Tuesday, October 6, 2009

Daily Hurriyet Column: The Dark Knight of crisis prevention

The unedited version of my third column covering The Meetings is below; you can read the final version at the Daily News web site. As you can see, the cheesy titles are continuing unabated. As for the article, another issue I did not spell out explicitly in the article is the familiar carrot and stick problem. Suppose the IMF went to Turkey and said "Look, we see such and such vulnerabilities in the financial sector and the financing of the current account". The Turkish authorities may say, "Wow, we had no idea, we'll take precautions right away" and really do something, or they say the same thing and do nothing. And there is nothing the Fund can do about it... One way to enforce the carrot would be for the Fund not to reveal the actual vulnerabilities it finds (too much of a fire problem), but how disclose which countries are reacting to its findings more than, say 50%, but I am just thinking aloud at this stage.

The IMF has not only been tying to be more responsive to crisis-stricken countries, as I outlined in my weekend column, it has also been charged, along with the recently-beefed up Financial Stability Board (FSB), to identify vulnerabilities, warn of risks and prioritize policy recommendations. The two institutions were mandated to collaborate in conducting aptly-named early warning exercises (EWE) back in April, and the long-awaited initiative was unveiled at an undersubscribed seminar Sunday afternoon.

There is not much point in going over the details of the different mechanisms set in place. Suffice it to say that I have found the framework not a step, but rather a whole flight of stairs over the ill-fated early warning system (EWS) models of the nineties, which did a great job in predicting past crises but a very poor one in forecasting future ones. Not only the framework is much more sophisticated, it also takes into consideration the critiques of the likes of Nassim Nicholas Taleb, not only by concentrating on tail risks, i.e. Black Swans, and comovement of assets during crises, but also by adopting a more heuristic approach through making use of more qualitative indicators such as consultations with academics, market participants and policymakers. In fact, the Fund stresses that this is not an exercise in timing of crises, but one of alternative scenario analysis.

Since the whole philosophy of the exercise has changed, it is not much of an argument to declare the efforts pointless based on the Fund’s past forecasting performance. As Jeffrey Frankel of Harvard University recently noted, the crisis has already caused profound changes (and is likely to result in even more) in Macroeconomics thinking, so if anything, the IMF-FSB initiative should be applauded for being one of the early adopters.

But this does not mean that the EWE will be able to prevent all the crises all the time. Even if you have the perfect set-up, you just have to live with the fact that crises, by their nature, are unpredictable. The EWE efforts seem to have gone to great pains in incorporating lessons from the ongoing crisis, but the next major global turmoil will probably be entirely different in nature. But even if we end up getting an analogous crisis, it won’t be a walk in the park, as Jean-Pierre Landau from the Banque de France eloquently put:

First, there is the problem of signal extraction. The reason many could not see the crisis coming is the same reason Americans did not see Pearl Harbor coming despite all the indications. The signals that look so obvious in retrospect come bundled with a lot of clutter that make jumping to conclusions difficult. Moreover, even if the EWE extracts the right signals, whether to prick a bubble now or later is in fact a social welfare decision. I would not be surprised if an elected government would try to delay the adjustment as much as possible.

Then, there are the political issues: Even if the duo makes the right call, it will be very tough for a democratically-elected government to stop when the music is still playing. At the extreme, one can argue that the initiative may not have a viable future: For one thing, as the normal returns and the EWE starts raising false alarms, the exercise will lose its value added, as Peter Garber related from his own experience devising similar models at Deutsche Bank. While the framework can be adjusted to minimize erroneous whistleblowing, a major missed crisis will lead to the duo’s demise. Moreover, policymakers can never know for sure if there would have been a crisis if they had not heeded IMF-FSB’s advice, as Martin Wolf noted. They might see the nonoccurrence of crises not as the EWE working but proof that the exercise has outlived its use.

There is also the matter of communication: Economists have been aware of self-fulfilling crises and multiple equilibria for the past two decades. Simply put, the only thing worse than shouting “Fire!” in a crowded movie theater when the curtain is burning is to scream at the first sign of smoke, when in fact it is only the projectionist cooking. If you choose little or no communication, then you run the risk of losing credibility for lack of transparency and being accused of not having changed.

All these concerns are valid, but at the end of the day, someone needs to do this dirty work, and barring the operational glitches they too are aware of (after all, this is a work in progress), the IMF-FSB is in the best position to be the silent guardian, watchful guard that the world needs right now. In short, a dark knight…

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