The Lessons from the Current Crisis for Macro-theory and Policy

Abstract

Executive SummaryThe US housing market is not the cause of the credit crisis and the current woes of the global economy. It is simply the symptom of the huge liquidity that was put in place by 'bad' financial engineering and some mistakes in the conduct of monetary policy, especially in the US. This liquidity has financed a number of bubbles in the last ten years with a major impact on the economy (internet, housing, and commodities) and a few more (shipping and private equity) with a minor impact on the economy. From a European perspective micro-economic fundamentals and country specific factors have differentiated the countries in the euro-zone area with housing bubbles emerging in some countries, like Spain, but not in others, like Germany. Thus, what is needed is both a macro-and micro-perspective to understand the full story.From a macro-perspective liquidity is the real culprit. Without this excessive liquidity there would have been no bubbles -no credit, no bubble. Although one might point to some errors on the part of the Fed in removing the accommodation bias on a number of occasions in the last ten years, financial engineering has played by far a more important role in creating this prodigious liquidity. Financial engineering is deemed in the press as synonymous to fraud -finding loopholes in the law and the regulatory environment to make money -and it is accordingly condemned. 'Bad' financial engineering has resulted in a 'shadow-banking' that developed and worked in parallel with regulated banking. The 'shadow-banking' operated outside regulation and control of the authorities. So, whatever was not allowed in regulated banking was developed in the 'shadow-banking'.The backlash of the greed of financial institutions is likely to be increasing calls for strict regulation of the industry. As the taxpayer is called to clean up the mess of the banks tougher regulation of the industry is very likely to ensue. But from a policy perspective it should be recognized that regulation is backward rather than forward-looking. Smart people will always take advantage of any given legislation by finding loopholes. Regulators will always react with a long lag to close the loopholes and in some occasions, like the current crisis, too late to prevent a calamity. A better approach than over-regulation is for the central bank to have a target on asset prices in a way that does not impede the functioning of free markets and does not prevent 'good' financial innovation. Since securitization implies the transfer of assets and the risk to the personal sector the ideal target variable for a central bank is the net wealth of the personal sector as a percent of disposable income, which is a stationary variable and therefore a target range can be set. In the US, for example, this can be a range around 5-times the net wealth of the personal sector. In this way the central bank will monitor the implications of financial innovations as they impact net wealth, even if it is ignorant of these innovations as in the case of SIVs. With a...

Financial Stability in the Aftermath of the 'Great Recession'

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