I am not confident at all that we have moved to the type of regulatory environment that is necessary to prevent the next crisis. I tend to agree with the IMF assessment that our model of financial regulation was deeply flawed. Loan brokers and mortgage originators had few incentives to more realistically assess risk which, in any case, they sold on to others—this was part of the “financial innovations” so warmly welcomed by market participants. Investors relied too unthinkingly, in assessing asset quality, on unrealistic or overly optimistic analyses done by credit rating agencies, which, again, proved a time-tested ability to be lagging indicators of crises (remember the 1997 Asian financial crisis?). Regulation and supervision were too concentrated on firms and not sufficiently focused on issues of systemic risk. None of these weaknesses is being addressed in a credible way yet.
The shadow banking system—investment banks, mortgage brokers, hedge funds, among others—were lightly regulated by a multitude of agencies. The assumption was that only deposit-taking institutions needed to be regulated and supervised, thereby encouraging financial innovation in the rest of the system which, the thinking went, would act under a regime of self-imposed market discipline, spurred by the self-correcting nature of financial markets. Obviously the system had a huge amount of moral hazard built in which, regrettably, the financial crisis has not eliminated. Excellent results in some financial institutions in recent quarters—and levels of compensation that in many cases are no worse than those last seen in 2007—are partly the result of risk profiles fuelled by public funds.
We need to move to a system where, as noted by the IMF in its latest World Economic Outlook, “all activities that pose economy-wide risks are covered and known to a systemic stability regulator with wide powers.” This would include banks, institutions issuing CDOs attached to mortgages or insurance companies selling credit default swaps. Disclosure obligations within this “extended perimeter” should then allow the supervisory authorities to determine relative contributions to systemic risk and to calibrate the scope of the prudential oversight needed. For instance, one would discourage the emergence of mega-banks. The financial system has become too concentrated. Over the past 20 years, the share of US financial assets held by the 10 largest US financial institutions has risen from 10 percent to 50 percent. This is not desirable and, not surprisingly, has led to calls for change—Chancellor Angela Merkel recently stated that “no bank should be allowed to become so big that it can blackmail governments”—a thoroughly sensible proposition. One way to achieve this is to simply force very large financial conglomerates to spin off assets, although there is also merit in proposals to do this via capital ratios that rise with the contribution to systemic risk. Indeed, many of the recommendations put forth by the IMF in the aftermath of the crisis are quite sensible, but we are not moving anywhere near fast enough to implement them. In particular, there seems to be a reluctance to address the issue of institutions that “are too big to fail” and the moral hazard that they imply. As expected, vested interests are working full time to prevent the implementation of such reform proposals. Paul Krugman is certainly correct in lamenting the extent to which vested interest (or, as he puts it, “corporate cash”) has “degraded our political system’s ability to deal with real problems.” But there are other problems as well, beyond vested interests. Alan Blinder from Princeton alludes to our “amazing capacity to forget” (the crisis was last year’s problem), an overcrowded legislative agenda in the US, bureaucratic infighting in connection with the rearrangement of supervisory responsibilities which the reforms would imply, and the fact that it is difficult to get the public excited about banking regulation, as dry and arcane a subject as there is.
The IMF also thinks that it would be desirable to mitigate pro-cyclical behavior, for instance by raising minimum capital requirements during upswings (when, in the US, the Federal Reserve has tended historically to take a hands-off approach) and allowing these to come down in a downturn, when, again, the Federal Reserve in the US has tended to be aggressive in loosening monetary policy. Many think that one could do the same for leverage—introduce a supplementary leverage ratio for banks. There is also a need to reform the system of incentives for compensation, which remain perverse and, at the moment, are rewarding many players in the financial system, as noted above, for assuming risk with public funds. It would also be desirable to sever or, in any case, weaken the connection between compensation and annual results and link it more to medium-term return on assets. An interesting question is whether it was a terrible mistake to have repealed in the United States the Glass-Seagall Act which separated commercial from investment banking. I am very sympathetic to the idea that in the financial system household deposits (which are insured) should only be invested in low-risk assets, which is not what we had at the outset of this crisis, when deposits were being used in high-risk activities.
Central banks need to broaden their definition of “financial stability” from an often exclusive concern with stabilizing inflation to looking at asset price increases, credit booms, leverage and ways in which financial innovations might be complicating the task of the authorities in setting monetary policy—you know you are in trouble when some instruments are so complicated that you no longer can tell whether they should be included in the definition of some appropriately broad monetary aggregate. The IMF is right when they say that it matters a great deal whether the boom is associated with high leverage. For instance, the dotcom bubble of the late 1990s was associated with limited leverage and thus its bursting had limited impact on economic growth. In the current crisis, asset price collapses have greatly affected the balance sheets of financial institutions.
However, there are several other issues, beyond purely aspects of the new regulatory regime that needs to be brought into being, which are a source of concern. I would like to highlight several. First, there is the question of fiscal sustainability.
There are several reasons why we should worry about the remarkable increases in public debt underway. One has to do with the constraints on government policy which high levels of debt normally imply. With debt levels in excess of 100 percent of GDP, governments are less able to invest in education, infrastructure and other productivity-enhancing areas, to say nothing of moving to a lower-tax environment. This undermines growth. High debt service becomes an important constraint on the ability of governments to respond to pressing social and other needs, including possibly responding to other unforeseen crises in the future.
Second, in a large number of the bigger economies there are unfavorable demographic trends which are resulting in the aging of populations. Increases in life expectancy combined with declining fertility will have systemic implications for the sustainability of pension systems, the ability of governments to remain faithful to the key elements of the social contract.
In fact, governments are having a tough time in getting the thrust of policies right. On the one hand, there has been and there may well continue to be a need for fiscal stimulus, to mitigate the effects of the recession. On the other hand, too much fiscal stimulus risks undermining government credibility, as debt levels are perceived by markets to be unsustainable; by 2014 many rich industrial countries will have debt levels on a par with Italy’s, an inevitable consequence of the bountiful flow of red ink everywhere. Particularly worrying is a scenario where foreigners become concerned that higher government financing would push up long-term US bond yields, leading them to want to reduce their exposure which would then put strong pressures on the dollar. One way to deal with this tension is to be judicious in the choice of stimulus measures. For instance, governments should target measures that bring long-term benefits to the economy’s productive potential—infrastructure spending is very helpful but I think that the crisis has also given us a great opportunity to spend more money for environmental protection and conservation. This might be an ideal time to introduce carbon taxes, to move a little closer to a world of full-cost pricing, which we are not doing by largely ignoring some of the more deleterious effects of global warming.
Third, we need to address fiscal challenges posed by aging populations. What does this mean? Let’s take the case of Europe. Solidarity and social cohesion are very much at the center of European policy debates. One element of the solution will be to work longer and retire later. We must, therefore, boost training of the workforce, to extend the useful productive life of workers, perhaps in increasingly flexible settings. This, in turn, will force governments to reconsider expenditure priorities with a view to making resources available for re-training. This is a key element of better management of the globalization process.
We must also deal more effectively with global imbalances. This is a reference to large current account deficits and surpluses in countries such as the US, Japan, Germany, China, which, under some scenarios, could cause a reversal of capital inflows into the US and cause a massive drop of the dollar. Massive capital inflows have been associated with excessive risk taking, exchange rate risk and other sources of systemic risk. I have done some quick calculations which show that the current account deficits of the US, the UK and Spain (a combined $909 billion in 2008) are just offset by the current account surpluses of Germany, Japan, China, Switzerland, Norway and the Netherlands ($903 billion).
But this is largely a US, China, Japan and Germany phenomenon, as the surpluses of these last 3 countries account for about 112 percent of the US deficit. These imbalances have been a huge source of risk to the global economy. Among the causes: structural high savings in China linked to the fact that in this country there are no effective mechanisms of social protection, no pensions, no unemployment protection. The large Chinese population saves for old age because of lack of mechanisms of social protection; in the presence of such a system surely they would have a higher demand for American and European consumer goods, which would bring their 9.5 percent of GDP trade surplus down.
In any event, it is evident that we need to have more effective mechanisms of international coordination to deal with the global nature of the crisis and ensure that we do not go back to a world of destructive protectionism.