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On the paradox of prudential regulations in the globalized economy; International reserves and the crisis: a reassessment

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  • Aizenman, Joshua

Abstract

This paper discusses two pertinent policy issues dealing with the global liquidity crisis - global prudential regulation reform, and reassessment of using international reserves in the crisis. We point out the paradox of prudential regulations – while the identity of economic actors that benefited directly from crises avoidance is unknown, the cost and the cumbrance of regulations are transparent. Hence, crises that had been avoided are imperceptible and are underrepresented in the political discourse, and the demand for prudential regulations declines during prolonged good times, thereby increasing the ultimate cost of eventual crises. While the seeds of the present crisis were mostly home grown, international flows of capital magnified its costs. Global financial integration produces the by-product of “regulatory arbitrage†– capital tends to flow to underregulated countries, frequently resulting in excessive risk taking, in anticipation of future bailout. Dealing with “regulatory arbitrage†requires coordinated prudential regulations that should apply as equally as possible to domestic and foreign players. A coordinated globalized prudential regulation, by increasing the cost of prudential deregulation, would mitigate the temptation to under-regulate during prolonged good-times, thus adding a side benefit. We also analyze the different approaches to the use of reserves during the crisis and what this means for the global financial system. The deleveraging triggered by the crisis implies that countries that hoarded reserves have been reaping the benefits. The crisis illustrates the importance of the self insurance provided by reserves, as well as the usefulness of policies that channel a share of the windfall gains associated with improvements in the terms-of-trade to reserves and sovereign wealth funds. The reluctance of many developing countries to draw down on their reserve holdings raises the possibility that they may now suffer less from the “fear of floating†than from a “fear of losing international reserves†, which may signal deterioration in the credit worthiness of a country. While the selective swap lines offered by the FED to several EMs help, it falls short of dealing with the fear of losing reserves. Mitigating this concern should be the prime responsibility of the international financial institutions.

Suggested Citation

  • Aizenman, Joshua, 2009. "On the paradox of prudential regulations in the globalized economy; International reserves and the crisis: a reassessment," Santa Cruz Center for International Economics, Working Paper Series qt5hx2x2kj, Center for International Economics, UC Santa Cruz.
  • Handle: RePEc:cdl:scciec:qt5hx2x2kj
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    References listed on IDEAS

    as
    1. Joshua Aizenman & Menzie D. Chinn & Hiro Ito, 2008. "Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time," NBER Working Papers 14533, National Bureau of Economic Research, Inc.
    2. Maurice Obstfeld & Jay C. Shambaugh & Alan M. Taylor, 2010. "Financial Stability, the Trilemma, and International Reserves," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(2), pages 57-94, April.
    3. Joshua Aizenman & Reuven Glick, 2009. "Sovereign Wealth Funds: Stylized Facts about their Determinants and Governance," International Finance, Wiley Blackwell, vol. 12(3), pages 351-386, December.
    4. Joshua Aizenman, 2008. "Large Hoarding Of International Reserves And The Emerging Global Economic Architecture," Manchester School, University of Manchester, vol. 76(5), pages 487-503, September.
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    Cited by:

    1. Majid, Nomaan., 2009. "The global recession and developing countries," ILO Working Papers 994482673402676, International Labour Organization.
    2. Anna M. Carabelli & Mario A. Cedrini, 2010. ">i>Indian Currency>/i> and beyond: the legacy of the early economics of Keynes in the times of Bretton Woods II," Journal of Post Keynesian Economics, Taylor & Francis Journals, vol. 33(2), pages 255-280, January.
    3. Layal Mansour, 2014. "The Power of International Reserves: the impossible trinity becomes possible," Working Papers halshs-01054614, HAL.
    4. Herrmann, Sabine & Mihaljek, Dubravko, 2010. "The determinants of cross-border bank flows to emerging markets: New empirical evidence on the spread of financial crises," Discussion Paper Series 1: Economic Studies 2010,17, Deutsche Bundesbank.
    5. repec:ilo:ilowps:448267 is not listed on IDEAS
    6. Frankel, Jeffrey, 2009. "On Global Currencies," Working Paper Series rwp09-026, Harvard University, John F. Kennedy School of Government.
    7. Jörg Bibow, 2010. "Global imbalances, the US dollar, and how the crisis at the core of global finance spread to "self-insuring" emerging market economies," European Journal of Economics and Economic Policies: Intervention, Edward Elgar Publishing, vol. 7(2), pages 325-359.

    More about this item

    Keywords

    Global prudential regulation; regulatory arbitrage; fear of losing international reserves; swap lines;

    JEL classification:

    • F15 - International Economics - - Trade - - - Economic Integration
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F55 - International Economics - - International Relations, National Security, and International Political Economy - - - International Institutional Arrangements

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