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Are All the Sacred Cows Dead? Implications of the Financial Crisis for Macro and Financial Policies

January, 2009, Asli Demirgüç-Kunt (DECRG)

Policy responses to the financial crisis have shaken confidence of the development community in the financial and macroeconomic policies underpinning Western capitalist systems.

The current financial crisis has shaken the confidence of developed and developing countries alike in the very blueprint of financial and macroeconomic policies that underlie the Western capitalist systems. In an effort to contain the crisis, U.S. authorities and many European governments have taken unprecedented steps of providing extensive liquidity, giving assurances to bank depositors and creditors that include blanket guarantees, and structuring bailout programs that include taking large ownership stakes in financial institutions. Few developing countries have even reintroduced capital controls to prevent capital outflows. It is not surprising that many analysts are already declaring capitalism dead, along with the mainstream policy view associated with it.

A new paper by Demirgüç-Kunt and Servén argues otherwise. Keeping in mind the importance of incentives and tensions between short-term and longer-term policy responses to crisis management, the paper addresses several questions about the implications of this crisis for financial and macroeconomic policies going forward:

  • Are blanket guarantees inevitable to halt a systemic crisis?
  • Should governments bail out and own financial institutions? 
  • Should governments regulate finance much more aggressively given the failures  in market discipline? 
  • Should monetary policy target asset prices? 
  • Should countries resort to capital controls to contain the crisis?

Crises recur in part because people forget the lessons from the previous ones. While every crisis is different, past crises provide important lessons that need to be learned so that policy makers need not reinvent the wheel every time a new one erupts.

The paper draws on a large body of analytical research, econometric evidence, and country experience to argue that the “sacred cows” of financial and macro policies are still very much alive. For the most part the confusion arises from an inability to recognize incentive conflicts and trade-offs inherent in short-term and long-term responses to a systemic crisis. Policies employed to contain a crisis—often in a rush to reestablish confidence and without regard for long-term costs—should not be interpreted as permanent deviations from well-established policy positions. While governments may end up providing blanket guarantees or owning large stakes in the financial sector in an effort to contain and deal with the crisis, this does not negate the fact that generous guarantees over the long term are likely to backfire or that government officials make poor bankers.

Financial crises often do expose weaknesses in the underlying incentive frameworks and the regulation and supervision systems that are supposed to reinforce them. But finance is risky business, and it is naive to think that regulation and supervision can—or should—completely eliminate the risk of crises, though they can make them less frequent and less costly. An often overlooked point is the importance of incentives. To be effective, regulatory reforms must improve the chain of incentives under which market discipline and official supervision operate. Reform proposals usually address the structure of regulation but not the incentive structure of regulators, which is likely to limit the effectiveness of the reforms.

Neither monetary policy nor capital controls can substitute for well-designed prudential regulation. While most observers agree that lax monetary policy in the United States in the early 2000s helped fuel the housing bubble, trying to use monetary policy to prick asset price bubbles may do more harm than good because identifying and bursting bubbles in a timely manner is very difficult.
More broadly, monetary authorities in most countries face two objectives: price stability and financial stability. Attempting to achieve two objectives with one instrument is not a promising strategy. A second instrument is needed for financial stability, and the best option is a prudential regime capable of dampening financial cycles of boom and bust. This is primarily a task for financial regulation. An important pillar of such regulation is the establishment of capital requirements that can automatically be adjusted over the business cycle, providing incentives for financial intermediaries to hold more liquid assets in good times so that they can be run down in bad times. Provisions, leverage ratios, and additional capital buffers can all be designed to be countercyclical. By switching the basis of capital adequacy requirements from levels of risk-weighted assets to their rates of growth, these measures require additional capital and liquidity when bank lending and asset prices are rising fast, and relax such requirements in the downturns.

These proposals can be seen as alternatives or complements to monetary policies intended to prevent asset bubbles and their bursting. Nevertheless, while it is politically feasible to apply these policies and relax requirements in downturns, it is questionable whether they will be as easily tightened in upturns, without greater accountability and appropriate incentive reforms for the authorities.

Despite their inherent fragility, financial systems underpin economic development. The challenge of financial sector policies is to align private incentives with public interest without unduly taxing or subsidizing private risk taking. Public ownership or overly aggressive regulation would simply hamper financial development and growth. But striking this balance is becoming increasingly complex in an ever more integrated and globalized financial system.

Aslı Demirgüç-Kunt and Luis Servén. 2009. “Are All the Sacred Cows Dead? Implications of the Financial Crisis for Macro and Financial Policies.” Policy Research Working Paper 4807, World Bank, Washington, DC.


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