Financial regulation and commercial protection: should policy change?

Barrell, Ray ; Weale, Martin

Introduction

When protection is discussed people normally have policies designed to restrict imports in mind. But the way in which the international economy has been affected by toxic financial assets issued in the United States suggests that countries might face problems not only because of the goods and services trade but also because of the financial assets they import. Thus, in discussing the case for protection, we consider first whether there is a case for protection to prevent economies importing some types of financial instrument and, secondly, whether there is a case for more traditional protection as a way of resolving the global imbalances of the world economy. We conclude that financial protection is a sensible way for countries to protect themselves from risky assets if the production and testing of such assets is not regulated internationally.

The situation with respect to import restriction or commercial protection is rather different. There is likely to be increasing pressure for the United States to adopt protective measures to restrict imports from China; however, plausible protective measures are unlikely to have a sharp impact on global imbalances and will damage welfare in the United States. One form of protection which the United States could implement, restricting imports of oil by means of taxes on fuel use, has the potential to reduce global imbalances sharply, and also helps to achieve global carbon emission targets, but is not very likely to be introduced.

We begin by reviewing the issues surrounding financial protection and then proceed to consider the question of restrictions on imports.

Financial protection

The financial counterpart of controls on the international movements of goods and services is controls on the flow of capital. No one expects to go back to the Bretton Woods world, where fixed exchange rates were sustainable only if there was a shared commitment to a common inflation rate with the system supported by means of exchange controls and a parallel market in investment dollars.

Capital controls prevent markets working in the large as well as the small. There are two main functions of international capital markets, with the large and important one involving the redistribution of savings from surplus countries to deficit countries, and the small one involving asset swapping in order that risks are shared efficiently.

Long-term structural surpluses and deficits exist for many sustainable reasons, as well as for some unsustainable ones. Countries with populations that are older, or ageing more rapidly than others, may need to save more as a per cent of income, and if capital markets work well they will run current account surpluses. If they do not, the excess saving will be absorbed by increased capital at home, and the marginal return on capital in the potential surplus country, for instance Japan, will be below that in the potential deficit country. Equalising returns increases global output for a given level of the capital stock. The same may happen between two countries with different habits over working time. If one country, say the US, has institutions that induce its citizens to work seven years longer than those in another region, say the Euro Area (as is currently the case), then there are structural reasons for US deficits and European surpluses. US citizens need more capital to work with than do Europeans, as they input more labour, but they will want lower levels of financial wealth as a proportion of their incomes as they need to save less for retirement. The reverse is true of the Europeans, and they will own US assets in order to provide incomes for their longer retirements. Hence, if they have the same technology and skills, then in a growing world there are good structural reasons for permanent net capital flows from Europe to the US that will increase global output.

The risk sharing function of international capital markets has nothing to do with structural deficits and surpluses, but it does have a great deal to do with the recent financial crisis. If individuals face different risks, then they may increase their expected welfare by sharing those risks. The same principal will be applicable to groups of countries. Risk sharing will only raise expected output and expected consumption if it also changes saving and investment behaviours. If it genuinely reduces risk premia in productive capital investment decisions, then output may be higher than it would otherwise have been and, if risk premia are made sustainably more equal across investment decisions in different countries, then output will be higher as a result of financial trade. The mathematics behind the Arrow Debreu theorems on risk sharing has fascinated economists with its beauty for some years, but it is not clear that beauty and significance have gone hand in hand. A desire to promote risk sharing has led to the construction of complex financial assets and the failure of such assets has been at the heart of the current financial crisis.

Regulation and protection

Financial regulation and financial protectionisms are, as in the case of trade in goods, two names for potentially the same action. Global regulation may obviate the need for country or region-specific protection, and region-specific regulation may also not be needed. The Bank for International Standards (BIS) and the Basel Agreements are meant to prevent 'competition in laxity' and ensure a level playing field. However, this requires the cooperation of all major parties and a commitment to common goals, much as the Bretton Woods system required. Financial regulations are changing in response to the crisis, and a new world financial order will emerge, and it will be different, and we would hope better at containing the risks of crises. The core problems behind the current crisis will hopefully be addressed, with the scale and complexity of financial products almost certainly being restricted. Of course other problems may emerge and financial innovations may get round new regulations, as Goodhart (2008) discusses. However, over the past 30 years, financial crises in the OECD appear to have a common set of causes, as Barrell et al. (2010), show. Low levels of liquidity and low levels of capital along with recent house price booms seeming to be the major explanatory variables driving crisis probabilities, and regulators are addressing capital and liquidity adequacy as well as discussing tighter regulation of housing market lending standards. Dynamic provisioning as discussed by Goodhart (2010) in this Review, which involves increasing capital adequacy requirement in response to rapid loan growth, may also be wise.

The financial crisis started as financial institutions in 2007 became worried about which of them had sustained the largest losses from loan defaults in the US. The interbank market seized up as a result, and institutions such as Northern Rock that were reliant on it risked failure. The liquidity crisis turned into a solvency crisis as losses on loan books wore away at the capital bases of the banking systems in the US and Europe, and a wave of nationalisations and recapitalisation measures inevitably followed the collapse of Lehman Brothers in September 2008. (1) The disruption to trade and production that resulted from the financial crisis induced a large-scale recession, and is expected to lead to a permanent loss of output of at least 3 per cent of OECD GDP, as Barrell and Holland (2010) discuss in this Review. Risk was underpriced, and the crisis has raised its price, and even when its pricing settles to a reasonable level the costs in terms of lost output are large.

Better financial regulation might have prevented the crisis, especially if it had addressed its core determinants. The IMF estimate that globally banks will have to acknowledge that they have lost $2.8 trillion by the end of 2010, with $1.3 trillion already declared by the middle of 2009 (IMF, 2009). As the capital base of the US banking system at the end of 2007 was around $1.5 trillion, the impact has been significant. We need, however, to look at the difference between induced and autonomous losses, as the crisis fed on itself and induced bankruptcies that would not otherwise have happened. The core losses have been those in the US sub-prime mortgage market that resulted from low grade lending in an under-regulated market. This lending was promoted by the US administration (2) and the losses were building up before the crisis broke, and were the main reason for it. Some types of these low grade loans have default rates as high as 80 per cent, and overall default rates on all mortgages and mortgage-backed securities in US banks are likely to be around 12 per cent, whilst they are expected (by the IMF) to reach 4 per cent in the UK, despite the much more severe downturn in the economy, and less than 2 per cent in the Euro Area as a whole, although these losses may be heavily concentrated in Spain. Loss rates in the US would look worse if securitised mortgages had not been sold on to the UK and the Euro Area banking systems, where 40 per cent and 30 per cent respectively of all anticipated losses are likely to be on foreign assets, and these are mainly US paper. This difference is a reflection of the peculiarly lax nature of US personal sector bankruptcy law (3) and new regulations have to reflect these differences, either through their removal, as we have suggested previously by advocating coordination of bankruptcy law, or by restricting trade in dubious financial instruments.

There are many changes to regulation currently being discussed, and macroprudential regulation is becoming more popular. Davis and Karim (2010) in this Review discuss some of the recent trends and suggestions. Capital requirements have already been raised, and the quality of capital will be improved as banks have to concentrate on their Tier One pure equity capital base. In addition, there have been discussions of bank employee remuneration and of the structure of the banking system. There has been a worry about banks being too big to fail, and there have been attempts to address this. Recent suggestions by the Obama administration to restrict both the scale and the activity structure of banks are discussed by Davis and Karim in this Review, and although they will restrict the operation of banks there are two major problems with these proposals. If US banks are prevented from in-house security operations, then unless the UK and the European regulators respond in kind and adopt the same pattern of regulation there will be a relocation of activity and a shift of risk, but not a great deal of reduction in the production of risk. The recent US proposals also do not address the key issue of the manufacture of risky and toxic assets, and this is one of the main issues regulators in other fields have to deal with. Proposals to try to limit the originate and distribute model of security production may make progress but, unless the US administration (and the BIS) make more progress with product regulation in relation to securitised assets, the case for cross-Atlantic protection will rise.

Product regulation and financial protectionism.

Under-regulated financial trade meant that low grade assets were bundled into structured vehicles and sold on to people who did not understand the risks involved. Many of those people were based in European regulated financial institutions, and hence the exchange of risks shifted the location of the crisis from being an entirely US problem to one shared by others. This exchange of risks left the US less exposed to its own problems than it otherwise would have been, and hence perhaps left US regulators and legislators with less incentive to limit structured vehicles and the risk amplifying originate and distribute models of asset creation. As a result financial asset trade probably resulted in the creation of risk as well as its sharing, and the welfare gains from risk sharing appear to have been overwhelmed by the costs of the induced risk creation. Risk sharing in the Arrow Debreu world is an exchange of exogenous risks to reduce their welfare impacts, but we do not live in such a world. Policy has to be designed to reduce the degree of asymmetry in the information about risks involved in assets and to ensure the production of optimal levels of risk as well as to enable individuals to insure against those risks.

The case for restricting the scale of financial trade is no different from the case for restricting trade in goods--if one is desirable, so might the other be. Shifting excess savings abroad is wise, and sharing risk is good. However, financial complexity leads to the production of financial products that are harmful, and the case for regulating and restricting potentially damaging financial products is no different from that for goods. The US has an excellent drug administration system as does the European Union, but both evaluate products and decide on whether they can be used inside their domain. It would be wise to replicate this system in financial markets, especially as preferences may differ between regions. (4) Given that Americans seem to have a preference for risky activities, and also because of their bankruptcy laws, they can produce financial products different from anything produced in Europe, so there is a case for specific financial product regulation. It would be wise to allow the use of complex products outside their domain of issue only once they had been fully stress tested in downturns, and even then it may be easier to allow European financial institutions (and others) to hold as many (5) non-European non-financial corporate and government bonds and non-financial system equities as they wish, but to restrict them to these products, along with more complex, but tested products produced within the single market for financial services in Europe. All sensible risk sharing and savings relocations could take place, but toxicity would be contained within the domain of the home regulator. However, such action should be taken with care as it breaks with the traditional caveat emptor approach, and purchasers of approved assets may feel they have a right to compensation from the regulator if those assets turn bad. This moral hazard problem can either be dealt with by appropriate insurance or better still by pre-agreed 'haircuts' on the level of compensation.

Financial protection before 2008 would also almost certainly have led to a reduction in the US current account deficit, as the costs of risky loans in the US would have been higher than they were and hence fewer of them would have been issued. The US housing bubble would have had less fuel to inflate it, and hence house prices would have risen less, and housing construction would have grown less. US consumers do treat their housing wealth as wealth, whatever economic theorists think they should do, and hence consumption would have been less buoyant. Weaker consumption and housing investment would have meant domestic demand would have been lower in the US and hence the current account deficit would have been smaller. If the excess deficit was a cause of crisis, its reduction through financial regulation would have reduced the risks of a crisis.

Commercial protection and the US deficit

The United States had an external deficit of 4.9 per cent of GDP in 2008 after 6 per cent of GDP in 2006. It had fallen to 3 per cent of GDP by the fourth quarter of 2009 and in our forecast we expect it to be sustained at around this level for much of the new decade. This is an obvious improvement; nevertheless we expect there to be increased pressure for protection, particularly against Chinese imports, first because, as figure 1 shows, the deficit against China accounts for a large proportion of the total deficit and secondly because with high unemployment there will be widespread complaints that jobs are being lost to unfairly competitive Chinese imports. In the background, but adding to this argument, will be the observation that the surplus countries, most notably China, face no pressure to increase domestic demand and that without protection it will be difficult for the United States to maintain full employment.

A case for commercial protection

The crude case for protection, by which we mean some combination of tariffs and import quotas, might be put as follows. Policymakers in the United States set monetary policy to maintain the level of economic activity which kept inflation low and stable. But the level of domestic demand which delivered this before the crisis was associated with a considerable excess of imports over exports. If some means were found of limiting imports by means of protection, then the same level of economic activity could have been maintained with a lower level of domestic demand.

This argument is very similar to that adopted by the Cambridge Economic Policy Group in the 1970s (Godley and May, 1977). They argued that the levels of domestic demand in the United Kingdom consistent with full employment led to unsustainable external deficits and these could be avoided by means of protection. Their argument perhaps held less force for a small open economy such as the UK than it does for a reserve currency country such as the US, where there may be little pressure on the exchange rate from large current account deficits, and hence little pressure on inflation in response to excess demand. The case seems particularly strong when considered in terms of Chinese imports because the Chinese currency does not float freely against the US dollar but is pegged to it by means of capital controls. (6)

Arguments against commercial protection

The case against protection has been known for much longer (Ricardo, 1817). Tariffs mean that people choose their consumption patterns facing prices which do not reflect relative scarcity of goods in international markets and this leads to a lower level of welfare than could be achieved if domestic prices better reflected prices of goods in international markets. Offsetting this partially is the so-called optimal tariff argument. Large countries have market power; by imposing tariffs they are able to move the terms of trade in their favour. This results in an income gain which compensates for the welfare loss arising from the distortionary effect of the tariff. The optimal tariff is that at which the overall gain from a tariff reaches its maximum. With very low tariffs the gain is small because the income effect is small; with very high tariffs the income effect is also small because very high tariffs have the effect of strangling trade, and between these there normally lies a maximum. Of course, if goods produced by different countries are close substitutes for those produced at home and by other exporters to the home country, then the case for a tariff to improve the current account is reduced, and the welfare gains from shifting the terms of trade will be smaller.

Of course the optimal tariff is optimal only taking the behaviour of the rest of the world as given. If other countries react to the imposition of an optimal tariff, by imposing an optimal tariff of their own, then the income benefits may be lost and the only outcome is the distortion to relative prices which results in a loss in welfare. Thus a general agreement not to impose tariffs should lead to a level of welfare higher than that which would be achieved if each country tried to impose its own optimal tariff. Nevertheless, tariffs do raise the incomes of those involved in the domestic production of those goods which are protected by the tariff; the pressure for them normally comes from sectional interests.

What is the relevance of these findings of classical trade theory when confronted with the crude case for protection made above? One of the shortcomings of the crude analysis is that it assumes that the full-employment level of economic activity is unaffected by protection. But, as the arguments above indicate, protection leads to a loss of welfare, equivalent to a reduction in the real wage measured in consumption goods. Unless the supply curve of labour is independent of the real wage, raising protection beyond the optimal level will itself start to depress the sustainable level of economic activity, thereby increasing the costs of the tariff.

Pre-war experience and the General Agreement on Tariffs and Trade

A rather separate perspective of the costs of protection was provided by the experience of the 1930s when, as the international crisis intensified, countries started imposing tariffs and other forms of import control. During the period of the crisis, from December 1929 to the low point in January 1933, the value of world trade fell by 64 per cent (Kindelberger, 1973, p. 172). The United States had passed the Smoot-Harley Tariff Act in June 1930, releasing a wave of retaliation. Initially Britain led opposition to tariffs but after the 1931 General Election policy changed. Britain raised tariffs in late 1931 and early 1932; France, the Low Countries, Switzerland and Scandinavian countries behaved similarly.

It is doubtful that protection played the major part in the decline in world trade which was largely driven by the collapse in economic activity that followed on from a badly managed financial crisis that led to a wave of bank failures across the US as well as in Europe. In this period raw materials were much more important in international trade than they are nowadays. The slump was associated with sharp falls in the prices of such goods and this explains much of the decline in the value of trade. Moreover, at least taking the UK as an example, it is unclear that protection had a major impact on trade volumes. Rates of protection in the UK, which had been small before 1932, were typically set at 20 to 33.3 per cent after 1932 (Kitson, Solomou and Weale, 1991). Ahead of protection, from 1929 to 1931 import values fell by 27 per cent while volumes rose by 2 per cent. Between 1931 and 1933 the value of UK imports fell by 20 per cent and the volume fell by 11 per cent. Although trade volumes did decline over this period, these data do not suggest that the tariffs introduced in 1932 had a powerful effect, especially bearing in mind also that the decline in import volumes after 1931 would have been influenced by the downward float of sterling after September 1931.

Much the same point can be made of the United States experience. Imports fell by two thirds between 1929 and 1933; however the price of imports halved and volumes fell by 34 per cent. Since, at the same time, GDP declined in volume terms by 27 per cent, the decline was not much larger than would have happened had the volume share of imports in GDP been constant. Nor would competitiveness effects have been as important as they are today because the price declines probably also affected US producers of competing goods.

Internationally, a more plausible explanation is that much of the decline in import volumes was due to a combination of declining incomes as a result of the depression and, as in 2008, a sharp reduction in international trade credit. Nevertheless, the experience of the interwar years was undoubtedly a factor behind the desire to promote agreements to limit tariffs.

As a result of both prewar experience and theoretical arguments, the General Agreement on Tariffs and Trade (GATT) was concluded in 1948. This evolved into the World Trade Organisation in 1995. The authors of the GATT were working in a world of fixed exchange rates in which movements of capital were restricted by means of exchange controls. In such circumstances there was the risk that countries would face balance of payments difficulties. The deficit countries faced more pressure than the surplus countries to adjust because deficits would lead to a drain in exchange reserves and thus to difficulty in maintaining fixed exchange rates. Surplus countries, by contrast, did not face the same problems because, while deficit countries might run out of exchange reserves, surplus countries could allow their reserve holdings to rise without limit. Exchange rate adjustment was one means of addressing this problem, but the Bretton Woods system was not designed to provide for frequent exchange rate adjustment. The GATT allowed countries facing balance of payments difficulties to impose restrictions on imports and the World Trade Organisation (WTO, 2009) has maintained these provisions although the documents do not offer any clear definition of what amounts to balance of payments difficulties. In terms of the magnitude of its external deficit, the United States could certainly have claimed that it faced such difficulties although, given the ready appetite internationally for Untied States paper it plainly did not face problems with financing its deficit.

International consequences of US protection against China

But, given the size of the deficit, one can reasonably ask what the effect of protection by the United States would have been and secondly whether, if one takes the view that financial imbalances were a proximate cause of the financial crisis, whether protection would have left the world less exposed to the financial crisis. First of all, suppose that the United States had protected itself only against imports from China. Had tariffs or quotas been specified with reference to the country of origin, then the effect would probably have been very small. People would have bought goods made in other countries to replace those made in China, and many of the businesses producing in China would have moved their production to countries not affected by the tariff. So exports from China would have been expected to decline, while those from other developing countries in the Far East would probably have risen. The amount of change would of course depend upon how substitutable are goods produced in different locations. If they were perfect substitutes, as with crude oil, all a country-specific US tariff would achieve would be to divert Chinese production to exports to Europe, for instance, and goods from elsewhere destined for the European market, including those produced in Europe, would be diverted to the US market. There would be no impact of the tariff on the US current account in this case. The less substitutable are the goods produced in different locations the greater the effects of a tariff on welfare, output and the US current balance.

The trade diverting effect might also be limited by supply constraints in competing countries. China has been able to expand its manufacturing labour force by drawing on workers migrating to the cities; nowhere else, with the exception of India, has similar reserves of agricultural labour, so this displacement effect could have been only partial and total imports by the United States of categories of goods covered by a Chinese tariff would have fallen; the deficit of the United States, both in trade with China and in aggregate would have declined.

In response to the tariff, and hence the rise in imported goods prices gross of the tariff, the amount demanded of imported Chinese goods in the US would fall, the Chinese would have reduced the prices of their exports both to retain some of their US market share and also to gain share elsewhere. The scale of the fall in price depends on the substitutability of Chinese consumer goods for the same type of goods produced elsewhere. Given the favourable impact on the terms of trade of both the United States and of other countries buying Chinese goods, global imbalances would improve even though the Chinese would have gained market share elsewhere. The existence of other markets means that the income effect in the United States at any given tariff level is lower than it would be if the United States were the only market and thus the optimal tariff is bound to be lower than it would be in a bi-polar world.

What might commercial protection achieve?

But could a plausible tariff have made a substantial impact in global imbalances? In 2008 the United States ran an overall external deficit of US$840bn on merchandise trade but a surplus on trade in services, giving an overall deficit of US$696bn. In the first eleven months of 2009 the goods deficit was US$469 billion. As figure 1 shows, the deficit with China accounted for nearly 45 per cent of this, with the next two countries, Japan and Mexico, contributing about 9 per cent each. On the one hand this suggests that a policy which had a substantial effect on imports from China would have a major impact on the deficit. If the United States imposed a 50 per cent tariff on imports from China, and if the price elasticity of demand for imports from China were one and the trade diversion and terms of trade effects were small, then the deficit with China would fall by under $100bn, or over 15 per cent of the 2008 total but only 0.8 per cent of GDP. On the one hand this is a large change, requiring a tariff higher than those imposed in the 1930s. On the other hand it would still have left the United States with a deficit of around 4 per cent of GDP. These calculations assume that, had protection been in place, the behaviour of the Chinese would have been unaffected. If a global imbalance leading to an annual United States deficit of almost $700bn were the cause of the financial crisis, one could hardly be confident that the crisis would have been averted had the deficit been limited to $600bn per annum.

Could the United States have protected itself against other countries as well, so as to bring its deficit down further? Canada and Mexico are both members of the North American Free Trade Association (NAFTA) which would be something of an obstacle. In any case the economic case for protection on balance of payments grounds is much stronger against a country like China, which relies on capital controls to prevent its exchange rate floating, than against countries like Canada and Japan against whose currencies the US dollar floats freely.

A more important point is that the deficit in petroleum-related products was $386bn in 2008, over half of the total deficit. Although oil prices are now lower, it remains the case that a substantial impact on the imbalance could be made only by reducing the petroleum-related deficit. In 2008 the US deficit was 4.9 per cent of GDR In that year expenditure on fuel (oil, coal and gas) absorbed around 4.9 per cent more of GDP in the US than it did in the UK. At current oil prices if the United States reduced its energy use, relative to GDP, to the level observed in the United Kingdom, and other European countries, and if that were fully reflected in fuel imports, its deficit would fall by about 3 per cent of GDP, or, in 2009, over US$400bn. Given the geography of the United States, such a large reduction in its fuel use is not easy to achieve. Nevertheless, it is clear that by using less fuel the United States could go a long way to reducing global imbalances.

The most obvious way of the United States reducing its fuel use would be not by imposing a tariff on imported oil but by means of imposing taxes similar to those found in most other countries; given the harmful externalities widely associated with carbon emissions this would be highly desirable. Thus the case for such a tax is much stronger than for a tariff on manufactured imports. It would probably have a powerful effect in depressing the world price of oil because the United States is the major oil importer. This would mean, in effect, that money currently paid by the US to oil importers would instead be paid to the US Treasury, reducing the government deficit substantially. The favourable impact on the United States terms of trade would probably be considerably greater than that of plausible tariffs on manufactured goods. But if the United States is not prepared to reduce its use of petroleum products very substantially, its scope for reducing global imbalances by means of protection is strictly limited.

Conclusion

The construction of a new set of global financial regulations is under discussion in Basel, Washington and elsewhere. It is beyond doubt that it will be impossible to prevent financial crises occurring. It is also clear that it is possible to reduce the probability of crises occurring and the severity of their impact on the economy. Raising capital adequacy and liquidity requirements should reduce the probability of crises, and should tighten prudential controls on lending for house purchases. Changing the potential costs to taxpayers could be achieved by ensuring banks are not 'too big to fail' or by requiring large banks to have living wills that set out who, amongst owners, depositors and borrowers, pays the costs of failure. The effects of crises on the level of output should also be reduced by these measures. It would also be useful to reduce the complexity and potential toxicity of assets, as that will reduce the effects on output when a crisis occurs. If toxicity cannot be addressed in Basel, and adequate global producer regulation appears unachievable, then regulatory domain-specific rules may be needed. This is a form of financial protectionism.

Continuing imbalances in trade between the United States and China are likely to lead to growing pressure for tariffs and other forms of protection. A case for this can be made on the grounds that the Chinese peg their currency to the US$ and sustain this peg by means of capital controls. The pressure for such controls is likely to grow and a reasonable assumption is that some tariffs on Chinese goods will be introduced in the next few years. These will raise profits in the industries producing the goods whose import is restricted or taxed. However, the nature of the imbalance is such that it is unlikely to be substantially corrected by plausible protection and, without a major change to domestic demand in the United States, a large external deficit will persist.

If the United States brought its energy use in line with that of other advanced countries, the United States deficit would largely disappear; however there is no reason to think that such a move is likely. Thus a reasonable conclusion is that commercial protection is likely to be introduced in a way which helps interest groups associated with specific industries facing Chinese competition but which is damaging to US consumers and, as a means of addressing global imbalances is not very effective. However policymakers need to be awake to the need for financial protection should global regulatory reforms be inadequate.

REFERENCES

Barrell, R. and Davis, E.P. (2008), 'The evolution of the financial market crisis in 2008', National Institute Economic Review, 206, October, pp. 5-14.

Barrell, R., Davis, E.P., Karim, D. and Liadze, I. (2010), 'Bank regulation, property prices and early warning systems for banking crises in OECD countries', NIESR Working Paper 331, forthcoming, Journal of Banking and Finance.

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Barrell, R., Hurst, A.I. and Kirby, S. (2008), 'Financial crises, regulation and growth', National Institute Economic Review, 206, October, pp. 56-65.

Davis, E.P. and Karim, D. (2010), 'Macroprudential regulation--the mising policy pillar', National Institute Economic Review, 211, January, pp. R3-16.

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NOTES

(1) Barrell and Davis (2008) discuss the build up to the crisis, and Barrell, Hurst and Kirby (2008) discuss the need for bank bailouts. The other papers in the October 2008 Review also looked at the emerging crisis, and are still of great relevance.

(2) In particular home ownership was promoted amongst low income families in 2002 which encouraged the sub-prime market to develop. Two speeches by President Bush in 2002 are particularly revealing. See President George W. Bush Radio Address American Dream Down Payment Fund 15 June 2002 and remarks by the President on home ownership at the Department of Housing and Urban Development Washington, D.C., 18 June 2002.

(3) Ellis (2008) discusses many of the relevant issues. The US housing boom was fed by the relaxation of lending standards and also by the growth of out of state second homes purchased through mortgage brokers who passed on all risks to others. US bankruptcy law varies from state to state, and in general mortgages are recourse. However, an out of state second home mortgage can be defaulted on with little cost, as recourse is not easy to obtain across state borders. Even where default is by a resident within the state, recourse is seldom pursued because of the costs of associated court cases.

(4) The US, for instance is happy that its milk farmers use bovine somatotrophin to raise milk yields even though there may be mastitis risks involved, but European regulators have not allowed the use of this product. See Millstone, Barrell and Brunner (1989) and Millstone, Brunner and White (1992).

(5) These products are sometimes described by the producers of more complex instruments as 'plain vanilla' assets.

(6) The Chinese exchange rate is better described as a crawling peg as it appreciated by 17 1/2 per cent against the $ between 2004 and 2008Q3, but has since stabilised.

Figure I. Contributions to the US deficit in goods trade
January-November 2009

Other, 15.1%
Malaysia, 2.5%
Italy, 2.8%
Saudi Arabia, 2.2%
Canada, 3.7%
Venezuela, 3.5%
Nigeria, 2.8%
Germany, 5.3%
Mexico, 9.0%
Japan, 8.6%
China, 44.5%

Source: US Bureau of Economic Analysis, US International Trade in
Goods and Services, November 2009 (12 January 2010).

Note: Table made from pie chart.