Financial crises: prevention, correction, and monetary policy.

• Author: Sanchez, Manuel

The financial crisis that surfaced in 2007 has stressed the need to identify the ultimate sources of the incentives that were behind the preceding credit and housing bubbles. To lower the likelihood of future financial collapses, prudent economic policies as well as an adequate regulatory and supervisory framework for financial institutions are required. Monetary policy, in turn, should be directed toward price stability, which is a central bank's best contribution not only to long-term economic growth, but also to financial stability.

Bubbles and Recurrent Crises

Since the late 1990s, the United States and other advanced countries exhibited rapid rises in housing prices that were supported by sizeable leverage taken on by households and firms. A credit bubble evolved, along with a housing bubble, as banks and other financial intermediaries facilitated borrowing by relaxing mortgage product standards. In some countries, notably in the United States, credit expansion was fueled by a substantial use of loan securitization and credit derivatives.

The eventual bursting of the housing and credit bubbles resulted in a global turmoil with severe consequences in terms of financial instability and a drop in income. Through contagion, this burden was shared by many countries that did not create any autonomous asset bubbles. The most affected nations were those holding close investment and trade ties with the United States, as was the case of Mexico. The widespread negative impact of the meltdown has justifiably called the attention of policymakers to finding ways to pursue financial stability and avoiding future collapses.

To be realistic, the scope of such an objective should be properly bounded. Financial bubbles, characterized by substantial rises in asset prices departing from previous trends that are suddenly interrupted by a sharp fall, have been common in economic history. While volatility in stock, currency, and commodities prices are the norm, occasionally bubbles emerge in many assets, including housing. (1)

Bubbles are formed because many people believe that the price of the underlying asset will continue to rise into the indefinite future and that they can sell the asset before a change of fortunes occurs. Long-lasting bubbles may reflect information asymmetries and costs associated with arbitrage in the form of short-sale constraints. In market economies, asset price fluctuations and bubbles could be interpreted as unavoidable and even beneficial as they become the means of rewarding good choices and punishing bad decisions.

One macroeconomic risk of asset price collapses is the possibility of a growth slowdown or a recession. The empirical evidence of the effects of price falls in stock and currency markets is somewhat mixed. However, the likely negative real consequences of housing bursts appear to be clearer. Statistical analyses reveal that housing prices are strongly pro-cyclical and that they are leading indicators of recessions and expansions. (2)

A second, potentially more serious cause of concern over large housing price fluctuations is that they have frequently ended in banking crises. These episodes may involve problems of liquidity and insolvency of certain financial institutions to the extent that the functioning of the economy becomes impaired, for instance, if they produce a widespread panic and loss of confidence. (3)

A target of smooth asset price behavior is hardly attainable through economic policy, given the intrinsic uncertainty involved in financial transactions and the imperfect information policymakers have at hand. More important, however, is the fact that such an objective is probably undesirable as it amounts to controlling risk and returns, thereby creating moral hazard and inhibiting innovation and growth.

What does constitute a sound policy goal is building conditions to ensure the continuous functioning of the basic financial system, particularly the banking system, without which the economy cannot work. This focus, which operationally requires delimiting what a basic system is, gives content to the objective of both financial stability and crisis prevention.

Preventing Financial Crises

The global crisis reflected excessive risk-taking and high leverage on the part of economic agents and financial institutions. A basic postulate of economics is that people respond to incentives. Hence, to reduce the probability of another financial collapse, it is necessary to learn from experience by identifying the ultimate sources of the incentives that led to the crisis. By this, I mean the environment that economic agents face in making decisions. Given this setting, private actions can be regarded as results, not as root causes of problems. Examples of such actions during the last crisis are the high bonuses paid to bankers for placing securitized loans and the poor credit evaluation of these instruments by rating agencies.

There is a large body of literature discussing the possible origins of the financial debacle. Of course, any list of factors is incomplete--not only to explain the crisis but to enable anticipation of future ones. Despite this obvious limitation, one can expect that correction of the identified conditions for inadequate incentives will lower the probability of banking disasters.

For expedience, the causes of the turmoil can be classified as cyclical and structural. In the first group, two contributing factors stand out. One refers to the low interest rates that prevailed in the years prior to the global crisis. Authors are divided in stressing, as the main source of this phenomenon, either an expansionary monetary policy reflected in short-term policy interest rates, or capital inflows from emerging markets to developed countries that affected long-term interest rates. (4)

There is much debate on the significance of the possible deviation of U.S. monetary policy from the "correct" Taylor rule during 2002-05. However, many empirical studies conclude that policy interest rates that were negative in real terms and deviated from traditional Taylor rules in the advanced economies did contribute to the gestation of the crisis. The verified channels include an increase in housing investment and prices, a stimulus to borrowing, greater risk-taking by economic agents and banks, an increase in bank leverage, and the loosening of lending standards. On the other hand, statistical evidence of a separate contribution of capital inflows to the crisis appears less conclusive. (5)

The other factor...