The subprime crisis is a massive failure of the shadow banking system that has affected all corners of the capital market and triggered worldwide deleveraging. We are in a severe credit crunch. Savers distrust private-sector dissavers, which gives rise to a fall in aggregate demand and a search for safe assets (“flight to quality”).
Therefore, the first priority should be to increase credit to the private sector. The trouble is that the process of deleveraging – partly explained by the virtual disappearance of investment banks – induces banks to lower their risk exposure. This is evident in the failure to produce noticeable credit expansion, despite bank recapitalisation and the US Federal Reserve’s absorption of commercial paper. Moreover, the credit crunch depresses asset prices and further discourages credit expansion, launching the economy into a vicious cycle.
Fiscal stimulus packages are second-best. These packages can help restore liquidity in the private sector and consequently increase capacity utilisation and employment. But rapid effects are unlikely, because output is credit-constrained and liquidity accumulation is time-consuming. Thus, solutions should aim directly at restoring credit availability.
Credit availability is not ensured by stricter financial regulation. In fact, it can be counterproductive unless it is accompanied by the establishment of a lender of last resort (LOLR) that radically softens the severity of financial crisis by providing timely credit lines. With that aim in mind, the 20th century saw the creation of national or regional central banks in charge of a subset of the capital market. It has now become apparent that the realm of existing central banks is very limited and the world has no institution that fulfils the necessary global role. The IMF is moving in that direction, but it is still too small and too limited to adequately do so. If, as in the past, IMF lending is tied to elaborate conditionality, it may be also too slow.
What would have happened if the subprime crisis had been met by an effective global central bank that could quickly provide liquidity to the shadow banking system? My conjecture is that the crisis would still have taken place, but its impact, especially on the real economy, would have been much less serious. Granted, effective central banks could give rise to moral hazard, but the latter is best attacked with a good financial regulatory system.
Financial regulation and the lender of last resort
Financial regulation without a lender of last resort has dubious value. In the limit, crises could be avoided by sheer regulations that paralyse financial intermediation and, thus, growth. One concern is that current discussion seems to be obsessed with the design of new regulations that would have prevented the subprime debacle. Typically, politicians look back, fight the last war, and strive to fix superficial defects – seemingly motivated by vendetta rather than deep understanding of the reasons why market failure in a small segment of the economy morphed into the worst global crisis since the 1930s.
Therefore, the first proposal that I would like to make is that the topic of financial regulation should be discussed together with the issue of a global lender of last resort. This is a major issue and I will not attempt to give a full road map here. Generating a full-fledged global LOLR will take time, but there are intermediate steps that are worth exploring. For emerging markets, for example, I proposed the creation of an Emerging Markets Fund (EMF), which would help stabilise their bond prices and insulate them from financial contagion.1 But the lender of last resort issue is so delicate and central that it may require a fundamental overhaul of the foreign-exchange system.
I doubt that unbridled floating exchange rates could be sustained in a new global system in which there is a much greater role for the public sector (in the form of a global LOLR and regulations). Moreover, large devaluations, which are a natural counterpart to flights to quality, could be detrimental to global coordination and cooperation by raising suspicions that they may be prompted by beggar-thy-neighbour motives. To be sure, these suspicions existed prior to current crisis and, as a general rule, do not seem to have had a major impact on international relations or trade in advanced economies.2 However, conditions have changed – finance will not be so readily available to smooth out the effects of large devaluations. Consequently, damage inflicted by large devaluations is likely to be more severe. Policymakers will likely find it harder to ignore them, because their effects will become easily apparent to the general public.
International financial institutions and sudden stops
The second point that I would like to make is that international financial institutions must be quickly endowed with considerably more firepower to help emerging economies through the deleveraging period. Recent experience with systemic financial crises shows that emerging markets can fall prey to sudden stops (of capital inflows) even though solvency is not at stake. In August 1998, for example, the emerging market bond market was hit across the board after the Russian default, despite the fact that Russia represented less than 1% of world output and was not a global financial centre. Like now, the spread of the crisis was attributable to a failure in the international capital market. World depression did not materialise because capital flows were channelled mostly to the US (and arguably sowed the seeds of the dotcoms and subprime crises), but in Latin America, for example, growth stopped for several years. Emerging markets in Asia and Latin America learned the lesson and sought protection in sizable accumulation of international reserves and stronger fiscal and external accounts.3 However, liquidity crises do not distinguish much between saints and sinners. The consequences could be severe and hard to reverse. Sudden stops bring about large and largely unexpected changes in relative prices, causing serious domestic financial turmoil to the point of occasionally obliterating the domestic payments system (e.g., Argentina 2002). These factors are politically destabilising and enhance policy uncertainty, which puts a serious brake on recovery by jeopardising the stability of the rules of the game.
Effectively coping with liquidity crises requires that economies have rapid access to sums that are sufficient to meet short-term financial obligations, e.g., debt amortisations, and avoid a major collapse in aggregate demand. For example, a recent report on Latin America, focusing on debt amortisation and fiscal needs, estimates are that the region may need around $250 billion in the event of a sudden stop.4 For Africa, Eastern Europe, and Latin America, another report focusing on funds required to keep investment at pre-sudden-stop levels – and ignoring factors stressed by the previous report – concludes that this region’s needs might exceed $300 billion.5
These sums are large in comparison with recent lending by international financial institutions to those regions. Moreover, prior to the present crisis, loans of rapid disbursal were practically non-existent. Several international financial institutions are actively devising new financial facilities to meet these needs, but a tentative assessment leads me to think that current plans may fall short of generating the necessary funds. Fortunately, several emerging markets in Asia and Latin America have accumulated a sizable stock of international reserves. But spending those reserves could trigger a confidence crisis. Therefore, even under those happy circumstances, it would be useful to have rapid access to international liquidity facilities.
One thing should be clear: liquidity funding need not be disbursed. If the sums or implicit loan guarantees are large enough, the private sector may provide the necessary finance. Insufficient funding may generate the worst of all worlds: the private sector will not participate, countries will be forced to get access to the international financial institutions’ facilities and, since funding will be insufficient, a sudden stop crisis will still take place, wreaking havoc on the real economy. Hence, it may be safer to err on the side of “too much” rather than “too little.”
In sum, financial regulations have to be accompanied by liquidity facilities mimicking a global lender of last resort. Without them, financial regulations could even become counterproductive. Moreover, in the short run, large liquidity facilities should be put in place to protect emerging market economies from possible sudden stop episodes associated with the current crisis and consequent deleveraging.
Note: I am grateful to Sara Calvo, Rudy Loo-Kung, and Carmen Reinhart for many insightful comments.
1 See Guillermo Calvo, Turmoil in Emerging Capital Markets: Bad Luck or Bad Policy? Cambridge, MA: MIT Press, 2005, Chapter 18.
2 However, empirical studies show that trade is affected by exchange rate volatility in developing economies (see, Calvo and Carmen Reinhart, “Fixing for your Life” in Calvo, op. cit. Chapter 14). Perhaps this is due to the underdevelopment of their capital markets, giving further support to the ensuing conjecture in the text, and another reason why floating exchange rates may be harmful.
3 Unfortunately, Iceland and several Eastern European countries paid little heed to the experiences in Asia and Latin America and accumulated large current account deficits and sizable foreign-exchange denominated debts (including household mortgage debt), presumably thinking that they were different. Also, while many governments in Latin America were successful in reducing their foreign currency debts, the private sector did much to offset this trend during 2001-2007.
4 See Latin American Shadow Financial Regulatory Committee (CLAAF), Statement No. 19, December 2008.
5 See Guillermo Calvo and Rudy Loo-Kung, “Rapid and Large Liquidity Funding for Emerging Markets”, Vox EU, 10 December 2008