Sunday, February 1, 2009

Policy prescriptions for the crisis

The ongoing global financial crisis turned economic recession is fast turning into a stag-deflation, where banks have turned off their credit taps, consumers have pulled back on consumption and businesses have responded by postponing their investments. Uncertainty and fear have unleashed a self-fulfilling cycle of psychological shocks among the major economic actors, paralyzing all normal economic activity.

As was discussed in an earlier post, "the specific economic and financial market conditions that created the crisis, bad as they are, have been overtaken by the psychological apprehensions and fears of the market participants. The increasingly entrenched rational expectations of the investors and lenders, consumers and businesses about themselves, others and future prospects, have brought all normal financial and economic activity to a virtual standstill. The challenge is to break this grid-lock and get economic normalcy restored".

Now, in a neat summary of the debate on the prescriptions for immediate action, the Chief Economist of IMF, Olivier Blanchard, draws the distinction between "subjective" (unknown unknowns) and "objective" (known unknowns) uncertainty, and claims that in the present economic environment the former rules, leaving investors, consumers and firms paralyzed. The result has been a flight from all forms of assets perceived as even slightly risky, including the emerging markets. His prescription

1. Reduce uncertainty, by removing tail risks, and the perception of tail risks, by - establishing atleast a floor price on distressed assets, ring fencing them and taking them off bank balance sheets; commit to do now and in future, whatever it will take to avoid a Depression, from fiscal stimulus to quantitative easing. The responses should be clear, decisive, immediate, and large.
2. Stabilize the financial markets by helping recycle the funds towards risky assets, through recapitalization etc. The governments should intervene aggressively with capital injections into the domestic financial markets and the emerging economies, which have been facing massive exodus by foreign portfolio investments.
3. Break the wait-and-see attitude of consumers and firms by incentivizing them to spend and invest now rather than later - temporary subsidies etc. Government infrastructure spending and other stimulus measures, tailored and communicated well, can not only stimulate and replace private demand, but also reassure consumers and firms.

Alberto Alesina cautions against any unlimited, blank-cheque monetary and fiscal stimulus, and points to the need to keep the budgetary constraints, especially for the future, in mind. He also finds fault with the unprioritized and "throw everything you have at the economy" approach advocated by Blanchard. More specifically, he advocates temporary incentives to make banks lend and investors borrow and invest - public insurance against defaulting borrowers for banks who lend; fiscal incentives to encourage private investors to invest this year rather than next (easily done with depreciation allowances); fiscal protection against stockmarket losses, using temporal variation in capital-gains taxes and loss deductions etc.

Robert Shiller draws attention to the importance of "confidence multiplier", as against the conventional "economic multiplier", which would improve economic agents' level of trust in other people and businesses, and thereby break the "wait-and-see" gridlock. He therefore advocates that the "focus has to get off of 'what fraction of this stimulus will be spent' to 'how does this stimulus affect confidence." Since "different kinds of stimulus have different effects on confidence, depending on how they are viewed and interpreted by the public", we need to keep this in mind while structuring the fiscal stimulus .

Mark Thoma argues that given the uncertainty about the sources of the problems, and about which remedies will be effective, we should "do the equivalent of throwing a full spectrum antibiotic at the problems and hope this somehow manages to work" - a "portfolio of policies", which are "too much rather than too little". He also underlines the need to reassure consumers, lenders, and businesses by "rebuilding and restructuring of these markets to insulate them against future problems — including regulatory changes".

Eswar Prasad draws attention to the importance of coordinated fiscal stimulus in major economies, which if "suitably trumpeted and implemented on a massive scale, could deliver a much bigger bang for the buck than uncoordinated policies". He also warns of the harmful effects of protectionist rhetoric, especially on businesses and investments.

Tyler Cowen is right in arguing that the policy solutions have to go beyond merely stimulating aggregate demand, and seek to restore confidence and dispel fears. He therefore advocates the use of placebo policies (placebos often wor as much as drugs!) - initiatives which appear bold and have great symbolic value, but which don't necessarily cost us very much. He points to the importance of making the "painful adjustment to lower levels of spending and debt", which requires "reallocation of resources out of construction, finance, and debt-financed consumption", all of which will be made harder by boosting aggregate demand.

Ricardo Caballero fears that the plummeting asset values and consequent de-leveraging could quickly wipe out equity capital values of financial institutions with with strict capital requirements (banks, insurance companies, and monolines), and simultaneously close their option to raise new capital. Further, "forcing them to raise capital, be it private or public, at panic-driven fire-sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fueling the downward spiral".

While his analysis is a partial explanation, the prescriptions can be disputed. He proposes the replacement of the "two functions of bank capital — a buffer for negative shocks and an incentive device to reduce risk-shifting — by the provision of a comprehensive public insurance, and by strict government supervision while this insurance is in place". Arguing against nationalization, he advocates a comprehensive insurance backstop for banks, after removing their rotten assets and recapitalising them on terms that are not penal to existing shareholders. He also feels that the government should become the explicit insurer for generalised, extreme, panic-driven risk, as opposed to the microeconomic risk and moderate aggregate shocks.

Free Exchange, proposes "contingent policies", widely known in advance, that are triggered when a predetermined bad state of the economy is reached. Such policies would reassure households, investors, and businesses that tail risks are less likely to be realised, and they should become more willing to spend or invest, further reducing those tail risks. Apart from conventional contingent policies like deposit insurance and Taylor rule, anc automatic stabilizers like health care subsidies and unemployment insurance, there is scope for others like Central Banks becoming lenders and insurers of last resort.

Update 1
Brad De Long (and here) analyses the four policy options to combat a depression - inflation, monetary policy, credit policy and fiscal policy. And he feels that only the last two are effective now, and we need to try both at the same time.

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