Guns, drugs, and financial innovation

Is there any difference between these, asks my latest column for Project Syndicate. All three provide private benefits (sometimes), but can cause havoc for the rest of us. Why do we approach regulation in each area so differently? (And how does Mark Thoma beat me to it every time, even when it is my own piece?)

Meanwhile, Carmen Reinhart and Ken Rogoff's new paper (summary here) makes the obvious but important point that financial globalization and financial crises are related. In their words, "Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically." Here is the picture that is words a thousand words.

Now what is important about this conclusion is that it runs counter to a growing piece of conventional wisdom in the academic literature, namely that there is no relationship between propensity to financial crisis and openness to foreign capital flows.  Rogoff himself (with co-authors) wrote in an earlier survey: "In sum, there is little formal empirical evidence to support the oft-cited claims that financial globalization in and of itself is responsible for the spate of financial crises that the world has seen over the last three decades." 

I think the difference may be between cross-sectional and historical evidence: the latter shows a close correlation, but this does not mean (perhaps) that the countries that experience the most crises during periods of high capital mobility are necessarily those that are financially the most open.  In any case, I find this a case of reason restored. 

(While I am on the subject, check out also the Fondad blog maintained by Jan Joost Teunissen which has an interesting discussion going on the current financial crisis.)

UPDATE: Carmen Reinhart writes to clarify her views:

In 1999, Graciela [Kaminsky] and I wrote in our twin crisis paper:

"Our results also yield an insight as to the links of crises with financial liberalization (Table 3). In 18 of the 26 banking crises studied here, the financial sector had been liberalized during the preceding five years, usually less. Only in a few cases in our sample countries, such as the early liberalization efforts of Brazil in 1975 and Mexico in 1974, was the liberalization not followed by financial sector stress. In the 1980s and 1990s most liberalization episodes have been associated with financial crises of varying severity. Only in a handful of countries (for instance, Canada which is not in the sample) did financial sector liberalization proceed smoothly. Indeed, the probability of a banking crisis (beginning) conditional on financial liberalization having taken place is higher than the unconditional probability of a banking crisis."

And to be clear, Rogoff's co-authors in the survey piece I referred to were Ayhan Kose, Eswar Prasad, and Shang-Jin Wei.

Comments

[Remy Piwowarski]

I believe that the reasons for financial crises seem to lie in bad governance: lack of transparency, lack of appropriate banking supervision, state interference into financial sector.

Not in openness...

The case of Asian countries may give some support to my opinion:

http://economicsinternational.blogspot.com/2007/09/phantom-menace-of-chinese-banking.html

***********

Remy Piwowarski
Executive Director
Economics International Open Forum
http://economicsinternational.blogspot.com/
House of Young Econ Wolves...

[Ricardo Hausmann]

I am sure Dani would agree that Silicon Valley venture capital, by allowing start-ups to be created and grow all the way to an IPO, is an incredibly productive financial innovation that no policymaker could have designed ex ante. One could say also many positive things about leasing and factoring and the list goes on and on. Financial innovation is part of the overall process of technological innovation that has been valuable throughout human history.

For example, according to Niall Ferguson, the 1688 Glorious allowed Great Britain to import from the Netherlands the institutions of trade credit and public debt that underpinned its subsequent growth. So, while there are costs to financial innovation, one does not want to belittle the benefits.

Crises also have an important information revelation angle. As emphasized by Chuck Sabel, Toyota through its just-in time approach, starved its production line of inventories not to save on parts and materials but to create mini-crises that would reveal defects in the existing production process and allow plant managers opportunities to improve on them, instead of hiding these deficiencies behind a mountain of inventories (or liquidity, if we apply the example to a bank).

A system that allows innovation in exchange for periodic crises may still be the best humans can achieve. Our objective should never be the elimination of financial crises - we can get there by prohibiting finance altogether - but to maximize the crisis-adjusted overall performance. So, the optimal outcome would involve some crises.
By the way, as crises go, this one is rather cheap. For a 14 trillion dollar economy, with financial assets several multiples of this figure, the current crisis, even at the high estimate of 1 trillion dollars is modest at best. There is a very big baby in that bathwater.

There is also the risk of regulatory failures not just market failures and these may well cause crises by themselves. Activist regulators may have rather peculiar objective functions and we should not dismiss the risks they bring with them. As a Venezuelan, I am keenly aware of them.

So, paraphrasing Forrest Gump, doo-doo happens. Life is like a box of chocolates.... Let us not close the door on its potentially promising surprises because of an excessive fear of disappointment.

[gordon]

Prof. Rodrik: "I think the difference may be between cross-sectional and historical evidence...".

Yes! There is a profound difference. Historical within-country experience isn't affected by all sorts of cultural and institutional National differences which confuse the outcomes of cross-country snapshots. YesYesYesYesYesYes!

[Publius]

Prof. Rodrik, would it be possible for you to post your thoughts on "Bad Samaritans," as well as any recent books (outside of your own, which I am reading...)

Who else is "getting it right," from your perspective?

[jared]

what about Naomi Klein's The Shock Doctrine, which shows how the Washington Consensus increases economic failures so that more drastic free market "cures" can be applied?

[Per Kurowski]

Well there are skeptics and skeptics. My point has always been that since risk is the oxygen of development, we need to be extremely careful with the limitations we put on risk taking. For instance what good would it do us manage to totally wrangle out risks from the financial sector but the financial sector does not do its job correctly?…and so that the last standing economic survivor is one huge world bank where we all have to work as economically efficient human alternatives to automated bank tellers?

Currently the only objective set up by the financial regulators and most specially by the bank regulators anchored on Basle, has been for the banks not to default… and I must say that to me sounds like a true purposeless objective. Sure we want more of our financial system.

A young entrepreneur with a good idea and lots of initiative but no financial backing will always find it more difficult o borrow money that someone who just wants to advance some consumption and has good earning prospects or other assets to guarantee his borrowing with. That is the market price for risk.

But, on top of that market premium for risk, as if it was not enough, our bank regulators have introduced, through the minimum capital requirements based on default risk as measured by the credit rating agencies, an additional tax on risk, a regulatory risk adverseness tax so to say.

We really have to start thinking again about a financial sector that produces more real sustainable results than the last western world growth cycle has to show for itself.

In that respect it would behoove us to think of risk more in terms of an element to be consumed in order to produce some other results than pure short-term profitability, like for instance units of risk of default per decent job created, per person educated or per environmental hazard avoided.

Additionally I have always said we need to measure the full boom-bust to find out the net results because focusing solely on the hangover (bank-crisis) will just keep us away from the parties.

[Franklin]

The financial innovation is one of the causes to create a boom, a "displacement" in Kindleberger´s words. And after the boom the crash is the next stage. The boom saw the seeds for the ensuing crash. This idea has been developed in an empirical framework in a working paper in university of Chile: http://www.bcentral.cl/conferencias-seminarios/seminarios/pdf/Agosin_Hauita_April2008.pdf
Professor Rodrik can be right when thinks the financial innovation could not be the last cause for the crises, probably a country which opened its financial account trasmited the sensation of new opportunities of investment to countries with similar features or in the same region, for this reason the capital flows to emerging countries in latin america and asia was moved in big amounts (surges and sudden stops) and in similar directions. It is tested in the paper.
This paper wil be presented in the IEA World Congress in june.

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