This may help Brad DeLong settle his
inner conflict over whether Greenspan made an error by not moving interest
rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that
the benefits of bubbles almost always outweigh their costs (and thus there's no
need for regulation to prevent them).
I think the authors are correct to point
out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:
Should we
rush to further regulate financial institutions?, by Guillermo Calvo and Rudy
Loo-Kung, Vox EU:
‘Tis better to have loved and lost,
Than never to have loved at all.
Tennyson, 1850.
In times of systemic financial distress, hunting
for culprits becomes a popular sport. The Madoffs of this world are easy targets
because crisis makes crookery harder to conceal. While there is no question that
crooks should be sent to jail, increasing financial regulation is a different
issue and requires careful analysis. Rushing to impose tighter regulations may
hamper recovery and growth. Empirical evidence strongly supports the view that
growth and financial development go hand in hand (Demirgüç-Kunt and Levine
2008). Although it is much harder to establish that financial development
causes growth, few would doubt that, at least temporarily, financial
deregulation could promote higher growth. A genuine concern, however, is that
the financial sector is prone to crises, which are typically associated with
serious effects on output and employment.
We cannot reach definite conclusions about the
desirability of risky financial arrangements in a short column. Our objective is
much more modest. We examine the welfare implications of financial deregulations
that result in higher growth but end in tears and perform the exercise in the
context of a benchmark case in which consumption is the ultimate source of
welfare, ignoring possibly relevant behavioural finance and political economy
considerations. We base our analysis on estimates of the costs of financial
crises in emerging market economies (since the 1980s), a cauldron of financial
crises in the last thirty years. Our results support deregulation even under
those dire circumstances.1
A model of growth, collapse, and welfare
More specifically, suppose that financial
deregulation is implemented at time 0 and that, as a result, consumption grows
at rate gH (where H stands for “high”); after T
periods, there is a crisis that produces a (symmetric) collapse-recovery
recession phase in consumption, resembling those observed in the 1990s’ Emerging
Economies crises (see Figure 1) . That is, we assume that, starting at time
T consumption decreases for a while and then begins to recover. The
recession phase takes DT periods. During the first half of this phase,
i.e., for DT/2 periods after time T, consumption declines at
the rate g*; and then, for the next DT/2 periods, consumption
resumes growth at the same rate g*. By construction, at time T
+ DT (end of the recession phase) consumption reaches its pre-crisis
level (i.e., the level prevailing at time T). Afterwards, we assume
that consumption grows at a lower rate gL (where L
stands for “low”). We assume that gL is also the growth rate
that would prevail if no financial deregulation had been implemented.
Thus, this corresponds to a financial deregulation experiment in which when
crisis hits authorities get cold feet and meekly go back to the old, low-growth,
financial system forever. This extremely pessimistic scenario will
allow us to make a stronger case for deregulation.
Figure 1. Consumption paths under
alternative regimes for the average emerging economy
Note: The consumption path associated with
financial innovation shows the calibrated collapse-recovery phase for the
average emerging economy and the calculated break-even T using a degree of risk
aversion (σ) equal to 4.
To calibrate DT and g*, we focus
on average output collapse and recovery patterns (the recession phase) observed
in emerging markets during times of systemic financial turmoil
throughout the period 1980-2004, discussed in Calvo, Izquierdo and Talvi (2006).2
More specifically, we set DT equal to the time that it took for average
output to recover its pre-crisis level. The growth rate g* is
calibrated to match accumulated output loss, which is defined as the sum of the
differences between the pre-crisis peak GDP and observed GDP within the
recession phase. This procedure suggests setting g* = 3.11% per year
and DT = 3.43 years.
Moreover, we set gH equal to
the average GDP growth rate observed in emerging markets during 1992-97, a
period in which many countries opened up to capital inflows. The low growth rate
gL is set equal to the average growth rate observed in the
previous ten years (1982-91). This leads us to set gH = 4.7%
and gL = 2.7% per year.3
We focus on the following question: How long should
the bonanza or high-growth period T last for financial deregulation to
be socially desirable? To answer that question, we examine the benchmark case in
which welfare can be expressed as the present discounted value of a utility
index which depends on aggregate consumption.4
We define the break-even T as the
number of bonanza years that would make deregulation welfare equivalent to not
deregulating at all and generating low growth, gL, at all
times. If the bonanza period exceeds break-even T, then financial
deregulation is preferable to doing nothing, even though it results in a painful
crisis. Table 1 and Figure 1 summarise the results (parameter σ is the
coefficient of relative risk aversion).5
Table 1
Emerging market episodes lasted 5 to 6 years on
average, implying that the experiments were socially beneficial despite ending
in large recessions. Admittedly, the boom-bust episodes are not identical across
economies. To test for robustness, we perform the same exercise for two polar
episodes in Latin American, namely, Argentina’s and Chile’s, for which the
bonanza period was 4 and 13 years, respectively.6 In both cases,
results point in favour of financial liberalisation for σ = 4. However, in the
case of Argentina (and σ=1), the methodology yields borderline results (Chile
passes the test with flying colours).7
Two points are worth making: (1) support for
deregulation is stronger if the coefficient of relative risk aversion is more
realistically set at 4, and (2) break-even T is the same if one assumes
that the cycle is repeated as many times as desired (high growth-bust-high
growth), and only after the last cycle the economy resumes low growth.8
This is more realistic because emerging markets returned to exhibiting high
growth during 2003-2007.
The analysis abstracts from the important issues of
poverty and income distribution, which might alter our assessment of past
deregulation episodes, but that does not make our analysis less relevant looking
forward. For example, for the type of social welfare function considered here,
if income distribution remains fairly constant, one would reach the same
pro-deregulation conclusions even if one entirely focused on the welfare of the
poor, à la Rawls. This shows that financial deregulation would be desirable
under the Rawlsian criterion if one can find suitable social protection
mechanisms, and that the effectiveness of those mechanisms should be explored as
part of the grand design of new financial regulations – especially before
enacting new regulations that would stifle the dynamism of the financial sector.
Conclusion
Our analysis in this column may help explain why
policymakers are hesitant to prick the bubble when it starts – they may simply
be trying to maximise social welfare and realise that a potential crisis is not
strong enough reason to prevent the bubble from developing (Tennyson’s verses
ringing in their ears?). Of course, no policymaker likes crises. When crises
strike, much of the discussion focuses on how to avoid them or lessen their
impact in the future. This is quite understandable. However, this does not
insure that “they are not going to fall in love again.” Therefore, the policy
debate should give equal time to discussing what to do when crises happen and to
developing institutions that help to assuage their blow.
In closing, we would like to point out that even
though this note gives some support to financial deregulation, it does not rule
out the existence of financial arrangements that are far superior to the ones
currently available. A case in point would be the creation of a global lender of
last resort. Central banks have successfully filled that role at the local level
and likely prevented many serious self-fulfilling banking crises in the last
seventy years. However, there is no equivalent to a lender of last resort at the
global level. Its absence was clearly felt in emerging markets in the aftermath
of the Russian August 1998 crisis. Even the subprime crisis suffered from the
absence of a fully effective lender of last resort. To be sure, central banks
stepped up to the plate early on in the current episode, but their coverage was
and still is quite limited. Many central financial institutions were left
without a safety net, or the net was stretched out after they hit the ground. We
feel that the issue of a global lender of last resort should be given more
weight in the current debate (see Calvo 2009).
References
Baldacci, Emanuele , Luiz de Mello, and Gabriela
Inchauste (2002) "Financial
Crises, Poverty, and Income Distribution" IMF Working Paper 02/4.
Barro, Robert (2006) “Rare
disaster and Asset Markets in the Twentieth Century”, Quarterly Journal
of Economics, 121(3).
Calvo, Guillermo (2009)
“Lender of
Last Resort: Put it on the agenda!”, VoxEU column, 23 March
Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2006) “Phoenix
Miracles in Emerging Markets: Recovering Without Credit from Systemic Financial
Crises,” National Bureau of Economic Research, Working Paper 1201, March.
Demirgüç-Kunt, Asli and Ross Levine (2008), “Finance,
Financial Sector Policies, and Long-Run Growth,” Commission on Growth and
Development, Working Paper No. 11, World Bank, Washington, DC
Rancière, Romain, Aaron Tornell and Frank Westermann (2008) “Systemic
Crises and Growth,” Quarterly Journal of Economics, pp. 359-406.
[1] Our results, thus, give further support to the
line of research advanced by Aaron Tornell and Frank Westermann since 2002,
which is inspired by the conjecture that financial liberalisation may be
socially desirable despite the booms and busts that it may generate. See
Rancière, Tornell and Westermann (2008) and their recent VoxEU column.
[2] The paper focuses on episodes in which GDP peak-to-trough contraction is
greater than the median fall in the sample. Note that including only the most
severe collapses in the calibration constitutes a more difficult test for the
case of financial deregulation.
[3] Countries included are those tracked by the J.P. Morgan’s EMBI Global Index:
Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Côte d'Ivoire,
Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Hungary,
Indonesia, Iraq, Jamaica, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama,
Peru, Philippines, Poland, Romania, South Africa, Sri Lanka, Thailand, Trinidad
and Tobago, Tunisia, Turkey, Uruguay, Venezuela, and Vietnam.
[4] More concretely, we assume that the utility index exhibits constant relative
risk aversion, σ, and the instantaneous rate of discount equals 3% per year.
[5] If parameters are calibrated on the basis of GDP per capita (instead of its
level) yields similar results, due to the high correlation between the two
series.
[6] In both cases, we set gL to average GDP growth rates
during 1951-1970. The parameter gH is set to the average GDP
growth rates during 1991-94 for Argentina and 1984-97 in the case of Chile; The
values and DT and g* are calibrated to match the
characteristics of the Argentine crisis of 2002 and the Chilean crisis of 1998.
[7] In an exercise in which the collapse in growth is modeled as a stochastic
event with constant probability, following Barro (2006), we also find support
for financial deregulation. In both cases, the break-even expected frequency of
these events is lower than the ones observed in the data
[8] It follows that T will be the same if the cycle is repeated an
infinite number of times.
[9] The empirical work of Baldacci, de Mello, and Inchauste (2002) suggests that
the financial crises that struck developing countries between 1960 and 1998 had
severe effects on poverty and, in some cases, income inequality.
is a classic statement of a polar position in the issue of the universality of
instrumental rationality and market institutions in explaining concrete
historical circumstances in the recent and distant past. Polanyi maintains that
the concept of economic rationality is a very specific historical construct that
applies chiefly to the forms of market society that emerged in Western Europe in
the early modern period. Market behavior came to replace other forms of
motivation within European society in this period, and individuals came to act
more and more on the basis of a calculation of self-interest. However, Polanyi
holds that this form of behavior, like the economic institutions of the market
within which it emerged, is highly specific to a particular time and place. To
make use of this model of action as though it were a universal feature and
determinant of human behavior is as unjustified as it would be to extend
medieval chivalry to all times and places.
