Academic journal article Economic Perspectives

Disruptions in Global Financial Markets: The Role of Public Policy

Academic journal article Economic Perspectives

Disruptions in Global Financial Markets: The Role of Public Policy

Article excerpt

When we think of the state of the world economy over the last 20 years, what we see is a mixture of the good, the bad, and the puzzling. On the one hand, we in the U.S. have experienced the longest period of uninterrupted growth in our history. We've actually had an extraordinary 17-year run, interrupted only by the rather short recession of 1990-91. On the other hand, this period has also been characterized by financial turmoil.

Worldwide, this period has seen the greatest concentration of financial crises since the 1930s. In the U.S., the cost of resolving the savings and loan crisis amounted to around 3 percent of our gross domestic product (GDP). [1] Yet this cost was dwarfed by crises in Scandinavia, Latin America, and, most recently, East Asia. Estimates of resolution costs for the Asian crisis countries are between 20 percent and 65 percent of GDP. [2] And there are still rumblings of concern in certain markets. For example, the Japanese banking system is generally regarded as undercapitalized, with official reported bad loans amounting to over 6 percent of total loans. The true volume of bad loans may be quite a bit higher. [3] Most observers would agree that financial disruptions of these magnitudes have substantial welfare costs. [4]

I'd like to focus on a particular manifestation of this problem: the so-called twin-crisis phenomenon, where banking crises go hand-in-hand with currency crises in emerging economies. We saw this in Mexico in 1995, in East Asia in 1997, and in Russia in 1998.

This new development is part of a broader phenomenon that creates both opportunities and dangers: the rapid globalization of financial markets. This explosion in cross-border financial transactions resulted from a confluence of economic, political, and technological factors. The rapid export-led growth of developing free market economies, notably the Asian tigers, especially by comparison to the relative lackluster performance of many state-controlled economies, has dramatized the potential gains from decentralization, deregulation, and reduction in restrictions on free movement of goods and capital. Technological developments have increased the ease and speed with which large volume cross-border transactions can be executed.

The great opportunity from globalization is that standards of living worldwide can grow as more and more countries exploit the gains from trade, and as capital flows to its most productive uses. The great danger is that globalization may carry with it new sources of financial instability and may exacerbate financial disruptions when they do occur. So I've briefly discussed the good and the bad--now the puzzle: "How should we respond to these challenges?"

This issue is of particular concern to the Federal Reserve System. The long-run goal of the Federal Reserve is to promote maximum sustainable growth through price stability. However, the Federal Reserve is also committed to safeguarding the safety and soundness of the financial system. The approaches we have used in the past are designed mainly for national financial systems. Now, I believe, is the appropriate time to consider whether these approaches are adequate in an environment where national borders are less and less important. In light of recent developments, how should we proceed?

A good place to start is with a discussion of the twin-crisis phenomenon: where a banking crisis and a currency crisis occur simultaneously and feed on each other. Perhaps the most dramatic example of this phenomenon is the Asian crisis of 1997. What happened? Why did these countries get hit by a sudden crisis so strong that it engendered output declines on the order of the Great Depression? [5]

First, let's rule out one candidate explanation. The crisis was not the result of poor macroeconomic policies. In fact, the crisis countries pursued rather conservative policies. Their economies were characterized by low inflation, budgets generally in surplus, and declining government foreign debt. …

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