How should policymakers signal/communicate in times of fin crisis?

(* This is a longish article)


The crisis is being analyzed from all possible angles and will take its own time to be resolved. However, one thing which comes across in this crisis is – how should policymakers signal about the financial crisis to financial market participants and the public in general?


It has often been seen that markets react differently to a policy response. Infact, whenever policies have been announced to support markets, equity markets have declined and credit spreads have widened. Moreover, we all know that financial crises are here to stay and this is neither the first nor the last financial crisis to impact mother earth. So, if we are discussing on mechanics of financial crisis we should also be discussing how should policymakers signal/communicate to the public in times of crisis.



Before some specifics, let us look at some economic theory. In 1970, research on information economics picked up (thanks to George Akerlof) with papers showing how information asymmetry affected various markets. However, little work showed how asymmetry could be reduced. Michael Spence in his research showed how parties can reduce information asymmetry by providing appropriate signals. Signaling has since been used to convey useful information about itself (about actions, views etc.) to another party usually via indirect modes of communication. The indirect modes could be a press releases, speeches, statements etc.


Spence developed his main idea on the job market with employees showing their productivity by signalling their education qualifications to the perspective employer. The importance of education is now an accepted norm for employee evaluation. Signalling concept is now used in all spheres of life e.g. political parties provide signals that if this candidate is elected following actions will be done, firms use advertising as a signal to show quality of products. It has been used to explain various ideas in financial economics – e.g. why firms buy-back shares, takeover decisions etc. (see this excellent Riley paper who covers 25 years of signalling)


Another field where signaling has been very useful and deserves a separate mention is –policymaking and communicating the same to public. Research has shown how policies are more effective when government signals its intentions to be serious about its policy actions. Dani Rodrik in a paper showed a government can get better aid terms if it can signal its seriousness to the aid-givers. The signal according to Rodrik is the reform process and the more serious the government is, the better are its chances of receiving aid and distinguishing itself from other non-serious countries.


Within policies, signaling has been used very effectively by central banks. The Central banks provide signals via press statements, speeches, etc and try and influence asset markets, exchange rates (in June Bernanke gave a speech which led to strengthening of the USD only to be reversed by Trichet a few days later) etc.


Research has shown that the best performing central banks are those who they signal their inflation fighting intentions to the public well in advance. This builds credibility of the central banks and lowers inflation expectations leading to lower inflation. The much success of inflation targeting central banks (though limited) comes from the fact that a target provides a signal to the people that the central bank will fight inflation come what may. Even non inflation-targeting central banks like Fed have been successful to keep low inflation as they provide signals that they would fight inflation no matter the situation.


However, little has been done to signal to the public in times of financial crisis. In financial crisis information asymmetry gets worse with counterparties not trusting each other. This leads to chaos with rumors and speculations worsening the situation. This has led developed economies policymakers to take steps like banning short-selling. There are 2 broad signaling approaches- one, reveal the true extent of the crisis upfront and suggest policies to overcome them (as Sweden did in its 1992 crisis). Two, take policy steps as the crisis shapes up (just like US has done in this crisis). The advantage with first approach is a disadvantage with second approach. In first, advantage is it leads to admission of the problem curbing speculations and rumors; disadvantage – one needs to be sure of the losses otherwise the plan backfires. With second, advantage is one can make polices as the crisis unfolds; disadvantage – public is never sure of what is coming next leading to speculations.


Hence, one is never sure of which approach to take and the result is for all to see. We see plans after plans being rejected by the financial markets/public. The central banks have had to cut rates higher than expectations just to provide relief to markets. The crisis is global and public is seeking consistency in the policy responses. The public easily sees the divergence and continues to respond negatively.


Apart from signaling, what is needed is to apply lessons from behavioral economics. Hungary Central bank Chief said:


There is totally irrational behavior and malicious gossip on the market. I can give you an example of the gossip: ‘Hungarian banks have Icelandic exposure’ — come on, this is a joke.

In today’s world you need a psychologist and not an economist to understand markets. When these things are happening you have to take every possible precaution to protect yourself, it doesn’t matter whether it’s logical or not logical.

One can see some lessons being applied already. New Zealand used an opt-in default strategy where banks had to choose to be part of the deposit guarantee program. The opposite is opt-out under which all banks would have been covered and if a bank didn’t want it could have opted out from the scheme. The main reason could be that NZ wanted to provide the signal that its banking and financial system is safe and it does not see any bank being affected. The same strategy backfired in Germany. German banks were in a worse shape, but if they opted for the scheme it would have sent the signal of its bad position to markets. As a result German Banks suffered. The same problem was also seen in Discount rate facility of Fed with no participant wanting to opt for it. As a result a separate facility called Term Auction Facility was used. Alternatively, in UK and France opt-out strategy of bank re-capitalisation was enforced.


To conclude, apart from debates on optimal policy responses we need to also focus on signaling and behavioral economics during the crisis. There is little research and awareness of the matter. May be we can ask Michael Spence (along with Daniel Kahnemann, Richard Thaler ) to step out from Growth Commission and help guide policymakers on this matter. This would help the cause of Growth Commission, as with frequent financial crisis, sustained growth is only likely to suffer.

One Response to “How should policymakers signal/communicate in times of fin crisis?”

  1. An insight into US Treasury fire-fighting policies « Mostly Economics Says:

    […] had written a very detailed post on the same issue a while back. The main challenge for policymakers remains to fight the crisis but […]

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