Wednesday, 17 September 2008

Rules versus discretion…

This is the end of market capitalism as we know it. 
Imagine this, someone asks you a week ago, to assign a probability to the Fed taking 80% share of AIG and thus the most important central bank of the world effectively nationalising the largest insurance company. Would you have just laughed? Or would you have bothered to actually say less than 1%? Or would you have got bogged down in giving a lecture on the main principles of economics, and explained - probably slowly - the idea behind rules versus discretion? 
Clearly, somebody got very scared yesterday. They did halt the immediate meltdown with one bold move. But they also considerably upped the stakes.
Short term worry one. Large. This move implies the promise of nationalisation of the entire US economy in a meltdown scenario. Not only participation in the risk pool is not voluntary any more, but the state now chops off the end of the distribution. Although a systemic collapse has been averted, at least for the time being, uncertainty about the framework in which the risks are being priced has increased considerably. Not only are we on a sailing boat out at sea in the middle of a big storm, but at the same time, someone is shaking the entire Earth. A whole new meaning to ‘choppy waters’. 
Short term worry two. Very large. This week we have seen the unthinkable. So, here is an ‘unaskable’ question: is the Fed large enough to deliver the implicit guarantee it made? What happens if the gamble of nationalising AIG does not pay off? There are a lot of signs, and even more rumours, about a host of other ‘immediate’ collapses. How much can the Fed and the US government pretend to be merely a clearing house and bankruptcy manager before the markets start discussing the limit to which the Fed can, rather than wants, to go? What would that do to risk perceptions? 
Long term worry. Gigantic. Rules are out of the window. In fact the concept of ‘rules’ is out of the window. Ad hoc solutions may be necessary in an emergency, but they nevertheless form expectations and change the perceived rulebook. How high can a pyramid of impulse actions be built before it collapses? This may seem a secondary worry now, given that the world has not yet sunk into abyss by mid-week, an achievement in itself, but will form very hard constraints in building up the post-crisis institutions. 
Global worry. Unknown magnitude. How much implicit global risk has the Fed taken on? Where is the legitimacy and mandate for that? What will the ultimate backers, the US taxpayers say about it? How adequate will the Fed’s implicit global economic management be for the rest of the world, either country by country, or - more importantly, for the entire global economy? There are strong arguments that what is unfolding now is the first truly global crisis. It’s not very likely that the unilateral approach from the US would be more successful in dealing with, say, global security issues. 
The last few days have changed the way we think about market economies. Systemic mispricing of risks, and thus collapsing financial institutions, could themselves be attributed to the globalisation of the effective economic systems in which these risks occur. We thought that new, global models would solve the problem. Now, the very foundations of the discipline of economics are being altered. Up until the rise of ‘unified macroeconomics’ the debate was between the proponents of a large state and those of a small one. In the past two decades this has given way to a new narrative, about what the state does irrespective of its actual size. Governance, institutional competition, and quality of government services are what mattered. This was, in a way, a downgrading of the state. You are not sovereign any more. You have to be smart. You have to compete for people and capital. What the Fed has done, the most unlikely institution to do so, has put the role of the state at centre-stage again. 


  1. Impressive! Maybe a week is too short: rumours arouse at least about 10 days ago, but, funny enough, last Thursday an "analysis" appeared titled "Why would not the Lehman go to bankruptcy?".
    Not long ago, one of my favourite philosophers, Gáspár Miklós Tamás (I guess this would be the correct order of his names in English) announced that the end of the capitalism is near, we will live it - on the sullen face of his reporter, he added: why, 25 years ago I said the same about communism.

  2. Peter Douglas, a friend of mine, has sent me a note in email, which I copy here with his permission:

    “This is massive, and will lead to a complete reshaping of the wholesale financial sector.  The only conviction opinion I have is that the world will be very different in a couple of years' time - but I don't know what it'll look like.  Don't forget the background of US geopolitical decline, climate change, huge shifts in demand patterns for all commodities not just energy...  The world could become very unstable indeed.”

  3. More than a week after the crisis started in earnest. People still optimistically assume that SOMETHING can stop the downward spiral. First the bail-out. Then the guarantees. The Fed and the US Treasury will solve it somehow. Denial of the abyss.

  4. Rules may be out, but the laws of economics are definitely not. See the point Krugman makes about the Fed's constraints.

  5. A perfectly timed research paper from the IMF about how to best deal with banking crisis, at least using a historical database. Brill.

  6. And here is an other IMF paper on the monetary policy consequences of bank losses.