Needed: A new monetary framework

At some point, hopefully sooner rather than later, we will have to start thinking about how the policy and regulatory framework will need to change in order to prevent a recurrence. From the macroeconomic perspective, the focus is very much on the role of excess liquidity, which is being viewed as the cause of the rapid rise in the increase in asset prices and, thereby, responsible for the explosion in the variety of financial products, which are at the core of the current situation.

The role of liquidity in fuelling asset price bubbles was certainly a concern when Alan Greenspan ended his 18-year tenure as chairman of the US Federal Reserve System in January 2006. His refusal to take asset dynamics explicitly into consideration in the Fed's interest rate decisions was seen by critics as a significant negative aspect of his legacy. He did occasionally try to talk markets down -- the phrases 'irrational exuberance' and 'speculative excess' are vivid examples -- but didn't go beyond that.

As it turns out, the events of the past year and a half, but more particularly of 2008 have, willy-nilly, resolved the debate on whether monetary policy should, in fact, take asset prices into consideration. Regardless of the academic debate on the merits of this position, it is now beyond doubt that, when asset prices are collapsing, central banks simply cannot sit on the sidelines.

The rationale for intervention by every possible means -- the rescue of failing financial institutions, significant infusions of liquidity into the system and, as we have seen in the past couple of weeks, rate cuts -- is that developments in the financial markets threaten economic activity. As the situation has unfolded, there is virtual unanimity that not only are these interventions warranted, there are really no alternatives; in fact, the major criticism is that policy-makers are not going far enough.

However, having become players rather than spectators in the asset price game, central banks have to begin thinking about symmetry. If the spectre of severe recession justifies massive intervention, don't rising asset prices, which provide a boost to the demand and production, also warrant a policy response? In other words, should central banks explicitly respond to rising asset prices by imposing specific restrictions on individual institutions, drawing liquidity from the system or raising policy rates?

The logic of symmetry would say 'yes.' As they return to some degree of normalcy, financial markets must recognise the new boundaries within which they will be expected to operate. Investment decisions will now have to build in the expectation that if government actions can provide a floor, they can also provide a ceiling.

Central bank assessments that there is irrational exuberance or speculative excess can no longer be merely expressed as words of caution; they need to be backed up by specific actions to rein them in. Within this new paradigm, asset prices will move in a far narrower range in the future than they have in the last few years. This may make for a boring market but, certainly, a more stable one.

However, there are limitations to the logic of symmetry. The argument presented above is premised on asset price bubbles -- ie that prices are rising far above their fundamental values and that this will inevitably cause them to come crashing down sooner or later. The research community generally recognises that identifying bubbles before they burst is a rather difficult task. Steady increases in asset prices may well reflect fundamental improvements in the productivity of capital.

In fact, Mr Greenspan's policy positions were influenced by the perception that information technology and globalisation were contributing significantly to that improvement. When exactly price dynamics begin to deviate from fundamentals, causing a bubble to emerge is a critical question for the viability of the new paradigm. If this point of inflection can be identified, it gives monetary managers the ability to intervene at the right time as well as markets the ability to anticipate that intervention and adapt to it.

Two sets of issues need to be addressed as global policymakers begin to grapple with systemic changes. The first is the choice of indicators, which are supposed to signal the beginnings of a bubble and will, therefore, justify a policy response. The current episode suggests a number of alternatives; something akin to a leading indicators index, which had had some success in predicting cycles in the real economy, will need to be developed and established as a benchmark for policy actions. The factors underlying asset price movements, ie returns on real assets, will have to feature centrally in such an index.

The second and far more complex one is the institutional framework for macroeconomic policy. Through the current episode, we are seeing an increasing degree of both centralisation and co-ordination between agencies, whose turfs are distinct and well-defined in more normal times. This is necessitated by the fact that different assets lie within different regulatory domains and any attempt to think of them in the aggregated way, which the new paradigm implies, will involve re-drawing these boundaries, with the objective of greater overlap. This may result in a permanently more centralised structure, which will come with its own drawbacks.

The need for co-ordination and, possibly, even centralisation, goes beyond national boundaries. Globalisation has meant that, even as markets for products and services are becoming more integrated, those for assets have moved far ahead. Individual countries can, of course, opt out of the process by imposing strict capital controls. However, many of them, having experienced the benefits of access to global markets, may look for a less drastic way to deal with the situation.

We already have a significant precedent for international macroeconomic policy co-ordination in the 1944 Bretton Woods agreement, which worked reasonably well for about two decades. A new agreement which accommodates the current global dispensation by giving appropriate roles to new players may be the way forward.

To conclude, a new monetary framework will rest on three pillars: the introduction of asset price dynamics into the policy response criterion in a symmetric fashion; a greater degree of co-ordination and centralisation between national regulatory agencies whose domains cover assets of any kind; and, the emergence of an explicit international policy co-ordination mechanism. But, let's not lose sight of the most important lesson from macroeconomic history: The solution to every crisis contains the seeds of the next one.