Monday, 27 October 2008

Sisyphus’s Next Job

Comedy in Three Acts

Dramatis Personae

Problem, son of Old Habits, in love with Global System

Solution, king of Cheap Talk, a.k.a Good Enough

Trouble, cute little Goodfellow, messing with the World

Governors, presidents, ministers, all kinds of further support. Running around the stage at high velocity, in random directions. Some without head attached.

Act I. Regulation

Scene 1. Financial sector rules
(Problem and Solution stand facing each other. Trouble enters, happy.)

Solution: Increase regulation.

Trouble: Increased regulation within the old regulatory framework would only work if an isolationist approach was adopted at the same time. This would cause major inefficiency in the global economy. It would mean the end of ‘global finance’.

Without isolation of the national financial sectors, systemic risk would ‘flow’ to the weakest regulatory regimes. Overall global risk would not be contained, nor would the impact on the national economies. 

Solution: Globally harmonised financial sector regulation. Agency: OECD (you get harmonised as you enter the rich-club), IMF(emphasis on extending the harmonisation umbrella to emerging markets, as well).

Trouble: Lack of enforcement creates incentive to cheat by national governments: free riding on the global stability while boosting financial sector at home.

Solution: More than harmonisation. Global regulatory body with enforcement capabilities.

Problem: There is no existing mechanism to either create such an authority, or to supervise it.

Scene 2. Dynamic regulation
(A large paper-maché puppet falls from the sky. As it lands, it breaks into three pieces and bursts into fire.)

Problem: The set of rules is only part of the effective regulation that creates the framework that channels financial sector activities. Not only the way the rules are enforced is part of any regulatory regime, but also the active and reactive supervision coming from the government and the central bank. 

Any regulatory rule is fully defined only by the framework of dynamic leverages.

Solution: Harmonise the dynamic regulation, as well.

Trouble: It is impossible to harmonise non-conventional intervention, which is the essence of successful central bank crisis management. Game-changing solutions, by definition, cannot come from the game itself. 

For instance, the Brazilian central bank beat the 1998 attack by using unconventional, previously taboo tactics, such as going against particular hedges of the attackers, and thus forcing them to take an unacceptable level of risk. In essence, they stopped the possibility of leveraging, through unexpected through-market tools.

The non-static, active part of any regulatory regime is directly geared towards monitoring and managing systemic risk. Thus the essence is the immediacy and out-of-the-box solutions.  

Solution: A global rapid-reaction central bank committee facilitating harmonised reaction.

Problem: This would never work unless all monetary policy is co-ordinated on a global level.

Act II. Monetary Policy

Scene 1. Interest rate
(A human sized musical note marches through the stage, singing in whispering voice.)

Problem: The market is unable to recover from a systemic shock.

Solution: Monetary policy intervention by individual central banks. If the markets fall due to capital flight, hike rates a lot. If the market falls due to recession fears, cut rates a lot.

Problem: The algorithm will not work. When everyone is having troubles in a full global contagion, both rapidly changing capital flows and recession are lurking. There is no clear equilibrium in the world-wide rate game. Monetary chaos is certain.

Trouble: Thus national level monetary policy action is ineffective both in managing the global economy directly, and in providing leadership through expectations.

Solution: One-off interest rate move harmonisation would provide ‘leadership’ in crisis.

Trouble: Expectations can only refer to future policy measures by existing institutions. Or, at least, institutions perceived to exist. Therefore, one-off interest rate move harmonisation makes sense only as a harmonised expectations management exercise within the national economy framework. One-off moves, thus, cannot move expectations, unless they contain an implicit promise of future harmonisation of policy.

Problem: Thus, one-off, ad hoc solutions as a rule cannot possibly fill the global policy vacuum.

Solution: Institutionalised interest rate harmonisation among at least the leading central banks. Move all rates at the same time, in a harmonised fashion.

Trouble: A half-point cut has very different effects in different monetary environments. Thus harmonisation of rate moves makes sense only if the interest rates are allowed to be different. Only the timing is harmonised, but the moves are independent (even if ‘discussed’). but in this case, not much has changed. There is still no effective global policy.

Solution: Global universal interest rate set by a body with global statute.

Trouble: There are two issues with a single rate for the entire global economy. First, the global economy’s needs in terms of crisis management are very different from the monetary policy demands in the post-crisis world. Effective crisis management means, as argued above, a strong and credible common action, frozen in, that is a global monetary policy authority that can promise future action credibly. For normal times, however, the universal intervention, whose promise is the key to sorting out the crisis now, is too early for the world economy. The needs of the different parts of the world are wide ranging.

Solution: An institution that covers only part of the global economy. Merging the Fed, BoE, BoJ, and the ECB would not be unthinkable, and would cover around 65% of the world economy. Throw in a couple of others, like the Reserve Bank of Australia, or the Swedish Riskbank etc., and the ratio goes up to 75%. That could be a good start.

Problem: Talk about the institutionalisation of a programmed conflict with China.

Solution: Good point. However, if the crisis becomes deep enough to generate the political will for such harmonised global action, then the establishment of a strong and lasting institution in this fashion is not entirely impossible. Political constraints are agenda-defined. As the agenda changes, so does the strategy space.

Trouble: There is a second major issue with the single global interest rate, though. The currencies.

Scene 2. Exchange rate
(A group of currencies, of mixed age, start trembling in the background. The wind blows.)

Solution: Universal interest rate with flexible exchange rate regimes would work. A global authority, with some straightforward decision-making mechanism, decides about the interest rate level. Exchange rate regimes stay in the current, mostly flexible framework.

Trouble: If capital flows stay largely free, then the presence of a flexible exchange rate would substantially weaken the impact of the interest rate move. The consequence would be a world economy that still had the effective interest rates varying across currency regions. Thus each currency would end up with its own interest rate engineered from futures. This would substantially diminish the ability of any global monetary policy to control the global economy.

Solution: Quasi currency union with universal interest rate.

Trouble: Either the currency levels are regularly administered -- but then what’s the point? It would be the same, but less effective than the market set flexible rate - or currency exchange rates are set in stone, but then…

Solution: ...common global currency, universal interest rate.

Problem: There is no political will anywhere around the world to create either a common monetary authority or a global currency union. This direction is entirely unrealistic. It belongs to Fantasyland. You might as well waste your time writing a blog about it.

Act III. Fiscal Policy

Scene 1. National treasuries competition
(Tropical forest. A number of beautiful plants climb high rapidly, with colourful flowers. All in parasitic relationships with the trees)

Problem: You can’t have monetary policy without some fiscal policy constraints: competing national treasuries would destroy the policy of any global monetary policy authority. Under a common monetary policy umbrella the inflationary impact of any individual governments deficit would be reduced substantially. Consequently the real rates would need to be kept much higher than management of the private sector would require to stave off the overspending impetus of national governments.

Solution: Cover the bad end of the tail: have a shared insurance umbrella for governments in trouble -- this would make crisis management of monetary policy easier.

Trouble: Not exactly incentive-compatible, is it? Anyway, an insurance umbrella would only limit the global damage arising from singular overspending. The bigger trouble is that if the global central bank was to set a policy for growth in normal times, this would translate into an incentive to overspend by all governments. The aggregate effect would be too lax fiscal policy on the global level.

Solution: Limit fiscal policy excesses. Implement a set of straightforward rules to which all government budgets should adhere.

Trouble: There are major difficulties with this. To start with, this is a political impossibility, for budgetary constraints would need outside policing if to be effective. That would require a level of transparency that many national governments will not sign up for under any situation.

Solution: Have a similar limited global core fiscal policy as in the monetary policy case. The countries that are listed in that 75% of the global economy are all democratic, and thus have largely transparent government accounting. Policing the budget rules would not take that much new intrusion into state secrets.

Scene 2. Global treasury
(The forest opens to a beautiful equatorial lake. With slow, almost animated movement, a group of crocodiles slides into the water.)

Trouble: This transparency argument is based on a myth, that the democratic, western governments have transparent budgetary accounting. Just take the example of what happened to Belgium after submitting itself to ECB scrutiny. What we learned was that before the setup of the Eurozone, the numbers that we were shown were mostly cooked. Or take Italy. Or Greece. This would not be an isolated problem of only a few governments. 

By the way, Eurozone. The second trouble with the pre-set fiscal rules is that they might allow overall limitation of fiscal excesses, and thus more or less effective monetary policy, but still impede any dynamic setting of fiscal policy. The Maastricht rules serve as a quasi-minister of finance, but a very rigid one. Thus there is no system-level fiscal policy. National governments find themselves facing an incentive structure to push to the limit of the rules. The management of the economy then becomes ineffective.

Solution: Actively harmonised global fiscal policy. Limits regularly adjusted to global economic climate, some ongoing decision-making mechanism is needed, as opposed to one-off setup at the beginning.

Trouble: This is not global fiscal policy, this is globally constrained national fiscal policy, what happens to global costs and spending? At least the cost of global institutions has to be covered in some way where the organisation is not hostage to the year-to-year budgets of national political processes.

Solution: Global treasury: tax framework, global treasury revenues, global government services.

Problem: There will never be political will for this. Any legitimate setup would need some kind of minimum harmonisation of the political system and thus political values, at least among the leading global regions. No chance.

Epilogue: The Case For Global Economic Authority

Thus is the argument towards the creation of a set of institutions that would generate and implement global economic policy. At the heart is the observation that neither global regulation, nor global monetary policy can be set without efficient, institutionalised decision-making mechanism, and enforcement. Arguably, if this crisis is truly a global crisis, then there will not be a ‘solution’ until a credible global policy framework emerges.

However, there is no political will at the moment to support the rise of such global policy institutions, and anyway they could not be effective without at least some kind of fiscal policy harmonisation, which would require a politically impossible intrusion into each other’s budgetary processes.

Trouble: Wouldn’t this mean that there’d be a global government that would be tempted to intervene in a host of other issues?

Solution: Like global warming, the relationship with the Biosphere, cultural diversity, etc?

Trouble: Yes… And also global government policing… Do we want that? Seriously.

(Exit all. The World wanders in, talking to herself in low voice. After a short while, she exits looking confused)


  1. The outgoing Bush administration has decided to stand up against regulation, this time the global one, as long as they are around. Which, as we learned it two days ago, is not that lon

  2. Tamas,

    Finally I found where you have put the content. If I may give you an advice, you need to spell it out in much more detail, with much less poetry. Just explain, in the plainest possible terms, what global economics is.