Download Wincott Lecture 11.13.2013

How the Financial Crisis Changed our World
Martin Wolf1
“My view is that improvements in monetary policy, though certainly
not the only factor, have probably been an important source of the Great
Moderation. In particular, I am not convinced that the decline in
macroeconomic volatility of the past two decades was primarily the result of
good luck, as some have argued, though I am sure good luck had its part to
play as well.” Ben Bernanke, Federal Reserve Board Governor, 2004.2
The past is a foreign country. Even the very recent past can be a
foreign country. In a celebrated speech on what economists hubristically
called the “great moderation”, Mr Bernanke talked about what now seems a
different planet - a world not of financial crisis and long-term economic
malaise, but of stability and superlative monetary policy.3 This may seem
exaggerated. But look at what then governor, now chairman, Bernanke, said:
“improved monetary policy has likely made an important contribution not
only to the reduced volatility of inflation (which is not particularly
controversial) but to the reduced volatility of output as well.”4
This now seems quaint. The economics establishment failed. It failed
to understand how the economy worked, at the macroeconomic level,
because it failed to understand financial risk, and it failed to understand
financial risk partly because it failed to understand how the economy
worked at the macroeconomic level. The work of economists who did
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understand these sources of fragility was ignored because it did not fit into
the imagined world of rational agents, efficient markets and general
equilibrium these professors Pangloss had made up.5
The subsequent economic turmoil has done more than make the
conventional wisdom of even a few years ago look as dead as the Dodo. It
has (or should have) changed the way we see the world. So what are the
dimensions of these changes and what are the chief policy implications? In
this discussion I focus on just five transformations and look at them from the
point of view of affected high-income countries and, above all, of the UK.
Those transformations are: economic performance, the fiscal situation,
monetary conditions, the financial system and economic ideas. For reasons
of lack of space, I ignore the impact of the crisis on the eurozone, on the
influence of the high-income countries and on globalisation. I ignore, too,
why this crisis occurred. Those interested in my perspective on those
subjects will need to wait for the publication of my forthcoming book on the
crisis.
Let me bring forward my main conclusions.
First, the crisis has lowered economic output vastly below the precrisis trend. In the case of the UK, gross domestic product was 18 per cent
below its pre-crisis trend in the second quarter of 2013. Similarly, drastic
declines have occurred in productivity, relative to pre-crisis trends. Many
believe that it is impossible to return to the pre-crisis trend. That is possible.
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But it is not obviously true. It is reasonable to be optimistic that the UK can
regain much of the lost ground, even though that is likely to take a long
time.
Second, the crisis has had dramatically adverse fiscal consequences.
But the UK was not compelled to adopt immediate austerity by this
undoubted fact. It had the luxury of timing the necessary turn towards fiscal
retrenchment. In this, its position was quite unlike that of the vulnerable
countries in the eurozone periphery. Furthermore, it is important to note that
UK public debt was exceptionally low, relative to GDP before the crisis hit,
and is still far below its long-term historic averages. The option of
aggressive use of fiscal policy was available to the UK if it had dared to
exploit it.
Third, the crisis has also had a dramatically adverse impact on the
operation of the monetary system. That has undermined reliance on
monetary policy as the principal tool of macroeconomic policy. Indeed,
given the dramatic impairment of the credit system, even highly aggressive
monetary policy failed to sustain pre-crisis levels of credit and money. More
could – and should – have been done to strengthen the financial system,
from the beginning. The breakdown of the privately run credit system has,
understandably resurrected ideas from the 1930s, such as the Chicago Plan,
which envisaged full or partial nationalisation of the creation of money, on a
permanent basis. Great economists, such as Irving Fisher and Milton
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Friedman have favoured such ideas for “100 per cent reserve banking”.
They are worth careful consideration and, even if rejected, provide a
benchmark against which more modest proposals can be assessed.
Fourth, the crisis has revealed the extreme fragility of the
contemporary financial system and so of the economy with which it is
intimately intertwined. The manic rule-making we now see disguises the
fact that its thrust is to preserve the system that existed before the crisis. But
though the aim is to preserve the global, complex and highly leveraged precrisis financial system, the regulatory effort itself reveals a breakdown in
trust between the authorities and finance. If we are to preserve something
broadly similar to the system that existed before the crisis, the most
important recommendation is for a big increase in capital requirements,
unweighted for risk, to a minimum of 10 per cent of outstanding assets. But,
beyond this, there are good reasons to question whether greater financial
globalisation and financial deepening are even desirable.
Finally, the crisis puts into question the pre-crisis conventional
wisdom, particularly on monetary policy. The notion of a “great
moderation” stands revealed as vainglorious. This has – or should – lead to a
ferment of new (and recovered old) ideas. The idea that monetary policy
should ignore what is happening in the financial sector has had to be (or at
least should be) abandoned. The least that is required is a new concept of
“macro-prudential policy”, buttressed by far higher capital requirements.
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But more radical ideas are also being advanced, as they should be. The case
for a radical transformation of the banking sector is strong.
In all, the crisis is a transforming event.
1. Economic transformation
Start with the most obvious point. The world economy has turned out
to be very different from what most people imagined even six years ago.
Economies that were deemed vigorous have turned out to be sickly. In all
the important high-income countries, output is far below previous trends and
the rate of growth is far below what had previously been considered its
potential. Even levels of activity are still far below pre-crisis peaks in a
number of important countries, notably Italy and the UK (see Chart 1).
Moreover, unemployment rates are elevated and persistent. The concern that
something similar to the lengthy Japanese economic malaise is about to hit a
number of high-income countries has, alas, grown more credible. Maybe,
the outcome will be even worse than in Japan: on balance, it has been, so
far.
Charts 2 and 3 indicate how big (and bad) a change the recession in
the UK has been. In the second quarter of 2013 GDP was 18 per cent below
its 1980-2007 trend. In 2012, GDP per head at purchasing power was 12 per
cent below the 1950-2007 trend. The last time, the UK experienced anything
like this was during the interwar slump and the immediate aftermath of the
Second World War. As Chart 4 shows, there has also been a huge shortfall
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in labour productivity, measured, in this case, by GDP per hour. Indeed, as
Chart 5 shows, the performance of UK productivity has been the worst of all
large high-income economies since the crisis.
Meanwhile, emerging countries have mostly recovered vigorously
and gained enormously, in size, relative to the high-income countries, since
2007 (see Chart 6). But they did so, in part, by replacing the external
demand they had lost with domestic stimulus. Unquestionably, this worked
in the short run, remarkably so in China. But such action has left a difficult
legacy, in the form of low-quality investments, asset prices bubbles and bad
debts, and may, for such reasons, be unsustainable. At the same time, the
emerging countries cannot return to the export-led growth cum reserveaccumulation strategies followed by many of the most successful, prior to
the crisis. The weakness of private demand within high-income countries
precludes that and, in particular, the loss of creditworthiness of consumers.
In all, the legacy of the crises includes deep practical challenges to
policymaking almost everywhere.
The collapse in the growth of output and productivity in high-income
economies has marked a watershed in economic performance. To get back
to the 1980-2007 trend growth over ten years would require the UK to
achieve compound annual growth of 5.6 per cent. Not all high-income
countries have been as badly hit as the UK, partly because the UK has such
a large financial sector and partly because of inept post-crisis policies. But
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nearly all have experienced very large declines in output relative to the precrisis trend. In the US, for example, the shortfall beneath the 1980-2007
trend was 15 per cent by the second quarter of 2013. In the eurozone it was
12 per cent below a much slower trend rate of economic growth.
An important question is whether the losses in output and
productivity are permanent or temporary. Even if it proved impossible to
return to trend over a period as short as 10 years would it be possible to
return to trend in the longer run? Or is the earlier trend now lost forever and,
if so, why? We should note how large the losses would end up being if
growth were now to run no higher than the pre-crisis trend, compared with
what was expected before the crisis hit. A permanent loss of 18 per cent of
GDP would amount to six times GDP, discounted at a real interest rate of 3
per cent. This is enormous, by any standards. It is why recouping lost
ground is so important.
One can identify at least three arguments why a large part of these
losses might indeed be permanent. The first is that the pre-crisis trend was
an illusion. The second is that the financial sector’s ability to finance
worthwhile investments has been permanently impaired. The third is that the
underlying trend growth of productivity has slowed, because of a worsening
of trend innovation. None of these is, however, close to convincing.
On the first, the immediate pre-crisis period was not marked by any
big deviation from longer-term trends (see Charts 2 and 3). It is true that in
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the UK one saw a large rise in household debt and in the balance sheets of
the financial sector. But the debt was overwhelmingly contracted in order to
purchase existing assets rather than finance consumption or investment.
Moreover, there was no sign of any general overheating, such as soaring
inflation or an explosive jump in the trade deficit. The growth of the
financial sector was surely unsustainable. But since its measured share in
total GDP rose only from 6 to 9 per cent between 1998 and 2008, this
cannot explain a loss in output, relative to trend, of as much as 18 per cent
of potential output.6 Similarly, a decline in the share of the financial sector
in employment will surely lower measured productivity. But the impact
should be modest, since the share of finance n total employment is only
around 3.5 per cent. Moreover, many of the workers employed in finance
are the most highly qualified and are likely, therefore, to have a relatively
high productivity wherever they work. Moreover, in the UK at least, there
was no big surge in construction, unlike in the US, Spain or Ireland. In
brief, there was surely some misallocation of resources during the pre-crisis
years. But it is hard to see why the economy could not have grown at about
the same rate with another allocation of resources and why, in consequence,
it should not be possible to return to the longer-term trend, once resources
are reallocated.
The second argument is that the ability of the financial sector to
finance productive investments is permanently impaired. This is
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implausible, for several reasons. One is that the role of traditional banking in
financing innovation is small, in any case. This is particularly true of the big
financial institutions that were damaged in the crisis. As Chart 7 shows, the
lending of UK financial institutions is overwhelmingly to one another and to
investment in real estate and construction, including, in particular,
household mortgages. Lending to manufacturing was a mere 1.4 per cent of
the balance sheet. Second, even if there were such an effect on the finance
of innovation - as Ben Broadbent, a member of the Monetary Policy
Committee of the Bank of England, argues - it is surely temporary.7 If good
opportunities do exist, someone will find a way to take advantage of them.
Thereupon, a period of catch-up on past opportunities should surely emerge.
Third, even if one accepts the controversial argument put forward by
Robert Gordon of Northwestern University - that US economic growth has
slowed permanently, because it has already exploited the best opportunities,
it does not follow that UK output and productivity cannot pick up once
again.8 One reason for this is that the US productivity performance since the
crisis has been substantially better than the UK’s (see Chart 5). Another is
that UK productivity levels are behind those of the US: output per hour at
purchasing power parity was 20 per cent behind US levels in 2012. In
addition, it is hard not to believe that a big part – if not most– of the reasons
for the slowdown are related to demand, rather than supply: short-term
constraints on the growth of credit and money; cut-backs in private
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spending, partly due to deleveraging, but also to extreme uncertainty and the
associated collapse in “animal spirits” emphasised by John Maynard
Keynes; and, finally, to fiscal austerity, offset, particularly when interest
rates were at the zero lower bound, by insufficiently effective monetary
policies. But, in the long run, fiscal austerity will be over, deleveraging will
be completed and the financial sector will heal.
At that point, surely much of the lost ground can be recouped. But it
is going to take a while. Moreover, the scale of those losses would have
been smaller and less enduring if the governments had acted more decisively
to restructure the financial system and encourage more rapid reductions in
debt, in combination with more determined efforts at promoting a recovery
in demand.
2. Fiscal consequences
As a result of these unexpected economic developments, crisis-hit
countries now have far worse fiscal positions than they had imagined. As the
work of Carmen Reinhart and Kenneth Rogoff, both now at Harvard
University, has shown, fiscal crises are a natural concomitant of financial
crises, largely because of the impact on government revenue and spending
of declining profits and economic activity, together with rising
unemployment. These come on top of direct fiscal costs of bank bailouts.9 In
the case of the current crisis, as was to be predicted, the biggest adverse
fiscal effects were felt in the countries that suffered a direct hit from the
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financial crises, such as the US, UK, Ireland and Spain, rather than in
countries that suffered an indirect hit, via trade (see Chart 8). Worse, the
longer-term fiscal positions of crisis-hit countries were always likely to be
difficult, because of ageing. Now room for manoeuvre will be curtailed by
the legacy of the crisis.
The deterioration in the fiscal position of many crisis-hit countries is
a fact. The policy implications are not. In particular, countries with floating
currencies have benefited from extremely low short-term and long-term
interest rates throughout the crisis. Countries with comparably large fiscal
deficits in the eurozone have had a very different experience, as the contrast
between Spain and the UK – two countries with similar profiles for public
debt – demonstrates (see Charts 9 and 10).
Countries with their own floating currencies have three advantages in
managing their fiscal positions, as the Belgian economist, Paul de Grauwe,
now at the London School of Economics, has cogently argued.10 The first is
that they are most unlikely to default. The central bank can see to that. There
is always likely to be an exit option, on foreseeable terms. Lenders to
countries that borrow in a currency they do not themselves create run a risk
of sudden illiquidity: a “sudden stop”, in fact, as economists specialising in
developing countries describe it. They protect themselves against this by
demanding an illiquidity risk premium. The second advantage is that shifts
in the desire to hold liabilities of the country can also be accommodated by
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an adjustment in the exchange rate, not just in the domestic price of assets.
The third advantage is that there will be savers who need to match domestic
currency liabilities with domestic currency assets and, especially, the safest
domestic currency assets, which are government bonds. For all these
reasons, countries with their own floating currencies will, other things being
equal, enjoy lower yields on their public debts, as the contrasting
experiences of Spain and the UK indicate.
Countries inside the eurozone are in an ambiguous position. In the
absence of common bond issuance, the provider of safe haven bonds is the
German government: thus, in a panic, investors who need a currency match,
in euros, flee into Bunds. Member countries do have a central bank, but they
lack control over it. Nevertheless, the central bank can play a decisive role.
Two important policy statements by the European Central Bank transformed
the vulnerable countries’ predicament: the offer of three-year long-term
refinancing operations to banks in November 2011, and, still more, the
announcement by Mario Draghi, the ECB president, in July 2012 that it
would do “whatever it takes” to preserve the euro, which led to the creation
of the Outright Monetary Transactions programme, in September. 11 The
striking fact is that these announcements, rather than domestic policy
decisions, led to the sharp reduction in Spanish yields shown in Chart 10.
This is particularly true of the OMT. That, in turn, confirms the hypothesis
that the role of the central bank in managing public debt is crucial. The fact
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that Italy’s interest rates paralleled those of Spain strongly supports this
hypothesis about central banks.
The implication is that the opportunities for the UK to postpone fiscal
austerity until recovery is advanced have been different from those of
eurozone members. Indeed, the principal determinant of the UK’s long-term
interest rates has been expected short-term rates. With actual and expected
short-term rates low, long-term rates have also been low. Markets do not
expect an outburst of inflation in a depressed economy. Thus, they do not
expect any sharp tightening by the central bank. So bond yields have
remained low. Fiscal deficits have nothing to do with this outcome, since
such deficits affect neither real interest rates nor expected inflation at the
zero lower bound. Indeed, over the long-term history, public debt has never
had much influence on interest rates, as Chart 11 shows. In the present
condition, when UK public debt is extremely low by historical standards and
short-term interest rates are at all-time lows, this must be even truer. Also
important is the fact that other countries with floating currencies, low
inflation, high public debt and low short-term interest rates have also had
low long-term government bond rates throughout the crisis: the US and
Japan are striking examples (see Chart 12). A simple indication of the
irrelevance of deficits to longer-term interest rates is that UK government
bond yields were unaffected by the massive overshooting of the
government’s fiscal plans (see Chart 13).
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The conclusion is not that deteriorations in fiscal positions do not
matter. In the long run, they surely do. The conclusion is rather that the
shorter-term options for use of fiscal policy are far greater than the deficit
and debt panic of recent years, in the UK and elsewhere, suggests. More
active use of fiscal policy was an option. Whether it was an option worth
taking depends on the effectiveness of monetary policy.
3. Monetary transformation
In all major countries, the growth of credit and so of money has been
impaired. In the UK, for example, the lending counterpart of broad money
(M4) declined by 19 per cent between March 2009 and September 2013.
The huge expansions of the monetary base, as a result of so-called
“quantitative easing” have limited the decline in broad money itself (See
Charts 14 and 15). Nonetheless, the breaks in pre-crisis trends are dramatic,
in both lending and the money supply.
In a credit- (or debt-) based monetary system, such as ours, the supply
of money is a by-product of the private creation of credit. The central banks
regulate the price of money, while the central bank and government ensure
the convertibility of deposit money into government money, at par, by
acting as a lender of last resort (in the case of the central bank) and provider
of overt or covert insurance of liabilities (in the case of the government).
But, because this financial crisis has been so severe, central banks have gone
far beyond standard operations. The Bank of England, has, for example,
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reduced its official intervention rates to the lowest levels ever seen (see
Chart 11). Central banks have enormously expanded their balance sheets,
with controversial long-term effects. If the aim of policy was to sustain the
growth of broad money, it failed. If the aim was to sustain the growth of
credit, it failed even more dramatically.
Could policy have been more successful? It depends on what one
wanted to achieve. It would have been possible to do more QE, since there
is, in principle, no limit to the scale of such operations. The case for doing
more was in fact strong in the UK, US and, above all, in the eurozone. It
would also have been possible for governments to borrow more from their
banks, at least outside the eurozone, where sovereign debt is risky. Finally,
it would have been possible to be more energetic in strengthening the
financial sector, though substantial further increases in credit might have
been unlikely, in any case, in the immediate aftermath of the crisis.
Deleveraging seems to be a normal consequence of large financial crises.
This was unlikely to be an exception, given the scale of the crisis and of the
build-up in debt that preceded it.
The most radical longer-term option would have been not just
temporary, but permanent, nationalisation of a part or all of the monetary
system. In other words, the state could have seized the ability to create fiat
money from the private sector. Although he does not put it this way, that is
what professor Laurence (Larry) Kotlikoff’s proposal for “limited purpose
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banking” amounts to.12 Similarly, in the 1930s, the Austrian economist,
Ludwig von Mises, concluded that the ability of private institutions to create
debt-backed money out of thin air needed to be brought under control, via
100 per cent reserve banking. Members of the Chicago School came to the
same conclusion. The economists involved were distinguished: Frank
Knight (1885-1972), Henry Simons (1899-1946), author of the most
complete version of the plan, Irving Fisher (1867-1947), the most famous
pre-second world war American economist and, after the Second World
War, Milton Friedman (1912-2006).13 Again, as with the Austrians, these
free-market economists concluded that the ability to create credit-backed
money had to end if the market economy was to be protected from massive
crises.
How might this work? The government would use the power to create
money, to finance itself permanently, instead of relying exclusively on the
sale of debt to the public. To manage such a transformation, it would have
permanently raised reserve requirements, at the limit to 100 per cent of
liabilities, reducing conventional banks to operators of the payment system.
Meanwhile, credit would be taken outside the monetary system and operated
via investment and unit trusts. A more limited option would have been to
ensure that a substantial fraction, though not all, of bank money was used to
back government, not private, debt.
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Such ideas have much to commend them. Banks would end up
holding large permanent claims on the central bank, which, in turn, would
offer steadily expanding accommodation to the government. Government
debt owned by the public would be smaller. Public finance would be
cheaper. New non-monetary means of financing the private sector would
need to be developed. It would be possible to combine such a regime with
control over inflation, provided the central bank had the job of deciding how
much to allow the overall money supply to expand in any given period.
Then, the permanent reserve ratio would determine what proportion of this
total was to be made available for financing the government. Of course,
nothing like this is in the least likely to happen. This is so for two quite
different reasons. First, the vested interests in the existing monetary and
financial system are profound, as has been shown by the (largely successful)
resistance to even quite modest changes in the policy regime affecting
banks. Second, it is widely accepted that the ability to finance the longerterm investment needed by the economy with the short-term liabilities of the
banking system demanded by the public greatly increases the total level of
productive investment and so growth.
For these reasons, such a radical reform of the monetary and financial
systems seems inconceivable. Nevertheless, these radical ideas are
attractive. Today’s monetary system creates a disturbingly intimate
relationship between the state and financial institutions, since it is the
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financial system that creates money and so through the financial system that
monetary policy works. It is also partly because of this intimate relationship
that the credit system has an extraordinary ability to generate the fuel on
which it feeds, so creating endogenous booms and then busts. As Adair
Turner has noted in an important recent lecture, many of the ideas on how
such a system works and how it destabilises the economy go back to the
great Swedish economist Knut Wicksell, from whom both Austrians and
Hyman Minsky learned their ideas, before they were forgotten in the more
recent era of supremacy of the neo-Walrasian barter economy cum general
equilibrium, approach.14
4. Financial transformation
The crisis demonstrated the extreme fragility of the financial system.
It established the dependence of the world’s most significant financial
institutions on government support. It underlined the existence of
institutions that are too big and interconnected to fail. It confirmed the idea
that the financial system is a ward of the state, rather than a part of the
market economy. It demonstrated that state of the art risk management
systems were dysfunctional. It showed that diversification by individual
institutions did not mean that the system was diversified. And it
demonstrated the tendency towards generating extraordinarily high leverage
within the financial system and, no less worryingly, in the economy as a
whole. Behind the disaster were not only misplaced incentives, but, more
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important, false beliefs about the future, partly due to the dynamics of the
financial system itself and partly to decisions about an inherently uncertain
future.15
In reviewing the massive and complex regulatory response, cynics
will be reminded of the remark in Giuseppe Tomaso di Lampedusa’s Il
Gattopardo: “If we want everything to stay the same, everything must
change”. They will conclude that the manic rule-making we are now
witnessing disguises the fact that its thrust is to preserve the system that
existed prior to the crisis: it will still be largely global: it will continue to
rely on the interaction of vast financial institutions with free-wheeling
capital markets; it will continue to be highly leveraged; and it will go on
relying for its profitability on successfully managing huge mismatches in
maturity and risk. But the new structure of regulatory oversight and rules
displays something equally important: the breakdown of trust between
authorities and finance. That was hardly surprising, given the huge costs of
the crisis. Thus, the authorities want largely to preserve a system they also
mistrust. That is why the regulatory outcome has been so complex and
prescriptive.
If we are to cut through the complexity, we must focus on the most
important single recommendation, which is for higher capital ratios. In other
words, the minimum ratio of equity to total assets in the bank should be
raised from the currently discussed level of 3 per cent to a minimum of 10
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per cent.16 Some economists would argue for far more equity than that.17
Risk-weighting of capital sounds sensible in theory. But painful experience
has shown that such risk weights are extremely unreliable, even if applied
honestly, and, worse, susceptible to gaming. In the UK case, for example,
risk weighting indicated that bank portfolios were at their safest in 2007, just
before the crisis hit.18
Higher capital is not everything. But it is the simplest way to increase
the ability of individual institutions and of the system as a whole to survive
unexpected adverse events. Once one is in a situation in which many of the
world’s most important financial institutions look as undercapitalised as
they did in 2007 and 2008, a panic becomes likely. The alternative to higher
capital ratios is more bail-in-able debt. But there remains a risk that, again in
times of crisis, the forced conversion of a large quantity of bank debt into
equity might cause a panic in funding markets. Certainly, such ideas would
only work if the holders of this debt were clearly able to bear the costs of the
conversion.
Furthermore, the globalisation of finance is also in question. The
reality of the world economy is that economies have become more
integrated, but political order still rests on states. In the case of finance,
taxpayers have bailed out institutions whose business is often heavily
abroad. Similarly, they have been forced to protect financial businesses from
developments abroad, including those caused by regulatory incompetence
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and malfeasance elsewhere. This is not politically acceptable, in the long
run. Broadly, two possible outcomes seem possible: less globalised finance
or more globalised regulation. This dilemma is particularly marked inside
the Eurozone, as Adair (Lord) Turner, chairman of the UK’s Financial
Services Authority, has noted. This is because financial markets are more
integrated and national policy autonomy is more limited than elsewhere.19
The biggest question is, however, whether ever-increasing financial
deepening and cross-border integration are even good things. The evidence
is increasingly against these assumptions. In an interesting recent paper, Stephen
G Cecchetti and Enisse Kharroubi of the Bank for International Settlements argued
that there is a "negative relationship between the rate of growth of finance and
the rate of growth of total factor productivity".20 Part of the reason for this is
that finance disproportionately benefits "high collateral/low-productivity
projects". Thus, as of August 2013, loans outstanding to UK residents from
banks were £2.4tn (160 per cent of GDP). Of this, 34 per cent went to
financial institutions, 42.7 per cent went to households, secured on
dwellings, and another 10.1 per cent went to real estate and construction.
UK banking is a highly interconnected machine whose principal activity is
leveraging up existing property assets. Why should its expansion promote
growth, other than its own? It may instead mainly exacerbate the British
economy 's debt-induced fragility.
Financial deepening does promote prosperity, but only up to a point.
Many high-income countries are probably beyond it. The huge expansion in
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finance since 1980 has not brought commensurate economic gains. Many
developing countries do have room to grow finance, to their benefit; India is
an example. Yet some may already have enough.
It is also far from clear that arguments for cross-border financial
integration carry over from those for trade in goods. Financial integration
carries with it risks of crises, as emerging countries have learnt. A desire to
protect domestic financial stability, by insisting that foreign banks create
subsidiaries, not branches, is wise. This is one of the main reasons why the
UK’s Independent Commission on Banking, of which I was a member,
recommended the ring-fencing of retail banking: some way needed to be
found to separate domestic retail banking from the global trading businesses.
In this way, moreover, banks should become more dissimilar from one
another, so making the entire system more resilient.
5. Challenge to ideas
Yet perhaps the biggest way in which the crisis has changed the
world is to have shown that established views of how (and how well) the
world’s most sophisticated economies and financial systems work were
nonsense. This poses an uncomfortable challenge for economics and a
parallel challenge for economic policymakers – central bankers, financial
regulators, officials of finance ministries and ministers. It is, in the last
resort, ideas that matter. Both economists and policymakers need to rethink
their understanding of the world in important respects. The conventional
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wisdom, aptly captured in Mr Bernanke’s speech about the contribution of
improved monetary policy to the “great moderation”, stands revealed as
complacent, if not vainglorious. The world has indeed changed.
The result is (or should be) a ferment of ideas, with many heterodox
schools – Austrians and post-Keynesians, in particular – exerting much
greater intellectual force and deeper splits within the neo-classical
orthodoxy, as well. Alan Greenspan was forced to admit that the self-interest
of shareholders did not work to keep financial institutions solvent.21 All
central banks have had to accept a need for much more intrusive regulation,
including “macroprudential regulation” of the financial system, with a view
to making its behaviour less pro-cyclical. The idea that monetary policy
could ignore what was happening to credit and leverage has also been, at
least in part, been abandoned. Meanwhile, those on the free-market end
propose narrow banking or some other radical approach to freeing banking
from intrusive regulation, while those on interventionist left envisage a
banking sector and monetary system more fully under state control.
Ironically, as I have indicated above, these ideas can converge to an
important extent.
Nor is this debate limited to long-run reforms. It is no less central to
the discussion of post-crisis macroeconomic policy between “austerians”
and Keynesians. As indicated above, the question of how best to respond to
the collapse in demand and output remains very definitely open and is likely
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to remain so as long as output languishes so far below the pre-crisis trend.
Are these losses to be regarded as permanent or, as I have argued,
temporary? If temporary, should the economy be allowed to heal itself,
while the government approaches its own finances as if they had little to do
with overall demand? If so, what should monetary policy do and how
effective can it be in bringing about the surge in demand that may be
needed.
This event, in brief, calls for an intellectual upheaval remininscent of
the response to depression in 1930s and then to inflation in the 1970s. As
Dorothy says in The Wizard of Oz, “Toto, I’ve a feeling we’re not in Kansas,
any more.”
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1
2
Chief Economics Commentator, Financial Times, London.
Ben Bernanke, “The Great Moderation”, 20 February 2004,
http://www.federalreserve.gov/boarddocs/speeches/2004/20040220/default.htm.
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3
James H. Stock and Mark W. Watson coined the term “great moderation” in
“Has the Business Cycle Changed and Why?” in Mark Gertler and Kenneth Rogoff
eds, NBER Macroeconomic Annual 20012, Volume 17 (Cambridge, Mass: MIT Press,
2003), http://www.nber.org/chapters/c11075.pdf.
4
Ben Bernanke, Loc. Cit.
5
Foremost among the economists whose views were widely ignored were the
late Hyman Minsky and Charles Kindleberger. See, for example, Hyman P. Minsky,
Stabilizing an Unstable Economy (New Haven, Connecticut: Yale University Press,
1986) and Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics and
Crashes: a History of Financial Crises, 6th edition (London: Palgrave Macmillan,
2011).
6
Stephen Burgess, “Measuring financial sector output and its contribution to
UK GDP”, Bank of England Quarterly Bulletin, 2011 Q3, Chart 2, p. 234,
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb110304
.pdf.
7
Ben Broadbent, “Conditional guidance as a response to supply uncertainty”,
23 September 2013,
http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech678.p
df.
8
See Robert Gordon, “Is US Economic Growth over? Faltering innovation
confronts the six headwinds”, National Bureau of Economic Research Working Paper
18315, August 2012, http://papers.nber.org/tmp/99513-w18315.pdf.
9
See Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different:
Eight Centuries of Financial Folly (Princeton and Oxford: Princeton University Press,
2009) pp.231-2.
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10
See Paul de Grauwe, "The Governance of a Fragile Eurozone." CEPS
Working Documents, Economic Policy, 4th May 2011,
http://www.ceps.eu/book/governance-fragile-eurozone and de Grauwe and Yuemei Ji.
“Panic-driven austerity in the eurozone and its implications,” 21st February 2013,
http://www.voxeu.org/article/panic-driven-austerity-eurozone-and-its-implications.
11
European Central Bank, “Speech by Mario Draghi, president of the
European Central Bank, at the Global Investment Conference in London,” 26th July
2012, http://www.ecb.int/press/key/date/2012/html/sp120726.en.html,
“Introductory Statement to Press Conference,” 6th September 2012,
http://www.ecb.int/press/pressconf/2012/html/is120906.en.html and “Technical
Features of Outright Monetary Transactions”, September 6th 2012,
http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html.
12
Laurence Kotlikoff, Jimmy Stewart is Dead: Ending the World’s
Ongoing Financial Plague with Limited Purpose Banking (Hoboken, NJ:
John Wiley & Sons, 2011).
13
Jaromir Benes and Michael Kumhof, “The Chicago Plan
Revisited”, WP/12/202, International Monetary Fund, August 2012,
http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf, op. cit., pp.1719.
14
Adair Turner, “Credit, Money and Leverage: What Wicksell, Hayek and
Fisher Knew and Modern Macroeconomics Forgot”, Stockholm School of Economics
Conference on “Towards a Sustainable Financial System", 12 September 2013,,
http://www.princeton.edu/jrc/events_archive/repository/credit_money_turner/Credit_
Money_Leverage.pdf.
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15
Andrew Haldane of the Bank of England discussed many of the most
important problems in his Wincott Lecture of 2011. See Andrew Haldane, “Control
rights (and wrongs)”, Wincott Annual Memorial Lecture, 24 October 2011,
http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech525.p
df.
16
See, on the minimum required capital ratio, David Miles, Jing Yang and
Gilberto Marcheggiano, “Optimal Bank Capital”, External MPC Unit. Discussion
Paper No. 31: revised and expanded version. April 2011,
http://citeseerx.ist.psu.edu/viewdoc/download;jsessionid=DA5FA4A3231E2B8A6263
D1A4035C469A?doi=10.1.1.193.8030&rep=rep1&type=pdf.
17
See Anat Admati and Martin Hellwig, The Bankers’ New Clothes: What’s
Wrong with Banking What to Do about It? (Princeton and Oxford: Princeton
University Press, 2013).
18
Independent Commission on Banking, Interim Report: Consultation on
Reform Options, April 2011, http://s3-eu-west-1.amazonaws.com/htcdn/InterimReport-110411.pdf, Figure 4.1, p.69.
19
Adair Turner, “Financial risk and regulation: do we need more Europe or
less?”, 27 April 2012, Financial Services Authority,
http://www.fsa.gov.uk/library/communication/speeches/2012/0427-at.shtml.
20
Stephen G Cecchetti and Enisse Kharroubi , “Why does Financial Sector
Growth Crowd Out Real Economic Growth?” September 2013,
https://evbdn.eventbrite.com/s3-s3/eventlogos/67785745/cecchetti.pdf.
21
“Greenspan concedes to ‘Flaw’ in his Market Ideology”, 23 October 2008,
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ah5qh9Up4rIg .
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