RIETI Report September 2007

Financial Globalization and Stability

Global financial markets seem to have achieved greater stability over the past several years. However, the recent market turmoil triggered by the subprime mortgage problem in the U.S. has generated concern about how to view financial stability. On September 6, RIETI and the Centre for Economic Policy Research (CEPR) organized the "Financial Globalization and Stability" workshop. RIETI Report interviewed the three key presenters, Drs. Richard PORTES, Philip LANE, and Philippe MARTIN about their views following the workshop, the factors behind the development of financial markets in Europe, and policy implications.

This month's featured article

Financial Globalization and Stability

Richard PortesPresident, Centre for Economic Policy Research (CEPR)

Professor of Economics, London Business School

Dr. Portes has been President of the Centre for Economic Policy Research (CEPR) since he founded it in 1983. He has also served as a Professor of Economics at London Business School since 1995 and as Directeur d'Etudes at the Ecole des Hautes Etudes en Sciences Sociales in Paris since 1978. His current research interests cover international macroeconomics, international finance, European bond markets, and European integration. Dr. Portes has held academic positions at numerous international institutions including Princeton University, the University of London, University of Stockholm, Harvard University, the Columbia Business School, and Haas Business School at the University of California, Berkeley. In addition, Dr. Portes has served as a member of the Group of Economic Policy Advisers to the President of the European Commission since 2001. He received a D.Phil. in Economics from Oxford University and B.A. degrees in mathematics and philosophy from Yale University. His recent publications include: "Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar" (with Elias Papaioannou and Gregorios Siourounis), Journal of the Japanese and International Economies, vol. 20, no. 4, December 2006; European Government Bond Markets: Transparency, Liquidity, Efficiency (with Peter Dunne and Michael Moore), City of London and CEPR, May 2006; "Toward a Lender of First Resort" (with Daniel Cohen), IMF Working Paper WP/06/66, March 2006.

Philip LanePresident, Centre for Economic Policy Research (CEPR)

Professor of Economics, London Business School

Dr. Portes has been President of the Centre for Economic Policy Research (CEPR) since he founded it in 1983. He has also served as a Professor of Economics at London Business School since 1995 and as Directeur d'Etudes at the Ecole des Hautes Etudes en Sciences Sociales in Paris since 1978. His current research interests cover international macroeconomics, international finance, European bond markets, and European integration. Dr. Portes has held academic positions at numerous international institutions including Princeton University, the University of London, University of Stockholm, Harvard University, the Columbia Business School, and Haas Business School at the University of California, Berkeley. In addition, Dr. Portes has served as a member of the Group of Economic Policy Advisers to the President of the European Commission since 2001. He received a D.Phil. in Economics from Oxford University and B.A. degrees in mathematics and philosophy from Yale University. His recent publications include: "Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar" (with Elias Papaioannou and Gregorios Siourounis), Journal of the Japanese and International Economies, vol. 20, no. 4, December 2006; European Government Bond Markets: Transparency, Liquidity, Efficiency (with Peter Dunne and Michael Moore), City of London and CEPR, May 2006; "Toward a Lender of First Resort" (with Daniel Cohen), IMF Working Paper WP/06/66, March 2006.

Philippe MartinResearch Fellow, CEPR

Professor of Economics, London Business School

Dr. Portes has been President of the Centre for Economic Policy Research (CEPR) since he founded it in 1983. He has also served as a Professor of Economics at London Business School since 1995 and as Directeur d'Etudes at the Ecole des Hautes Etudes en Sciences Sociales in Paris since 1978. His current research interests cover international macroeconomics, international finance, European bond markets, and European integration. Dr. Portes has held academic positions at numerous international institutions including Princeton University, the University of London, University of Stockholm, Harvard University, the Columbia Business School, and Haas Business School at the University of California, Berkeley. In addition, Dr. Portes has served as a member of the Group of Economic Policy Advisers to the President of the European Commission since 2001. He received a D.Phil. in Economics from Oxford University and B.A. degrees in mathematics and philosophy from Yale University. His recent publications include: "Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar" (with Elias Papaioannou and Gregorios Siourounis), Journal of the Japanese and International Economies, vol. 20, no. 4, December 2006; European Government Bond Markets: Transparency, Liquidity, Efficiency (with Peter Dunne and Michael Moore), City of London and CEPR, May 2006; "Toward a Lender of First Resort" (with Daniel Cohen), IMF Working Paper WP/06/66, March 2006.

Interview

RIETI Report: Could you give us your thoughts on today's workshop?

Lane: Maybe the single most important message from today is that there is great uncertainty about whether the current financial volatility will have major real effects. First of all, within the financial sector, in other words will the hedge funds losing money simply be offset by other financial institutions replacing them? Second is whoever is making the losses, will that have any real effect? Because we know that, in general, banks in the world are in a good position. We know the real economy is going quite quickly. The single biggest open question now is with the central banks. Is it right for them to cut interest rates? If so, for how long? And what is the inflation risk? And then, from today's discussion, I think an interesting element is; what exactly is the international transmission mechanism? How much do problems in the U.S. mortgage market affect the markets for Europe and Japan? And I think what we were saying today is that it does matter, but we should not exaggerate the risk. There was a certain amount of exposure but it's not as bad as some other crises. So it's a very interesting period, but maybe it isn't time yet to get too worried about it.

Martin: I thought one interesting set of questions that was difficult today, and I don't think we can find all the solutions, is the comparison between what's happening in Asia and what's happening in Europe in terms of the global imbalance adjustment; that it's much more of a problem for Asia than for Europe. In terms of financial integration, Asia, especially Japan and China, seems to handle this quite differently from other countries. In terms of trading assets, Asia is also in a very different position from European countries. For trade integration and also financial integration, without even talking of monetary integration, it is much less strong than in Europe.

RIETI Report: Dr. Portes, you indicated that financial markets have made remarkable developments in Europe over the past decade. What are the factors behind this?

Portes: I think there are three factors behind the rapid development of financial markets in Europe over the last decade. The first and obvious one is the euro; the economic and monetary union in Europe. Particularly the monetary side has been extremely important in giving a basis for the expansion of the capital markets, especially the development of securities markets; both the corporate bond market and the government bond market. The euro has unified those markets among the countries that take part in the monetary union. That has radically improved the liquidity of securities that are issued in to that market and are traded in that market. So securities both of companies of individual countries and governments of individual countries are now traded as part of a unified, much bigger pool of liquidity. The result has been a very important improvement in the availability of finance, both for governments - in many cases the yields have come down quite dramatically on government securities - but most importantly to corporates and possibilities for new issuance. That issuance comes partly from within the euro area, but also we are seeing a good deal of issuance in the euro area from companies and governments outside the euro area; issuance in euro-denominated securities, so much to the point that issuance in euro-denominated securities at the international level is now greater than in issuance in dollar-denominated securities. Nobody would have imagined that 10 years ago.

The second factor is the so-called Financial Services Action Plan (FSAP). That is a set of measures that have gone through legislation in the EU, essentially developed by the European Commission and passed by the European Parliament, sometimes in detailed negotiations, with the Commission and with the Council of Ministers (the representatives of individual member states). Some of these turned out less ambitious that some of us would have liked. For example, a new takeover regulation inspired so much opposition among politicians in certain countries, particularly Germany, that it was weakened rather dramatically before it actually went through, and it does not make much difference. On the other hand, the huge new regulation that has ramifications throughout the EU is called the Markets in Financial Instruments Directive (MiFID). This has given a legal basis for much greater integration of securities markets across Europe; both from the point of view of the financial institutions and the markets themselves. MiFID will increase transparency, for example, quite dramatically in the equity markets.

The third and final factor comes from outside the euro area but inside the EU; this is the development of London as a global financial center. Over the last decade, we have seen in London the development of a community of the big international banks and a dramatic expansion of financial-sector activity. To some extent there is a shift of business from New York to London. London, of course, also carries out a lot of financial business involving the euro. London is essentially the financial center of Europe, despite the efforts of Frankfurt and Paris. In fact, business has grown in London and that has been good for the entire European financial markets and financial institution structure. We see the results in all sorts of ways. For example, the movement of top executives out of New York to Europe - based in London - for all the major investment banks. They are all increasingly shifting activity to Europe. That has been a significant factor in financial market development because the big American banks have brought great improvement in the way people do business. They have the technology and expertise that the Europeans really did not have. Some of the European banks, as a result, have consolidated and are having to compete. And some of them are competing very well. Deutsche Bank as an investment bank has radically improved its performance in the face of its competition. Similarly, Santander is a remarkably effective bank. That is in part a result of this international competition.

RIETI Report: Today you spoke on policy implications from current developments (turmoil) in the global financial market. Which of these developments do you see as having the largest implication?

Portes: There are two levels at which to look at this. One is the short-term, the immediate; and there the issue is the central banks - the Fed and the European Central Bank in particular, and also the Bank of England. The question is whether they are willing to intervene more aggressively and more helpfully than they have done so far. They have done some things, but we still have a three-month money market that is very disrupted. We still have illiquidity in the asset-backed commercial paper market, which is going to cause big problems for the banks for rolling over paper that is reaching maturity as we speak. So how do central banks intervene? There are two blocks that they seem to perceive; neither of which, in my view, is very important. The central banks are overstating, overestimating the risks of intervening more aggressively. First is the question of moral hazard. The story is that this financial turmoil really can be traced back to the intervention with the Fed's radical easing of monetary policy after the technology bust and the mild recession in the U.S. The Fed pumped in liquidity, it bailed out the market (so the story goes), that then set the stage for all the excesses that we have seen in the past couple of years and hence the current problems. I think that's rubbish. I don't think it's nonsense to say that the Fed did not tighten thoroughly enough, did not withdraw the liquidity that it had injected early enough after the events of 2000-2001. But that doesn't mean that they have to make the same mistake again. The injection of liquidity and the monetary policy easing at that time was the right response, and the result is that the recession in the U.S. was very mild and brief. It was the right thing to do. The wrong thing was that the Fed didn't reverse policy soon enough. This time the story is that if the Fed does it again, the markets will think that they are always going to get bailed out; that if anything bad happens, the federal government will come to the rescue and nobody will end up losing money. Even if they act aggressively now, however, people will lose money. They've already lost money. The problems in the subprime mortgage market are not going to go away. The values of many of those securities will go down. A lot of hedge funds will lose money. The quantitative hedge funds have already lost a lot of money because they made the wrong bets. They're not going to get that money back. They'll make new money, but the money they lost is lost. So the story that central banks should be worried about moral hazard is just wrong. I don't believe that they should bail out individual financial institutions or people who made bad investments, but I feel very strongly that they are responsible for making sure the markets continue to function, and the markets are not functioning properly; that is clear.

The second thing that is intimidating them is perception that they should be focusing on inflation, that that's their job, in particular the European Central Bank and the Bank of England which should be looking at inflation targets. And there is all this turmoil in the financial market, particularly in Europe with the very rapid rates of growth of money and credit. The European Central Bank has been worried about this, which is why they wanted to raise interest rates, but now they won't do it1. The idea is that they are worried about inflation and the Fed is worried about making sure that they don't let inflation expectations get out of hand. At this stage of the game, you act aggressively in the money markets and you take out the liquidity quickly when markets stabilize. And the markets learn that you know what you are doing, you do have strong anti-inflation preferences, and you retain your credibility. So I do not think that should be an obstacle either. But I'm not a money market person. They have many specialists who work on these things who ought to be able to figure out how to get the asset-backed commercial paper market going again, and how to bring down the London Interbank Offered Rate (LIBOR) and the three-month money market rate.

In the medium term there are two issues. One is regulation. Should there be more regulation of hedge funds? Should there be more regulation of credit rating agencies, and so on? There is a lot of political pressure as to whether they should or they shouldn't. I believe that there is no particular reason to impose regulation on hedge funds. I can think of no regulations that would make any practical difference to their behavior, and if they lose some money then that will make a difference. Otherwise I do not see them as dangerous actors in this story. If you really look at the problem, some of the hedge funds are suffering damage as a result of it, but they are not at the center of the problem; not right now anyway. There are some dangers but they have not yet materialized. The credit rating agencies are another matter. They have a clear conflict of interest, and they clearly misrated a lot of these financial instruments that are now in trouble. Whether they misrated because the credit rating agencies just did not understand them and the ratings were based on models that had not been market-tested and so forth, or whether they did it to some extent because they get paid by the institutions whose securities they are rating, and they were negotiating with them about the way in which they would structure securities so as to get good ratings and so forth; I can't judge that, I'm not close enough to it, but of course a lot of people think that. What's clear is that they shouldn't be doing those things at the same time. And there ought to be more competition in that sector as well.

The final issue is global imbalances. Exchange rates, current account deficits, and so forth have not played a big role in the current turmoil so far. But in the medium term, global imbalances could be a significant problem and getting those current account deficits down, getting the U.S. current account deficit down, and getting exchange rates in a somewhat better configuration than we have now are important. The International Monetary Fund (IMF) began a so-called multilateral surveillance procedure a year ago to try to deal with that. They claim this has been very successful, but they haven’t told us the actual outcome, and we don't see the Managing Director of the IMF out there telling governments, "These are the results of multilateral surveillance. Why aren't you implementing the policies that are agreed upon?" That will be for the IMF's next Managing Director.

1Interview conducted on September 6, 2007 by RIETI

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