FED MYER'S SPEECH
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Thursday April 22, 9:53 pm Eastern Time
Note: this article has a followup with more
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TEXT-Fed's Meyer speech to Jerome
Levy Institute
WASHINGTON, April 22 (Reuters) - The following is the full
text of Federal Reserve Governor Laurence Meyer's speech
issued in Washington Thursday before the Jerome Levy
Economics Institute at Annandale-on-the-Hudson, New York:
"Structure, Instability, and the World Economy: Reflections on the
Economics of Hyman P. Minksy
This paper has its origin in a request by Don Brash, Governor of the
Reserve Bank of New Zealand, to present a central banker's perspective on
the Asian crisis to a group of Southeast Asian central bankers. So the
central banker's perspective remains an organizing theme.
Central banks have two core missions: the pursuit of monetary policy to
achieve broad macroeconomic objectives and the maintenance of financial
stability, including the management of financial crises. The latter
mission is closely connected to regulation and supervision of the banking
system, so I include this within the central banker's perspective, as
well as broader issues related to systemic risk in the financial sector.
Central banks also often have or share with Finance Ministries control
over exchange rate policy, including the choice of an exchange rate
regime and the management of that regime. So, today, I consider the role
of exchange rate policy, macroeconomic policy, and bank supervision and
regulation in the crises and suggest some lessons in each case.
As I was writing the paper, it became clear that my interpretation of the
sources of, and appropriate policy responses to the crises among the
Asian emerging economies, drew heavily upon the work of Hy Minsky.
Perhaps that should not be surprising since Hy and I were colleagues for
more than two decades at Washington University. But the truth is, in many
respects, Hy and I came from different worlds. My highly traditional
background in economic theory was in rather stark contrast to Hy's
self-proclaimed war on neoclassical economics. While it is true that I
never lost my commitment to traditional models--not a surprise to those
who still hear me talk about the critical importance of the NAIRU
framework to understanding inflation dynamics--I have often found words
coming out of my mouth that reflect the distinct and powerful influence
that Hy has had on my thinking. The truth is, there are few who have
influenced my thinking about economics more than Hy. Indeed, he had so
much to offer that if I only accepted a small dose, it was still enough
to be a powerful complement, and perhaps antidote, to my otherwise
conventional upbringing.
Hy's analysis of the sources of financial crises--his "financial
instability hypothesis"(1)--is the foundation for my interpretation of the
sources of the Asian crisis. In addition, his work on how policies and
institutions in advanced capitalist economies have evolved over time to
mitigate the risks and attenuate the effect of financial disturbances--as
developed in "Can It Happen Again"(2)--is central to my discussion of how
to mitigate the risks of such serious financial and banking crises in the
future.
I. Sources
Recessions, in general, and especially when accompanied by financial
crises, are the product of a coincidence of adverse shocks on an already
vulnerable economy. External shocks which would have been shrugged off by
a robust economy can lead to seemingly disproportionate declines in
economic activity when they fall on an economy characterized by excessive
leverage, speculative excesses in asset markets, poor risk management,
and inadequate regulation and supervision in the banking sector. The
adverse shocks that appeared to trigger the crises included the slowdown
in export revenue due to a slump in the semiconductor market; the slump
in Japan in the spring of 1997, which removed a source of demand for the
region; and the appreciation of the dollar relative to the yen which
undermined international competitiveness in the region. These
shocks--individually and collectively--did not seem large enough to
account for the dimension of the crises, thus, the importance of
understanding the vulnerabilities that I believe were instrumental in
transforming a series of modest shocks into disproportionate effects on
these economies.
Hy's work focused particularly on the endogenous nature of evolving
vulnerabilities. Indeed, he often viewed his major contribution as the
explanation of the upper turning point in the business cycle. I have
often described his views as suggesting that "stability is
destabilizing." That is, that a period of stability induces behavioral
responses that erode margins of safety, reduce liquidity, raise cash flow
commitments relative to income and profits, and raise the price of risky
relative to safe assets--all combining to weaken the ability of the
economy to withstand even modest adverse shocks. This is, at least in my
interpretation, the substance of Hy's "financial instability hypothesis."
In the case of the Asian emerging economies, there was evidence of
speculative excesses in financial and real estate markets in some of the
countries. There was, in addition, an extraordinary taking-on of risk in
the form of enormous leverage in the non-financial sector and in the
financing of longer-term domestic investment projects with shorter-term
foreign denominated borrowing. The failure to respect risks was not only
evident in financial markets and financing practices, but also in the
investment decisions themselves. These risks were compounded by poor risk
management and inadequate bank supervision and regulation. It should be
noted, however, that not all the countries were affected by all of these
vulnerabilities or to the same degree.
Financial sector vulnerabilities often increase during a cyclical
upswing, as Minsky emphasized so often, setting the stage for the
subsequent downturn. But in the case of the Asian developing economies,
there was also a systemic source of these vulnerabilities: weaknesses in
corporate governance and moral hazard associated with implicit or
explicit government guarantees. The result was incentives for excessive
risk taking.
To understand the dimension and spread of the crisis among Asian
developing economies, we also have to take account of the vulnerability
generated by fixed exchange rates in the presence of volatile
international capital flows, the role of market psychology, and the role
of contagion effects.
Financial sector weaknesses, pegged exchange rate regimes and volatile
capital flows combined to yield a highly combustible mixture that, with
the spark of adverse shocks, resulted in the igniting of currency and
debt crises, including the collapse of banking systems throughout the
region. The result was both a particularly sharp economic downturn and
significant obstacles to recovery, specifically the joint problem of
restructuring of the banking systems and resolving the excessive debt in
the nonfinancial corporate sectors.
The dramatic declines in currency and equity markets in this case were
also affected by the sharp swing in market psychology. In part due to a
lack of transparency, markets had a hard time sorting out what the
fundamentals dictated in terms of exchange rates and equity prices. That
made the markets very sensitive to factors that affected confidence in
the policies followed by the countries. This meant that prompt and
decisive policy action in advance of IMF programs was very important, and
that a perception of government commitment to IMF programs, once in
place, was imperative.
Hy's work helps us to bring a balanced perspective to the debate that
still rages about the Asian crisis. Was it due to vulnerabilities in the
Asian economies or was it an illustration of the inherent instabilities
of global capitalism? Hy, I expect, would have concluded that the answer
is both. Capitalism, in its domestic or global form, brought great
potential for higher living standards, but also the potential for
instability, including occasional financial and banking crises. The key
was to maximize the opportunity to take advantage of the benefits, while
mitigating the risks.
Still, it is important to appreciate the interplay between developments
in the industrial countries and in the emerging market economies leading
up to the crisis. The weakness in Japan certainly took its toll on the
emerging Asian economies. The extraordinary inflow of capital into
emerging Asian economies from the industrial countries contributed to
possible overheating and set the stage for the abrupt and dramatic
reversal of capital flows that was a defining feature of the crises.
Contributing to the surge in capital inflows to the region were
shortfalls in risk management by financial institutions in these
countries, misperceptions about the riskiness of such investments, and
attempts to diversify portfolios in these economies following a run-up in
domestic equity prices.
In "Can It Happen Again? " Hy argued that advanced capitalist economies
have found ways to mitigate the risks of financial and banking crises, or
at least attenuate their adverse effects. Hy emphasized the evolution of
the central bank's role as lender of last resort and the stabilizing role
of a large government as the central features of this policy and
institutional evolution. I'll take a somewhat broader view of the nature
of the policy and institutional evolution of capitalist economies and, in
turn, of the structural reforms that would mitigate risks of future
crises in the emerging market economies. This broader view might also
extend to the appropriate evolution of international financial
institutions and cooperation to keep pace with the increasingly global
form of capitalism.
The importance of robust institutions and sound policies in mitigating
the risks associated with inherent instabilities in capitalism suggests a
role for policy "sequencing" in emerging market economies. It is widely
argued, for example, that capital account liberalization in emerging
market economies should be preceded by improvements to the institutional
infrastructure to make the economies less exposed to risks associated
with the volatility of capital flows. These include both appropriate
exchange rate and financial regimes.
But, in fact, we seem to only play lip service to such an optimal
sequencing of policies. Some worry, perhaps with reason, that sequencing
might become an excuse for not moving ahead with capital account
liberalization. What we really seem to encourage is rapid liberalization,
independent of the state of the banking and financial sector, hoping that
financial liberalization will pressure the authorities to move more
quickly with improvement in supervision and regulation. The Asian crisis
is, I believe, a test of this approach. At the very least, we have to
match the pace of capital account liberalization with careful
consideration of exchange rate regimes and efforts to improve corporate
governance and bank regulation and supervision.
The sequencing perspective also suggests that the story behind the crisis
in emerging Asian economies may have less to do with the inherent
instabilities of global capitalism than with a mismatch between the
evolution of institutions and policies and the pace of liberalization of
financial markets and the capital account, the critical entry points to
global capitalism. What may be in play, therefore, are the transition
costs of a rapid increase in globalization, and especially transition
costs associated with entry of emerging market economies into the global
economy.
A third theme in my interpretation of the Asian crises is perhaps a
lesser focus in Hy's work, but he was nevertheless quite prophetic in
relation to the recent crises. Hy warned that the ability of a central
bank to act as a lender of last resort is limited to debts denominated in
the country's own currency.(3) When countries finance their domestic
projects with foreign denominated debt, therefore, they lose the
stabilizing potential of their central bank's lender of last resort power
and confront a far more challenging and potentially unstable environment.
In the case of the Asian crisis, the financing of domestic projects with
foreign denominated debt--either directly or through the banking
system--created an important vulnerability, one that was dramatically
aggravated by the sharp depreciation of the currencies in the crisis
countries, and one that domestic central banks had limited power to
arrest.
So, what are the lessons from this framework for thinking about
recessions in general and the Asian crisis in particular? It would be
tempting to encourage countries to avoid adverse shocks. But of course,
shocks are, by definition, unavoidable. To be sure, risks can be avoided
or mitigated by limiting vulnerabilities. It is especially important not
to become complacent during a period of excellent macroeconomic
performance about the underlying strength of balance sheet positions,
debt-income ratios, credit quality, quality of bank credit risk
management, and adequacy of prudential supervision. This experience only
reinforces the wisdom of the adage that "bad loans are made on good
times." Normal times may also be opportunities to transition from to more
flexible exchange rate regimes. But, to an important degree, there is an
almost inexorable tendency for vulnerabilities to build to some degree
during expansions. Therefore, another key lesson is the importance of
policies and institutions that mitigate the risks that evolving
vulnerabilities will trigger serious crises. This episode emphasizes the
importance of robust institutions--such as exchange rate regimes, bank
regulation and supervision, and corporate governance--as well as sound
policies in promoting good economic performance.
II. Exchange Rate Policy
Pre-crisis policy: the case for flexible exchange rates
Many countries have tried to run exchange rate regimes that fall
somewhere between fully flexible exchange rates and "very fixed" exchange
rates, meaning a well-designed currency board arrangement or even, in the
extreme, dollarization. However, arrangements between the extremes are
often difficult to sustain indefinitely and when such arrangements break
down, the result can be very painful. Whether or not currency boards are
a viable option remains controversial. Such arrangements may increase the
durability of fixed exchange rate systems, but perhaps at great expense
to the real economy. Therefore, I conclude that one of the lessons from
the Asian crisis is that a flexible exchange rate regime is, in general,
preferable to pegged exchange rate regimes as a means of minimizing
vulnerability to adverse shocks.
Exchange rate policy during currency crises
In principle a devaluation or float of the exchange rate, by allowing the
exchange rate to reach a more sustainable level, should lead to a
subsequent easing of interest rates and other financial pressures. But,
during the Mexican crisis of 1994-95, and the more recent crises in Asia
and Russia, devaluations have served to intensify downward pressures on
financial markets: currency values plummeted, interest rates skyrocketed,
capital outflows intensified, and economic activity dropped off sharply.
The adverse consequences of devaluing or floating during speculative
attacks represent all the more reason for countries to exit from pegged
exchange rate regimes into more flexible regimes during periods of
normalcy.
If a country has failed to exit from its pegged exchange rate regime
during normal times and is confronted by a speculative attack, then the
key question becomes whether and when to abandon the peg. The answer
depends on whether or not a successful defense is possible. If the
country's position is strong enough--i.e. the financial sector is sound,
output gaps are not already large, and foreign exchange reserves are
large--to avoid devaluing during a financially volatile period, it
probably should endeavor to do so through some combination of monetary
tightening, structural reform, and foreign exchange rate intervention.
Defending the peg in this way may entail costly increases in interest
rates and declines in economic activity, but these costs might be
substantially less than in the alternative case of an uncontrolled
devaluation spiral.
Of course, this leaves the key practical problem of identifying the
probability that a peg can be defended. This is an extremely difficult
proposition, even for a completely objective analyst. Not-so-objective
players, such as national governments, have often been excessively
optimistic about their chances of defending a peg. And, it was also the
case, in this episode, that the pegs were not strongly defended during
the early stages of the crisis. The increases in interest rates were too
timid, and the willingness to take other preemptive moves to restore
investor confidence too limited.
Conversely, recent experience could suggest that, in the face of a
speculative attack, an exchange rate peg should be abandoned as soon as
it is clearly unsustainable. The sooner the peg is abandoned in this
circumstance the better, since the government is likely to have more
reserves remaining, financial institutions will have incurred fewer
losses from high interest rates, the maturity structure of the debt will
have had less time to shorten, and expectations are less likely to have
galvanized around the exchange rate. Still, the lessons from this period
are not always so clear. Indonesia and Malaysia gave up their pegs within
a month after the Thai baht floated, but suffered comparable consequences
to Thailand. Another lesson from this episode is that early devaluations
are not a cure-all.
III. Macroeconomic Policy
Pre-crisis macroeconomic policy
By conventional standards, the monetary and fiscal policies of the
developing Asian economies prior to the crisis were largely disciplined
and appropriate. In all of these countries, consumer price inflation--the
prime metric for the success of monetary policy--was relatively subdued,
especially by emerging market standards. By the metric of public sector
deficits, fiscal policy also appears to have been disciplined prior to
the crisis. Therefore, another important lesson of the Asian crisis is
that sound macroeconomic policies alone do not preclude crises. This
experience also suggests that sound macroeconomic policy must be
complemented by sound financial practices, effective bank supervision,
and effective corporate governance.
I suspect, however, that Hy might have raised a serious question about
this favorable assessment of pre-crisis policy. There was, as I noted
earlier, some evidence of speculative excesses in financial and real
estate markets in some of the countries and, despite the relatively good
inflation performance, an argument could be made that the speculative
excesses were evidence of overheating and could have been remedied by
macroeconomic policy. Higher interest rates, on the other hand, would
have encouraged still more capital inflows and appreciation of the
currencies at a time of increasing current account deficits. Fiscal
restraint would have, in retrospect, been desirable, but, at least on the
spending side, would have to be weighed against the substantial
infrastructure and other priorities.
While the inflation performance was good by developing economy standards,
it was consistently higher than inflation in the U.S., the country to
which exchange rates were pegged. As a result, there was a tendency
toward real appreciation, which contributed to the deteriorating current
account deficit in several of the crisis countries.
Monetary policy during the speculative attack
While monetary policies may not have been inappropriate in the years
prior to 1997, they were probably not tightened sufficiently or for long
enough in the immediate pre-devaluation phase of the emerging crises in
the developing Asian economies. Had monetary policy been tightened
adequately in order to defend exchange rates in the first part of 1997,
it is possible that the crisis might have been moderated, if not avoided.
Monetary policy after exchange rates were floated
One of the most controversial aspects of post-float policy has been the
appropriate stance of monetary policy. From a theoretical standpoint, the
jury is still out on the usefulness of monetary policy tightening once
the exchange rate is floated after a speculative attack. Proponents of
tightening point to the usefulness of keeping rates high in order to make
domestic assets attractive and to help contain inflation expectations
following a nominal depreciation. Detractors argue that by weakening the
financial system and corporate balance sheets, and by depressing economic
activity, higher rates may further reduce country creditworthiness and
thereby heighten downward pressures in the currency. Both positions have
merit and economic theory offers little guidance as to which deserves
greater weight.
Recent experience also fails to offer decisive guidance on the most
appropriate monetary policy immediately following a float forced by a
speculative attack. There is little in the Asian post-float experience to
convincingly support the view that higher domestic interest rates did
help to support the exchange rate. Currency values, for example, fell as
much in countries that raised interest rates sharply--Thailand and
Korea--as in countries where interest rates were raised by less, such as
Malaysia. These trends, of course, mostly reflect the endogeneity of both
the exchange rate and interest rates to swings in investor confidence.
Countries where investor sentiment declined most strongly both
experienced sharper falls in currency values and were required to raise
interest rates higher to prevent even sharper depreciation. This suggests
that, during the months following devaluation, exchange rates were driven
as much by broad concerns about creditworthiness as by concerns about
interest rate differentials.
These considerations suggest that, once the exchange rate is floated and
broader concerns about an economy's financial position emerge, there is a
limited contribution that monetary policy can make to stabilize the
situation. Of course, by abandoning an exchange rate peg, a reliable
nominal anchor is lost at a time when the devaluation threatens higher
inflation; it is essential that monetary policy be conducted with
appropriate attention to controlling inflation. Striving to keep real ex
ante interest rates positive may be a reasonable benchmark for
post-devaluation monetary policy. Once the exchange rate stabilizes and
inflation expectations moderate and pressure on the capital account
eases, it may be useful and appropriate to lower interest rates. The
interest rate policies eventually followed by the Asian countries roughly
followed this pattern. At present, in fact, nominal and real interest
rates are below their pre-devaluation levels. At the same time, the
increase in inflation has been very modest.
Fiscal policy during the financial crisis
In retrospect, it seems clear that the initial objectives for tightening
fiscal policy set by the IMF for the affected Asian countries were
inappropriate. The markets clearly recognized that fiscal profligacy was
not behind the crisis and did not view fiscal austerity as a policy that
was likely to resolve the crisis. Output in these countries has declined
by more than anyone anticipated, and so fiscal loosening rather than
fiscal tightening is required.
An important source of initially inappropriate fiscal targets may have
been poor forecasts. As forecasts were adjusted, new fiscal targets had
to be negotiated, because the targets themselves were set in terms of the
overall rather than the structural deficit. This renegotiaiton took time
and often appeared to put the Asian economies in the position of asking
for relief from IMF conditionality, undermining investor confidence,
rather than as a disciplined and appropriate response to changing
conditions and more realistic forecasts. This suggests setting targets in
terms of structural deficits, or at least allowing built in fiscal
stabilizers to continue to operate. However, estimates of structural
deficits are only now being developed for Asian countries and such
estimates may not be straightforward enough to form the basis for IMF
performance criteria. But the principle should be respected.
(Note: this article is ''in progress''; there will likely be an update soon.)
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