topic of the conference.

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe “financial infrastructure” very broadly, to include not only the “hardware” components of that infrastructure–the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions–but also the associated “software,” including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction.

This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the “hardware” and the “software” components

Financial regulation has always been scoffed at and this is dfficult to understand as regulation has been pretty effectivein other markets. Financial markets need better regualtion as information asymmetry is much higher here compared to other markets. Bernanke then discusses how to strengthen the finacnial infrastructure.

One suggestion which has emerged from the crisis is that regualtors need to look at systemwide risk and not just a  firm specific risk. So far, regulators just look at individual firms and act only if individual firms are in trouble.

The integration of financial markets imply though individually firms may be fine but when analyses from a systemwide perspective they could pose high risks. This has been suggested by BIS for quite some time now but has been ignored. In the subprime crisis it was felt that Banks were in good shape as they had adequate capital cushions but we still had a systemwide crisis. Hence the focus on systemwide implications (also called macroprudential regulations) is increasing.

Bernanke says:

Going forward, a critical question for regulators and supervisors is what their appropriate “field of vision” should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

At least informally, financial regulation and supervision in the United States already include some macroprudential elements. …..For example, following lengthy comment periods, in 2006, the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending

And then he provides a reality check:

 Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise. It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions. International regulatory coordination, already quite extensive, would need to be expanded further.

Macroprudential supervision also presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, as such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that financial crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more, rather than less, likely.

This is pretty useful reality check by Bernanke. I had not really thought about the costs and difficulty associated with assessing systemwide risks. Though, regulation is needed we have a number of issues to be sorted out. This area of financial regulation requires urgent attention. 

For long we have discussed financial regulation from a design perspective – principles based vs rules based or single regulators vs multiple regulators. What is needed now is to understand it from a functional perspective and get the basics right. Otherwise, either we would stifle financial innovation (markets) or would have too many crisis.

Understanding India’s Political economy

August 26, 2008

One seldom comes across different papers on Indian economic system (IES). There are usual papers – India’s growth prospects, the need to reform India’s financial markets, the need for reforms etc. We still don’t know so much about Indian economic system- like labor markets, the legal system, property rights etc (for each we know we need to reform it). I am unaware of different papers on IES and would be great if the readers could point to a few.

I came across this superb paper by Sadiq Ahmed and Ashutosh Varshney on Indian political economy. It is a wonderful read and discusses the nuances of how political decisions are taken, what shapes these decisions, relation with economics etc.

The authors first discuss the growth trends growth composition, states performance, poverty etc in India. They then ask:

  • How exactly does the policy process operate in India?
  • How did the transformation in policies begin to come about in the 1980s and pick up momentum in 1991?
  • Why was the economic strategy not changed earlier despite a long period of low growth?
  • What role did leaders play in ushering change? How did they learn what was wrong and, more importantly, how to set things right?
  • Why did they change some policies (investment, trade, exchange rate), but not others especially labor laws)?
  • Why has growth rates of different states diverged so much in the second period?
  • Finally, moving forward, inclusiveness is a critical issue, especially as urban-rural, interpersonal, and regional inequalities have grown. Are the decision makers thinking about inclusiveness?

The authors then seek answers and this is what makes a fascinating reading. I can’t discuss the entire paper….Wull just point to a few interesting points:

Surprising as it may seem, economic issues and policies have generally not made, or unmade, governments in India. On the whole, economics does not determine India’s election results. The sole exception is inflation.

Why should this be? Read this:

The concept of master narratives of politics also makes clear where economic policy belongs in India’s political space. Religion and caste have dominated mass politics in India; economic policy has basically been a contentious matter in elite politics (Varshney 2000a and 2007).

What are the key differences between mass politics and elite politics? The primary arena of mass politics is the street and the ballot box.

The major theaters of elite politics are the English language press, the Internet, university seminars, corporate conferences, and the corridors of power, where corporate executives, officials of the international financial institutions, foreign government representatives, and lobbies meet with the bureaucrats and politicians.

Negotiations, discussions, and bargaining are the typical forms of elite politics. Voting, agitations, protests, and demonstrations are the principal forms for mass politics; riots are also sometimes a key element. Only occasionally disrupted by mass agitations and protests, authoritarian polities are normally driven by elite politics.

This is so true. So how do mass politics decide when to oppose or let go of a policy?

Three factors are typically critical: (a) how many people are affected by the policy, (b) how organized they are, and (c) whether the effect is direct and short-run, or indirect and long-run. The more direct the effect of a policy, the more people are affected by it and the more organized they are, the greater the potential for mass politics. Underlying, long-run, and indirect links do not flourish in mass politics where the basic message has to be simple, intuitive, clearly demonstrable, and capable of arousing mass action.

This explains why only inflation is a matter of concern:

Within economic policy, following this reasoning, some issues are more likely to arouse mass contestation than others. For example, inflation, by affecting more or less everybody except those whose salaries are inflation indexed, quickly becomes part of mass politics. Privatization, a change in labor laws, withdrawal of agricultural subsidies, and reforming the reservation policy for small-scale industry also have similar properties. Either a large number of people are negatively affected in the short run (agriculture and small-scale industry), or those so affected, even when not in large numbers, are well organized in unions (privatization and labor laws).

And this also explains why certain reforms go through:

Contrariwise, stock markets directly affect the shareholders, whose numbers are not likely to be large, and who are also not likely to be organized, in a poor country. As a result, short of a financial collapse, stock market fluctuations and the developments in the capital markets rarely, if ever, arouse mass politics in less developed countries. Similarly, overhauling industrial investment rules— delicensing—concern primarily the investor, foreign and indigenous. Their numbers are also typically small. Since 1991, India’s reformers have achieved their greatest success in reforming capital markets and investment regimes.

if trade is a small part of the economy, as has been true of India and Brazil historically, changes in trade and exchange rate regimes remain peripheral to the mass concerns. In 1991, India’s trade/GDP  ratio was a mere 15 percent. Of late, this ratio has been rising rapidly, nearing 35–38 percent. Trade is likely to be a matter of mass contestation before long.

This is precisely the point I keep making. Max reforms have taken place in financial markets and the elites want more of it. There is hardly any movement in other reforms and duo make a good point why this is so….

The authors then go on and discuss the political economy in a timeline and the impact etc.

Overall A fantastic paper. Highly recommended.

Assorted Links

August 26, 2008

1. JRV points to the much discussed Buiter paper

2. WSJ Blog points to a Fed paper that supports usage of core inflation

3. IDB on NREGA and India’s Education gap

4. NB on why employers cut jobs not wages during recession

5. PSD Blog on creative capitalism.

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