Market failures warrant policy responses
by William White
The Tides of Capital is a must read for policy-makers. It is short, and they have little time. But more importantly, it punches above its weight in identifying the sources of problems faced by governments and central banks and the terrible trade-offs they are commonly confronted with.
This brutal realism is not surprising since Julia Leung was a policy-maker in Hong Kong for over 20 years and has been tempered in the fire of successive crises. She puts that practical experience, and the insights revealed in the book’s earlier chapters, to particularly good use in a remarkable final chapter. There, she suggests a framework for monetary and financial stability in Asia as well as improvements in international co-operation in the monetary and financial spheres. There is a great deal to learn in this book.
It is also essential reading for academics, and those influenced by them, particularly in the west. For many, it will not be pleasant reading. Leung reviews, chapter by chapter, a number of Asian economies, with her observations on China particularly absorbing and rather frightening when one looks to the future. Economies are not self-stabilising as many academic models assume. Moreover financial markets are not only extremely important for the real economy; they are also far from efficient, being subject to many forms of market failure. In particular, capital inflows and outflows are ‘flighty’ and momentum trading can violate the law of uncovered interest parity for long periods of time. Exchange rates might then go anywhere.
Policy advice based on academic assumptions that bear little relation to reality is useless. Indeed, Leung suggests it can be worse than useless. There is an ‘edge’ to her prose that reveals the lingering, bitter heritage of the Asian crisis and the policies forced upon many Asian governments at the time. The fact that western policy-makers, including the International Monetary Fund, have now embraced an Asian perspective seems actually to have worsened the distrust. In addition, the IMF has been slow to enact governance reform through ‘chairs and shares’ to recognise the increasing importance of emerging market countries.
Asians resent their ‘excess saving’ being blamed for the current global crisis. Rather, they think it had more to do with the US and others ‘living beyond their means’. The lesson must be that it is crucially important to find ways to put this distrust aside if we are ever to make progress in reforming the dysfunctional international monetary system.
As her title suggests, Leung is mostly concerned with the disruptive role played by international capital flows in Asia and elsewhere. They were at the heart of the Asian crisis. Volatile inflows and outflows from western countries have proved troublesome since the beginning of the global crisis. They bring inflation and ‘imbalances’ (not least elevated asset prices) on the way in, which implies a real vulnerability when the subsequent outflow begins. ‘Spillovers’ from easy monetary policies in advanced countries to emerging markets are real and important. Letting one’s currency float more freely might well be desirable but it is no panacea.
I agree with all of the above, and with the broad thrust of Leung’s suggestions concerning policies that might work to deal with this problem: capital controls, domestic macroprudential instruments and foreign exchange intervention to amass buffers against outflows. Market failures warrant, even demand, administrative responses. Where I tend to disagree is with the degree of confidence she has in the efficacy of these measures, both past and presumed. We are still on a journey of intellectual discovery, albeit with the Asian experience being an important way station.
Leung’s suggestion that macroprudential policies have been ‘effective in limiting growth in household credit and cooling house prices’ seems to me to go too far. In her own words, house prices in Hong Kong rose an ‘astonishing 90%’ between 2009 and 2013. This is not to deny that the use of instruments like loan to value ratios might have made the banking system more stable. Recall too the vigorous use of ‘dynamic provisioning’ in Spain which, while helpful, failed to avert the crisis and problems of bank insolvency.
To repeat, this book is well worth reading. If its exposure of policy shortcomings, both intellectual and practical, makes us all feel a little more humble that is no bad thing.
■ William White is chairman of the Economic and Development Review Committee, OECD. Back