Ricardo Caballero
-- once my favorite macroeconomist -- is optimistic about our current situation. He could, however, put a bit more meat on his description of what mandated macroeconomic insurance for the banking (finance?) system would look like and what incentives and rule would be needed to implement it, especially across jurisdictions.
Normality is just a few policy steps away
Economic agents of all sorts, from creditors to consumers, are
frozen waiting for some sense of normality to be restored amid the
financial crisis. However, normality is much closer —just a few bold
policy steps away— than is the conventional wisdom.
The system we had before the crisis is not permanently broken, but
it needs to be made more resilient to aggregate shocks, especially
panic-driven ones.
I build my analysis and policy prescription on three premises and observations.
First, before the crisis the world economy had an excess demand for
assets, especially AAA assets, and this will not change significantly
once the crisis ends.
Second, and contrary to what investors thought at the peak of the
boom, the (private) financial sector in the US is not able to satisfy
this demand for AAA assets when large negative aggregate events take
place.
However, the US government does have the capacity to fill this
gap, especially because it is the recipient of flight-to-quality
capital, even when the core of the global financial crisis is located
in the US.
Third (and with the benefit of hindsight), the main policy mistakes were made during rather than before the crisis.
These observations hint at a policy framework for the crisis and the
medium run. For the latter, we can go back to a world not too different
from the one we had before the crisis (real estate prices and
construction sectors aside), as long as the government becomes the
explicit insurer for generalised panic-risk.
That is, while monolines and other financial institutions can lever,
their capital for the purpose of insuring microeconomic risk and
moderate aggregate shocks, they cannot be the ones absorbing extreme,
panic-driven, aggregate shocks. This must be acknowledged in advance,
and paid for by the insured institutions.
Reasonable concerns about transparency, complexity, and incentives
can be built into the insurance premia. Collective deleverage, as being
done, should not constitute the core response; macroeconomic insurance
should.
The structural policy framework for the medium run also carries over
to the crisis-policy itself. The essence of a solid recovery should
build not from deleveraging and a forced brutal contraction of the
financial sector, but from the explicit and systemic insurance
provision against further negative aggregate shocks to their balance
sheets caused by
panic or predatory actions.
The recent intervention of Citi, with a mixture of (paid) insurance
and capital, is promising, and so is the second intervention of AIG
(see the recent FT-forum articles by Caballero and Krishnamurthy, and Kotlikoff and Merheling for similar assessments).
These interventions need to be scaled up to the whole financial
system (banks and beyond), and it is better to do it all at once, for
in this case the likelihood of the government ever having to disburse
funds for its insurance provision becomes negligible.
The good side of panic-driven contractions (as opposed to those
driven by more structural factors) is that the potential for a strong
recovery is always around the corner.
Although the current crisis has already caused enough collateral
damage to add persistence to the recession, there are still plenty of
resources waiting on the side to make a sharp rebound possible.
I do not mean to say that this recession is an imaginary one. On
the contrary, I believe it is a very serious recession. My point is
simply that good policy has an opportunity to bring the recession back
to familiar turf by defeating the extra gloom, and if this happens, the
recession will become a manageable one from which current asset prices,
on average, will look like once-in-a-lifetime deals.
Along the ideal recovery path described earlier, the real interest
rate would remain at record low levels for a long time; risk-spreads
and the VIX index (the Chicago Board Options Exchange Volatility Index,
known as Wall Street’s “fear gauge”,) would decline gradually but
consistently; asset prices and financial leverage would rise
rapidly; the yen and dollar would depreciate vis-á-vis most other
currencies, helping net exports in Japan and the US; commodity prices
would recover but not to record levels.
In addition, non-residential investment, inventory accumulation, and durable expenditures would snap back, joining and
leveraging on the fiscal and monetary expansions; global imbalances
would stabilise and build back a bit; unemployment would peak at single
digit levels and then begin to turn around; and inflation would rise
only gradually in the developed world, creating the needed space for a
recovery consolidation.
There is no way out of a dreadful last quarter of 2008 and well into
the first quarter of 2009. But the big difference with the consensus
forecast is in the sharp recovery after that.
The source of this difference is in the assessment of the dominant
nature of the recession. Slow recoveries follow the typical credit
crunch, as financial resources have to rebuild for growth to resume.
But while I think this was the nature of the mild recession
preceding the events at stricken insurer AIG, and Lehman, the collapsed
investment bank, the dominant recession now is very different in nature.
It is a systemic run on all forms of explicit and implicit insurance
contracts, but with no shortage of resources on the side. If
confidence recovers, the resources to support the recovery are abundant
and ready.
Nick Bloom, assistant professor of economics at Stanford
University, provides the best available evidence of how an economy is
likely to react to a temporary bout of volatility.
He estimates that such a shock causes a sharp contraction for two
quarters, which is then followed by abnormally high growth. I think
this is the correct way to view the current recession, as long as
bold policy actions are undertaken.
Of course many things can go wrong to cause a disastrous outcome,
but enough has been written about these negative scenarios. It is time
to, at the very least, begin to sketch what the good scenarios may
look like.
Ricardo Caballero is the head of the department of economics,
the Ford international professor of economics and co-director of the
World Economic Laboratory at Massachusetts Institute of Technology
