A blog of the NYU Colloquium on Market Institutions and Economic Processes
by Andreas Hoffmann*
Most economists agree that the latest crisis was caused by risk-taking incentives (competition for profits, wrong ratings, false policies, moral hazard) along with financial innovations that allowed banks to lend excessively. While monetary policy prevented, for better or worse, a collapse of the financial system, an increasing number of economists also agree that it is not possible to safeguard the financial system over and over again. There are limits to intervention. Therefore we have to find a way to deal with the very causes of the crisis.
Currently the only policy solution seriously discussed is regulation of financial markets or certain instruments. Success of regulation is questionable due to two reasons: First, financial innovation is a process that does not stop after regulators finished the job. Excessive credit lending is still possible given the current monetary system. Second, risk-taking incentives remain unsolved. Regulation does not address moral hazard due to lender of last resort and bail-out expectations.
To solve these problems serious thought must be given to reforming the current monetary system. There are two ways to tackle this issue:
First, one can try to solve the problems within the current monetary framework. Central banks would need a new policy rule. They could e.g. have to counter-cyclically react towards credit expansion by "?leaning against the wind' when asset prices skyrocket and credit aggregates explode (link). If they communicate their intention to do so, the incentives for risk-taking may be limited in the first place. This solution assumes the central bank's ability and will to act accordingly.
Second, alternative monetary regimes should be discussed. In this respect, a commodity standard could limit credit expansion via financial innovation (link). Free banking may further promote self regulation and could restrict bank's risk-taking when the lender of last resort is absent (link). Alternatively a world fixed real exchange rate regime might improve international financial stability (link).
Surprisingly most economists do not seriously consider reforms of the monetary system. In the recent gold standard discussion many economists quickly dismissed and ridiculed the idea with reference to the experiences of the Great Depression. Had the current system proven to be more stable and less crisis prone, this would be understandable!
*University of Leipzig and New York University. Share this: Share Email Facebook Print Digg
A nice post.
I agree on the need for moentary reform and Andreas sets forth alternatives. As it happens, Jim Grant has an op ed in todayâ??s NYT, which makes the case for gold. http://www.nytimes.com/2010/11/14/opinion/14grant.html?pagewanted=1&_r=1&nl=todaysheadlines&emc=a212
It will take a serious examination of the Fedâ??s actual performance relative to the classical gold standard and national banking system to change minds. The Selgin-Lastrapes-White paper linked to at Coordination Problem is a good start.
To be fair, one must mention a monetary rule like the Taylor Rule. Also, there are the advocates of 100% banking.
[...] post does a nice job of framing monetary issues and alternatives, and providing supporting links: Reform the Monetary System? ThinkMarkets by Andreas Hoffmann* Currently the only policy solution seriously discussed is regulation of [...]
This suggested approach is also the most profound lesson we can learn from constitutional economics if we apply it to monetary institutional economics. Thank you for this piece, Andreas.
Thanks for the comments. I like Jim Grantsâ??s piece.
Certainly research is needed to test whether any of the abolished systems would have brought about better outcomes than the current one, including something like BW or a gold standard.
I think there should be an open discussion about all kinds of possibilities to stabilize our unstable monetary system. Maybe this has to be done internationally. This would not be an easy task as interests of countries may differ. We might need a new Machlupian â??Bellagio groupâ?? to come to an agreement
This piece seems to refute itself in part.
It first refers to the inherent futility of regulation and then, in the first of the two resolutions posited, suggests restructuring â?¦ the regulations! Maybe Iâ??m putting too broad a brush into the writerâ??s hand.
Iâ??m also frustrated by the diffident, tentative choice of words: â??discussâ? alternative monetary structures? This is merely a stylistic, emotional complaint on my part, but it nonetheless informs my reaction. â??Consider?â? Better.
Better still: â??select,â? or even â??move to.â? Sounding precipitous, here? Well, if so, thatâ??s YOUR stylistic, emotional reaction.
N.Joseph Potts,
thanks for your critique. But I disagree a bit with your interpretation.
Maybe the difference I make between new monetary policy rules and regulation in the market is not clear here:
Regulation of the financial industry â?? such as banning derivatives or so â?? is not the same as changing the rules of the monetary framework.
Proposing â??leaning against the wind policiesâ?? is more than simply banning an instrument because it changes the monetary policy rules â?? and, as proposed by e.g. Borio and White or Roubini, restricts banks from overexpansion when asset markets hike. Currently central banks are not supposed to restrict lending as long as cpi increases remain at low levels.
This may not be a perfect solution. Fine!! But it could improve the outcome. So it should be considered, especially as it is the easiest change to implement.
For the wording:
I do not want to anticipate results. In my opinion â??selectâ?? or â??move toâ?? is inappropriate at this stage. Proclaiming a different system without serious comparison of the merits would suffer from pretence of knowledge.
What about everyone just doing the RIGHT thing! Follow the Golden Rule and be honest. The love of money gained by dishonest people has corrupted our monetary system and are entire way of life.
â??Machlupian Bellagio Group.â? I like it. Itâ??s actually something we should think about. We need a group committed to monetary reform. Beyond that, no preconditions.
Catoâ??s annual monetary conference is being held this Thursday and can be viewed online. Iâ??m up on the first panel: â??Does Monetary Policy Cause Asset Bubbles?â? I donâ??t how much we will get into monetary reform. My paper does so a bit at the end, but I have only 12 minutes to summarize it.
Nice comment about â??leaning against the windâ? policy. I donâ??t have a link, but Trichet has said that ECB should restrict money growth and â??lean against the windâ?, so maybe at least ECB is reforming its policy. Thus, I totally agree with your suggestion.
But, I think history tells us that free banking just does not work as we might assume. I think banks were more or less free â??back in the daysâ?. Was is not the panic of 1907 after which Fed was created? As we very well know, the panic ended to intervention of J.P. Morgan. Now the panic ended to massive government bail-out. It also dead certain that banks would have created these financial innovations regardless (or lack) of regulation. So, I do not think that putting blame on too much regulation is the right conclusion about the crisis. I do not think that data or even theory supports it (see for example: Akerlof ja Romer (1993), "Looting: The Economic Underworld of Bankruptcy for Profit"?, Brookings papers on Economic Activity 2:1"â??73). It is likely that the only policy decision that really contributed to the crisis was the creation of Fannie and Freddie, i.e. government intervention to housing market.
And last but not least, tying money to some commodity is not a good idea. In general, economic theory does not seem to have a very good understanding of what money is. Like I allready wrote on the fb discussion, money should not be tied to production process, because it controls/transforms/guides the production process. Itâ??s sole purpose is to transform the value of certain production process to an other (and sustain value). If you think of it this way, tying money to some part of production makes no sense.
Jerry,
The conference schedule looks very promising.
Tuomas,
I have a link for â??leaning against the windâ? in the post.
I do not understand your last comment: In my reading â?? as you put it â?? moneyâ??s â??sole purpose is to transform the value of certain production process to an other (and sustain value)â? makes the case for a commodity standard. Maybe I misunderstand this paragraph.
I think we agree that the current system failed in providing a stable framework. We also do not know if it provides a more stable framework than previous regimes.
Therefore considering options, which include free banking, should be natural. It is possible that free banking had its flaws. Maybe they are even worse. This needs to be further investigated.
We certainly did not have free banking in the US in 1907. It was the National Bnaking System, which had many limitations and restrictions. Arguably, however, it performed as well or better as the Fed era. Likewise the gold standard + BOE in the 19th century wasnâ??t half-bad compared to modern experience.
What is called free banking in the US ended with the National Banking Act. The US free banking system differed from the Scottish. All this is explained at length by Selgin and White.
Name (required)
E-mail (required)
Website
XHTML: You can use these tags:
Read Full Article »
