The Global Crisis started ten years ago and proved a turning point in global economic policy. CEPR organised a high-level conference to discuss whether the regulatory reaction has been sufficient and where the next crisis might come from. This column summarises the conference discussions and introduces a set of video interviews with leading economists at the conference, including Paul Krugman, Anat Admati, John Vickers, Paul Tucker, among others.
A decade on from the Global Crisis, consensus on policy responses is finally emerging as the narrative of the event takes shape. The conference, "Ten years after the crisis: Looking back, looking forward", organised by CEPR in collaboration with the Brevan Howard Centre for Financial Analysis and hosted by EY, took place in London on 22 September 2017 and addressed how perspectives have changed over the last decade, and how policymakers can prevent another crisis of this scale.
Mario Monti, former prime minister of Italy, opened the event with some personal observations on both the Global Crisis and the Eurozone Crisis. Within five years of the advent of the Crisis, the policy debate across Europe on tackling it focused on demand management and monetary policy. Despite German reluctance, public investment was an important and undeniable policy goal. But given that different countries needed different treatments, it was difficult to agree on one common policy. Eventually, through many more negotiations, a unanimous resolution was reached, affirming the Eurozone’s conviction to do what was necessary to ensure financial stability, with some caveats.
But in the years since, problems of insufficient public investment – and problems with the Stability and Growth Pact – have persisted. In particular, there have been numerous violations of the 3% deficit rule – including by France and Germany. The Pact threatens to divide North and South Europe – the former objects strongly to any violations of which it is not the protagonist, while the latter objects to the rules themselves. In Monti’s view, Europe now has a window of one or two years in which the Pact must be renegotiated, which should include a reconsideration of public investment. Such a review will provide members with myriad flexibilities that would erode the credibility of the ECB, and if previous experience is anything to go by, it could take years for any changes to have a practical effect. Ten years ago, Europe believed itself invulnerable to crisis. In the wake of rising populism across the Anglo-Saxon world, continental Europe has become the voice of rationality. It must resist the temptation to commit the same mistakes again.
Watch Mario Monti below
Financial stability: Has regulatory reform gone far enough?
The day’s first panel session considered the success of regulatory reform, and whether or not it has gone far enough in response to the Crisis. Vittorio Grilli (JP Morgan and CEPR) argued that the success of regulatory reform could be assessed in four contexts: the amount of risk currently in the system, the trade-off between regulation and growth, the economy’s resilience to future shocks, and the frontiers between regulated and unregulated areas of the market. There has been considerable success, for example in too-big-to-fail (TBTF) policies. But some issues remain unaddressed, such as homogenising regulation on a Europe-wide and global level in order to promote growth. As financial activity migrates from the banking to the non-banking sector, policy must also make Europe a safer world with more participants. Current levels of fragmentation within the market indicate regulation has a long way to go in making Europe resilient to another crisis.
Catherine Mann (OECD) argued that the success of regulation should be measured in terms of growth, risk, and equity (i.e. income equality) – with inherent trade-offs between these targets. Financial regulation typically presents a balance between growth and risk, and as different countries pursue different policy sets, cross-border incompatibilities inevitably occur. Examples of incompatibilities that are not inclusive are TBTF, which lowered risk at the cost of growth; a wage premium across all jobs in the finance sector being a symptom of inequality; and ‘zombie’ firms capturing resources that banks could then not reallocate to more productive areas. Prior to the Crisis, policy focused predominantly on growth, but since then it has turned to address risk, somewhat at the cost of other targets. In particular, economic policy must become more inclusive of equality considerations.
Watch Catherine Mann below
In terms of capital reform, John Vickers (University of Oxford) argued that a major discrepancy exists between official and academic views of the success of regulation, arising from different measurements of leverage in the economy. While the Bank of England’s position is that banks are now subject to much higher standards of capital requirements, this is based on the book values of broad assets whereas, in reality, price-to-book value ratios have consistently been less than one throughout the post-Crisis period. Raising the capital requirements also presents costs to banks and to society that are unaccounted for by the Bank’s position. Additionally, the Bank’s assessment of capital requirements was based on ‘normal risk’ assumptions, which is a poor context for preparing to mitigate another crisis.
Watch John Vickers below
Key issues: Too big to fail, derivative markets, shadow banking
The second panel addressed the three major issues of regulation: the too-big-to-fail question, derivative markets, and shadow banking. Tamim Bayoumi (IMF) argued that the roots of the Global Crisis date back to the 1980s. First, due to regulation changes such as the 1996 Single Market Act, banks (particularly European ones) grew to be too big to fail as they increased the use of capital to expand balance sheets. This remains the case today, as despite ECB supervision, banks continue to be allowed to use internal risk models. Second, 1970s inflation and the migration of wholesale deposits led to the advent of the shadow banking system – as deposits moved, so too did loans from more regulated (commercial) to less regulated (investment) environments. With the SEC expansion of repos, mortgage-backed securities became an instrument for liquid assets rather than providing housing.
Watch Tamim Bayoumi below
Charles Goodhart (LSE and CEPR) argued that post-Crisis monetary policy failed to address moral hazard in two ways. First, many economists had advised that leverage ratios needed to be increased in the aftermath of the Crisis, but did not prescribe how this should be done. Rather than raising equity, banks opted to reduce loans, without much consideration of the transitional effects. Second, the massive fines imposed on many banks failed to punish the actual perpetrators. Thus, no policies efficiently reduced systemic risk. Possible remedies would be to remove limited liability from senior shareholdings and to readdress the fiscal imbalance, without which systemic risk cannot be lowered.
Watch Charles Goodhart below
Tom Huertas (EY) argued that mandatory clearing amplifies systemic risk despite reducing the probability of systemic collapse. As mandatory clearing causes systemically important banks to be more exposed to central counterparties in return for being less exposed to each other, it means that if a central counterparty fails and cannot be resolved, the impact of a systemic collapse would be far greater than without the mechanism.
Watch Tom Huertas below
The conference’s keynote speech was given by Professor Paul Krugman (City University of New York and CEPR), who discussed several bad policy models which were adopted during the Crisis, instead of Keynesian responses being implemented and their effects waited for. Proponents of each type of policy are reluctant to admit their mistakes, and economists in favour of the Keynesian treatment have not been vocal enough. Krugman gave examples of four such models that echoed policy mistakes made in the wake of the Great Depression.
First, ‘Austrianism’ policies assumed that ‘bust’ periods paid for the excesses of booms – echoing arguments that the Great Depression was the ‘morally required’ aftermath of the sins of the 1920s. But such a cycle would be accompanied by resource transfers from less productive to more productive industries, increasing region- and industry-specific unemployment. During the Crisis, unemployment increases were cross-regional, and cross-industry. Second, proponents of ‘structuralism’ asserted there was no way unemployment could fall back below 5% in the US after the Crisis. The same argument made during the Great Depression was disproved by the onset of WW2. Third, the ‘Treasury view’ posited that fiscal policy could not be used to stimulate demand, which also did not hold up to the US experience at the start of WW2. And while measuring the success of fiscal policy is difficult due to its endogeneity, the use of austerity in the Eurozone has proven to be a good natural experiment. Some proponents of the Treasury view suggested that government borrowing would increase interest rates, counter to the Keynesian model. Recent experience has shown the latter to be correct. Finally, ‘monetarism’ – the idea that large increases in the monetary base would lead to higher inflation – has found significant political support, in particular recently. Such views have been disproved over time.
Watch Paul Krugman below
Where could the next crisis come from? Advanced and emerging economies
The third panel explored the potential causes of the next global crisis, particularly in the divergent contexts of advanced and emerging economies. Christian Thimann (AXA) argued that the last crisis was preceded by a general feeling of complacency – an exuberance not seen today. But three areas where the ingredients of a potential crisis do exist are geopolitical tensions (e.g. rising nuclear tensions), demographic change (e.g. the low-income retirement crisis), and financial markets (albeit differently from a decade ago). In response to the Crisis, many of the reforms in regulation addressed the banking sector, but short-term stabilisation here has come at the cost of a long-term impact on lending and project finance, which drive real social and economic value.
Watch Christian Thimann below
Paul Tucker (Harvard University and Systemic Risk Council) pointed to the regimes for maintaining financial systems, which either have cracks appearing or improperly working incentives, or are missing altogether. Two examples of this are the Basel III capital requirements calibration, which did not leave room for the possibility that ten years on economies would still be anywhere near the zero lower bound, and the lack of regime for managing shadow banking, a missed opportunity given that bank incentives encourage non-bank activity. An effective regime would properly address accountability and capitalisation within the banking sector. Until such a regime comes together, we remain vulnerable to a repeat of the Crisis.
Watch Paul Tucker below
Shang-Jin Wei (Columbia Business School and CEPR) argued that the risk of another crisis is more present in emerging markets than the developed world. China’s economy presents huge potential for global spillovers. Risk is present in the economy’s substantial corporate debt – although China is in a good position to consolidate its assets and liabilities in the event of a downturn – and in housing, as housing collapses are usually accompanied by consumption declines. But in China’s case, the housing boom was not accompanied by increased consumption. Alongside China’s huge social housing plans, which will bolster input demand in the event of a downturn, this risk is also mitigatable.
Watch Shang-Jin Wei below
Perspectives now and in 2007
The final session of the day made a wider assessment of how perspectives of the Crisis have changed from its advent in 2007 to today. Anat Admati (Stanford Business School) argued that financial corporate governance has not been sufficiently reformed. Banks have been fined for their misdeeds, but continue to make large profits – and while ‘credit’ is perceived as a positive thing publicly, any money banks pay in dividends could have been put to more productive use elsewhere.
Watch Anat Admati below
Randy Kroszner (University of Chicago, Booth School of Business) agreed that incentives have not been sufficiently adjusted since the Crisis, demonstrating a lack of awareness. Perspectives in the last decade have changed insofar as the broad directions policy must move towards – e.g. more capital, better incentives and accountability – are now acknowledged, but any solution still eludes an ideal method of implementation. For example, central banks are perceived as being able to do whatever it takes – a credibility the banks are keen to take on themselves – but this can result in over-promising, and “the path to hell is paved with good regulatory intentions”. This over-commitment of the central banks is where problems may arise in the future.
Klaus Regling (European Stability Mechanism) was more optimistic. He argued that the next crisis will not come from the same place as either of the last two crises – global and European – either in terms of geography or financial markets. Europe in particular has responded well in several ways, including the ECB’s contribution, troubled countries (except Greece) going to great lengths to solve their problems domestically, fiscal expansion, the creation of the ESM, and the sum of different measures (of which monetary policy is one part). As a result, the EU recovery has been strong.