This is an inspiring paper to read. It is a report by a man who has made his living on Wall Street observing the US financial system for more than 30 years. It is a story about evolution, more specifically about financial sophistication and deregulation. The paper forces the university economist living in the equilibrium world to think about the effects of institutional change.
I would like to focus on two issues in this paper, both related to the macroeconomic consequences of the process of financial deregulation: first, the effects of financial deregulation on the business cycle, and second, the effects of financial deregulation on the power of central banks or on the efficiency of monetary policy. These issues are not novel ones, they have been with us for a long time.
The first theme is associated with the old question: has the business cycle changed its character? There are variations on this theme. One school argues that the business cycle has been dampened, even suggesting that the end of the business cycle is near.
The position of the author is unclear on this point. On one hand, he suggests initially that the US business cycle has been "gentler and kinder" in the past 15 years. On the other hand, at the end of the paper he fears that the future will see growing financial instability due to the rise of non-bank financial intermediation. From this I would expect him to argue that the business cycle will display greater cyclical instability.
Basically there are two schools concerning the effects of financial deregulation on macroeconomic stability. One school maintains that financial sophistication will allow households and firms to adjust easier and quicker to economic disturbances, thus smoothing the business cycle, reducing its amplitude.
The other school holds the opposite view. The enormous growth of financial markets has increased instability and volatility. On a international scale, disturbances will spread more rapidly in the world economy through well integrated financial markets. We will thus see a future with larger volatility than presently. This is the view of Wojnilower.
Which hypothesis is the correct one - ignoring the status quo view of no change? How shall we approach this issue? One approach is to look at the history of business cycles during different financial regimes, preferably comparing periods with deregulated financial markets with periods with financial regulations in power.
By now there are a number of empirical studies of the amplitude of the business cycle covering for example the pre-1914 gold standard, a period of "free" and well functioning capital markets, and the Bretton Woods period, which was a period of far-reaching controls of financial markets, both of domestic and of foreign flows of credit and capital. These studies do not suggest that the business cycle has been dampened by financial controls as far I have seen.
Let us look at the post-Bretton Woods period. Which has been the role of financial markets since the early 1970s? The existence of financial markets facilitated the adjustment of the world economy to the macroeconomic shocks of OPEC I and II. I will conjecture that financial deregulation has contributed to stability in this sense, facilitating recycling of debt after the oil crisis and allowing governments to borrow in periods of financial strain.
In another sense, the process of deregulation, that is the movement from a non-market system of controls to "freely functioning" capital markets has caused a number of severe transition problems in many countries - a process similar to the march from the planned economy to the market economy in the former USSR. Events in Sweden and Finland nicely illustrate such developments. Deregulation was initially accompanied by a credit expansion, asset inflation, euphoria, and then by a credit crunch, asset deflation, financial instability and economy wide depression in these two countries.
I would like to stress that this process of sudden major financial deregulation was not an ordinary business cycle event. It was a structural shift or more precisely a shift of the financial regime that was not counterbalanced by appropriate economic policies.
The second major issue raised by Wojnilower deals with the power of monetary policies and thus of the monetary authorities. He suggests that the US central bank had stronger control over the volume of credit, money and interest rates as well as over financial institutions during the system of financial regulations in the 1950s and 1960s than the case is today. In Wojnilower's words: the financial jungle was controlled by having all the animals locked into separate cages in the zoo.
In the past 25 years the Federal Reserve system has moved to a monetary policy regime based on influencing short-term interest rates. The animals have been let out of their cages and now roam freely. The growth of non-bank financial intermediaries relative to commercial banks has weakened the efficiency of monetary policy. The volume of credit relative to the monetary base is ballooning, implying growing financial fragility of the financial structure. The system is moving towards Knut Wicksell's vision of a pure credit economy.
Is the Fed now loosing its power to control? Presently, it seems that the US Federal Reserve system is quite successful in containing inflation and fostering a climate of financial stability. Wojnilower's paper is actually a testimony in favor of this view. Inflation rates have come down from two-digit levels in the 1970s and are now at a historically low level while US employment and US economic growth is high. Non-inflationary growth seems to prevail - at least for the moment. The Federal Reserve System and the US economy is regarded with envy and admiration outside the US. So far, the US central bank does not appear to have lost its capacity to control monetary and credit conditions and to influence the US economy.
To sum up, I have discussed two issues raised by Wojnilower's paper: first, the effects of financial deregulation on economic stability, and second, on the power of the monetary policy makers. I do not share Wojnilower's guarded pessimism. I would rather like to be a guarded optimist. However, we know only one thing for certain. Time will tell us more about the macroeconomic effects of financial deregulation. I hope that the lesson-making will not come through major disasters.