I’ve been meaning to respond to this piece by Eduardo Porter from a few days ago on both recent and historical stirrings in global financial markets. I found it to be unduly depressing and defeatist. At least, I think it’s “unduly” so—there’s a chance the Porter’s right.
The piece argues that the future holds bigger and badder bubbles and busts and there’s just not much that anyone can do about it. What’s driving this unfortunate cycle is the interaction of savings imbalances, skittish global capital, and aggressive central banks.
The US housing bubble contains all the features of the story. Trade surplus countries used massive foreign reserves to help finance an unregulated real estate bubble. When the bubble burst, the central bank put the monetary pedal to the metal in order to offset the demand contraction, leading investors to trot the globe in search of higher returns. As the central bank starts thinking about returning to more normal operations, the specter of higher rates leads to unpredictable and sudden shifts in the flows of global money.
Economists quoted in the piece point out that such booms and busts are “older than the hills” and are likely to get worse before they get better…actually, none of them said anything about getting better. Economic officials in emerging markets hit by capital outflows are calling for international monetary coordination, but it’s unclear what that would look like and even more so, why the US Fed, for example, would hold rates down to protect, e.g., the Turkish currency (Chair Yellen recently said she wouldn’t, btw).
“It’s not even clear,” Porter argues, “what governments should do about presumed bubbles. Should they “lean against” them by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way?”
In fact, the key word a few ‘grafs up is “unregulated.” The problem with all of this is that it assumes that successful regulation of financial markets is beyond our capacity. Again, I’m not sure that’s wrong, but I think it is. And we won’t know if we don’t try.
Porter mentions that “macroprudential rules.” These include capital reserves against overleveraging, strong underwriting and risk-retention principles to counteract the no-skin-in-the-game effect of securitization on loan quality, financial transaction taxes to internalize the externality costs of flash trading, and so on. They also include more vigilance at central banks themselves—remember, both Greenspan and Bernanke claimed they could neither spot nor deflate bubbles. Yellen, on the other hand, has said othewise (“I think it’s important for the Fed, as hard as it is, to attempt to detect asset bubbles when they are forming”).
Now, many economists, including most cited in the piece, do not believe we can get this right. The innovators are always many steps ahead of the plodding regulators. There’s a risk that we’ll push too far and kill the golden goose—I was debating a prominent conservative economist on this point the other day and his view was “sure, if I never leave my house, I’ll never get run over.” And let’s not forget that the opponents of financial regulation are often the funders of the politicians making the rules, a pretty strong recipe for the economic shampoo cycle: bubble, bust, repeat.
Yet while the forces pushing the other way are surely mighty, we have no choice but to try to better regulate the financial sector. To not do so is to accept the inevitability of ever frequent and larger bubbles and busts, to accept that central banks can’t ply stimulative monetary policy without inflating assert bubbles, and to accept taxpayer-funded bailouts that reward the very sector that caused the damage.