Thank you for your kind invitation – it is a great pleasure to be here.
When we think about the global economy, I imagine many of us feel the trepidation of the little black cat that Victor Hugo described in Les Miserables:
"We all know the habit of cats of hesitating in an open doorway - hovering uncertainly at the risk of being crushed by the closing of the door."
It is a time when economists tend to equivocate more than ever – so I’ll try and be clear in offering thoughts on:
- the financial crisis;
- the state of macroeconomic policy;
- the dialogue taking place in the G20; and
- the future of the financial services industry.
The Financial Crisis
Organizations often fail because
- they become ideas-constrained; or
- they fail to manage tail risk, or very low probability events with major impact.
Lehman, Merrill, and part of AIG disappeared from the corporate landscape because they could not manage tail risk. And we saw BP lose over 50 percent of its market cap because it sought to recover oil in a mile deep of water without the technology to counter major event risk.
The global financial crisis is also a tail risk event. It follows 5 years of the strongest global growth in 4 decades. Its human and financial costs have been devastating and include:
- the loss of 17 million jobs in the OECD economy – 10 million of them in the US; and
- an additional 65 million people in the developing world living in extreme poverty (living on under USD1.25 per day ppp adjusted).
We have also seen an unsustainable build-up of public debt in advanced countries. By 2011, public sector debt to GDP ratios in advanced countries are projected to be 30 percentage points higher than in 2007 – and to increase by more than half in the US, 4/5 in Spain, double in the UK, and treble in Ireland.
Meanwhile, the asset portfolios of central banks in the US, Japan and Europe doubled in size at a time when policy rates are essentially zero.
Few economists forecast the crisis, and policymakers seriously underestimated its impact when it arrived.
For example:
- In 2005, Alan Greenspan suggested that the biggest global systemic financial risk was the credit exposure of the Chinese banking system;
- Ben Bernanke, in his March 2007 testimony to Congress, said “At this juncture, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained;” and
- In early 2008, US representatives in meetings of the G20 Deputies, IMFC Deputies, and the Financial Stability Forum, suggested that the sub-prime crisis did not have economy-wide implications.
The crisis led to a revaluation of every asset across the globe and massive portfolio adjustments in the balance sheets of households, corporates, banks, and governments. These balance sheet adjustments – and especially for households and governments – are likely to dominate the economic landscape in most advanced countries over the next 5 years.
Global growth is currently slowing. The fragility of the US recovery has increased in recent months, the Chinese have tightened monetary conditions, and the Japanese are deeply concerned about yen appreciation.
However, the risks of a double dip recession and deflation spreading beyond Japan, remain low. In part, this is because of the multiple growth poles in emerging market economies. These economies currently account for half of the growth in global output and 40 percent of the increase in world import demand.
Instead, I see two major risks.
First, that the portfolio correction in household, corporate, bank, and government balance sheets is deeper and more prolonged than anticipated. This could happen if governments become unwilling to continue their fiscal and structural reforms, or if shocks in commercial real estate markets cause bank balance sheets to deteriorate further, or additional distress in housing markets further damages household balance sheets. The concern is that governments have already deployed much of their macroeconomic weaponry.
The second concern is that current account imbalances appear to be widening again – especially in the US, China, Japan, and Germany – in an environment of abundant liquidity with investors searching aggressively for higher returns. Capital flows to emerging markets are accelerating and their policy makers will need to manage the pressures on exchange rates, liquidity, the accumulation of reserves, asset price bubbles, and increased inflationary pressures. In the past, these have been the ingredients for economic cycles and banking distress. They could easily re-emerge, and increasing payment imbalances and high unemployment will generate further calls for protectionism - at a time when few feel empowered to save the Doha Round.
Implications for the Design of Economic Policy
Following several years of high growth and low inflation, many economists believed they knew how to master the business cycle.
To be fair, there were grounds for confidence. After all, policy had responded successfully to the October 1987 stock market collapse, the Long-term Capital Management crisis, and the bursting of the high tech bubble at the beginning of the decade. And no one believed that all of the elements forming the Basel II pillars, including market discipline, could fail in a G7 economy.
The crisis is stimulating considerable reflection within the economics profession. Governments have traditionally been lenders of last resort. Now, many are guarantors and investors of last resort. And their ownership interests extend well beyond their traditional investor habitat and levels of risk tolerance.
But there have been other surprises as well. For example:
- How quickly macro instability developed beneath small output gaps, sound fiscal positions, and price stability;
- The speed and scale with which governments had to take responsibility for private sector debt obligations;
- How quickly the medium term framework for fiscal policy got overwhelmed, including policy anchors such as golden rules, deficit and debt to GDP targets, and fiscal responsibility legislation; and
- How rapidly the framework to establish separate policy signals and transmission mechanisms for monetary, fiscal, financial and debt management policy became blurred.
Some commentators suggest that the market economy has failed. I do not view it in these terms. Instead, there have been macro-policy mistakes, serious governance failures, and a rational response to poorly designed regulatory policy. There will be greater skepticism about financial models based on efficient markets and smooth market clearing processes, and with business models that assume that personal and corporate objectives of managers are always aligned.
We are likely to see some rethinking of policy issues such as:
- The degree of openness of the capital account, the preconditions for liberalizing capital flows, and how quickly domestic financial markets should be deregulated;
- The impact of incentive structures on risk taking within institutions;
- The role of financial safety nets and the merits of self-insuring by building up large foreign exchange reserves;
- The best range to target inflation, e.g. whether a slightly higher annual inflation target is desirable in order to give policymakers more room to cut interest rates in a crisis. (IMF staff have produced a discussion paper on this issue);
- What is a sustainable non-accelerating inflation rate of unemployment? For example, is an unemployment rate of 4.5 percent in the US sustainable;
- The role of monetary policy in pressing against asset price bubbles; and
- There will be challenges to the view that current account imbalances do not matter if the government runs fiscal surpluses and policies are not distorting private sector saving and investment decisions.
Dialogue in the G20
Established in 1999, G20 membership accounts for about 85 percent of global GDP. But the G20 did not become a key element of the global financial architecture until the London Leaders Summit in April 2009 when governments and international financial institutions agreed to provide USD 1.1 trillion of financial assistance, including USD 750 billion for the IMF.
The G20 has enjoyed success on 3 levels.
First, as a forum for frank dialogue on the financial crisis. The debate has been particularly vigorous around the withdrawal of macro-policy stimulus. At the recent Toronto Summit, G20 Leaders agreed to at least halve their fiscal deficits by 2013, and stabilize their government debt to GDP ratios by 2016.
Second, as a potential vehicle for multilateral surveillance. At last year’s Pittsburgh Summit, G20 leaders launched a mutual assessment process to coordinate policy actions and generate stronger, sustainable, and more balanced growth. Countries are required to report on policies to help meet these goals at the Seoul Leaders Summit in November.
Third, the G20 monitors progress in the Basel Committee and Financial Stability Board. At their recent Toronto meeting, G20 Leaders requested that new capital standards be agreed at the Seoul Summit in November, and that the new standards be phased in by the end of 2012. The Financial Stability Board was asked to recommend measures to strengthen oversight and supervision, including around systemically important financial institutions.
But, in spite of its success, the G20 faces several challenges.
- First, countries outside the G20 resent their lack of representation and voice.
- Second, it’s unclear how effective the G20 can be outside of crisis conditions. A significant test will be: what can the mutual assessment process deliver when individual countries are assessed, and global economic and national political and economic interests clash?
- Third, some issues cannot be resolved by Finance Ministers unless there is prior broad agreement among G20 Leaders. For example, the language on the Doha Round has been hollow rhetoric, and G20 Finance Ministers were unable to agree how to finance climate change prior to the Copenhagen Summit.
Banking Regulation and the Financial Services Industry
Financial regulators have always had to balance the market’s potential for delivering social benefits and costs. Most governments in advanced countries chose to regulate their financial sectors relatively lightly in the belief that managers in financial institutions would prudently evaluate credit exposures and avoid the risk of insolvency.
Regulators were comforted by the discipline they believed that the credit rating agencies imposed, and the fact that few banking crises had occurred in advanced countries over the past two decades. Regulation and supervision focused on the soundness of individual institutions and markets, rather than macro prudential issues associated with broader financial stability.
As the crisis evolved, G20 governments quickly decided to redress the balance between private reward and taxpayer risk. Agreeing on a reform agenda was easy. It included strengthening bank capital and liquidity standards, reducing the moral hazard risk posed by systematically important financial institutions, improving OTC derivatives markets, and enhancing incentive structures and transparency.
Implementation is a different story. We have seen some good developments - new financial services regulation in the US, announcements to restructure the supervisory framework in the UK, and within the EU, some jurisdictions have imposed higher capital requirements and lower leverage ratios on their banks. And, the US, UK, and Europeans have conducted stress tests on banks. But, for the most part, progress in addressing these issues has been very uneven. Once final recommendations are agreed within the G20, governments will need to move concertedly in order to avoid rent seeking and regulatory arbitrage by banks and other investors.
Although the final shape of the regulatory and supervisory framework is uncertain, its potential impact on the financial sector is clearer.
- The relative size of the financial sector in G7 economies, just like the real estate sector, is likely to decline;
- The quality of supervision around the banking sector will improve and there will be a clearer assignment of responsibilities;
- The transparency of derivative trading will increase and more derivatives will be traded over exchanges;
- Banks will be better capitalized and have lower leverage. The BIS reports that financial firms have been underpinned by leverage (measured by total assets over total shareholder’s funds) about 5 times that of firms in other sectors. High leverage has allowed these firms to generate a competitive return on equity despite a low return on assets;
- Individual institutions will be less risky from a systemic perspective because they will be better capitalized and inhibited from investing in certain areas;
- The cost of intermediation will increase as banks reduce their leverage and face higher financing costs when the special liquidity support is removed; and
- Banks will seek to reduce their operating costs to boost profitability.
Conclusion
Winston Churchill once said “The farther backward you can look, the farther forward you can see.”
It is interesting to look back 350 years to the frenzied market for rare tulip bulbs. The Dutch economy boomed for 12 years before collapsing in 1636. At the height of its activity, prices for the rarest bulbs range from 6 to 20 times the annual income of artisans, and twice the amount that Rembrandt received for painting the Night Watch in 1639. The collapse of the bubble and a wave of bubonic plague, led to a 40 percent decline in house prices.
There are parallels with the current crisis. As Tulipmania developed, there were fraudulent credit practices, questionable derivative trades involving tulip bulbs offshoots, widespread default, and a failure in market discipline and regulatory policy.
Unlike the tulip bubble, the current financial crisis has global implications, and its origins lie in policy mistakes and governance practices in the most affluent economies in the world.
There are huge uncertainties as to how long it will take for the balance sheet adjustments to play out in the current crisis. One of the papers most discussed at the recent Jackson Hole Conference was whether the portfolio adjustments in the US will lead to a decade of slow growth.
We understand many of the demographic and economic transformations that are likely to take place in the global economy over the next 40 years. But, over the next five years, we will see another set of major changes as deleveraging continues across the globe, new banking regulation is adopted, the global financial architecture continues to evolve, the consequences of global payment imbalances become apparent, and serious rethinking of the role of government and macro theory and policy takes place.
As Abraham Lincoln said in 1863, “The best thing about the future is that it comes only one day at a time.”
Thanks very much.
