Monetary Policy and Financial Stability:

Lessons from the East Asia Crisis

Hong Kong

December 15, 2000

Central Questions and Theses• What has been the role of monetary policy on economic

performance and stability? Especially in response to crises?– The use of monetary policy to respond to crises has been

ineffective, worsening economic downturns, and, worse still, contributing to overall global instability.

• How do we explain seemingly perverse policies? – IMF changed its mandate from Keynes’ original conception,

focusing on global financial stability, to "bill collector of the advanced industrial countries“

• How do we explain this change in mandate?– Governance structure of institution

Basic Facts

• Financial and economic crises have become deeper and more frequent over the past twenty five years

  • High interest rate policies in response to the

East Asia crisis did not work, did not stabilize exchange rates

Monetary Policy: central point of contention

• IMF now concedes:A. Magnitude of downturn was originally underestimated

B. Fiscal policy was excessively contractionary

C. Financial sector restructuring was mismanaged, (e.g. in Indonesia)

D. Insufficient recognition given to trade interdependencies

• But role of monetary policy is defended

Understanding Appropriate Role is Important Because

A. There will be further crises

B. Crises may be mismanaged

C. How crises are managed affects incentives and therefore likelihood of future crises

IMF’s Premises

• Important to prevent further deterioration in exchange rate

• Raising interest rates can do this

• Benefits of raising interest rates outweigh the costs

Is it desirable to prevent deterioration of exchange rate?

 Premise:

– - Market determined exchange rate not "socially desirable"—overshooting- International or national bureaucrats can do a better job at setting exchange rates than markets

• Note intellectual incoherence:– In general markets are efficient– But government intervention required in exchange rate market – Question: what is special about exchange rate market?– Worry: inflationary effect of exchange rate depreciation

• Evidence:– Government (IMF) not done credible job in deciding when to intervene

• Russia• Brazil

– Depreciation may not have major inflationary effect• Brazil• East Asia

Do Exchange Rate Interventions Work?

• On average, sometimes, sometimes not 

• Why should raising interest rates increase exchange rates?– Makes it more attractive to put money into a country if

bankruptcy probability unchanged– But bankruptcy risk was at heart of crisis– With high leverage, short term indebtedness bankruptcy

risk would increase• direct effect• indirect effect through aggregate contraction

Why should short run, temporary intervention lead to high equilibrium

exchange rate?

• Implied assertion:movement along demand curve leads to shift in demand curve

 • Theory:

– “Confidence“– +“Signaling"

 • Confidence questionable

Raising interest rates "restores confidence"

• Why?• Hard to restore confidence in country going

into depression• High unemployment leads to social,

political turmoil• Hard to restore confidence in country with

high levels of social and political turmoil• Economic recession leads to capital flight

Signaling• Can provide signal without high costs• Ignores general principle of signaling: only costly signals

convey information• Who bears cost? workers• Independent central bank: reduces cost to central bank• Therefore reduces effectiveness of signal• Why should action today convey information about future

actions?• Theory may have made sense when problem was

excessively lax monetary authority, wanted to signal "prudential" behavior

• But loose monetary policy not problem in east asia. Addressing East Asia crisis with wrong medicine conveyed negative, not positive signal

IMF Asserted Trade-Off• Damage of high interest rate vs. Damage of low

exchange rate

• Above analysis suggest high interest rate was lose-lose policy, not trade-off

• IMF asserted that there would be short-run pain, for long-run gain

 • Above analysis suggests that high interest rate policy

led to high short-run pain and long-run losses

But assuming there was a trade-off; What was the trade-off?

• There was an alternative policy to limit the damage of a decreasing exchange rate: Bankruptcy

• Bankruptcy is part of capitalism, not an abrogation of contracts

Assuming one did not want to allow bankruptcy;

What was the trade-off

• Differs across countries• Adverse effects of high interest rates greater where short

term leverage was highest--as in East Asia• Adverse effects were greater where banks had assets which

were sensitive to interest rate (stocks, collateralized loans)• Within East Asia, adverse effects of depreciation depended

on variety of conditions– Exposure (low in Malaysia)– Who is exposed

• in Thailand--exporters, real estate firms• marginal impact therefore small

– Requires micro-economic analysis

Policies Contribute Ex Ante to Moral Hazard Problem

• Probably more important than standard bail-out problem

• Reduces need for cover• Moral issue: saving those who failed to buy

insurance and gambled, at the expense of innocent bystanders

• With other forms of intervention, providing the food for speculative sharks

High Interest Rates have Large Distributional Effects

• Creditors gain from increasing interest rates

• Creditors may especially gain if high interest rates force "fire sale" of assets in order to pay back loans

Explaining Policies• Originally, IMF was supposed to encourage and provide funds for expansionary

policies 

• How do we explain systematic bias towards contractionary policies?

• Hypothesis: interests of creditors became paramount, not maintaining economic strength

• Building up reserves creates funds to repay dollar loan

• Best way of building up reserves is beggar-thy-self policies– Devaluations can hurt creditor countries (U.S. response to steel imports)

– If devaluations and tariffs ruled out, then only way to build reserves is to induce recession

• Trying to avoid bankruptcy is in interest of creditors– But IMF did not manage this well

• Firesales are in interest of creditors– High interest rates enable them to pick up assets on the cheap

– Consistent with emphasis on need for foreign capital

– Not needed given high savings rate

– Domestic management had proven metal in most industries

– Financial sector makes money simply out of transactions

Explaining IMF’s Changed Mandate

• Keynes turning over in grave

• Governance

• IMF controlled by advanced industrial countries

• IMF controlled by finance ministers, central bankers - reflecting interests of financial community

• Outcomes predictable

Reforms

• Governance--not likely

• Process--transparency

• Exposure of "hidden agenda" may circumscribe behavior

• Scope--conditionality

Exchange Rate Regime• Monetary policy should be directed at enhancing economic

stability, not exchange rate stability• Exchange rate stability, inflation means to ends, not end

themselves• Major confusion between means and ends• Evidence that, by and large, fixed exchange rate system and

more broadly government intervention has contributed to instability at high cost

• Argentina: slow growth, high unemployment• a focus on exchange rate stability leaves one exposed to Hong

Kong double play• Simultaneously speculating against exchange rate, stock market• Hong Kong managed this well? Will others be able to do so

well?

Conclusions• Bad economic models lead to bad policy• Need to incorporate finance into macro-economics• Need to incorporate good micro-economics into macro-economics• Little excuse for these failures: models focusing on finance and

bankruptcy were already formulated• Experiences verified predictions of those models• Cannot ignore the political economy and politics of political

institutions• Focusing monetary policy on inflation and enhancing probability

that creditors get repaid does not contribute to global economic stability

• Reinforces conclusions: importance of democratic accountability• If those affected by policies had had a stronger voice in policies,

arguably different policies would have been pursued.