Wednesday, February 19, 2014

Not Too Loose, Not Too Tight - And Let The Crumple Zone Do Its Job

The recent volatility in emerging markets has reignited debates about the appropriate level of currency flexibility and capital mobility. It's clear that excessive volatility in currencies and capital flows can be destabilizing to a domestic economy. But it seems to me that the systems have worked exactly as they should in most countries.

To make an analogy, if you're anything like me, you'll look at this picture and think...

"Holy sh*t, I hope no-one was hurt." That's a natural reaction, and totally fair. But to some extent the damage we see is designed precisely to prevent passengers from being hurt. The crumple zone in the front part of the vehicle is designed to absorb energy from a collision through controlled deformation. 

From Wikipedia: "Crumple zones work by managing crash energy, absorbing it within the outer parts of the vehicle, rather than being directly transmitted to the occupants, while also preventing intrusion into or deformation of the passenger cabin. This better protects car occupants against injury. This is achieved by controlled weakening of sacrificial outer parts of the car, while strengthening and increasing the rigidity of the inner part of the body of the car, making the passenger cabin into a 'safety cell', by using more reinforcing beams and higher strength steels." 

To take the analogy further, appropriate monetary policy and supply-side reform are the rigid inner body of the car, while some accumulation of foreign reserves is an airbag. The crumple zone and airbag in most economies have worked as designed, so there's no reason for a resurgence of "fear of floating".

I'm not arguing for complete capital mobility, though, particularly in small economies with poorly developed financial systems. I especially detest it when hedge funds criticize countries for restricting capital mobility. That's just hypocritical: hedge funds employ "lock-ups" to manage capital flow volatility, quite rightly arguing that investor panic can hurt not only the withdrawing investor, but other investors too, if the fund is forced to liquidate assets in a fire-sale. Similarly, policymakers have every right to slow the flow of hot and fickle money.

So I guess what I'm arguing for is a plucking model of central banking. No, not the plucking model made famous by Milton Friedman. Rather, another theorist noted that "The over-tight string produces an unpleasant sound and is moreover likely to break at any moment. The string that is too loose does not produce a tuneful sound. The string that produces a tuneful sound is the string that is not too tight and not too loose."

That was, of course, a disciple of the Buddha, whose attempts at meditation were in fact hampered by his excessive control. Not too loose, not too tight - and let the crumple zone do its job.

No comments:

Post a Comment