by Ricardo Hausmann, guest blogger
The discussion about avoiding a repetition of the current financial crisis has centered on the potential role of financial regulation. Hank Paulson announced on March 31 an organizational overhaul of the financial regulatory agencies. This seems more about process than substance, as argued by Paul Krugman. Many, inter alia Martin Wolf, argue that if the Fed’s safety net is extended beyond commercial banks to other market participants, prudential regulation should also be extended to avoid moral hazard. Those that argue in this direction may have a point. But it is hard to see how the kind of financial regulation that would be called for would have avoided the current crisis. At best it would reduce the risk of an even bigger future crisis caused by the impact of the precedent of the Bear Stearn rescue on future financial players. But the current crisis occurred in spite of the fact that current players could not have had the certainty of a rescue. And the crisis still took place. I believe that financial regulation is the wrong place to focus the policy discussion about the causes of the current crisis. It is macro policy, not financial policy that needs to be at center stage.
I propose we engage in the following counter-factual scenario. Let us suppose that more stringent financial regulations had been adopted in 2003 or some such date. Let us discuss two macroeconomic scenarios.
Consider first the case where the Fed would have set the same interest rates as we observe in the historical record. In this case, the new regulations would have lead to a smaller rate of credit expansion because the regulations would have meant that, for any interest rate set by the Fed, the market for credit would have been smaller. Presumably, there would have been less mortgage lending, fewer home equity loans and less junk mail offering zero percent loans on credit cards. Aggregate demand would have been lower and presumably so would have been the rate of growth, the level of employment, the inflation rate and the current account deficit.
Now, consider the alternative scenario in which the FOMC would have set interest rates following the way monetary policy is conducted, with the same inflation and employment targets. What would have been the consequences of this alternative and more plausible financial scenario?
Obviously, the Fed would have lowered interest rates until the amount of lending required by the inflation and employment targets had been achieved. The financial system would have been asked to find other ways to expand credit.
Maybe, that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But I am not so sure that this would have been the case. With the even lower level of real interest rates, the incentives for financial engineers to invent new instruments that could be placed in large numbers would have been enormous and many more bright minds would have been hard at work at circumventing the new regulations than those that had crafted them.
My bottom line is that it is impossible to discuss the lessons of this crisis without talking about macro policy. I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households.
In the end, it is hard to believe that a macro policy that overshoots the sustainable growth rate by encouraging millions of citizens to over-borrow is going to be made safe through financial regulation.