FREE ELECTRONIC LIBRARY - Dissertations, online materials

Pages:     | 1 |   ...   | 2 | 3 || 5 |

«Abstract What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large ...»

-- [ Page 4 ] --

Another example of the lack of checks and balances relates to quantitative easing.

This refers to the action of many central banks, and in particular the Federal Reserve, of creating money to buy back long-term government bonds and other securities. Quantitative easing has not been used much before, and yet there has been very little discussion on its potential benefits and costs. For example, how likely is such a policy to increase inflation?

Does it increase likelihood of another crisis, this time perhaps a currency crisis? When it was used in Japan in 1990s, quantitative easing did not solve the problems the economy was facing but neither led to inflation. Probably, though, it led to a larger yen carry trade than would otherwise have occurred.

To illustrate the riskiness of quantitative easing, suppose that after increasing the money supply there is a burst of inflation. Then what the Fed is likely to do is to start soaking up liquidity by selling the bonds that they have bought. However, this may be

–  –  –

decide to take some of their money out of the U.S. and start increasing their euro and yen investments. It is quite conceivable that in this kind of scenario there will be a run on the dollar and subsequently stagflation. There has been very little public discussion of these risks. There is little in the current governance mechanisms that ensure there is a balanced debate about whether what the Federal Reserve is doing is a good idea. We believe it is desirable to have a better system of checks and balances to restrain risk taking in the public sector.

A good illustration of the deficiencies of the current system is provided by Chancellor Merkel’s June 2, 2009 speech in Berlin concerning quantitative easing. She heavily criticized the Federal Reserve and the Bank of England for their programs of quantitative easing arguing that this kind of unconventional monetary policy could sow the seeds of the next crisis. It is highly unusual for a German Chancellor to discuss monetary policy so this was a significant break with tradition. The next day Chairman Bernanke issued a statement that he respectfully disagreed with the Chancellor’s views. In subsequent weeks there were stories in the press that there were internal doubts in the Fed about quantitative easing because of the inflation risk. This unusual sequence of events shows that more formal checks and balances are needed to prevent the Federal Reserve and other central banks from taking large risks. The current governance arrangements in the U.S. break with its long tradition of checks and balances within government.

One possible reform is to impose a mandate of financial stability on the Federal Reserve. This might help to ensure the risks involved for financial stability in undertaking

–  –  –

staff that focuses on financial stability issues may help to achieve this.

Another possibility is to create a Financial Stability Board with its own staff and resources separate from the Federal Reserve that would not be dependent in any way on them. Representatives from this Board could participate in Federal Open Market Committee meetings and could be given several votes. Since their focus would be on financial stability issues they would necessarily focus on the risk created by the public sector. The Federal Reserve would be independent from politicians but there would be checks and balances. We believe some kind of reform along these lines would be helpful going forward.

10. Preventing global imbalances As mentioned above, the IMF arguably exacerbated the problem of global imbalances through the harsh policies that a number of countries were forced to undertake in the 1997 Asian Crisis. There was no reliable mechanism to stop this because the Asians are underrepresented in the IMF governance process. Today, the Asian countries have become much richer. They are the ones with very large reserves amounting to several trillion dollars.

They are the countries with the economic power and this should be reflected also in the governance process of the important international organizations.

In the current crisis Asian countries such as South Korea have done much better than they did in 1997. Rather than raising interest rates and cutting government expenditure as the IMF forced them to do then, South Korea cut interest rates and allowed a large fall in the value of their currency. In contrast to the 1997 crisis when unemployment rose to more than 9 percent, it has only changed slightly in the current crisis. The reason that they were able to

–  –  –

and did not have to approach the IMF. They ran their reserves down but they always maintained a large balance.

While it is individually advantageous for countries to self-insure by accumulating reserves, this is an inefficient mechanism from a global perspective. The countries that are accumulating reserves must lower their consumption to do so and there must be other countries that run deficits to offset these surpluses. In practice the U.S. was the main country that did this. The resulting buildup of debt and its role in triggering the crisis meant that this was very undesirable. This raises the question of what are the alternatives to self-insurance through the accumulation of reserves.

The IMF can perform an important role by providing funds to countries that are hit by shocks. If countries could always rely on being treated fairly and equitably and not being forced to implement harsh measures, they would not be a need to accumulate large levels of reserves. In order for this to happen the IMF needs to reform its governance structure so that Asian countries play a much larger role. This should be accompanied by an increase in Asian staff at all levels. Unfortunately, current proposals do not go far enough in this regard and it seems unlikely that the IMF will be sufficiently reformed to make large reserves in Asia unnecessary in the short to medium run.

A number of Chinese officials have made proposals for a global currency to replace the dollar. This kind of approach has the great long run advantage that reserves can be created initially without large transfers of resources and the attendant risk of a crisis. All countries could be allocated enough reserves in the event of a crisis so that they could survive shocks. The problem with this proposal is that there would be a need for an

–  –  –

be the issue of whether Asian countries would be properly represented.

A more likely medium term scenario is that the Chinese Rmb becomes fully convertible and joins the U.S. dollar and the euro as the third major reserve currency. With three reserve currencies there would be more scope for diversification of risks and China itself would have very little need of reserves in just the same way that the U.S. and Eurozone countries do not need significant reserves. In our view this is the most practical solution to the global imbalances problem. With the help of the U.S. and Eurozone governments, China should start moving in the direction of making the Rmb fully convertible as soon as possible.

11. Other key reforms So far we have suggested three important reforms. The first is that banking regulation should be based on a coherent intellectual framework of correcting market failures. The second is that the Federal Reserve and other central banks need to be subject to more checks and balances than is currently the case. The third is that either the IMF needs to be reformed so that Asian countries can rely on being treated better than in the 1997 Asian Crisis or more plausibly that we move towards a situation where the Rmb joins the U.S.

dollar and the Euro as the third reserve currency. In this section we consider several other key reforms.

“Too big to fail” is not “Too big to liquidate” One of the most important principles guiding policy during the current crisis has been that large institutions are “Too big to fail.” The notion is that if Citigroup is allowed to fail,

–  –  –

the contagion problem discussed earlier. The way that this policy has been implemented is that governments have bought preferred shares and common stock in many institutions that would otherwise have failed. They have made clear that these institutions will be provided with the capital that they need in order to survive.

In our opinion this is the wrong way to deal with the “Too big to fail” problem. As Lehman Brothers’ demise illustrated, contagion is a very real problem and large banks and non-bank financial institutions should not be allowed to simply go bankrupt. However, “Too big to fail” doesn't mean that we should allow these institutions to survive. It's a very bad precedent to provide failing banks with the funds they need to survive. In the future, it is likely that banks and other financial institutions will grow and become large knowing that they will not be allowed to fail. These banks will be willing to take large risks since they receive the payoffs if the gambles are successful while the government bears any losses.

However, “Too big to fail” does not mean “Too big to liquidate.” Financial institutions should definitely be prevented from failing in a chaotic way. The government should step in and take them over in order to prevent contagion. But rather than allowing them to continue, these institutions should be liquidated in an orderly manner, even if this may take several years. That would allow the other institutions that didn't fail and that were well-run to expand and take over the failed institution’s business. Propping up the weak ones that did badly is not a good idea in the long term. It rewards risk taking and, perhaps more importantly, it prevents prudence from being rewarded. Well-run banks that survive should be allowed to benefit.

–  –  –

by temporarily taking over failing institutions is to have bankruptcy rules for financial institutions that allow the equivalent of prompt corrective action for banks. With a bank, the government can step in before it goes bankrupt and take control. There doesn’t have to be a vote of the shareholders. Such a mechanism is needed for all financial institutions. That's what the government should have been able to do with Bear Stearns and Lehman Brothers.

This would have prevented the great uncertainty that occurred when they failed.

Resolution of large complex cross-border financial institutions A major difficulty in designing a framework that allows financial institutions to be liquidated is how to deal with large complex cross border institutions. In particular, there is the problem of which countries should bear any losses from an international mismatch of assets and liabilities. This has proved a thorny problem for the European Union in designing a cross border regime to support its desire for a single market in financial services. For countries without political ties like the EU it is an even more difficult problem. Designing such a system is one of the most urgent tasks facing governments.

One possible way to proceed would be to eliminate cross border branching. Then any subsidiaries would be regulated by the host country. These regulators would be charged with ensuring that they were comfortable with any imbalances between assets and liabilities in their country. They would be responsible for intervening should a foreign subsidiary or home institution come close to failing and would be responsible for covering any shortfalls of cross border assets and liabilities that failure would lead to.

–  –  –

to be addressed. Current proposals have made very little progress on this issue.

Limited government debt guarantees for financial institutions In the current crisis bank bondholders have effectively had a government guarantee.

An important issue is whether this is desirable. Such a guarantee prevents disorder in bond markets, but again the guarantee provides undesirable long term precedents. Going forward holders of bank debt will know it is guaranteed and will not have any incentive to exert market discipline. If failing banks are taken over and liquidated in an orderly manner as discussed above, it should be possible to impose losses on long term bondholders and other debt holders. This should provide incentives for market discipline by bondholders.

Limits on leverage of financial institutions Many financial institutions started the crisis with very high levels of leverage. It has been widely argued that the deleveraging of these institutions during the fist stages of the financial crisis considerably exacerbated the effects of the crisis (see, e.g., Adrian and Shin (2009) and Greenlaw et al. (2008)). We agree with this view. Some limitations on the leverage of financial institutions seem desirable. However, implementing such restrictions in practice may be problematic. The issue will be exactly what should be included in debt and what should be included in equity. Financial innovation will undoubtedly be used to try and circumvent the restrictions.

–  –  –

It has been widely suggested that convertible debt should be issued by banks that could be converted into equity in the event of a crisis. In this case it would not be necessary for banks to raise capital in difficult times as it would already be available. The issue of this kind of security by Lloyds in the U.K. is an example. This certainly sounds attractive but the securities suffer from a number of potential problems. First, there will be issue of whether moral hazard is increased by such instruments. Second, why not use equity from the start instead? One argument is that equity is costly. This is widely assumed to be true in academic studies. Why exactly is equity costly? It is often suggested that it is because of tax advantages. If this is the case it may be better for governments to eliminate tax subsidies for debt as discussed next.

Pages:     | 1 |   ...   | 2 | 3 || 5 |

Similar works:

«The Great Divide and Beyond – Financial Architecture in Transition By Erik Berglof* and Patrick Bolton** * SITE, Stockholm School of Economics, and CEPR ** Princeton University, NBER and CEPR We are grateful to Philippe Aghion, Mike Burkart, Tore Ellingsen and, in particular, Enrico Perotti for helpful discussions, and to Jan Hanousek and participants in the JEP workshop at CERGE-EI and SITE, Stockholm School of Economics for comments. Rudolfs Bems has provided excellent research assistance....»

«PAPER EA021 A series of background briefings on the policy issues in the May 2015 UK General Election #ElectionEconomics Productivity and Business Policies Anna Valero and Isabelle Roland CEP ELECTION ANALYSIS Productivity and Business Policies  UK productivity (GDP per hour) and income grew faster than in France, Germany and the United States between 1979 and 2008, reversing a century of relative decline. Increases in higher education, tougher product and labour market competition, the...»

«Enron Case Study Commentary Ask WHY? Instructions: So What is this Company Worth—ballpark, estimate? See Financial Statements. Take all numbers as fair and accurate.Take no more than 20 minutes: Determine whether this business is worth investing in. What is it worth? Why? Is this a good business? Why or why not? What critical information do you need to get or look at if you wanted to fully analyze this company? To get to the essence of the company I go right to the financial statement or...»

«Dominant Designs, New Firm Survival and Competitive Dynamics in Nascent Market Categories A Thesis Submitted to the Faculty of Drexel University by Tianxu Chen in partial fulfillment of the requirements for the degree of Doctor of Philosophy June, 2011 © Copyright 2011 Tianxu Chen. All Rights Reserved. ii Acknowledgements This dissertation would not have been possibly completed without the kind help and contribution of the dissertation committee and the faculty at the Management Department of...»

«Unreported Discards Under IFQ Management: Survey Responses of Alaska Halibut Fishermen by Gunnar Knapp Institute of Social and Economic Research University of Alaska Anchorage 3211 Providence Drive Anchorage, Alaska 99508 907-786-7710 (telephone) 907-786-7739 (fax) afgpk@uaa.alaska.edu (e-mail) May 1999 ISER Working Paper Series: Surveys of Alaska Halibut Fishermen About Effects of IFQ Management Funding for the research discussed in this paper was provided by the Alaska Sea Grant College...»

«Excess Cash and Mutual Fund Performance Mikhail Simutin The University of British Columbia∗ November 22, 2009 Abstract I document a positive relationship between excess cash holdings of actively managed equity mutual funds and future fund performance. The difference in returns of portfolios of high and of low excess cash funds amounts to over 2% annually, or approximately 3% after standard risk adjustment. I study whether this difference in performance can be explained by the differences...»

«2011 Forum: Accommodating Islamic Banking and Finance in Australia 413 ACCOMMODATING ISLAMIC BANKING AND FINANCE IN AUSTRALIA SALIM FARRAR∗ I INTRODUCTION Although still in its infancy and small in comparison with its US$200 trillion conventional cousin,1 Islamic banking and finance (‘IBF’) has become a growth area in recent years and according to conservative estimates is expected to have almost US$2.8 trillion in assets by 2015.2 Perceived by its advocates as not only halal (Islamically...»

«Idolatry and Redemption: Economics in Biblical Perspective By Prof Tim Gorringe, March 2013 Since we are all beholden to him let’s begin with Adam Smith and understand economics as the study of the way in which human communities obtain ‘the necessities and conveniences of life’. In the course of human history many different forms of economy have been pursued and they can be measured both by their effectiveness in producing the means of life, by their sustainability, and according to the...»

«Strategic analysis and evaluation of Norwegian Air Shuttle ASA Copenhagen Business School September 2011 Study program: Cand. merc. International Business (IBS) Number of standard pages: 120 Number of characters: 276 950 Executive summary During the recent decade, Norwegian Air Shuttle ASA (NAS) has managed to become a highly successful company, and is today the third largest European low-cost carrier and the second largest airline in Scandinavia. However, we believe that prior success is no...»

«REVIEW of BUSINESS & FINANCE CASE STUDIES VOLUME 1 NUMBER 1 2010 CONTENTS Steve Sharpe: A Stock Report 1 William P. Dukes, Zhuoming (Joe) Peng, Margaret M. Tanner Variety Enterprises Corporation: Capital Budgeting Decision 15 Ilhan Meric, Kathleen Dunne, Sherry F. Li, Gulser Meric Where Should General Motors Go from Here? 27 Balasundram Maniam, James B. Bexley, Jolene Bon-Jorno McFarlane What Executives Can Learn from U2: An Exploratory Study 37 Francis Petit Optimal Equipment Investments for...»

«Financial instability and optimal monetary policy rule Hossein Sedghi-Khorasgani Financial Instability and Optimal Monetary Policy Rule Hossein Sedghi-Khorasgani Department of Economics, University of Leicester, Leicester, LE1 7RH, UK Email address: hs128@le.ac.uk ABSTRACT This paper investigates the effect of financial instability on the design of monetary policy rule for a small open economy. We find evidence that optimal monetary policy rule reacts directly to financial imbalances and, as a...»

«Sexuality and Gender Identity Background and problem statement Background Sexuality is a central aspect of being human throughout life and encompasses sex, gender identities and roles, sexual orientation, eroticism, pleasure, intimacy and reproduction. Sexuality is experienced and expressed in thoughts, fantasies, desires, beliefs, attitudes, values, behaviours, practices, roles and relationships. While sexuality can include all of these dimensions, not all of them are always experienced or...»

<<  HOME   |    CONTACTS
2016 www.dissertation.xlibx.info - Dissertations, online materials

Materials of this site are available for review, all rights belong to their respective owners.
If you do not agree with the fact that your material is placed on this site, please, email us, we will within 1-2 business days delete him.