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On Instability

di - 22 Dicembre 2009
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7. On the basis of this theoretical framework it is extremely unlikely that capitalism will be  ever transformed into a stable system, through either legislation or policy. Realistically, the answer to the question whether in each and every circumstance crises can be prevented has to be negative. Real and financial crises will continue to happen in the future. They are rooted in the intrinsically unstable dynamics of the capitalist system.
Less philosophically, crises are like earthquakes, extremely difficult to forecast, nearly impossible to detect before their explosion. It is largely arbitrary to label as “excessive” a certain degree of speculation on specific commodities or assets. This is especially true – as in 2008 – in a non inflationary macroeconomic situation. The same applies to the degree of leverage of financial and non financial firms, whose sustainability depends on a host of other variables, such as interest rates, profitability, cash-flows. Market expectations, and especially their potential change, are hard to interpret and even harder to influence and moderate. The spark which makes the fire burn can be everywhere and nowhere. It can even consist in a warning by the government against speculation and/or in policy measures taken to curb speculation timely.
More generally, the attempt to prevent crises faces the “rules  vs. discretion” issue which is typical of economic policy. Rules – such as disincentives to risk taking, ceilings to leverage, incentivety to transparency, prohibition of certain business practices – can, at best, avoid the repetition of crises similar to the ones experienced in the past. They are unable to prevent instability when it takes new forms and follows unusual sequences. Discretionary measures, on the other hand, are predicated on the assumption that Treasuries, central banks and supervisory bodies can be better informed than market participants, which is not always the case. Besides, discretionary measure by administrative authorities can be, or might appear, highly intrusive. They tend to be refused by the business community, which lobbies against them, and are downplayed by the main body of mainstream neoclassical economics.
It has to be admitted that even today, with the benefit of hindsight, it is arduous to identify the rules and/or the measures which with a reasonable degree of confidence would have avoided the present crisis.
The Financial Stability Forum, founded in 1999, considered the possibility of a serious crisis – sooner or later – but along the following sequence of events: growing foreign indebtness of the U.S., fall of the dollar, interest rates hike, difficulties in the hedge funds industry, recession of the building sector in several countries, losses for the banks more exposed towards this sector. Things went differently. In particular, the dollar strengthened, basic interest rates fell, the hedge funds industry was not involved.

8. If instability cannot be eliminated and “innovative” crises prevented – which is frustrating – very much can be done to circumscribe these phenomena and to limit their negative repercussions.
Experience and keynesian economic theory suggest that policy action should at the same time support the financial system and aggregate demand. Both the financial and the real side of the economy have to be taken care of, in a consistent way. Otherwise, if the financial sector is in a disarray the lack and cost of finance will, sooner or later, provoke a recession; if economic activities stagnate or shrink bad loans and depreciating securities will cause illiquidity and insolvency in the financial industry.
The main ingredients of the recipe are known. Treasuries and central banks should supply liquidity, insure risky assets, channel private capital – and as a last resort public capital – to stabilize the financial system. Monetary policy should be expansionary and aggressive, to the limit of zero nominal interest rates. Budgetary policy ought to accept widening deficits, centered on tax reductions and, preferably, on productive investment expenditure and public works. Minimizing moral hazard in banking and finance, refraining from fueling monetary inflation in the long run, planning credible fiscal consolidation beyond the crisis: these are the constraints which stabilization policies have to respect in order to avoid inefficiencies, instability, and inflation in the future. Needless to say, loopholes in regulation and weaknesses in supervision of the financial sector disclosed by the new crisis ought to be removed. The aim should be to avoid the repetition of similar crises, without pretending that the additional rules can prevent any crisis in the future.

9. We can ask whether the measures taken until now to cope with the present crisis respect the aforementioned criteria.
The financial system has been stabilised. Banks and financial intermediaries are returning to profit. The interbank markets are back to normality. A credit crunch has been avoided, as well runs to convert bank deposits into currency. Perhaps too much public money has been injected into the financial system, but the overdose can be justified by the fact that the policy loss function in a critical situation as the one of 2008-2009 is highly asymmetrical … As to new rules and supervisory methods and bodies, until now no relevant decision has been taken. This is true even in the U.S., where the Treasury has contributed a white paper – “Financial Regulatory Reform, a New Foundation: Financial Supervision and Regulation” – with a long list of proposals. Before introducing new rules and new tools of control it is probably wise to wait for the definitive resolution of the crisis, The financial system is already vastly regulated and  largely supervised. In spite of its pitfalls, during the last two decades it has been capable of sustaining rapid economic growth in  the United States and in other parts of the world.

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