Had I been there in that room, this would have been my message to both the Finance Ministers and the bankers:
With every passing day, as asset prices rise and economies appear to stabilise, the sense of urgency for action is fading. But, that would be a pity. Critical issues thrown up by the 2008 global financial and economic crisis remain unaddressed. They need to be addressed if the world were to minimize the chances of another crisis and to put more time between that one and the last one.
First, it is worth reiterating that it was a global financial crisis. Explanations that focus on US-centric practices both within and outside the banking industry are incomplete. Housing bubbles happened in many countries. Many risky assets were priced to perfection. A fund manager travelled the world in January 2007 and wrote of the global nature of the bubbles that he saw.
Two main causes for the global nature of the bubble stand out. One is that interest rates were low and for long, in the US. Given the US dollar’s reserve currency status and its de facto influence on other countries via the exchange rate, monetary policy in other parts of the world was also too loose.
Asymmetric responses to economic contractions (quick to cut rates) and to economic expansions (rates normalizing too slowly) should be recognized as a principal sources of mispricing of risk.
Low short-term rates lead to mispricing of risk as it gives rise to excessive systemic leverage, boosting returns on financial assets, making them appear safer than they are. Credit ratings are at their best at the peak of the cycle. Counter-cyclical approach to ratings, to leverage ratios and to the pricing of risk is needed.
Low interest rates, mispricing of risk and the resulting excess financial returns lead to excess compensation in the sector. The problem is not that higher returns or profits generate higher personal income but that they are not risk-adjusted since risks manifest over time and not immediately.
Excessive personal incentives in the financial sector have also contributed to the depletion of talent in other parts of the economy. The world needs to create real assets to absorb the liquidity and money creation of the financial system. That requires allocation of resources (including human resources) to real sectors of the economy. For that reason alone, compensation practices in the financial sector should not get too far out of line with the rest of the economy. Further, they need to be risk-adjusted, as both gains and losses from risk-taking have to be borne by those who engaged in risk-taking.
That brings me to another point. One of the biggest grievances that the rest of the world has with our sector (I refer to the joint letter signed by many distinguished pro-market economists from across the world, as an illustration) is not that it played an important role in precipitating the economic crisis but that the losses generated by the sector have been passed on to segments of the population that had nothing to do with those losses.
In other words, one of the crucial tenets of capitalism – that rewards and losses for risk-taking have to be borne by those who knowingly took those risk – has been neglected in most cases in the post-crisis repair work. Going forward, such mechanisms have to be put in place before the event since, post-crisis, legitimate fire-fighting takes precedence over other normative considerations.
Lastly, the developed world experienced great moderation between 1982 and 2007 or at least for most of this time. Growth was stable and inflation rates declined. This was because, for the most part during this period, commodity prices declined, inflation rates climbed down, interest rates dropped from high levels in the early 1980s and demographic trends were favourable. These, together with regulatory attitudes, created conditions for the financial sector to assume a position of dominance in many respects.
These factors are unlikely to repeat themselves and more importantly, they are set to reverse too. For starters, the growth-inflation trade-off is unlikely to be as favourable as it was during that quarter-century due to resource constraints and given current state of technology. Therefore, it is reasonable to expect macro-economic volatility to rise rather than remain stable or decline.
In such a scenario, low cost of capital can create asset price bubbles that bear no relation to macro-economic reality. They would be sources of profound instability when they bust, as they inevitably do.
All the players in the financial system – public and private – have to be mindful of this risk. That is, they should factor that into their policies and practices such that financial markets (i.e., asset prices) hold a mirror to the real economy, and not become the tail that wagged the dog.
For better or worse, the US remains the intellectual fountainhead for the world of finance and capital markets post-War. If the global housing bubble was precipitated by the US monetary policy, the US credit bubble (housing finance bubble) was precipitated by its regulatory forbearance and imported by others to avoid regulatory arbitrage.
Hence, the United States has to play a role in the creation of a new balance between financial markets and the rest of the economy not only in the US but in the rest of the world too.
Originally published at The Gold Standard and reproduced here with permission.