June 30, 2009This may help Brad DeLong settle his inner conflict over whether Greenspan made an error by not moving interest rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that the benefits of bubbles almost always outweigh their costs (and thus there's no need for regulation to prevent them).
I think the authors are correct to point out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:
‘Tis better to have loved and lost,
Than never to have loved at all.
In times of systemic financial distress, hunting for culprits becomes a popular sport. The Madoffs of this world are easy targets because crisis makes crookery harder to conceal. While there is no question that crooks should be sent to jail, increasing financial regulation is a different issue and requires careful analysis. Rushing to impose tighter regulations may hamper recovery and growth. Empirical evidence strongly supports the view that growth and financial development go hand in hand (Demirgüç-Kunt and Levine 2008). Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth. A genuine concern, however, is that the financial sector is prone to crises, which are typically associated with serious effects on output and employment.
We cannot reach definite conclusions about the desirability of risky financial arrangements in a short column. Our objective is much more modest. We examine the welfare implications of financial deregulations that result in higher growth but end in tears and perform the exercise in the context of a benchmark case in which consumption is the ultimate source of welfare, ignoring possibly relevant behavioural finance and political economy considerations. We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years. Our results support deregulation even under those dire circumstances.1
A model of growth, collapse, and welfare
More specifically, suppose that financial deregulation is implemented at time 0 and that, as a result, consumption grows at rate gH (where H stands for “high”); after T periods, there is a crisis that produces a (symmetric) collapse-recovery recession phase in consumption, resembling those observed in the 1990s’ Emerging Economies crises (see Figure 1) . That is, we assume that, starting at time T consumption decreases for a while and then begins to recover. The recession phase takes DT periods. During the first half of this phase, i.e., for DT/2 periods after time T, consumption declines at the rate g*; and then, for the next DT/2 periods, consumption resumes growth at the same rate g*. By construction, at time T + DT (end of the recession phase) consumption reaches its pre-crisis level (i.e., the level prevailing at time T). Afterwards, we assume that consumption grows at a lower rate gL (where L stands for “low”). We assume that gL is also the growth rate that would prevail if no financial deregulation had been implemented. Thus, this corresponds to a financial deregulation experiment in which when crisis hits authorities get cold feet and meekly go back to the old, low-growth, financial system forever. This extremely pessimistic scenario will allow us to make a stronger case for deregulation.
Figure 1. Consumption paths under alternative regimes for the average emerging economy
Note: The consumption path associated with financial innovation shows the calibrated collapse-recovery phase for the average emerging economy and the calculated break-even T using a degree of risk aversion (σ) equal to 4.
To calibrate DT and g*, we focus on average output collapse and recovery patterns (the recession phase) observed in emerging markets during times of systemic financial turmoil throughout the period 1980-2004, discussed in Calvo, Izquierdo and Talvi (2006).2 More specifically, we set DT equal to the time that it took for average output to recover its pre-crisis level. The growth rate g* is calibrated to match accumulated output loss, which is defined as the sum of the differences between the pre-crisis peak GDP and observed GDP within the recession phase. This procedure suggests setting g* = 3.11% per year and DT = 3.43 years.
Moreover, we set gH equal to the average GDP growth rate observed in emerging markets during 1992-97, a period in which many countries opened up to capital inflows. The low growth rate gL is set equal to the average growth rate observed in the previous ten years (1982-91). This leads us to set gH = 4.7% and gL = 2.7% per year.3
We focus on the following question: How long should the bonanza or high-growth period T last for financial deregulation to be socially desirable? To answer that question, we examine the benchmark case in which welfare can be expressed as the present discounted value of a utility index which depends on aggregate consumption.4
We define the break-even T as the number of bonanza years that would make deregulation welfare equivalent to not deregulating at all and generating low growth, gL, at all times. If the bonanza period exceeds break-even T, then financial deregulation is preferable to doing nothing, even though it results in a painful crisis. Table 1 and Figure 1 summarise the results (parameter σ is the coefficient of relative risk aversion).5
Emerging market episodes lasted 5 to 6 years on average, implying that the experiments were socially beneficial despite ending in large recessions. Admittedly, the boom-bust episodes are not identical across economies. To test for robustness, we perform the same exercise for two polar episodes in Latin American, namely, Argentina’s and Chile’s, for which the bonanza period was 4 and 13 years, respectively.6 In both cases, results point in favour of financial liberalisation for σ = 4. However, in the case of Argentina (and σ=1), the methodology yields borderline results (Chile passes the test with flying colours).7
Two points are worth making: (1) support for deregulation is stronger if the coefficient of relative risk aversion is more realistically set at 4, and (2) break-even T is the same if one assumes that the cycle is repeated as many times as desired (high growth-bust-high growth), and only after the last cycle the economy resumes low growth.8 This is more realistic because emerging markets returned to exhibiting high growth during 2003-2007.
The analysis abstracts from the important issues of poverty and income distribution, which might alter our assessment of past deregulation episodes, but that does not make our analysis less relevant looking forward. For example, for the type of social welfare function considered here, if income distribution remains fairly constant, one would reach the same pro-deregulation conclusions even if one entirely focused on the welfare of the poor, à la Rawls. This shows that financial deregulation would be desirable under the Rawlsian criterion if one can find suitable social protection mechanisms, and that the effectiveness of those mechanisms should be explored as part of the grand design of new financial regulations – especially before enacting new regulations that would stifle the dynamism of the financial sector.
Our analysis in this column may help explain why policymakers are hesitant to prick the bubble when it starts – they may simply be trying to maximise social welfare and realise that a potential crisis is not strong enough reason to prevent the bubble from developing (Tennyson’s verses ringing in their ears?). Of course, no policymaker likes crises. When crises strike, much of the discussion focuses on how to avoid them or lessen their impact in the future. This is quite understandable. However, this does not insure that “they are not going to fall in love again.” Therefore, the policy debate should give equal time to discussing what to do when crises happen and to developing institutions that help to assuage their blow.
In closing, we would like to point out that even though this note gives some support to financial deregulation, it does not rule out the existence of financial arrangements that are far superior to the ones currently available. A case in point would be the creation of a global lender of last resort. Central banks have successfully filled that role at the local level and likely prevented many serious self-fulfilling banking crises in the last seventy years. However, there is no equivalent to a lender of last resort at the global level. Its absence was clearly felt in emerging markets in the aftermath of the Russian August 1998 crisis. Even the subprime crisis suffered from the absence of a fully effective lender of last resort. To be sure, central banks stepped up to the plate early on in the current episode, but their coverage was and still is quite limited. Many central financial institutions were left without a safety net, or the net was stretched out after they hit the ground. We feel that the issue of a global lender of last resort should be given more weight in the current debate (see Calvo 2009).
Baldacci, Emanuele , Luiz de Mello, and Gabriela Inchauste (2002) "Financial Crises, Poverty, and Income Distribution" IMF Working Paper 02/4.
Barro, Robert (2006) “Rare disaster and Asset Markets in the Twentieth Century”, Quarterly Journal of Economics, 121(3).
Calvo, Guillermo (2009) “Lender of Last Resort: Put it on the agenda!”, VoxEU column, 23 March
Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2006) “Phoenix Miracles in Emerging Markets: Recovering Without Credit from Systemic Financial Crises,” National Bureau of Economic Research, Working Paper 1201, March.
Demirgüç-Kunt, Asli and Ross Levine (2008), “Finance, Financial Sector Policies, and Long-Run Growth,” Commission on Growth and Development, Working Paper No. 11, World Bank, Washington, DC
Rancière, Romain, Aaron Tornell and Frank Westermann (2008) “Systemic Crises and Growth,” Quarterly Journal of Economics, pp. 359-406.
 Our results, thus, give further support to the line of research advanced by Aaron Tornell and Frank Westermann since 2002, which is inspired by the conjecture that financial liberalisation may be socially desirable despite the booms and busts that it may generate. See Rancière, Tornell and Westermann (2008) and their recent VoxEU column.
 The paper focuses on episodes in which GDP peak-to-trough contraction is greater than the median fall in the sample. Note that including only the most severe collapses in the calibration constitutes a more difficult test for the case of financial deregulation.
 Countries included are those tracked by the J.P. Morgan’s EMBI Global Index: Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Côte d'Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Hungary, Indonesia, Iraq, Jamaica, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Romania, South Africa, Sri Lanka, Thailand, Trinidad and Tobago, Tunisia, Turkey, Uruguay, Venezuela, and Vietnam.
 More concretely, we assume that the utility index exhibits constant relative risk aversion, σ, and the instantaneous rate of discount equals 3% per year.
 If parameters are calibrated on the basis of GDP per capita (instead of its level) yields similar results, due to the high correlation between the two series.
 In both cases, we set gL to average GDP growth rates during 1951-1970. The parameter gH is set to the average GDP growth rates during 1991-94 for Argentina and 1984-97 in the case of Chile; The values and DT and g* are calibrated to match the characteristics of the Argentine crisis of 2002 and the Chilean crisis of 1998.
 In an exercise in which the collapse in growth is modeled as a stochastic event with constant probability, following Barro (2006), we also find support for financial deregulation. In both cases, the break-even expected frequency of these events is lower than the ones observed in the data
 It follows that T will be the same if the cycle is repeated an infinite number of times.
 The empirical work of Baldacci, de Mello, and Inchauste (2002) suggests that the financial crises that struck developing countries between 1960 and 1998 had severe effects on poverty and, in some cases, income inequality.