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MEMORANDUM FOR
Minister of Finance
FROM
Alan Bollard
Governor
DATE
21 December 2011
SUBJECT
Briefing for Incoming Minister – Appendix
What Lessons Have We Learned from the GFC1
FOR YOUR
Information
The world’s recovery from the crisis has been disappointingly slow and fragile. History
suggests that it will take several years for economies to work off their debt overhang,
and that over that period they will continue to suffer through asset price adjustments.
Events in the eurozone also suggest that it is too early to call an end to the crisis.
Figure 1: Post-crisis recession was long and deep
(Annual growth in real GDP)
While our understanding of the crisis is still developing, we should take stock of how the
lessons learnt thus far can improve policy and enhance the resilience of our financial
system. Crises tend to be unpredictable and triggered differently each time. In an ever1
Principal author: Richard Sullivan, Adviser, Economics Department
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changing environment, the challenge is to have institutions capable of taking on board
those lessons and acting swiftly to deal with problems.
Among the lessons, the crisis brought home the dangers of allowing credit or housing
booms to gather speed. It highlighted the importance, when those booms unwind, of
short-term regulatory forbearance to avoid a credit crunch. Allowing banks to use
buffers rather than requiring banks to maintain regulated minimums of capital and
liquidity at all times can, to some extent, limit the spread of problems from individual
institutions to the wider economy and financial system.
A big unknown is the extent to which behaviour has fundamentally changed, and so
how debt burdens will affect the recovery of investment and consumer demand. In the
wake of the crisis, households and firms have restrained their spending in order to
reduce their debt exposure. Many households may now be poorer in real terms than
when they took on debt, and have lowered their expectations of future income. These
are issues we are keeping a close eye on.
A reasonable argument can be made that what is now known as the GFC in fact had its
seeds planted in past crises and policy responses – notably the East Asia Crisis in
1997/98 and the bursting of the tech bubble a couple of years after that. This reminds
us that we need to be wary of what our policy actions now might imply for the
development of new imbalances in the future.
The major lessons can be categorised as follows:
1. International crises will affect New Zealand
New Zealand’s geographical isolation is no protection from economic events abroad. If
major world economies have a significant economic problem then that is going to affect
us too. New Zealand’s export commodity prices and currency swung wildly in the
aftermath of the crisis, with little connection to the country’s underlying fundamentals.
When problems in the global economy involve banking and financial crises, the overall
economic impact is going to be worse and recovery slower. If the banking system
manages to transfer its liabilities on to Government, then it is going to be very much
worse again, further prolonging the period of economic adjustment. Rogoff and
Reinhardt’s ‘This Time it is Different’ suggests that where banking crises are involved, it
takes economies several years to recover (like in the 1930s Depression) whereas
recoveries post-war have typically taken several quarters..
Experience shows that regions cannot ‘decouple’ themselves from global financial
events, though the timing and transmission of shocks can be quite different. For
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example, New Zealand’s increasing reliance on Asia as a trading partner reflects export
market flexibility and has helped growth, but could not shield us from the slowdown in
world demand, or the drying up of financing, even if it has meant a smaller drop in
demand for our exports.
When large economies take remedial measures such as the bailouts in the eurozone
and quantitative easing in the United States, it can have major distortionary effects on
New Zealand. Such measures affect financial market pricing, access to credit and
international capital flows.
On the financial side, New Zealand’s main vulnerability has been, and remains, its
large external debt position. During the late 2008-early 2009 period, and again
recently, our banks have experienced difficulties raising term funding and have faced
large increases in pricing. The Reserve Bank’s new prudential liquidity policy,
introduced in 2010, has helped to reduce this vulnerability by requiring banks to hold
more ‘core funding’ (i.e. retail deposits and long term wholesale funding). However, the
underlying vulnerability will remain until New Zealand achieves a sustained
improvement in national savings.
While we have found that it is very difficult to predict such crises or to model them
afterwards, academics continue to work on this in the light of the plethora of new data
generated in the last few years.
2. The world balance has moved
The GFC has changed the balance of economic power, particularly between debtor
and creditor countries. The GFC likely implies an end to cheap money from Emerging
Market Economies (EMEs). Further, how to share the burden of the crisis between
EMEs and advanced economies is a complex problem, and the discussion could be
tense.
In the eurozone there is huge tension between an economically strong core and a
financially weak periphery. Survival of the eurozone is likely to require significant
moves in the direction of a fiscal union. The United States is consumed with the
problems of slow recovery, debt ceilings, fiscal stress, demographic pressures.
Questions are also being asked about the future role of the US dollar as the dominant
international reserve currency. The credit downgrade and the upcoming Presidential
election mean that economic policy and the economy will be internally-focussed for the
foreseeable future, and not an engine of global growth.
The role of the EMEs is growing with their economic size, commodity demand, rising
consumption and large holdings of foreign reserves. But their part in international
policy coordination, and increasing influence over international economic policy more
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broadly, will not be achieved easily. The major industrial powers continue to dominate
the International financial Institutions and there is not yet an adequate international
coordinating mechanism for issues such as exchange rate policies. Emerging
countries have become trade powerhouses, but don’t have financial markets to match,
and this could become problematic if the eurozone region quarantines itself.
Finally, the policy responses of the major economies can have a major impact on the
efficacy of smaller country policy responses. The main example of this has been the
very easy monetary stance of the US Federal Reserve which has weakened the US
dollar and kept currencies such as the NZ dollar high even though local domestic
policies have been accommodative.
3. Both monetary and fiscal policy have important roles to play
Monetary policy
Monetary policy can be effective when operating in normal territory (i.e. when nominal
interest rates are positive, and so can be cut if needed in response to falling activity
and inflation). Positive inflation and positive inflation expectations help sustain positive
nominal interest rates over time.
Inflation targeting has indeed allowed scope for big cuts in interest rates around the
world over the last few years. But with the ‘zero bound’ coming into play in some
advanced economies – policy interest rates near zero with no scope for further cuts –
and little threat from underlying inflation, there is likely to be less focus on inflation
targets over the next few years in those economies.
Quantitative easing (QE) and other unorthodox monetary policy tools have been
employed abroad and are worth considering at the zero interest bound. However, they
have unpredictable effects – carrying some funding and behavioural risks, and may be
hard to exit. Where QE has been employed it is still too early to judge the overall
impact.
If there are country-specific sources of economic stress, a flexible exchange rate helps
adjustment. In late 2008 the New Zealand the exchange rate was able to cushion the
effect of sharply falling commodity prices. In the eurozone at present, many peripheral
countries are finding it very hard to adjust without the benefit of a flexible national
currency.
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Figure 2: A flexible exchange rate aids adjustment
Index
Index
320
75
300
280
70
260
240
65
220
200
60
180
160
55
140
120
2002
ANZ Commodity Prices (world prices)
2004
2006
NZD TWI (RHS)
2008
50
2010
However, many small open economies – notably EMEs – have suffered damaging
international exchange rate pressure as a result of large capital flows in the lead-up to
and following the GFC. This has prompted considerable analysis of capital flows in
EMEs and potential measures to moderate their influence.
We have also learned about the effectiveness of various exchange rate interventions,
ranging from a variety of capital controls to ‘successful’ interventions like the Swiss and
‘unsuccessful’ ones like the Japanese.
Central banks should worry about asset price inflation. In particular housing has been
of special concern this time. Macro-financial policies may be a useful adjunct in the
next boom, but their effects are not yet well understood and they have a limited role
during this stress period. Good bank regulation is crucial, but it needs to be prepositioned, and regulating and resolving complex institutions is difficult.
The global financial crisis has highlighted the ongoing difficulty of real time interaction
between applied economic research, modelling and policy formation. It also highlighted
new areas of research and central bankers need to formally incorporate lessons into
their policy consideration. Monetary policy research and application has traditionally
focussed on growth and cycles and the assumption that stability in prices and activity
implies broader stability. We now know that macroeconomic models need the ability to
incorporate financial market developments, desirably linking banking and housing
sectors, with appropriate agent heterogeneity. The Great Depression brought new
thinking on labour market frictions; we now need to reassess financial frictions and
market imperfections. We need to better understand the micro foundations of financial
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failures, and the pressure that can result on fiscal policy. Models must better allow for
non-linearity and sudden stops, and also the international transmission of financial
contagion. We need ways to incorporate asset price and credit flows into monetary
policy, and to analyse the effects of monetary policy at the zero lower bound.
Fiscal policy
A major crisis can deliver a severe combination of reduced revenue, higher transfers,
and bank debts on to a government’s balance sheet. That exposes other structural
problems like population ageing and long-term savings and investment imbalances.
Fiscal policy can provide useful stimulus if the recession is deep and/or long enough,
but needs to be swift and credibly sun-setted. Fiscal policy also needs to be determined
cognisant of the like monetary policy reaction. This requires a strong fiscal position and
effective institutions leading into the crisis, otherwise it leads to longer term structural
and financing problems.
Public borrowing capacity is being much more tightly constrained by credit ratings, fiscal
projections and market discipline. Sovereign debt markets look to have ultimately borne
the brunt of the GFC as private institutions have required government assistance, and
governments have also increased deficits in response to weak activity levels. The crisis
seems to be manifesting itself in a ‘slow-burn’ way, and financial markets have
reassessed their capacity to fund large and growing levels of government debt. This
limits what governments can do to stimulate economies in the future if there were to be
a double dip.
The sovereign funding markets have put a premium on public transparency, foresight,
exchange rate flexibility, credible debt management, and good political economy.
Governments are consequently becoming more focussed on producing structural
budget balances, or at least a timeframe for achieving these.
Savings policy has become a more topical issue, with a realisation that privately-optimal
outcomes may not always be socially-optimal, because it has become clearer that
pressures from demographic trends, sovereign funding, and household rebalancing all
point to more focus on private savings.
Statistics take on a new importance during crises, especially on balance sheets and
credit. This has exposed some big gaps in NZ balance sheet data. The Bank is
currently engaged in a project to improve the measurement of institutional balance
sheets.
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4. Major crises impose large demands on lawmakers
There could be more stress between executive and legislative arms of government, and
between politically and technically acceptable solutions to economic stress.
We should not assume that politicians can always act in the interests of short-term
stabilisation (e.g. Greek Conservative opposition to austerity, Washington gridlock on
debt ceilings). In the medium term, political stances will need to respond to market
pressures, but getting to the point of sustainable fiscal policies could be a rocky road in
some countries.
There is more public concern and engagement on economic and financial problems,
e.g. the ‘Occupy’ movement. Social media are playing a new role in reflecting public
concerns about crisis and debt.
5. Lessons on bank regulation
During good times, bank governance is very important, and tail-end risk on bank
balance sheets – the risk from very large but ex ante low-probability events – can be
very hard to calculate. In particular, small open countries need to be careful of the size
and ambitions of their banking sectors (e.g. Iceland, Ireland, Cyprus).
The GFC demonstrated that under certain circumstances, banks need more capital and
longer maturity funding to ensure survival in tough times. The increasing global
interconnectedness of the financial system appears to have made each national system
more susceptible to global shocks, despite the efforts of financial institutions to diversify
their risks. Accordingly the international regulators have agreed to bolster the minimum
capital adequacy and liquidity requirements of banks, as set out under the ‘Basel III’
proposals on prudential standards. The Bank expects these new standards to be
broadly applied to the New Zealand system, with some tailoring for local circumstances.
The crisis has shown that we cannot rely on good peace time home-host regulatory
arrangements staying cooperative; during a crisis short term national interests
predominate. In particular, in any future bank funding crisis, we must expect that the
Australian regulators will strictly enforce their limits on the lending of parent banks to
their New Zealand subsidiaries.
During a crisis, stresses on bank balance sheets are correlated, sometimes in
unexpected and uncontrollable ways. The larger and more complex the institution, the
more difficult the regulatory task becomes. The issue of ‘too big to fail’ needs to be
addressed. For this reason the Bank is focussing on alternative ‘failure resolution’
options as well as bolstering prudential standards. In particular, the Bank is requiring
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the large banks to pre-position for its ‘Open Bank Resolution’ (OBR) policy in order to
give the Minister a realistic alternative to the full bail-out of a failing systemic bank.
Government guarantees for banks can end up being very costly on government balance
sheets, and they distort bank incentives. But funds are mobile, and competitive
implementation of guarantees internationally can leave a country like New Zealand with
limited choice but do so also.
Central banks have learned a number of ways in which they can use their balance
sheets to provide liquidity to stressed institutions and to further stimulate the economy.
But the ultimate objective for central banks should be financial system stability not
propping up individual institutions. And there has been a lot of interest in new macrofinancial tools. These do not represent silver bullets, but look as if they could be useful
to assist in slowing a future asset/credit boom.
Fortunately, the New Zealand banking system was relatively well-positioned to handle
the GFC. The major banks all have similar risk profiles; their predominant risk
exposures are to the local housing market and to agriculture, two sectors that
experienced only quite limited loan losses. We are alert to the possibility that the next
crisis could impact these sectors in a more systematic way and have moved to enforce
capital requirements (under the Basel II framework) that are relatively conservative by
international standards.
The crisis also highlighted the importance of bank supervisors having access to timely
information on liquidity and credit quality. The Bank has implemented a framework for
swift private reporting of key metrics.
In a modern retail bank crisis there is still likely to be a rush to cash. Central banks
should hold significant reserves of high denomination notes to meet ‘store of value’
demand in times of uncertainty. It was the very high denomination notes that were
demanded around the world, and demand was higher and more persistent in many
countries than in New Zealand. Outstanding stocks of cash have stayed high in some
countries.
The GFC cash experience and the Christchurch earthquake supported the view that
countries with a high use of electronic methods of payment (like New Zealand) are more
vulnerable with respect to the need for cash in crises because many people hold very
little cash. Consequently, countries like New Zealand need to hold higher levels of
reserves and they need to be readily available.
We should not over-state what bank regulators can do. Sophisticated international
regulators were unable to predict and control the crisis. Financial innovation was, and
will continue to be, an integral part of a growing banking sector. The next crisis will be
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different, but as in the past, will likely involve the less-regulated parts of the financial
system. Regulators must be as innovative as the practitioners.
Payment and settlement systems could have presented big operating risks during the
GFC. Instead the ‘plumbing’ held up very well, coping with surging flows and market
disruptions.
It was very useful to be a ‘full service’ central bank during the GFC. The Reserve Bank
had good information flows, could share them internally, and had a wider range of policy
tools that could operate in concert. In addition relationships with the Minister of
Finance, the Treasury, other regulators and the banks themselves all need to be close,
and will be tested, in such a crisis.
6. Behaviours are changing
In many countries, including New Zealand, the crisis experience has changed
householders’ views with regard to consumption, saving, debt and leverage, housing,
balance sheets, and employment security. Businesses have seen some recovery in
earnings, but are proving very cautious about new hiring, borrowing and investment.
Both households and businesses have attempted to reduce their debt exposure.
However, it takes a very long time for economic agents to reduce the proportion of debt
on their balance sheets, especially in the household sector when house prices are
falling. This means that over-investment and high leverage can take a long time to
clear.
At the same time, banks have become very cautious about lending volumes and risk, so
reducing their willingness to lend. They are building up capital and liquidity, partially in
response to tougher regulatory requirements but also because they are concerned
about future market funding and rising risk premia. The supply of domestic savings to
banks is assuming a new importance.
As mentioned above, Governments are relearning the virtue of having good quality
balance sheets, and the risks of taking on uncapped risks from the banking sector.
7. Markets react differently in times of crisis
International equity markets are linked and anticipate economic and financial events.
They hold useful predictive value and can move very fast in crisis and recovery.
Exchange rate, housing and other asset markets move in concert, but can over/under
shoot for prolonged periods and don’t always follow economic fundamentals in a
predictable way. The markets can be difficult to read.
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Commodity markets have become increasingly important, and increasingly driven by
political economy, climate, emerging market demand, small inventories and financial
trading. Prices look to be on an upward trend, but volatility will continue.
Bond markets are huge, and increasingly dominated by movements in risk premia.
Spreading yields demand immediate action. The AAA bond market has contracted
hugely, with fewer and fewer issuers able to attract high ratings.
Funding markets (even highly liquid conventional ones) can freeze up under stress,
despite the apparent availability of funds and credit-worthy borrowers. The fragility of
market liquidity, irrespective of the apparent depth of the market, was a major new
lesson from the GFC.
Sovereign debt markets are the markets of last resort, where banks have managed to
transfer unfunded liabilities to governments and governments have issued debt to fund
the transfers. Stress in these markets can exhibit itself in slow-burn ways (cf bank debt
markets where flare-up is faster).
8. Someone has to pay
At its peak the GFC constituted the world’s largest ever loss of wealth, particularly
caused by value loss in equities and housing. Some home-owners have had to face a
brutal re-assessment of their own wealth and prospects. Further, taxpayers have ended
up bailing out bank shareholders and other, often supposedly sophisticated, investors,
and they are starting to revolt against this.
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Figure 3: Falls in house prices contributed to massive losses of wealth
(House price Index = 100 in March 2007)
The current business cycle is showing up as a recovery in returns to capital but not to
labour in a number of countries. That is not unusual at this stage of a cycle, but this
time the recovery is very slow. And within a depressed labour market there are big
inter-generational impacts. Long term unemployment has risen. People around
retirement age are realising they will have to work longer due to pressures from both
fiscal consolidation and reductions in household wealth. Meanwhile, younger people
cannot compete with this experience in the job market and are being discouraged from
participating in any recovery.
Outlook
The current economic recovery is very slow and fragile and there will be more problems
ahead; it may take some years to get back on to the previous growth track. We must be
wary of the as-yet unknown lessons from the crisis. Even after three years it is still early
days and we don’t know enough about the GFC and its consequences to fully assess all
the lessons.
The seeds of this crisis were laid in past ones (especially the East Asia Crisis and the
Tech Wreck). If we are not careful, our responses to the current crisis could be laying
the seeds of the next crisis.
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