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Sunday, September 30, 2007

What do we learn from recent events?

Rakesh Mohan

The turmoil in global financial markets has set off fresh thinking on how financial regulation should be improved so as to avoid such crises.

RBI's monetary policy framework fell into place long ago, based on the knowledge of monetary economics that was prevalent at the time. Today, in mainstream monetary economics, a central bank which has notions of multiple objectives, non-transparency, etc. is seen as part of the problem and not part of the solution. So ordinarily, RBI people look at their shoelaces when there is any talk about a sound monetary policy framework.

Rakesh Mohan has mounted a spirited defence of the RBI intellectual framework, claiming that the difficulties seen in global finance are caused by the revolution in monetary policy of the last 30 years that gave us transparent central banks with predictable behaviour, low inflation and low inflation volatility. He says:

It may be ironic that the perceived success of central banks and increased credibility of monetary policy, giving rise to enhanced expectations with regard to stability in both inflation and interest rates, could have led to the mispricing of risk and hence enhanced risk taking. Yet another view is that more than success or failure of central banks, the repeated assurances of stability and guidance to markets about the future path of interest rates, coupled with the availability of ample liquidity was an invitation to markets to underprice risks. This view, consequently, puts the blame on those central banks who failed to give space to markets to assess risks by eschewing surprise elements in policy.

If he's right - if central banks can help matters by building in elements of surprise - it would amount to a major revolution in monetary economics. As Andrew Rose once said about a paper by Surjit Bhalla : `This is either a home run or it's totally wrong'.

Reading between the lines, the subliminal argument is that an RBI which is non-transparent and unpredictable, one that delivers high inflation and high inflation volatility should be kept safe from reform.

Alan Blinder

This is not the mainstream view amongst the top people in monetary economics. Alan Blinder and Fred Mishkin are remarkable thinkers, combining top quality knowledge of academics economics coupled with real-world experience in policy making. Alan Blinder offers his views in the New York Times on how financial regulation should be improved in the wake of the difficulties with sub-prime loans in the US housing market. His `fingers of blame' are:

  1. You could blame households for reckless borrowing. But in all probability, such frailty in the thinking of individuals will recur, and you can't do anything about it.
  2. Some lenders sold mortgage products that were plainly inappropriate for customers.
  3. Bank regulators should have done more in protecting lending practices.
  4. Investment bankers dreamed up and marketed complex products.
  5. Credit rating agencies didn't get it right, and credit rating agencies suffer from serious underlying conflicts of interest.

Blinder summarises saying `we don't have to destroy the subprime market in order to save it', and no, he does not require a radical reshaping of monetary economics to accomodate recent events.

Fred Mishkin

And, Fred Mishkin reminds us of the analytical core of monetary economics:

  1. Inflation is always and everywhere a monetary phenomenon
  2. The benefits of price stability
  3. No long-run tradeoff between unemployment and inflation
  4. The crucial role of expectations
  5. The Taylor principle [link]
  6. The time-inconsistency problem
  7. Central bank independence
  8. Commitment to a nominal anchor
  9. Financial frictions and the business cycle.

Putting it together

As Blinder and Mishkin suggest, learning from recent events does not require a counter-revolution in monetary economics, to undo the remarkable achievements of the last 30 years.

In my understanding, a monetary policy framework like the RBI recipe of non-transparency, unpredictability, multiple objectives, and eschewing plain English, etc. is not new. It has been tried for many decades by various central banks worldwide. We know what it does. It gives elevated GDP volatility, it exacerbates the business cycle. Roughly 30 years ago, the smart central banks of the world started moving away from that policy framework. This change in the monetary policy regime has yielded big payoffs.

In the task of preventing RBI reforms, the argument is often made that ideas on monetary economics have changed repeatedly in the last 100 years, hence all proposals for progress are mere fads. I find this to be a pretty anti-intellectual defence. Yes, we use computers today and we used calculators only 30 years ago, and there is a certainty that the devices we will use 30 years from now will be different from where we stand today. But that is no basis for suggesting that one should not change in response to changing ideas, that one should not stay at the frontiers of human knowledge. Just because people moved on from using calculators to using computers, it doesn't mean we should continue to use calculators today.

Tailpiece: credit rating agencies

While I'm on this subject, I should also point you to a wealth of interesting material which has appeared on credit rating agencies. In addition to my earlier blog entries, look at:

  1. Unsafe at any rating by Mark Gilbert
  2. Rating firms' practices get rated
  3. How and why credit rating agencies are not like other gatekeepers by Frank Partnoy, 2006.
  4. Credit and blame, in The Economist
  5. Rethinking the emphasis on credit rating agencies in Basle-II by Willem Buiter
  6. Model revisions at Moody's


  1. Two agencies that always have to be on cutting edge for a nation to be secure and prosperous: the military and, in this case, RBI. The Indian military is transforming itself to be on the cutting edge looking to the future instead of the past. Unfortunately RBI continues on with it's old way as most GOI ministries and departments (like our dept of meteorology and urban (non)planning agencies of our cities).

    As you say, the word to describe defence of current slough is indeed anti-intellectual.

  2. To me the whole sub-prime debacle raises one question: Is there a point where a financial instrument gets too complicated for everyones good? Most financial engineering today seems a competition to design instruments that only the creator feels he can value and then make money on the mis-valuation of the rest of the players.


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