Mr Meyer considers the role of exchange rate policy, macroeconomic policy, banking
supervision and regulation
Remarks by Mr Laurence H Meyer, a member of the Board of Governors of the US Federal
Reserve System, at the Ninth Annual Hyman P Minsky Conference on Financial Structure at
the Jerome Levy Economics Institute, Bard College, Annandale-on-the-Hudson, New York on
22 April 1999.
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 pre-emptive 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
postdevaluation 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
predevaluation 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
renegotiation 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.
IV. Banking and Corporate Debt Problems
Weaknesses in the financial sector and excessive leverage in the corporate sector clearly
contributed to the crisis in the emerging Asian economies. Indeed, the defining character of
these crises was the intersection of currency, banking, and corporate debt crises. The
weakness in the financial sector, in turn, was encouraged by the moral hazard associated with
perceived wide-ranging government guarantees and political interference in lending decisions
by banks. As a result, banks had insufficient incentives to manage their credit risks and firms
had inadequate incentives to limit their leverage and make sound investments.
There are two broad lessons that emerge from this episode and earlier experiences involving
financial crises. First, to reduce the vulnerability of an economy to banking and financial
crises, a high priority should be given to sound corporate governance, narrow and explicit
government guarantees, and adequate prudential supervision of banks. Second, while it is of
course desirable to encourage robust institutions to minimize the likelihood of such problems
in the future, once the crisis has occurred, the first priority should be to repair the damage
done by the crisis to banking and corporate balance sheets. Corporate balance sheets need to
be de-levered and banking systems need to be restructured and recapitalized in a pro-active
and timely manner, or insolvent banks and corporations will continue to be an enormous
macroeconomic weight on the economy and a serious obstacle to recovery.
What do emerging market economies need to do?
Some financial sector safety net appears to be essential to avoid bank runs and promote
systemic stability. But, safety nets should be narrow and explicit, as opposed to broad and
implicit. As a general principle, it is constructive to have safety nets in place that protect small
depositors at depository institutions and thereby protect the functioning of the payments
system from bank runs in the face of severe adverse shocks. Elsewhere market discipline,
supported by effective disclosures and sound corporate governance, should be relied upon to
control risk taking.
Even narrow, explicit safety nets for the banking sector result in moral hazard incentives for
excessive risk taking, and therefore must be complemented with adequate prudential
supervision. Such supervision not only promotes the safety and soundness of the banking
system, but also limits the government's contingent liabilities associated with the safety net.
Still, there are limits to the ability of supervisors and examiners to monitor banks effectively
and control their risks. Market discipline therefore has to be enhanced to support sound
corporate governance and complement bank regulation and supervision.
The practices of directed lending to support government priorities and lending to
wellconnected firms undermined normal incentives for prudent behavior by both banks and
business customers. Poor incentives on the part of both lenders and borrowers are a recipe for
the insolvency of both. Therefore, improved corporate governance is an essential part of
structural reform, encouraged by freeing banks from political interference in lending.
It is difficult to see how the economies can get back to sustainable growth without taking the
necessary steps to strengthen their banking sectors. What needs to be done includes a familiar
list: restructuring loans, taking losses, recapitalization, improving corporate governance and
disclosure, and enhancing supervision. However, unlike Japan, the burden of recapitalizing
the banks is likely to be a significant burden on Asian emerging market economies and they
may lack the technical expertise to accomplish the steps necessary for successful banking
system restructuring on their own. Foreign technical assistance, international official financial
support and/or foreign bank investments will be required. The debt problems of banks are
closely related to the excessive leverage and weak financial conditions of the corporate sectors
in these economies. So, resolving financial sector weaknesses means both restructuring and
recapitalizing banks and orderly workouts of the debt problems of their corporate sectors.
Another clear lesson from the Asian crisis is that widespread insolvencies in the nonfinancial
sector can be even more difficult to remedy than banking sector problems. The absence of
adequate bankruptcy laws and procedures has in many cases meant that there was an absence
of established mechanisms for allocating the burden of excessive debt problems among the
borrowers and the lenders.
What can industrial countries do?
First, we need to continue work by expert groups to develop standards. An excellent example
of an effective process and excellent execution is the Core Principles for Effective Banking
Supervision produced by the Basle Committee on Bank Supervision. The process that
produced this set of standards sets an important standard of its own. The experts should set
and, as necessary, update standards in a cooperative effort of supervisors and regulators
around the world. It is important that these efforts include emerging market economies.
Second, we need to improve monitoring of compliance with these standards. In particular, the
IMF is incorporating into its country assessments compliance with international standards for
banking and bank supervision.
Third, we need to have sufficient resources dedicated to technical assistance for countries that
are working to converge to best-practice standards and incentives for countries to comply.
Market discipline, encouraged by more limited safety nets and enhanced disclosure, could
play an important role here. This could be reinforced by market access policy in developed
countries; i.e., limiting access to domestic banking markets to banks from countries who meet
international standards for bank supervision. Finally, proposals for pre-conditionality are
intriguing, though fraught with practical problems and obstacles. There have recently been
proposals for contingency funds for countries that met certain conditions, perhaps including
compliance with international standards. This might be a way of enhancing incentives to
comply with international standards.
However, questions that have to be resolved include: Why would emerging market economies
want to participate, if doing so singles them out as in potential need of liquidity lines? This
may be similar to the reluctance of banks to borrow from the Federal Reserve discount
window. Would the IMF (or whoever is implementing the lines) be willing to remove access
to the liquidity facility if policies and conditions deteriorated in the country in question and
threaten to precipitate a crisis in the process? Do we know enough about early warnings of
crises to identify countries that meet appropriate standards and therefore deserve to qualify for
such a facility?
Moral hazard incentives affect foreign as well as domestic lenders. It is, therefore, important
to find ways to ensure that foreign private lenders bear the consequences of the risks they take.
Imposing losses on creditors will, of course, limit their willingness to extend credit to other
borrowers. Doing so in the midst of a crisis is obviously problematic. Deciding how and when
to involve the private sector in responding to international financial crises remains a
challenge. Progress can be made at the margins. In particular, it might be worthwhile to look
for ways to encourage the inclusion of collective action clauses in sovereign bond contracts to
encourage greater cooperation among creditors when financial crises occur. Another
promising direction is to promote the adoption of sound bankruptcy codes in emerging market
countries to handle private debts more effectively. These measures can move the process in
the right direction, but they are no panacea. We must continue to struggle to find ways to
contain and resolve international financial crises without offering undue protection to
international investors.
Industrial countries, as well as the emerging market economies, have supervisory issues
related to emerging country ris