Confronting Asset Bubbles, Too Big to Fail, and Beggar-thy-Neighbor Exchange Rate Policies

by Morris Goldstein, Peterson Institute for International Economics

February 2010

Morris GoldsteinThe global financial crisis presents an opportunity—for the first time in many years—for wholesale reform of the international financial and monetary system. The root causes of the crisis, says Goldstein, can be found in both the financial and monetary spheres and so reforms must be prescribed for both. On the financial side, he emphasizes two problems: pricking asset price bubbles before they get too large and confronting "too big to fail" financial institutions. On the monetary side, he concentrates on what can be done to induce large, surplus economies to abandon now—and avoid in the future—beggar-thy-neighbor exchange rate policies.

Central banks and regulatory authorities need to try much harder to identify bubbles before they get too large and consider a better bubble-busting tool kit, which would include some combination of instruments such as regulatory capital and regulatory liquidity requirements, margin requirements, loan-to-value ratios on residential and commercial mortgages, and lending standards. To confront "too-big-to fail," if higher capital requirements for larger financial institutions are not enough, Goldstein prescribes taking together four policy measures: requiring all systemically important institutions to have wind-down plans that would prevent unacceptable spillovers; ensuring that special resolution authority exists for all systemically important financial institutions; designing resolution authority in a way that supports market discipline; and imposing explicit size limits on systemically important financial institutions relative to GDP.

Goldstein then draws attention to China's highly significant case of beggar-thy-neighbor exchange rate policy and the International Monetary Fund's abysmal surveillance of the problem. He recommends that the Fund become far tougher on errant countries than it is now. The Fund's engagement with members who have emerging exchange rate problems should be made less subject to politicization and long delays. There needs to be a workable framework for the Fund's exchange rate surveillance that is capable of sending the message that the Fund views the country's exchange rate policy not only as ill-advised but also as being inconsistent with the country's obligations as a member of the Fund and, hence, that the policy has to be changed. Finally, there needs to be a workable, graduated set of penalties for countries that refuse persistently to honor their international obligations on exchange rate policy.

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