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New battle plan needed for a crisis-prone world

By Stephen Roach

Published: Last updated: May 17 2010 16:40

The pace and severity of financial crises has taken an ominous turn for the worse. Over the past 30 years, a crisis has occurred, on average, every three years. Yet, now, only 18 months after the meltdown of late 2008, Europe’s sovereign debt crisis has hit with full force. With one crisis seemingly begetting another, and the fuse between crises now getting shorter and shorter, the world economy is on a very treacherous course.

Each crisis has its poster child – from Thailand, to dot-com, to subprime. But they all have one thing in common – easy money. The “Greenspan put” – the notion that central banks would be quick and aggressive in backstopping financial market disruptions – was the short-term anaesthetic that repeatedly set the stage for the next crisis.

In the aftermath of the Asian financial crisis of the late 1990s, über monetary accommodation fed the equity bubble. Once that bubble burst in 2000, another dose of extraordinary monetary ease set the stage for massive property and credit bubbles. The aftershocks of that post-bubble carnage have now brought Europe to the brink.

Sadly, central banks are doing it again – policy rates near the zero bound in nominal terms and negative in real terms. And in the parlance of the Federal Reserve, this destabilising condition is likely to persist for an “extended” period. As day follows night, this is a recipe for the next crisis. Whether that crisis is spawned by another asset bubble, a credit binge, or CPI inflation is impossible to say. But any – or all – of these options are conceivable in yet another undisciplined post-crisis climate.

Breaking this daisy chain won’t be easy. But a new approach is desperately needed. History gives us a guide as to how and where to find the answer. Think back to the late 1970s. At the time, there was a deep-rooted sense of despair and hopelessness over the seemingly intractable Great Inflation. Politicians and policy makers were convinced that the system was unwilling – or perhaps unable – to accept the pain of the cure. Sound familiar?

Paul Volcker dispelled that notion – breaking the back of inflation by pushing the federal funds rate up to 19 per cent in 1981. Just as monetary discipline was the answer nearly 30 years ago, I suspect it is the only way out today. For a world in the depths of crisis and despair, another “Volcker moment” may well be at hand.

No, I am not suggesting that central banks tighten monetary policy in the midst of a crisis. But it is high time to banish the moral hazard of macro policy – the false sense of security provided by open-ended fiscal and monetary accommodation as the world lurches from crisis to crisis. Central banks need to lead the way in regaining policy traction by laying out credible and transparent exit strategies from the unprecedented stimulus now in place.

Three things are required here: an explicit target for a “normal” policy rate; a macro forecast that would identify the conditions under which this normalisation would occur; and a specific timetable of adjustments in the policy rate that would achieve this result.

As an example of how this approach might work, consider the task of the Federal Reserve.

Step One: Announce a target of restoring the real federal funds rate back to its long-term average of 2 per cent.

Step Two: Lay out a three-year macro forecast of the US economy. For the sake of argument, plug in average real GDP growth and inflation of 2.5 per cent and an unemployment rate that falls back to 6 per cent by the end of 2013.

Step Three: Conditional on that forecast coming to pass, announce a normalisation plan of nine moves of 50 basis points in the federal funds rate – spread out over 18 months and commencing as soon as the dust settles on the euro crisis.

This is a hypothetical example of how a new approach might work. Admittedly, it is predicated on an imperfect forecast, and hostage to forces that might render that forecast wide or short of the mark.

But it has the advantage of identifying the parameters of a restoration of monetary discipline – something that has been sorely missing over the past 15 years. And it avoids the perils of the “asymmetrical reaction function” – the aggressive monetary easing in a crisis followed by the baby steps of post-crisis normalisation that have allowed the “cure” of one crisis to sow the seeds of the next one.

Central banks are imperfect institutions – and more so in recent years as they have abdicated their political independence. They were outstanding in waging the battle against inflation. They have failed in managing the post-inflation peace. The only hope for a crisis-prone world is a new battle plan.

Stephen Roach is the Chairman of Morgan Stanley Asia and author of The Next Asia (Wiley 2009).

Copyright The Financial Times Limited 2010