The Reserve Bank of India organized the Eleventh L.K. Jha Memorial Lecture on February 24, 2010 at the Y.B. Chavan Centre, Mumbai. The Lecture was delivered by Prof. John Brian Taylor, Mary and Robert Raymond Professor of Economics at Stanford University on ‘Lessons from the Financial Crisis for Monetary Policy in Emerging Markets’.

Governor Dr. D. Subbarao, in his welcome address at the lecture introduced the speaker to the audience. He briefly touched up on the impact of global financial crisis on the emerging market economies and called up on Prof. Taylor to deliver the lecture.

Prof. Taylor provided an analysis of the global financial crisis and drew policy conclusions. Prof. Taylor was of the view that this financial crisis was triggered by monetary policy being too loose for too long in many advanced countries, particularly in the US. Prof. Taylor attributed the resilience of emerging market economies to good policies.

Following is the brief abstract of the lecture:

• The lecture discussed three separate questions: what started it, what prolonged it and what made it so severe during the fall of 2008. The initial flare-up of the crisis occurred during the summer of 2007, it went on for more than a year and the culmination was the incredible panic that hit in September and October of 2008. For each question, it was found that certain government actions and interventions came to the top of the list of what went wrong.

• The crisis was precipitated by monetary excesses. These excesses took the form of interest rates that were held too low for too long by the Federal Reserve and some other central banks. The low interest rates led to a housing boom which eventually ended in a bust and was a significant factor in the crisis. The low interest rates also were a probable factor in excessive risk-taking as people searched for higher yields. Between 2003 and 2005 the interest rate was held usually low compared to the Taylor rule, and at levels that we had not seen since the turbulent 1970s. Prof. Taylor stated that there was a growing agreement that an excessively easy monetary policy was a key factor leading to the boom and thus to the bust and the crisis.

• The housing bust had impact on the financial markets as falling house prices led to delinquencies and foreclosures. It is important to note that the excessive risk taking and the low interest rate monetary policy decisions are connected. Delinquency rates and foreclosure rates are inversely related to housing price inflation during this period. During the years of the rapidly rising housing prices, delinquency and foreclosure rates declined rapidly. The benefits of holding onto a house, perhaps working longer hours to make the payments, are higher when price of the house is rising rapidly. When prices are falling, the incentives to do so are much less and turn negative if the price of the house falls below the value of the mortgage. Hence, delinquencies and foreclosures rose.

• Interest rate spreads between three month LIBOR and the overnight federal funds rate jumped to unprecedented levels in August 2007 and remained high for over a year. Bringing the interest rate spread down, therefore, became a major objective of policy, as well as a measure of its success in dealing with the market turmoil. According to Prof. Taylor, the flare-up was caused by counterparty risk in the banking system due to defaults and expected defaults of securities on the bank’s balance sheets and not due to a shortage of liquidity. The policy makers misdiagnosed the problem, treating it as a shortage of liquidity rather than an increase in risk.

• According to Prof. Taylor, the sharp cuts in Fed rates in the winter of 2007-08 were overdone in terms of Taylor rule. The result was some rapid dollar depreciation, and oil prices went up sharply, helping bring on the recession. Thus, the government’s initial reaction exacerbated the problem. According to Prof. Taylor, the fiscal policy though provided additional income to individuals and families in the United States; it did not result in jump start consumption and the economy. This has been attributed to the permanent income theory of consumption in terms of which people spend little of the temporary infusion of cash.

• Understanding the events surrounding the Lehman bankruptcy is particularly important for assessing what went wrong. Many in government now argue that the cause of the panic in the fall of 2008 was the failure of the government to intervene and prevent the bankruptcy of Lehman. However, the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector.

• The big surprise, however, was the amazing resiliency of the emerging market countries including India in the face of shocks associated with the financial crisis. The contrast with the 1990s, when emerging markets were suffering their own crises, was stark. The most important reason is that they had moved toward better macroeconomic policies in the 1990s and they stuck to those policies during the crisis. According to Prof. Taylor, the emerging market countries were careful not to borrow in foreign countries, and here Indian regulatory policy deserves special credit in discouraging such borrowing by Indian banks. They built up their foreign reserves so they could intervene in the case of a big shock like they received. They kept inflation relatively low and were more careful with public sector deficits.

• According to Prof. Taylor, throughout this period there were market problems of various sorts. Mortgages were originated without sufficient documentation or with overly optimistic underwriting assumptions, and then sold off in complex derivative securities which credit rating agencies rated too highly, certainly in retrospect. Individuals and institutions took highly risky positions either through a lack of diversification or excessive leverage ratios.

Prof. Taylor mentioned that for policy makers it is important to reinstate or establish a set of principles to follow to prevent misguided actions and interventions in the future. The following major policy measures have been proposed :

• Emphasis should be on proposals to reduce the likelihood of government interventions and actions that led to the crisis. Going forward this means dealing with the very large budget deficits and rising government debt; scaling back or at least not adding more Keynesian stimulus packages; exiting as fast as possible from the extraordinary monetary policy actions which have questioned central bank credibility and threatened their independence; and ending the bailout mentality that will take governments further into the operations of private businesses.

• Reform of financial regulation is clearly in order. Based on recent experience, closing present and future regulatory gaps and de-conflicting overlapping and ambiguous responsibilities would help reduce risk, especially as new instruments and institutions evolve. Examining new instruments, looking for new risks and gaps, and making recommendations for changes in regulations by using the ideas from conferences like this one would also help.

• For the most part, the policy implications of the crisis are that those central banks that deviated from good policy should get back to what they were doing before the crisis. They need to earn back credibility and preserve their independence. Systematic monetary policies focusing on a credible goal for inflation worked well in the past and they will work well in the future. For central banks that were following sounder policies—and here credit should be given to the progress made in India and other emerging market central banks—they should continue to do so.

• The crisis does reveal some potential new fault lines, largely related to the increased globalization and international connection between financial markets, which was so evident during the panic. The central banks will have to learn to cope with the shock originated in the developed countries.

Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India highlighted the main messages of Prof. Taylor’s lecture and offered a vote of thanks.

G. Raghuraj
Deputy General Manager

Press Release : 2009-2010/1171