Tuesday, August 21, 2007

A fine balance

If global financial markets emerge from this round of turbulence with only minor scratches and bruises, much of the credit will undoubtedly go to the quick response of the European Central Bank and the US Federal Reserve. However, their intervention always raises the question of moral hazard. Are central banks, by repeatedly showing their willingness to bail out the financial system in such situations, creating incentives amongst both investors and financial service companies to engage in practices that heighten the risks to the system? If so, is the global economy better off without this guarantee of safety?

Theoretically speaking, the merits of non-intervention are strong. The ability of modern financial systems to efficiently price risk and quickly eliminate, through arbitrage, all opportunities for investors to earn higher returns for relatively lower risk is indeed its hallmark. Investors looking for ways to break through this barrier do succeed for a while, but soon the rest of the market catches up. In this context, the safety net that a central bank bail-out provides investors only serves to distort their risk-return calculations. Bets that, if wrong, could cost them their fortune now become that much easier to make. When a large number of investors abandon prudence and discretion to make such bets, we have the makings of a crisis. The certainty that central banks will not bail them out of one should be enough incentive for many of them not to make these bets.

A practical benchmark for effective regulation is that no two crises have the same cause. By that token, the balance between regulation and intervention has worked reasonably well. Your thoughts...?



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