Macroeconomic Stability and Financial Regulation: Key Issues for the G20

Reviewed by Abel Mateus

With contributions by: Richard Portes, Philip Lane, Stephan Gerlach, Takatoshi Ito, Willem Buiter, Markus Brunnermeier, Raphael Repullo, Jesús Saurina, Cralos Trucharte, Hendrik Hakennes, Isabel Schnabel, Marco Pagano, Paolo Volpin, Mathias Dewatripont, Jean Charles Rochet, and Marco Bechet

This book consists of a set of papers contributed to a seminar jointly organized by the CEPR and Reinventing Bretton Woods Committee that took place in January 31, 2009, in London, with the G20 Deputies, in order to prepare the April 2, 2009 G20 London summit. The aim was to use economic analysis to shed light on the financial crisis and propose policies for its solution. As the Introduction states, sound economic analysis helps “(i) to eliminate policy options that are appealing yet inefficient or costly to taxpayers; (ii) identify the most efficient solutions, so that these can anchor the discussions and make it easier to reach a consensus; and (iii) facilitate estimating the cost and benefits of each policy proposal.” This is a formidable task, in view of the different views not only of the diagnosis of the crisis, but also the economic theories that could explain it or the economic policies to solve it. On this last point, we have at one extreme the Minnesota-Chicago School that, using dynamic general equilibrium models, puts the blame of financial crises on massive government interventions that cause distortions on the market where otherwise rational agents act; this school of thought advocates a hands-off policy. To the other extreme of the spectrum are interventionists like Stiglitz-Krugman who advocate massive monetary supply increases and fiscal stimulus, as well as a strong regulatory system on the financial sector, due to the existence of market failures of all types. The majority of the authors in this book take a kind of middle road in that spectrum. However, they hardly touch the theory side. For example, there is hardly any reference to the credit channel of monetary policy and its importance to the crisis nor is there analysis in the area of speculative bubbles.

Portes starts by putting the blame for the crisis on the large disequilibrium that was generated by different policies in the world financial and trade system that led to large accumulation of reserves in China and large current account deficits in the US. Facilitated by low interest rates, this led to the underpricing of the risk and all types of speculation. But the book blames both macro and micro-factors for the crisis. On the regime switching that originated the collapse of the financial system, the book identifies three factors: liquidity shortages due to the disruption of money markets and the confidence crisis associated, the build-up of huge portfolios of CDSs in a small number of institutions, and the collapse of credit ratings awarded to structural securities. Regulatory failures also contributed, such as the pro-cyclical bias of Basel II regulation, the lack of a system to deal promptly with insolvent banks, and the tendency of bank compensation systems to encourage excessive risk taking in the banking system coupled with poor corporate governance. Using data from Spain, the authors propose a method to correct the pro-cyclicality of the solvability ratio by the deviation of the GDP growth rate from its long-run growth rate.

This book, however, is mainly aimed at producing recommendations in five areas. Firstly, to correct global imbalances it recommends the creation of credible insurance mechanisms to lower the incentive of countries like China to accumulate foreign exchange reserves in view of the possibility of “sudden stops.” This is one of the most difficult recommendations to implement, because of the coordination mechanisms needed at the international level, as well as its lack of enforceability. Another measure, the deepening of financial domestic markets in emerging economies, is clearly a long-term proposition. Secondly, in the area of macroeconomic policy, the book proposes a zero interest rate policy (ZIRP) to fight deflation with quantitative easing coupled with fiscal stimulus within an international cooperative scheme that would distribute the burden sharing adequately. These were the types of policies that have been largely used by the central banks of the U.S., UK, and ECB, and their respective governments (although no central bank has yet fully endorsed a full ZIRP policy). As we know, after a lot of arm twisting, there was very little cooperation in the international framework in distributing equitatively the burden sharing of fiscal adjustment.

The other three proposals were on regulatory reform. First, the authors propose eliminating the pro-cyclicality of Basel II. Second, they advocate creating central clearing houses for CDSs, increasing disclosure of portfolios of securities by banks, and reforming the incentives for rating agencies. Finally, they propose establishing a harmonized regime for banks’ bankruptcy and establishing an International Stability Fund. On this last point there is not much hope, although the resources of the IMF were finally increased. Another recommendation is to change the funding of the rating agencies: substitute the commissions paid by investors by payments by the issuers of the financial paper. Also, proposals are made to have clear governance and transparency rules, but so far it is difficult to see how these policies would be implemented in practice. In fact, not much has been done on the reforms of the rating agencies. These and other proposals were largely inspired in the Geneva report. For the harmonized regime for dealing with banks’ bankruptcy, the book proposes a similar system to the U.S.’s “prompt corrective action,” giving supervisory authorities power to intervene before a bank is technically insolvent, and using a simple battery of indicators to signal the situation. There is a major problem in applying such a system to the EU with the current decentralized system of supervision that is currently under discussion.

In conclusion, this is a book worth reading, by some of the best economists working in the area of macroeconomics and banking. It certainly contributed to most of the recommendations that came out of the London Summit. Unfortunately most of these recommendations will fizzle into thin air, as the juggling of interest groups and the pressure of the crisis lets down, sowing the seeds for the next one.

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