randall s kroszner : recent events in financial markets speech by mr randall s kroszner, member of the board of governors of the us federal reserve system, at the institute of international bankers annual breakfast dialogue, washington dc, 22 october 2007. * * * good morning. in my remarks this morning, i will share my views on events in u. s. financial markets over the past several months. specifically, i will describe what i believe were contributing factors in the breakdown of the price discovery mechanism in certain markets, and i will assess the future prospects for these markets. while i will draw some preliminary conclusions about recent market events, my views and those of other policymakers will likely continue to evolve as we develop a more informed perspective and benefit from further analysis. 1 price discovery when markets are functioning properly, one of the key roles that they perform is what economists refer to as " price discovery. " 2 essentially, price discovery is the process by which buyers and sellers ’ preferences, as well as any other available market information, results in the " discovery " of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. this market - determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change. in well - functioning markets, the price discovery process represents the efforts of market participants to use all available information to decide whether to buy or to sell or to abstain from buying and selling. in efficient and competitive markets, participants will tend to undertake a certain amount of due diligence before making their decisions. this means that prices do not just appear by themselves ; a substantial amount of work is required by buyers and sellers for markets to produce prices that clear markets and provide useful signals to consumers and producers. indeed, this is one of the brilliant aspects of the market mechanism in that a number of participants, each pursuing their own interests and trying to maximize their own welfare and profits, determine a market - clearing price. a core principle of economics is that markets are more competitive, and therefore more efficient, when accurate information is available to both buyers and sellers. but for markets to work best, market participants must utilize available information, including analysis of costs and benefits of obtaining such information. in the case of new and innovative products, there might be a particularly strong demand for information. then this information must be processed appropriately before decisions

in the past. but even those most concerned about potential instability in international capital flows would have to admit that comprehensive capital controls, if applied for any extended period, might solve one problem at the cost of creating a more serious one - namely, the inhibition of growth and development that occurs when nations lack access to international capital markets. at best, then, restrictions on capital mobility should be viewed as a temporary expedient, a second - best or third - best solution to the problems presented by flawed or immature institutions in a nation at early or intermediate stages of development. in the medium run, the better approach - admittedly, one not always so easy to implement - is to commit to making the nation ’ s legal, regulatory, and fiscal framework stronger and more transparent. if foreign investors are thus reassured that their capital will be employed efficiently and its returns repatriated smoothly, the risks of capital flow reversals under a regime of free capital mobility should be much reduced. if we agree that every country should set a goal of achieving at least some degree of capital mobility, then the trilemma for developing countries ultimately boils down to the choice between flexible exchange rates ( and the associated independence of monetary policy ) and fixed rates ( which do not allow monetary independence ). for the remainder of my remarks i will focus on that choice. i should acknowledge immediately that to state the choice as one of “ fixed versus floating ” is to oversimplify. both types of regime are actually broad categories, each of which contains a number of variants. fixed exchange rates are almost never irrevocably fixed, for example : crawling pegs allow the rate to be adjusted in a controlled manner, while some putatively fixed rates are actually re - set at frequent intervals, either as an instrument of policy or under external pressure. so - called hard pegs, including currency boards and dollarization, may draw credibility from various institutional impediments to changing the rate ; but even full dollarization can be reversed, as liberia proved in 1982. 3 floating exchange rates cover an even wider range of policy behavior than fixed rates - from full reliance on the foreign exchange market for the determination of the exchange rate to a carefully managed float. so what should developing countries do about the exchange rate? theory suggests that any group of countries whose economic structures and trade linkages satisfy the requirements of an optimum currency area, in the sense of mundell ( 1961 ), would be well served by fixing the exchange