Archive for December 29th, 2008

World Economy: Three priorities for recovery

Monday, December 29th, 2008

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“…On the basis of this admittedly brief sketch, I arrive at three policy priorities for 2009. The first is for central banks to avoid deflation. If ever there has been a need for a central bank to target price stability, it is now. I mean this in the European sense of the term, meaning a small but distinctly positive rate of inflation, say 2 or 3 per cent annually. I assume that central banks will succeed in this endeavour, given the full power of policies deployed. I worry, though, that the US will try to raise inflation afterwards, which would reduce the real level of US debt but create massive distortions in exchange rates and financial flows and produce another global financial and economic crisis.

The second priority is to shrink the financial sector. A disorderly collapse would be catastrophic, but it is neither desirable, nor possible, to maintain the financial sector at its current excessive size. Take the market for credit default swaps, an unregulated $50,000-$60,000bn casino that serves no economic purpose except to enrich its participants at massive risk to global financial stability. [ed- best sentence all year]. I would be in favour, as a matter of principle, of regulating any financial activity on the basis of its economic purpose. Since a CDS constitutes insurance from an economic point of view, we should treat it as such and subject it to insurance regulation (which would kill it of course). [ed. - hallelujah!]

In particular, we should try to avoid the temptation to regulate too much in detail. This is a game regulators will lose. The financial sector is good at deploying existing instruments, and creating new ones, to circumvent any inflexible rule set. We should instead focus on breaking up too-large-to-fail banks and reducing the size of the financial sector in relation to a countryĆ¢??s GDP. In particular, we should not try to guarantee the obligations of a banking sector several times the size of our economies.

Third, and perhaps most important, we need to co-ordinate the policy response at global level, since this is a global crisis with many global spillovers. What I would like to hear from US President-elect Barack ObamaĆ¢??s economic team is not a narrow-minded discussion about whether the stimulus will be $700bn or $850bn, or which programmes it will be spent on. What I want to know is how they intend to co-opt the Europeans and the Chinese into a joint strategy…”