Guest post by Michael Spence, New York University,
Professor Emeritus Stanford University, and
co-host of the Conference on Macro and Growth Policies in the Wake of the Crisis

It was a privilege to participate in the IMF conference devoted to rethinking policy frameworks in the wake of the crisis. Highly encouraging was the openness of the discussion, the range of views, the willingness to question orthodoxy, and the posture of humility.

One gets the impression that the crisis has triggered a response that it should trigger, and we have embarked on a path of rethinking conceptual frameworks and policy choices in a way that will contribute to the stability of the system.


That said, the good news is that we recognize that in finance and parts of macroeconomics the models or frameworks are incomplete. That represents a challenge to the academic community. But it also means that, in the short run, participants and regulators will be operating with incomplete models. This will require judgments (which will be uncomfortable in contrast to the earlier sense of certainty). There will be mistakes. And, as Olivier Blanchard said in his excellent summary, we will proceed step-by-step, evaluating the impacts of policy choices and sometimes reversing course.

This is relatively familiar territory in developing countries, where changes in the institutional depth of the economy mean that models (especially advanced country models) are not very precise in predicting market responses to policy choices. Nevertheless theory is still useful when used judiciously. In that context, you can think of this as analogous to navigating with charts that are incomplete.

Having said that, we do in principle have the option of returning to old patterns while waiting for different or more complete models to be developed and tested, I think there is a widespread recognition that this would be a risky mistake.

I offer some thoughts stimulated by the spirit of the conference; not as a summary, or even an ordered set of priorities, but as a contribution to a general discussion that we all hope might stimulate further research and policy analysis, and ultimately progress.

1. The Dynamics of Risk in the Financial System

The dynamics of the risk characteristics of the financial system are not well understood by the participants or the regulators. Fixing this represents a central challenge and opportunity for economists. I think it is one of the hardest challenges in the area of economic and financial theory.

With most investors paying more attention to risk factors, and the costs and benefits of liquidity, they are constantly adjusting their investments and the structure of the assets they hold. So, relationships between assets, prices and risk may only remain stable for a few months at a time. The old model with stable relationships, implemented through a largely fixed asset allocation framework is broken. That doesn’t mean that diversification is a silly idea. But the challenge is to implement it effectively.

Most of the discussion concerns adjustments to the regulatory approach. This is too narrow. Although self-regulation failed in the run up to the crisis, and cannot be relied as the principal element of stability, it remains important. A financial system in which the participants and regulators accurately perceive risk will behave differently, and defensive action by participants when is accurately perceived will be a contributing factor.

2. Multiple Targets and Instruments

It may not be unanimous, but it is close, that the single target – single instrument approach to policy is not sufficient for achieving financial and macroeconomic stability. Nor are policies that focus on the flow of funds or resources, and prices likely to be sufficient. And given the state of our knowledge, at this point, we are going to have to pay attention to balance sheet variables and linkages at the micro and macro levels.

There will be warning signs or puzzles, and we are going to have to be willing to act on them without being able to give air tight arguments that there are problems. That is at variance with our earlier mindset in which the preferred course was inaction unless there was a clear case for intervention. This asymmetric attitude needs to be abandoned in favor of a more balanced assessment of the benefits and risks of inaction versus action.

3. Understanding Structural Changes in Advanced Economies

The structure of all economies evolves in ways that affect the income distribution and employment opportunities. This evolution is driven by powerful market forces operating in the global economy. And, after these changes, economies don’t return to their previous average behavior.

The vast majority (by population) of the emerging economies only become big once. Major technological innovations can also produce shifts in structure. Paying attention to structural evolution and incorporating it into longer term policy frameworks seem to me important and worth institutionalizing, with supporting research. It is of course easier to think about efficiency and market failures and even stability, than it is to address distributional issues and consider interventions that may adversely affect dynamic efficiency at the global level. But the alternative, ignoring the distributional and structural issues, doesn’t seem right and has risks. There are more and less harmful ways to nudge structural evolution. Ignoring the issue raises the risks of choices that run toward the more harmful end of the spectrum.

4. Ban High Speed Trading

I would ban high speed trading—the automated, computer-driven trading of large volumes of financial assets in a short timeframe—by introducing lags in the trading process or increasing capital requirements or both. As far as I can see, it is entertaining, but it’s largely a zero-sum game, using resources, contributing potential volatility in markets. The economic benefits in terms of enhancing the pricing, capital allocation and risk spreading functions of the financial system, seem negligible.

5. Financial Regulation

Financial regulation is a huge subject, rightly receiving lots of attention. These are just a few thoughts. At the macro level, it seems clear that we need to restrict excessive leverage. Ditto for banks.

Regulating the shadow banking system is crucial. The crisis experience surely tells us that. I would have liked to hear much more about what is needed to properly regulate this part of the financial system in order to ensure stability. This involves ratings, capital requirements, incentives, and structures that, unlike the present ones, allow the unwinding of securitized assets in an efficient way after a shock or crisis. As far as I can tell, the procedures for dealing with underwater mortgages held in trusts supporting securitized assets are essentially broken. This makes recovery from crisis, shocks, and asset bubbles less efficient and much too lengthy.

Finally, it seems to be that the current structure of the financial system—as it has evolved with a pattern of reduced regulation with respect to the separation of functions—is shot through with actual and potential conflicts of interest. These adversely affect incentives and performance and perhaps more importantly trust. This needs to be addressed by regulators, but also by the industry itself. There remains much more to be done, particularly on the industry side.