EconSouth (Fourth Quarter 1999)

Research Notes

Research Notes highlights some of the research recently published by the Federal Reserve Bank of Atlanta. For complete text of these articles or papers on this Web site, see the links below.

What can asset prices tell us about the future?

It is fairly obvious that in market-based economies prices act as a constraint on individual behavior, providing a means by which goods and services flow to those most willing and able to pay for them. But prices play an additional role in the economy — that of signaling the present and expected future state of affairs. Having accurate forecast information is particularly important to policymakers, who are concerned with acting in advance to avoid bad economic outcomes rather than simply reacting to events.

In a recent article, Stephen Smith reviews the theoretical literature regarding the extent to which asset prices aggregate information and examines evidence on the ability of financial asset prices to forecast inflation, real output or consumption, and recessions. Given the available evidence, Smith finds it difficult to argue that monetary policymakers should give more weight to financial market variables. What can be argued is that, according to theory, financial asset prices should aggregate at least some information about future performance of economically important variables.

The author concludes that more work is needed along both theoretical and statistical lines for collectively figuring out what role, if any, financial asset prices or yields should play in forecasts used in conducting policy. Meanwhile, these variables will remain at most a source of information that policymakers can choose to use as a supplement to more traditional indicators.

ECONOMIC REVIEW
THIRD QUARTER 1999

Mexico's banking sector rescue spawns political tensions

In Mexico, the devaluation of the peso in December 1994 provoked a profound economic downturn and revealed a fragile banking sector. Fearful that the financial system would collapse under a rising level of past due loans, the Mexican government mounted a rescue of the banking sector by intervening in the daily operations of some problem banks while establishing a series of capitalization and restructuring programs available to all banks.

A recent article by Elizabeth McQuerry examines Mexico's bank rescue efforts (1995–98) with a particular focus on the role of the deposit insurance fund, the Bank Fund for the Protection of Savings. According to the author, the governmental rescue programs prevented a systemic collapse of the banking sector but cost more than $55 billion dollars. The rescue was not entirely successful in restoring the banking sectors' credit function to a productive role in the Mexican economy.

The article also attempts to place the overall rescue effort within a larger context by looking at its economic and political consequences. The Mexican experience suggests that country-specific factors can profoundly affect the success of government policies. The outcome of the bailout in Mexico was significantly shaped by the process of political democratization under way there. The polemical debate surfacing out of the legislative battle over the costs of the bank rescue demonstrates the need for governments to pay more attention to political matters, even when the problems appear economic or technical in nature.

ATLANTA FED DOLLAR INDEX
Dollar Index chart

After edging up in July, the dollar dropped slightly in August and September versus the 15 major currencies tracked by the Atlanta Fed. During the three-month period, the dollar declined consistently against currencies in the Pacific subindex — which includes Australia, China, Hong Kong, Japan, Malaysia, Singapore, South Korea and Taiwan — while its performance versus the Americas and European currencies was mixed.

Note: For more detailed, monthly updates and historical data on the dollar index, see the Atlanta Fed's World Wide Web site at www.frbatlanta.org/econ_rd/dol_index/di_index.cfm.

ECONOMIC REVIEW
THIRD QUARTER 1999

Which type of settlement is best in wholesale payments networks?

Most people are familiar with retail payments systems such as checks and credit cards. Less familiar are wholesale payments systems, which consist of electronic networks used for sending large sums among banks. A feature common to all wholesale networks is that settlement is carried out by exchange of funds held in banks' reserve accounts at a central bank, though the rules for settlement vary.

In a recent article, Charles M. Kahn and William Roberds consider the question of what is the best design for a wholesale payments system, in particular whether it should settle on a net or a real-time gross basis. They also consider some of the difficult policy questions facing both participants and regulators of wholesale systems.

For the benchmark case in which bank asset quality is fixed and bank assets can always be liquidated at book value, the authors show that the advantages of some type of net settlement dominate real-time gross settlement. However, the optimal net settlement scheme may necessarily involve some chance of default. If the quality of bank assets is a choice variable, the authors find that the potential costs of net settlement rise because of negative effects on bank asset quality.

Kahn and Roberds conclude that the design of a wholesale payments system must take into account numerous policy trade-offs, the most critical being the one between the costs of liquidity versus the costs of default.

ECONOMIC REVIEW
THIRD QUARTER 1999


Capital flow barriers may improve welfare

Until recently, the trend in world capital markets has been toward increasing globalization. Recent events in Latin America and Asia have caused many in policy-making circles to question whether this trend should be wholly, or at least partially, reversed. It is commonly argued that, at a minimum, countries should be given the discretion to erect such barriers, at least in certain circumstances.

Recent events, then, have forced a rethinking of the desirability of unrestricted world capital flows. The general presumption appears to be that the "victims" of highly volatile capital flows should be allowed to limit or restrict inflows and outflows of funds. But outflows of funds from smaller and less developed economies often represent inflows of funds to larger and more developed economies. This outcome raises the issue of whether there would be benefits associated with larger and wealthier economies taking actions to limit capital mobility.

A working paper by Marco Espinosa-Vega, Bruce Smith and Chong Yip presents a formal analysis of erecting barriers to international capital flows. The authors find that, in contrast to conventional thinking, when there are substantial differences in per capita GDP across countries, long-run output in all countries can be increased by having wealthier economies erect some partial barriers to capital mobility. Wealthier economies need not persuade poorer economies to cooperate: by implementing an appropriately selected tax on capital flows it will often be the case that the wealthy economy can unilaterally obtain a higher steady state welfare level for businesses, households and other economic agents in all economies.

The authors also show that these same barriers need not eliminate endogenously arising volatility in income, capital flows and asset returns. Under some circumstances, then, if it is desirable to reduce such volatility, this reduction must be accomplished by other means. However, the case for imposing barriers on capital flows does not depend critically on the ability of these barriers to eliminate excess volatility.

WORKING PAPER 99-6
July 1999

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