Who will regulate the policymakers?

Last Sunday I went to the Leaders in Dubai Business Forum to listen to James Wolfensohn, former President of the World Bank.

He started his address by reading a couple of paragraphs from an article in Gulf News in which I had argued the case of the relative strength of Gulf economies in the face of a global recession largely due to their prudent fiscal management.

Wolfensohn acknowledged the logic, but sounded sceptical about the sustainability of the Gulf's economic growth amidst a global meltdown. Having headed the World Bank for a decade until 2005, he definitely has a better insight on the working of the global economy.

Dwelling further on the global financial crisis, he blamed the fault-lines in financial regulation as the main cause for the current situation.

Quoting statistics from the Bank of International Settlements, he said the world financial system is sitting on more than $630 trillion (Dh2,314 trillion) worth of derivative trades, most of which are leveraged positions.

Indeed, a host of speakers at the Leaders in Dubai Forum and previous World Economic Forum decried the regulatory mishaps over the shortsighted and excessively risky behaviour of financial institutions.

No doubt, these trillions of dollars of risky exposure are totally out of synch with what prudent risk management would have called for, and regulators should have been on that case.

But I doubt that regulations alone could have prevented this disaster. One should not forget that at the core of this crisis lay fundamental macro issues, namely flaws in the monetary and fiscal management of the US economy.

During the early part of this decade when the US economy faced downward pressure on prices, the Fed lowered interest rates and facilitated increases in the money supply. That created a quest for yield financial institutions. The result was the increase in the utilisation of debt securitisation.

The conversion of illiquid to liquid assets stoked the fire of mortgage debt. Armed with these make-believe assets, securitisation spread to other forms of debt, such as student loans, credit card debt, and to the securitisation of the securities themselves.

Right policy mixture

The weight given to prospective yield fell drastically as market participants increasingly applied greater weight to the expectations of their fellow participants, a herd-like behaviour that lost touch with underlying reality regarding value.

Joseph Stiglitz, the Nobel-winning economist from Columbia University, recently wrote in his blog that this crisis was the result in particular of a tax cut for the rich, which did not stimulate the economy, which "put the burden of keeping the economy going on monetary policy". The Federal Reserve responded, he said, in a short-sighted way, providing ample credit with low interest rates. Combined with lax regulation, "it was an explosive mixture - and it exploded."

That being so, shouldn't economists and opinion-leaders focus their energies more on seeking the right policy mixture rather than wasting their time on debating what should be the optimum level of regulations that could sustain the global economic system?

After all, the failure of regulation is just a symptom, rather than the disease itself.

I doubt that regulations alone could have prevented this disaster. One should not forget that at the core of this crisis lay fundamental macro issues, namely flaws in the monetary and fiscal management.