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«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 ...»

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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

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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

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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

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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

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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,

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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.

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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.

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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.

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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.



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