WITH THE STATE OF THE GLOBAL ECONOMY making headlines daily, we at GSB Chicago thought it would be
enlightening to hear what GSB faculty members have to say about
risk management, the Asian economy, and the U.S.s ability to
resist recession. In October, George Constantinides, Anil Kashyap,
and Randall Kroszner gathered over lunch in Rosenwald Hall to
debate the issues. What follows are excerpts from their discussion.
GSB Chicago: Most economists characterize the U.S. stock markets recent volatility
as a response to the economic crisis in Russia. Is it time to
exercise greater control over investments?
CONSTANTINIDES: Are you referring to control of hedge funds and
portfolio managers or control of the institutions that lend to
hedge funds, like banks? It is true that the economic crises in
Russia and in the countries of Southeast Asia have increased the
volatility of the U.S. and international stock markets and derivatives
markets. But by imposing capital controls, the countries in crisis
neither help their economies nor dampen the market volatility.
KROSZNER: I dont understand how trying to slow down the international
movement of funds would help at all. I think it would increase
the problemsthe reason these countries have enjoyed such rapid
growth over the last three decades has been due to foreign inflows
of capital. With capital controls, theyre simply not going to
grow as quickly.
KASHYAP: The problem in Russia wasnt hedge funds, the problem
is that they cant collect taxes, they cant enforce contracts,
things are massively corrupt. And theres nothing we can do on
the outside thats going to help that very much, unless maybe
we dedicate some funding to try and improve the situation and
have the IMF [International Monetary Fund] ride in there and say,
OK, you guys have got to get your court system up, and were
going to subsidize honest judges. Investors have to have the
ability to pull their money out on short notice if they cant
be guaranteed the right to enforce contracts in the courts.
KROSZNER: And its the discipline of the capital markets that
is exactly what helps the politics in these countries. If the
governments wont have rule of law and wont enforce contracts,
then they will be cut off from the markets. Then theyre not going
to be able to grow, but the people want economic growth.
GSB Chicago: Should there be greater control of hedge funds?
KASHYAP: Consenting adults should be able to do whatever they
choose. The problems come when the government comes in after the
fact and decides that its going to rescue people and save them
from their own stupidity. With Long-Term Capital Management, the
crime was the Fed[eral Reserve] not saying unambiguously, Warren
Buffetts put some money on the table, you guys go work something
out. But thats got nothing to do with hedge funds, thats got
to do with just terrible decision making at the Fed.
Greenspan dissembled in the worst possible way. For him to say,
We shouldnt regulate hedge funds because those are private activities,
and we dont really have any scope over it, and then to undercut
that by the Feds own actions was incredibly hypocritical. On
the other hand, if he really thought there was a systemic problem,
the Fed had the authority, still has the authority, to intervene
directly. But they would have had to make the case convincingly,
and they would have had to explain to the public exactly what
the consequences would be. Instead, they took this unbelievably
poor hybrid action of a bailout.
CONSTANTINIDES: I am against greater control of hedge funds. In
any case, the issue is moot because hedge funds can evade U.S.
government controls by operating from overseas.
Let me clarify something regarding the governments role regarding
Long-Term Capital Management. When we say bailout, it was a
bailout not by the government but by the lending banks. Government
money was not involved, it was the banks. The government did
coerce the banks to reverse their earlier mistakes in being so
free to lend without proper collateral and without credit checks.
KASHYAP: Fair enough, but what business does the government have
doing that? There ought to be an overarching principle that if
theres private money available to solve the problem, the government
has the ethical, moral, and I would have hoped legal obligation
to get out of the way and let the market work.
What signal does this send? If you get into trouble you can count
on the government to coerce somebody else to help you or maybe
help you directly. It also discourages people from keeping track
of whats going on, on the chance that hey, maybe they can swoop
in and buy up a bargain.
KROSZNER: In the old days, before we had the Fed, we had J. P.
Morgan, the Warren Buffett of his day. He had the money and the
ability to call people into his office and say, Weve got to
work something out here. During the bank panics, thats what
he would do. Hed get people together and say, Weve got to save
this bank because its good for us in general.
Warren Buffett is not a philanthropist, hes someone who has liquidity,
he has the funds to go in when theres trouble and say, Well
maybe I can make money here. The markets have always done that,
will always do that, except of course, as Anil [Kashyap] said,
when the government intervenes the Warren Buffets and J. P. Morgans
of the world may not want to do that anymore because after doing
the due diligence to find out whether the investments worthwhile,
they make an offer, and the government says, Well, its not a
good enough offer, well put pressure on someone else to make
a better offer.
CONSTANTINIDES: I do not favor more regulation of the banks; however,
the government should pay a little more attention to the banks
and make sure that the banks understand their exposure to credit
risk. I think that, in this respect, banks failed in their role.
KASHYAP: The market risk calculation that the big banks are supposed
to be engaging in is supposed to provision for this. In principle,
the regulations are there, we just have to enforce them.
CONSTANTINIDES: Are you referring to the Basle capital requirements?
Those would not be adequate to address this problem.
KASHYAP: Right, those are designed for credit risk, but as of
January this year theres a set of laws in place that are intended
to deal with so-called market risk.
CONSTANTINIDES: And they apply this set of models generally called
VaR, Value-at-Risk, and I think what happened shows that the VaR
approach, as commonly applied, is totally inadequate to take into
account the rare events that occur. Looking at the time series
of the fluctuations and their correlations, it was all conditional
on the rare event not having occurred, so that by construction
you are not building in the possibility of these rare events happening.
Markets that normally appear uncorrelated, like Brazil and Russia,
become correlated when the big event hits. The models themselves
are blind to some of these correlations. This kind of cascading
effect can lead to serious problems.
So the idea of banks having a well thought-out, well organized
procedure of looking at their overall risk exposure is definitely
a step in the right direction, but I would say that the banks
are at the very early stage in developing systems that would be
effective enough to address the kind of problems rare events present.
In addition, whether the VaR model is or is not adequate, we have
to plug in accurate inputs. Banks were lending, say, $200 million,
and did not even know what their risk exposure was because they
We agree, if I may propose this, that banks are not undercapitalized,
and a regulation to increase capital requirements is not the issue,
but prodding banks to think harder about their risk management
models is. There is evidence already that banks are beginning
to ask their existing clients about their overall risk exposure.
KASHYAP: I disagree. I think at some level they are undercapitalized
because would they not have the federal guarantee, they would
be capitalized at levels like other financial services.
KROSZNER: Like finance companies, which have double the capital
levels of even the relatively high capital levels banks have now.
Finance companies dont have government guarantees, they get involved
in very similar sets of activities to banks making lots of short-term
loans to consumers and business and investing in all different
types of activities, but the market forces them to hold much higher
KASHYAP: Even if banks had perfect risk management models, part
of the reason they get away with the capital levels they do is
this view that the government is there to help them. The more
we can encourage them to mimic the guys who dont have the government
guarantees, the better.
KROSZNER: You can either try to take away the guarantees, which
arent really credible, because people always figure that you
will bail out the big boys, which is probably true, or you can
approach it from the other side and say, Well, if you are going
to get this benefit from the government, then theres going to
be some cost. Youre going to have to make sure not to expose
taxpayers to too much risk.
GSB Chicago: Can anything the U.S. doeslike the Feds rate cutshave an impact
on the global situation or prevent us from getting sucked into
a global economic crisis?
KASHYAP: I think those are two rather different questions. On
the one hand, can the Fed do anything to help Russia? Probably
not. Can the Fed stop a recession from happening in the U.S.?
The question is, Can a recession in Russia spread to the U.S.?
I think anybodys got to conclude the answer is, Not easily. Japans
been in the dumps for seven years, Southeast Asia has been crushed
for a year, Russias gone down the drain, theyre going to have
a hyperinflation, and the U.S. just keeps rolling along.
We have a tendency to give the Fed so much influence over things,
maybe its psychological; we want to feel like somebodys in control,
but there are real limits to how far the Fed can go on these matters.
They cant do very much to clean up the Thai banking system, they
cant even control the Japanese, who have the money to do something
sensible, so I dont think that by wiggling around the Fed funds
rate youre going to get very far fixing the rest of these countries
CONSTANTINIDES: The Fed can help alleviate the irrational illiquidity
in some markets, which is an overreaction to the economic crisis.
We observe a big discrepancy between the yield of the 30-year
bond and the yield of the 29-year bond. It is not a rational discrepancy.
In terms of fundamentals, the two yields should be very similar
because nobody can really forecast what will happen to interest
rates between years 29 and 30. Yet there is a big difference.
Everybody wants to hold something safe, so they want to hold the
30-year bond. This is an issue of illiquidity now that has nothing
to do with credit risk.
KROSZNER: If were willing to consider some more radical solutions
than those weve discussed, the Fed could very indirectly help
out these other countries.
Many countries have taken a first step toward effectively adopting
Alan Greenspan as their central banker by either pegging to the
U.S. dollar or by setting up a currency board.
Now, the pegs dont work very well, because theyre only as good
as the domestic monetary policy is. They say were going to fix
to the U.S. dollar at a certain rate, and if things work out properly,
they would then follow the same policies as the U.S. follows.
The Asian Tigers fell because they pegged to the U.S. dollar but
didnt pursue the same low inflation, low fiscal deficit policy
that the U.S. was pursuing. When a number of Asian countries were
starting to slow down about two or three years ago, they stepped
on the gas pedal, trying to boost up their money supply growth
rates. You then had this tension and inconsistency between the
internal policy and the external policy. Once you get that, either
youre going to have to have a realignment with the exchange rates,
done voluntarily, or its just going to burst. And we saw it burst.
A currency board is one way to adopt the U.S. policy in a more
direct way. Hong Kong has been able to maintain its relationship
with the U.S. dollar very well through the storms. But with a
currency board, theres always a chance to say, Well, well just
switch back to the peso or the Hong Kong dollar.
The surefire way to get the full benefit of Greenspan is to fully
adopt him, not to have him as a foster child but as a member of
the family. And how do you do that? You just eliminate the local
currency and use U.S. dollars. Panama has done this. Theres no
risk premium, because theres no concern about the local currency
versus the U.S. dollar currencytheres only the other currency.
So in some sense we could prevent some of the problems weve seen
if these countries were willing to fully give up control of their
monetary policy and just use U.S. dollars directly. But thats
a very radical solution.
GSB Chicago: Is that likely to happen in any of these countries?
KASHYAP: If things get bad enough.
KROSZNER: Clearly Asias fallen apart, and Brazil is in deep troubletheyre
going to get together $30 billion, $60 billion, maybe $90 billion
to try to save this highly overvalued exchange rate between the
Brazilian real and the U.S. dollar. It doesnt make any sense.
It would be much better if they just said to heck with this charade
and just adopt the U.S. policies directly.
KASHYAP: But no country wants to give up their sovereignty, being
able to issue a picture of one of their dead leaders instead of
one of ours. If you ask someone to do that, theyre going to reject
it unless the situation is pretty horrible, and I dont think
weve gotten to that level of pain yet. Although Russias heading
there pretty fast.
In fact, probably what the U.S. should do is stick to mostly domestic
affairs. We dont have a tremendously good record of being able
to convince people to do what we want them to do, leaving aside
whether or not we know what the right answer is.
GSB Chicago: The IMF is calling for greater disclosure and a culture of transparency,
is that. . .
KASHYAP: IMF can start at its own borders by making its own actions
transparent, but I agree with the principle. Its more than transparency,
its actually deregulating, saying that if a foreign financial
institution wants to lend or collect deposits locally, it can
do it without having to worry about being nationalized or being
subject to arbitrary rules that domestic financial institutions
arent subject to.
KROSZNER: Where domestic financial institutions have collapsed
there are probably still good projects that could be financed
if there were a solvent institution there to provide the financing.
Many industrialists want credit but cant get it from the local
institutions. In many of these countries, local banks are subject
to political whim. They are nothing more than fiscal arms of the
state. Foreign banks can be a much more stable source of funds
than local banks.
In the United States, we got rid of interstate barriers and have
a much more stable system because money can flow from California
and New York down to Texas when Texas banks get into trouble.
The same thing could happen if foreign banks developed a large
presence in countries like Malaysia and Korea.
GSB Chicago: Youre suggesting that the answer to the global economic crisis
is to create a true global economy. What do we have now?
KROSZNER: A Frankenstein monster, a hybrid of the worst of some
regulation and some market-oriented approaches. The worst of both