Day: December 18, 2008

Managing Financial Innovation

Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.

When Will the G7 Intervene?

The dollar is depreciating in eye-catching and headline-grabbing fashion.  The Japanese authorities are signalling that they are prepared to intervene.  The G7 (remember them?) has the established role of coordinated intervention in major currency markets when things get out of hand.  So where are they now and when will they come in?

The answer is: you may have to wait a long time.  This round of dollar weakening is the direct result of easing monetary policy in the US.  The Fed doesn’t usually talk about the dollar (leaving this to the Treasury, which has a tradition of obfuscation on the issue), but dollar depreciation is fully consistent with (1) wanting to prevent deflation, and (2) hoping to stimulate growth through exports.  The spinmasters would probably also say that actions to restore confidence in the global financial system are reducing demand for dollars as a safe haven, and this is reflected in currency markets.

You may or may not agree with this logic, but from a US perspective there can be little interest in immediate intervention.  The Japanese are obviously unhappy when their exchange rate appreciates beyond 95 yen to the dollar, but their G7 partners are pretty unsympathetic at that level – Japan has been running a massive current account surplus (hence its reserves of over $1trn) and has long been in line for some appreciation.  At 85 yen to the dollar, things would start to get more animated, and almost everyone would support intervention at 80.

The dollar-euro thinking is even more interesting.  The US (and my former colleagues at the IMF) are obviously pressing for a big fiscal stimulus in Europe.  But key European governments are just as obviously demonstrating the desire to free ride, i.e., you put through a hefty fiscal package of $850bn and I’ll get back to growth through selling you more BMWs.  While the US will of course observe every diplomatic nicety in this situation, privately the outgoing and incoming administrations must be enjoying the fact that dollar depreciation puts the European Central Bank – and particularly the Germans’ export driven economy – very much on the spot.

Personally, I think the euro-dollar rate would have to move much further, probably close to 1.6 dollars per euro, for the intervention conversation to get serious.  Of course, if markets become “disorderly” so that prices jump around in an unusual way, there are always grounds for intervening.  But, on the other hand, in this situation you can rationalize almost any short-term exchange rate movement as the market adjusting to new fundamentals.  And you can look very pointedly at the European Central Bank when you say this.