Donald L Kohn: Jackson Hole Conference - panel discussion "Financial
markets, financial fragility, and central banking"
Remarks by Mr Donald L. Kohn, Governor of the Federal Reserve Bank of Kansas City, at a
symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming,
27 August 2005
* * *
My perspective on this interesting and stimulating paper by Raghu Rajan has been very much
influenced by observing Alan Greenspan's approach to the development of financial systems and their
regulation over the past eighteen years.1 I believe that the Greenspan doctrine, if I may call it that, has
reflected the Chairman's analysis and deeply held belief that private interest and technological
change, interacting in a stable macroeconomic environment, will advance the general economic
welfare.2
Chairman Greenspan has welcomed the ability of new technologies in financial markets to reduce
transactions costs, to allow the creation of new instruments that enable risk and return to be divided
and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations
to be securitized and traded, and to make obsolete previous divisions among types of financial
intermediaries and across the geographical regions in which they operate. At the intersection of
market developments and monetary policy, he has led the Federal Reserve's efforts to understand the
implications of changing financial technology, such as the growing ease of housing equity extraction,
and to use the newly available information about market expectations and the price of risk embodied in
market prices.
The Greenspan doctrine holds that these developments, on balance, improve the functioning of
financial markets and the real economies they support. By allowing institutions to diversify risk, to
choose their risk profiles more precisely, and to improve the management of the risks they do take on,
they have made institutions more robust. By making intermediaries more robust and by giving
borrowers a greater variety of lenders to tap for funds, these developments have also made the
financial system more resilient and flexible - better able to absorb shocks without increasing the effects
of such shocks on the real economy. And by facilitating the flow of savings across markets and
national boundaries, these developments have contributed to a better allocation of resources and
have promoted growth.
That is not to say that the Greenspan doctrine holds that private markets always get it right. Prices in
these markets are driven by the tendency of human nature to project the recent past - to waves of
complacency and gloom - and hence are subject to overshooting. And private parties, left entirely to
their own devices, do not always produce a market structure and market relationships consistent with
adequate protection of financial stability. However, the actions of private parties to protect themselves
- what Chairman Greenspan has called private regulation - are generally quite effective. Government
regulation risks undermining private regulation and financial stability itself by distorting incentives
through moral hazard and by promising a more effective role in promoting financial stability than it can
deliver.
In this situation, government regulation has a function but it should be based on clear objectives,
narrowly tailored to meet those objectives, and, given the iron law of unintended consequences, it
should be clearly superior to private regulation. Regulation can be justified if incentives for private
regulation are weak - perhaps because of other government programs, such as deposit insurance - or
if market participants are likely to be ineffective, as for example small savers and borrowers.
Regulation may also be justified to promote greater flow of accurate information to enable private
participants to make better informed decisions.
New technologies and changing market structures imply that regulation should be constantly under
review; at times rolling back regulation - for example, by lifting the Glass-Steagall restrictions on
banking organizations - will benefit competition and help the financial sector deliver services more
efficiently and effectively. Moreover, regulation itself can benefit from competition. Running regulated
and unregulated markets side by side gives people a choice of whether they want protection and helps
to constrain regulation. Some of the same purposes can be served by having multiple regulators for
the same function; in some circumstances, the possible adverse consequences of competition in laxity
may be smaller than the potential for regulatory conformity and regulator risk-aversion to impinge on
innovation and change.
The Greenspan doctrine has had a perceptible influence on the evolution of markets and the
regulatory structure that applies to them. Raghu Rajan voices some concerns about this evolution. In
particular, he posits that the shift from depository intermediation to professional asset management
has increased tail risk to socially excessive levels and has left the world more vulnerable to rare but
potentially very serious tail events; he suggests some ways in which regulation should be increased.
In assessing this argument, we might find it useful to separate the question of whether the world is
riskier from the question of whether systemic risk has risen. The increased ability to disentangle risk
and tailor risk profiles should mean that risk has come to be lodged more in line with investor
appetites, a change that has probably tended to reduce the price of risk and encouraged riskier capital
projects to be funded. But individual investors at greater risk need not imply increased systemic risk -
fatter tails and greater potential for losses feeding back on the macroeconomy.
In fact, industrial economies have been marked by much less variability in output and inflation over the
past twenty years. Many reasons have been given for this so-called great moderation, but
developments in financial markets have likely played a role in making the economy more resilient. As
a consequence of greater diversification of risks and of sources of funds, problems in the financial
sector are less likely to intensify shocks hitting the economy and financial market .
The experience of 2001-03 is instructive. Unusually large declines in equity prices and increases in
defaults and risk spreads - surely tail events by most definitions - reduced wealth and raised the cost
of capital but did not aggravate the downturn by impinging on the flow of funds. Financial
intermediaries were not so troubled as to cut off the provision of credit, and in any case, many
borrowers had alternative sources of funds.
In addition, we have not seen a clear upward trend in volatility of financial asset prices over the past
twenty-five years, as one might expect if herding had increased in importance. Judging from options
prices, market participants are expecting the volatility of financial asset prices to be damped in the
future; they are also requiring lower-term premiums for placing funds for longer terms.
I do not share Raghu's nostalgia for the systemic-risk implications of bank-dominated finance.
Oldstyle crises involving impaired depository institutions had substantial spillover effects; their repair took
time, during which economic activity was affected; and emergency measures to deal with them often
involved moral hazard because they were aimed at stabilizing ailing intermediaries. I think we would all
agree that the industrial economy that has suffered the greatest systemic strains from problems in the
financial sector in the past fifteen years is that of Japan, which remained tied to the commercial bank
model Raghu finds safest. The macroeconomic effects of new-style crises involving market liquidity, as
in 1998, or outsized movements in asset prices may be more readily cushioned by monetary policies
aimed at bolstering the general level of liquidity and reducing interest rates. Such policies also carry
less risk of increasing moral hazard.
Although investment managers receive substantial funds directly from households, many of their
counterparties are sophisticated investors in positions of fiduciary responsibility. In addition, most
asset managers are employees of institutions - mutual fund families, bank holding companies - that
are in the market for the long haul. It is not in their interest to reach for short-run gains at the expense
of longer-term risk, to disguise the degree of risk they are taking for their customers, or otherwise to
endanger their reputations. I would expect these counterparties and employers to enforce
compensation schemes that foster their objectives. As a consequence, I did not find convincing the
discussion of market failure that would require government intervention in compensation. Moreover,
compensation regulation is likely to be easily evaded and fraught with risks of untoward
consequences. One only has to recall the congressional action of 1993 that, by imposing
lessfavorable tax treatment on some forms of executive compensation, fostered the shift to stock options
that in turn was thought to have contributed to some of the transparency and corporate governance
problems of the late 1990s.
Regulatory and supervisory systems do need to evolve to reflect the shift to market-based
transactions. As intermediation shifts from depositories, with their specialized knowledge of borrowers,
to markets, disclosure and transparency become more important to allow diverse private parties to
assess risk properly, exert appropriate discipline, and contribute to the efficient allocation of resources.
Greater reliance on markets also elevates the importance of the safety of clearing and settlement
systems. Private-sector participants have every incentive to demand these disclosures and to ensure
that their trades go through as contracted. But government may need to act in concert with private
parties to arrive at collective decisions that strengthen markets and reduce systemic risk but might not
be in the interest of individuals acting separately. And with more of the fluctuations in asset prices
passing through to a large number and wide variety of households, educating people to make
informed choices and protecting retail customers from abusive practices remain key governmental
functions.
A particularly interesting strand of the debate about excessive risk-taking concerns the interaction of
monetary policy and perceptions of risk in financial markets. Some analysts are concerned that
several aspects of the conduct of monetary policy in the United States have induced market
participants to reduce their expectations about risk too far, setting up the financial markets and the
economy for an unpleasant and possibly destabilizing surprise.
In this view, the low short-term interest rates that policymakers have thought were required over the
past few years to meet macroeconomic objectives are said to have encouraged reaching for yield -
settling for risk compensation that the investors themselves view as probably inadequate but which
they feel compelled to accept, perhaps to achieve targeted levels of real or nominal returns. The
tendency of policy to react strongly to sharp declines in key asset prices, and thereby limiting the
extent of the decreases, has been thought to induce risk-taking by imparting an asymmetry to asset
price movements. Finally, a concern is that the fairly new practice of telling the public about our
expectations for the path of the federal funds rate may have given market participants a false sense of
security about the future path of policy.
These practices have been the result of a monetary policy focused on price and economic stability
over the intermediate term interacting with the particular characteristics of the economy. The global
decline of inflation and spending induced a global reduction in interest rates to unusually low levels in
recent years. Those low rates were, in fact, intended to stimulate risk-taking and investment when
private agents pulled back. The tendency for asset prices to fall more quickly than they rise has largely
produced the more rapid and noticeable response of stabilizing monetary policy to declines than to
increases. And the importance for economic performance of more-accurate expectations about
monetary policy, along with the unusually low policy rates, led the Federal Open Market Committee to
undertake a more extended discussion of its policy expectations.
To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and
contain financial crises, risks are genuinely lower, and that development should be reflected in the
prices of assets. To the extent that the central bank can convey something useful about its intentions,
markets that take account of these intentions will be priced more accurately.
The risk is that private agents overestimate the ability or willingness of central banks to damp volatility
in asset prices or the economy, or that they fail to appreciate that future policy actions depend on an
imperfectly predictable economic outlook. But developments should have partially alleviated some of
these concerns. Investors have had an opportunity to observe that policy actions in 1987, 1998, and
2001-03 cushioned the economy, but they did not stop major declines in the prices of equity in 1987
and 2001 or of risky credits in 1998. Short-term rates have risen substantially in the past year,
reducing the profitability of "carry trades" without triggering an unwinding that drove long-term interest
rates higher or widened risk premiums. And expectations that policy tightening would remain gradual
over the near-term have not stopped long-term rates from fluctuating substantially in response to
incoming data; the movements of future or forward rates out the yield curve after surprises in data
have been at least as large since 2003 as they were before.
That is not to say that we have nothing to worry about. As I already noted, Alan Greenspan, himself,
has often been concerned about market complacency - as recently as his latest monetary policy
testimony. People may well perceive the economy as more stable than it is or central banks with
greater power than we have to smooth the economy or to foresee our own actions.
Clearly, reminders to the public of the inherent uncertainty in economic developments and policy
responses are appropriate and should have some effect. The question is whether these warnings
should be supplemented by actions to inject uncertainty into policy pronouncements by saying less
than we can or into the economy by shifting our objectives away from seeking the best outcome for the
economy over the intermediate term. In my view, such policies would result in less accurate asset
pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy
excellence of the person whose era we are examining at this conference.