Only a year or so ago, the global economy as a whole was looking in pretty
good shape. Although there were some dark clouds on the horizon, they did
not seem to be immediately threatening. But then the sudden storm hit global
financial markets last summer, a stark reminder that economic and financial
stability go hand in hand. There cannot be one without the other.
With the benefit of hindsight we all should have seen the storm coming. In the
face of the economic slowdown in the industrial world in the early years of
the decade, when inflation was generally under control, official interest
rates generally were reduced to abnormally low levels. That had already
given rise to potential social, as well as economic, concerns - a rapid rise
in household debt and rapidly escalating house prices in many countries. We
were very conscious of this internal imbalance in the UK and tried hard not
to do more than had to be done to keep the economy moving forward. But what,
perhaps, was not expected were the wider financial market consequences of
what came to be called the “search for yield”.
There were two sides to this equation. Those with money to invest showed an
increasing appetite for marketable debt assets yielding higher returns. That
provided an incentive for other financial intermediaries, notably banks, to
increase their earnings through fees on the origination of loans which might
initially be held on their balance sheets funded by borrowing in the
wholesale money markets, but which could then be sold down into the
market-place. And the banks were not at all slow to respond to that
incentive.
What followed was a dramatic increase in leverage on financial transactions
generally. At the same time there was a sharp and progressive narrowing of
spreads between higher and lower-risk debt instruments until last summer in
what can clearly now be seen as a widespread mispricing of risk.
That is not to suggest that the financial world went completely mad. New
financial instruments and techniques will no doubt have contributed to
economic activity, at least in the short term. And in principle the
spreading of risk ought to mean that, while individual financial
institutions can still fail, there is actually less risk of systemic crises
than before. But that is not what has been seen since last summer.
An important part of the explanation is that, as things have turned out, the
scale of debt origination and of selling the debt down across the global
financial services industry has reduced the transparency of the overall
extent of debt within the system as a whole. It has also obscured awareness
of where the risk has ended up.
Many had expressed unease about the “search for yield” for some time before
last summer. But no one, anywhere, to my knowledge, ever anticipated the
dramatic events that we saw last summer.
As it was, the surprising revelation of substantial US sub-prime losses in two
relatively small German banks prompted a frantic re-examination of the
possible scale of outstanding debt and where it might be located. The almost
instant reaction was a wholly unprecedented freezing up of the markets in
securitised debt instruments and in the wholesale money markets. Banks that
in fact had adequate liquidity were reluctant to lend. Many faced massive
writedowns as the price of their holdings fell. Not only did this affect US
sub-prime debt but marketable debt instruments more generally declined, if
indeed a market price could be identified.
Happily the big central banks have calmed things down in the wholesale money
markets. They have made very large amounts of liquidity available, for
longer periods, against a wider range of collateral, and at less penal rates
of interest. It's too soon to say that the systemic liquidity crisis is
over. But, as I see it, the central banks are very much on the job and have
things under reasonable control.
Many banks and other institutions have had to make massive provisions
reflected in their share price, and raised large amounts of additional
equity. Some senior executives have lost their jobs. It's been very tough.
But the only real catastrophe here in the UK has been Northern Rock, which
was an extreme case of reliance for liquidity on the wholesale debt and
money markets.
The debate about Northern Rock will no doubt continue to rumble on. It is
ironic that the queues of depositors wanting their money back started only
after the Bank of England had announced massive liquidity support which made
the depositors' money safer than it had been for weeks. The FSA, some say,
should have seen the problem coming. Frankly, I don't know of anyone who
did, and I don't see how one can expect the regulator to foresee what
happened when management doesn't.
Others say that the problem could have been avoided if the Bank of England had
acted more promptly and more discreetly than it did. But that seems wholly
unrealistic to me. And if the suggestion is that the Bank or the Treasury
should have acted to save Northern Rock as an independent entity, that, to
my mind, would have set a highly dangerous precedent, in terms of moral
hazard.
The uncomfortable fact is that the buck stops essentially with management and
shareholders. That may sound hard-hearted. But, if we move away from that,
we will revert to the days when the authorities were directly controlling
the financial system as a whole, which would certainly not be in our overall
economic interest.
There are, certainly, important lessons to be learnt from all of this. As far
as the authorities nationally and internationally are concerned, the need is
for greater transparency in our increasingly sophisticated and integrated
financial system. That may well involve greater co-ordination between
regulators as well as greater cross-border co-ordination.
The approach to liquidity risk management also needs to be reconsidered.
Regulators already set minimum liquidity standards, typically requiring
banks to hold sufficient liquidity to meet potential liabilities for a
period ahead. But, in measuring that liquidity, “marketable assets” are
regarded as immediately available cash (the assumption being that cash would
always be available to banks wishing to borrow against them or to sell
them).
The depositor protection regime also needs to be reviewed. There may well be a
case for increasing the size of the deposit protected and perhaps for
accelerating the compensation process. But there would be a point at which
depositors would simply place their deposits with whoever paid the highest
rate of interest, with more prudent depositors effectively being left to
pick up the tab in the event of a failure elsewhere.
The big question now is what impact will the financial turbulence have upon
the future evolution of the macroeconomy. There's no doubt that the
financial developments discussed here will contribute to a slowdown in the
rate of growth of demand. That is not necessarily a bad thing in that it
should contribute to reducing the external and domestic imbalances that
we've lived with for some time. The question is essentially one of degree.
Will it mean an absolute decline in demand and negative growth, or will the
slowdown be more modest?
There is reason to be hopeful that the central banks are now more on top of
the liquidity problem and the financial storm will blow itself out. The
repricing of risk is now under way; and many of the banks most severely
affected by substantial losses and writedowns have moved aggressively to
raise new equity. But it may take time before markets accept that this is
happening.
In the meantime, the big industrial countries face a macroeconomic policy
dilemma. The slowdown in demand growth associated with financial turbulence
is currently being compounded by the increase in inflation stemming from the
rise in world oil and energy, food and commodity prices. As demand growth
slows, so too should these inflationary pressures, but that too will take
time. In the meantime, inflation is likely to remain above target in the UK
and the eurozone, and higher in the US than I am sure they would ideally
like to see. That carries the risk that inflationary expectations may
escalate, affecting economic behaviour.
Maintaining stability, in the broad sense of balance between overall demand
and supply-side capacity to meet that demand, will not be easy over the next
year or two. But I'm reasonably optimistic, which is strong language for a
central banker, even a retired central banker, that it will be achieved
looking further ahead. That is because I'm convinced that the broad
political consensus on the overall approach to macroeconomic management
remains very much intact. But it won't be an easy ride.
Sir Edward George was Governor of the Bank of England, 1993-2003. This is an
edited version of a pamphlet, Banking on Stability: a framework for economic
success, published yesterday by Politeia.
