Start Taking the Prozac

Panic: the word itself, when applied to financial markets, has a quaintly antique sound. And the truth is that most economists, myself included, had almost forgotten what a good old-fashioned panic was like. Well, now we know.

There are some economists who claim there was nothing wrong with Asia’s economies a year ago – that the weaknesses we now see are consequences, not causes, of their financial crisis. I do not share that view; I believe that crony capitalism in general, and moral hazard in banking in particular, created a “bubble economy” that had to burst sooner or later.

Yet it is hard to deny that there was also a strong element of self-fulfilling panic in the Asian crisis, or that the world economy is starting to look like a dangerous place even for countries whose policies are fundamentally sound. The question is why.

Or perhaps we should look at the issues the other way around. In the good old days, panics were a common, even routine feature of financial markets. Then there was roughly half a century, from the 1930s to the 1980s, when they more or less disappeared. So perhaps we can understand why they have reappeared by asking why they temporarily went away.

Panics are possible because of the existence of financial intermediaries, which borrow short (providing liquidity) and lend long (permitting productive investments). This is a vital function, but one that exposes the economy to the risk of self-validating bank runs, in which everyone tries to liquidate his claims before everyone else does.

To prevent such runs, governments long ago evolved a sort of tripartite defense. First, deposit insurance eliminated the incentive for the insured to join a bank run. But deposit insurance creates problems of moral hazard, of banks gambling with depositors’ money. So, second, insurance had to be backed with regulation. And third, supporting the whole system was the ability of national central banks to act as lenders of last resort, in a world in which the balkanisation of the world capital market meant that even nervous creditors wanted pesos or rupees, not dollars.

It was not a good system. Banks, protected by regulation from effective competition, were too often sluggish and inefficient. In general, they did not do a very good job of transferring savings to the people who could best invest them. But the system was more or less panic-free.

Over the past generation, deregulation and globalisation have eliminated many of that system’s vices. Today’s system is marked by intense competition; it has shown itself able and willing to transfer large quantities of funds to where they can do the most good – particularly in emerging markets. But competition means that, in order to be profitable, intermediaries must be willing to take big risks – in other words, moral hazard is back, in a way that has outrun the policing capacity of domestic regulators.

The creation of a global capital market means that when things go wrong and investors become nervous, they want what most central banks do not have enough of: dollars. The result, as we have seen in the Latin American and Asian crises, is a system that is terrifyingly prone to panic attacks.

Put it this way: we have in effect moved from national to global financial markets without creating a corresponding global version of national regulation or national safety nets. If politics were no constraint, the solution would be obvious: recreate at a global level the safeguards that used to work at a national level.

This would mean a sort of super-International Monetary Fund, with the huge resources needed to act as a full-fledged lender of last resort, and with extensive direct regulatory powers over the banks of member countries. And while we are at it, let us have cold fusion, a cure for the common cold, and brotherly love among all men. The point is that nothing like this is going to happen for the foreseeable future; we will be lucky if the existing, far-from-super IMF gets the modest funding increase it is seeking. So what do we do?

One answer is to accept crises as part of the way the world works. No doubt the Asian crisis will lead to better national banking regulation; countries will not repeat the Asians’ mistakes. But they will make other mistakes, and sooner or later there will be another wave of crises. Perhaps that is just the price of having a global capital market.

But is that price worth paying? After all, there is an alternative: restrictions on capital movement, in particular limits on the ability of domestic residents to incur short-term foreign-currency debt. Obviously, there is a downside: like any government attempt to limit markets, such restrictions will often prove costly, ineffective, or both; they will prevent some beneficial transactions; will impose an extra burden of paperwork; and will lead to clever and sometimes successful attempts at evasion.

Moreover, controls would at best reduce the risk of crisis, not eliminate it, since there are many ways for an economy to go wrong. All the same, these drawbacks need to be weighed against the costs of financial panic. Would not most countries be willing to sacrifice some microeconomic efficiency in return for a significant reduction in the probability of economic catastrophe?

The current case for capital controls is the same as the case for treating psychiatric disorders with mood-altering drugs. These drugs typically have side-effects; in an ideal world it would be best to treat the true source of the disorder. But in this case the best is the enemy of the good.

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