Progress and Pitfalls in Banking and International Finance

Since real data effectively crushed monetary policy linking GDP and inflation, the world’s central banks have stabilized inflation by becoming more predictable, said Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance. “Central banks try to raise interest rates when inflation is high or when the economy is booming to try to prevent imbalances from emerging,” Kashyap said during a panel at the 2007 Conference on Chicago Economics presented by the Becker Center on Chicago Price Theory, at the Charles M. Harper Center November 10. In addition to Kashyap, the panel on banking and international finance included Douglas Diamond, Merton H. Miller Distinguished Professor of Finance; Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance; and moderator John Huizinga, Walter David “Bud” Fackler Distinguished Service Professor of Economics.

Central banks’ primary issue today is not how to control inflation directly, but how to manage the indirect factors that might influence inflation, he said. “The biggest debate now is this: suppose you see house prices in your country starting to accelerate and you think they’re at a level that is unlikely to be sustained,” Kashyap said. “There is a huge disagreement as to whether the central bank should take preemptive action.”

The best way to provide incentives to get banks to monitor borrowers on behalf of lenders who don’t have access to them is through a diversified bank that offers deposits to senior claimants who retain junior claims, said Diamond. “Banks can then control the borrowers without having anybody monitoring them collecting private information, without having outsiders have to keep an eye on the bank,” Diamond said. “All the outsiders have to do is essentially close the bank or punish the bank if they default on their deposits.”

Incentives can be created by requiring the “delegate bank” that collects the loans paying the senior claimants and face penalties if those payments are too small, he said. “The bank has to be diversified for this to work,” Diamond said. “It needs to have a pool of loans that are independent yet identically distributed. A diversified bank can cross-subsidize - what I call ‘work out’ the bad loans and collect the good loans. Then it would only fail when both types of loans did poorly and could save a lot in financial distress costs.”

In countries facing economic crisis, the International Monetary Fund has increasingly adopted the view it cannot force countries to implement adequate institutional controls over banking, said Rajan. “It has to be that the government actually wants to change, because underlying the reasons for the crisis are deep problems the country itself has to fix,” Rajan said. “Unless those are fixed, we’re going to have recidivism as we saw in the 1960s.”

In the last seven or eight years, countries have quickly recovered from crises by shifting the focus of their economies from domestic to foreign demand, particularly U.S. demand, he said. “Servicing external demand provides discipline that might not be available in your own country because of weaker institutions,” Rajan said. “The problem we’re seeing today is that even the U.S.’s institutions are somewhat inadequate for maintaining a tremendous amount of domestic demand, such as with the housing crisis.”

The banking policies discussed on the panel are absolutely crucial to the state of business today, both globally and nationally, said first-year student Harsh Kanda. “It controls everything,” Kanda said. “Hopefully t his is what you use to make sensible decisions going forward.

- Phil Rockrohr