Carlos Gustavo Cano: On the crisis
Speech by Mr Carlos Gustavo Cano, Co-Director of the Bank of the Republic, at the
Universidad del Rosario School of Economics graduation ceremony, Bogotá, 25 April 2012.
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An important body of literature has come to light on occasion of the latest international
financial crisis, known as the Great Recession, which began to form in 2007 and had the
mortgage market in the United States at its core. Produced by the most prestigious
economists in academia, this literature focuses on the etiology of that crisis and the
suggested courses of action to prevent its reoccurrence. Several documentary films have
been produced as well, which help to illustrate and stir the debate.
One of the most valuable exercises is that developed by Carmen Reinhart and Kenneth
Rogoff (2009). Its title carries the ironic essence of one of its central messages: This Time Is
Different, thereby reflecting the typically arrogant attitude often assumed by those
responsible for economic policy, and particularly for financial regulation in the affluent world,
when confronted with phenomena of this type, which have been recurrent, at least
throughout the last two centuries.
Excessive exposure to financial risk, above all during the so-called "good times," has been
the main cause of these crises. During the last 25 years, this exposure was exacerbated by
the much celebrated and lauded "financial revolutions," which provoked the largest bubbles
and "manias" in the real estate and securities markets.
The term "manias" suggests a loss of contact with reality and is akin to the idea of "mass
hysteria". Indeed, during a boom, people over-borrow in order to invest. The longer the
euphoria provoked by the boom lasts, the more risks lenders take. And, so it goes until the
income generated by the assets acquired by borrowers is no longer enough to repay their
debts. Creditors then tend to demand loans be paid immediately, forcing over-indebted
investors to sell their speculative assets precipitously to pay back their loans, causing the
prices of those assets to drop sharply.
The hard lessons derived from these experiences - forewarned by eminent scholars who are
no longer with us, such as Charles Kindleberger (2005) and Hyman Minsky (1992, 2008)
- and regrettably often ignored but fortunately reiterated and recalled by a group of other
learned contemporary writers and central bankers, such as Paul Krugman (2009a, 2009b),
Nouriel Roubini (2010), Charles Goodhart (2005) and Paul Volcker, show investors do not
respond to the "efficient market" theory, based on the false assumption of absolute rationality
on the part of economic agents.
On the contrary, in the real world, false illusions and collective insanity tend to outweigh
rationality. As a result, investors very often are exposed to "herd behavior," attacks of
"irrational exuberance" or unwarranted panic. If we were truly rational and the markets were
indeed efficient and perfect, unemployment would be voluntary and recessions, natural and
therefore desirable, as noted by Krugman (2009b), the 2008 Nobel Laureate in economics.
Moreover, to fulfill the objective of their mission, financial intermediaries raise funds from the
public, which generally lacks the knowledge and sufficient means to assess the solvency and
liquidity of those intermediaries, and to understand the nature and scope of the risks involved
in how those funds ultimately will be used.
Therefore, the State must assume a fundamental responsibility to fill this delicate vacuum. It
can do so primarily by educating, guiding and protecting the consumer, by reinforcing
- through regulation and oversight - the confidence savers and depositors have in the
broader financial system, by ensuring its social effectiveness, by promoting competition
among its agents and avoiding dominant positions in the market, by minimizing the risks and
the costs of crises, by ensuring the smooth operation of payment systems, and by giving rise
to and preserving the faith citizens have in the constituted authority that is responsible for
monetary policy, regulation and oversight.
Ultimately, what is at stake are the criteria for deciding who may or may not use the public's
savings and for what purposes; who may or may not undertake new businesses; and who
may or may not preserve or increase their positions of economic power.
As to the constitutional duty of the country's monetary authority, which is essentially to
secure and maintain low and stable levels of inflation through controls on demand and on
growth of the amount of money in circulation, the efforts of today's central bankers could
easily end up being offset by new and very near substitutes for the latter.
I am talking about some of the latest credit and financial "innovations." Their development
has paralleled that of the so-called "shadow banking system," with a capacity to issue
currency by virtue of those innovations that goes beyond the reach of the central bank's
monopoly or control over that function.
Clearly, the regulation of classic and new financial intermediation, rather than supplementary,
must be an essential and urgent part of the management of the monetary base in all its
accepted forms and varieties.
Rather than distorting the use of a traditional instrument such as the interest rate to achieve
that second objective, what we need is a second instrument with counter-cyclical features of
the kind that make it possible to exercise effective control over growth in the loan portfolio
during asset price booms, such as those involving real estate and securities. Obviously, the
issue at hand is one of regulation and oversight.
The appearance of new non-bank intermediaries with a strong appetite for risk - hedge
funds, private equity funds and venture capital funds, among others - is the most formidable
contemporary challenge the authorities now face. Within the "broader financial system," in
most of the planet and especially in the United States, duly supervised banks occupy an
increasingly reduced space, as indicated by another of today's most noted experts,
Raghuram Rajan (2005, 2010). At the time, he was labeled as backward by the heads of the
financial conglomerates and their counterparts in the public sector. Yet, ultimately and
because of deregulation, it was they who sparked the crisis.
Therefore, if regulation and oversight are to be effective, they must apply to the
conglomerates, instead of being applicable only to individual firms in a separate manner. The
entire system must be covered comprehensively and seamlessly.
As illustrated by Reinhart and Rogoff (2009), there is a striking correlation between the
degree of freedom in capital markets and the occurrence of crises. Clearly, the booms in
capital flows have been particularly important factors in causing financial crises, as least
since the 1970s when the markets began to be deregulated in a major way.
Thirty years ago, in the face of that the deregulatory wave, Minsky (1992, 2008) warned that
a sophisticated, complex and dynamic financial system like ours endogenously generates
destabilizing forces than end in equally serious economic depressions as a natural result of
noninterventionist capitalism. "Do not allow the markets to operate freely," he said. As
happened to Keynes, many accused him of being a socialist, and even a Marxist, when
actually what he was trying to do was save the capitalist system. Since then, the "Minsky
moment" has been popularized in economic literature to characterize the symptoms of this
type of crisis.
In addition, the possibility that the effects of sharp increases in capital inflows, combined with
high terms of trade, might be multiplied by the financial system through more lending,
thereby generating asset price bubbles, constitutes a risk that warrants careful monitoring.
Similar scenarios could trigger the formation of bubbles, and equally unusual increases in
current account deficits and excessive vulnerability of the financial system.
The behavior of asset prices, although not included in conventional indicators of inflation,
also should be an issue of concern to the monetary authority, namely the central bank,
because of its impact on the solvency and stability of the financial system.
The idea is to steer regulation towards dealing with the systemic risks in the financial sector
as a whole, as opposed to addressing isolated parts. This means supplementing the
conventional objective of monetary policy by adding the mandate to anticipate potential asset
price bubbles. For that reason, regulating the supply of credit is crucial.
What is needed to do so, apart from interest rates, reserve requirements and capital controls,
which must continue to be available and applied, when warranted under the circumstances,
are other tools now referred to as macro-prudential regulation. These include minimum
liquidity and capital requirements for intermediaries; ordinary and counter-cyclical provisions;
leveraging limits; criteria on risk management and investment portfolio diversification; limits
on loan-to-value and loan-to-income ratios for housing and other consumer durables , as well
as limits to financing securities through "margin accounts"; prevention of currency and
maturity mismatches between leveraging by intermediaries and their loan portfolios;
counter-cyclical capital requirements for intermediaries, according to credit performance; and
separation of commercial banking activity from proprietary trading.
In short, the task at hand is essentially to prevent excesses caused by financial and credit
innovations, to offset the formation of asset price bubbles and to prevent them from bursting,
and, above all, to protect the consumers of financial services.
Colombia can proudly show off its sold and transparent institutional system in the realm of
monetary policy and regulation and oversight, which is recognized and respected both at
home and abroad.
The severe crisis the country suffered at the end of the 1990s taught us some harsh lessons.
Fortunately, they were learned well and assimilated by our central bank, which is known for
its outstanding and proven technical capacity.
Since then, coordination with the Finance Ministry and the Office of the Superintendent of
Financial Institutions in the area of regulation and oversight has been particularly close and
fruitful. Nevertheless, in my opinion and regardless of how suitable and responsible
management fortunately has been, this last agency should have a degree of independence
and autonomy similar to what the central bank (Banco de la República) enjoys, with a Board
of Directors and fixed terms for its members and for the Superintendent. Its public credibility
would be further strengthened through such reforms, as would its harmony and coherence
with the Board of Directors of Banco de la República, which is essential.
James Madison, the foremost architect of the United States constitution and the foundations
of its public institutions, wrote the following in the fifty-first edition of the Federalist Papers:
"If men were angels, no government would be necessary. If angels were to
govern men, neither external nor internal controls would be necessary. In framing
a government which is to be administered by men over men, the great difficulty
lies in this: you must first enable the government to control the governed; and in
the next place oblige it to control itself."
Inspired by Madison's judgment, in an excellent book just published by MIT entitled The
Guardians of Finance, the authors, who almost certainly are the leading experts on these
topics at present - James Barth, Gerard Caprio and Ross Levine (2012), added:
"If men had only angelical intentions and the markets were perfect, there would
be no need for government or financial regulation. But people are not angels, nor
are the markets perfect."
On this particular point, United States Senator Carl Levin, who is quoted in the book, said:
"The recent financial crisis was not a natural disaster. It was an economic assault
perpetrated by men. People did it...and it will happen again unless we change
the rules."
The moral of these considerations leads us to recognize that history is the master inspiration
of economics; psychology, the language by which it can be understood; and ethics, its
cradle.
Those who disregard history, like Sisyphus, will never cease to wrongly believe "this time is
different".
Those who ignore psychology will never be able to understand that economic is essentially a
science of human behavior. Were it not so, then how can one explain the fact that the 2002
Nobel Prize for Economics went to the most celebrated psychologist of our time, Daniel
Kahneman (2011)?
Finally, let us not forget the first great work written by Adam Smith, the pioneer of modern
economics, was The Theory of Moral Sentiments, followed by The Wealth of Nations, which
is better known to us for having concentrated on the specific object of our profession as
economists. But the order in which these works appeared is not coincidental. Clearly, the
former provided the underpinnings for the latter; hence, their contents are bound essentially
by cause and effect.
References
Barth, J.R., Caprio, G., Levine, R. (2012). Guardians of Finance. The MIT Press.
Goodhart, Ch. (2005).Financial Regulation, Credit Risk and Financial Stability. National
Institute Economic Review.
Kahneman,D. (2011). Thinking Fast and Slow. New York: Farrar, Struss and Giroux.
Kindleberger, Ch. (2005). Manias, Panics and Crashes. New Jersey: Wiley.
Krugman, P. (2009a). The Return of Depression on Economics. New York: Norton.
Krugman, P. (2009b). "How Did Economists Get It So Wrong?" NYT: Sept. 6, 2009.
Minsky, H.P. (1992)."The Capital Development of the Economy and the Structure of
Financial Institutions."Working Paper No. 72.The Jerome Levy Economics Institute of Bard
College.
Minsky, H.P. (2008).Stabilizing an Unstable Economy. Mc GrawHill.
Rajan, R.G. (2005). "Has Financial Development Made the World Riskier?" IMF.
Rajan, R.G. (2010).Fault Lines. Princeton University Press.
Reinhart, C.M. and Rogoff, K. S. (2009).This Time is Different. Princeton University Press.
Roubini, N. and Mihm, S. (2010). Crisis Economics. New York: The Penguin Press.