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Thursday, 3 July 2008

Martin Wolf: the lessons from today's financial crisis

"We told you so." The Bank for International Settlements has long warned of the dangers of unrestrained credit growth and asset price inflation. In this year's annual report, the last to be prepared under the direction of William White, its long-serving Canadian economic adviser, it felt free to point out how right it had been. But it did so with restraint: "Rather than seeking to apportion blame," it says, "thoughtful reactions must be the first priority."

The report provides just such reactions. But it also describes the mess created by those who ignored its earlier warnings. "The current market turmoil in the world's main financial centres is," it claims, "without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless."

As readers of BIS annual reports would expect, this one gives good answers to four big questions.

First, why did it happen? The report states that "loans of increasingly poor quality have been made and then sold to the gullible and greedy, the latter often relying on leverage and short-term funding to further increase their profits. This alone is a serious source of vulnerability. Worse, the opacity of the process implies that the ultimate location of the exposures is not always evident."

Obviously, internal governance and external oversight were deficient. "How," asks the report, "could a huge shadow banking system emerge without provoking clear statements of official concern?" How, indeed? Moreover, one of the features of the crisis is how widely distributed securitised loans turned out to be. The resulting uncertainty about who owns them, along with parallel uncertainty about what they are worth, has blighted money markets for almost a year (see charts).

Yet, insists the report, the drivers were not so much new inventions as old errors: a long period of easy money, asset price inflation and rapid credit growth. I have much sympathy with this view, along with its corollary, that central bankers bear part of the blame, with a caveat. As I argued in a speech * at a BIS conference last week, the "savings glut" and reserve accumulations by exchange-rate-targeting countries also explain the low long-term real interest rates and monetary easing of the US in the early 2000s.

This then brings us to a second question: how big are the risks now?

The answer is: very large. This is partly because the world economy is poised between deflationary financial and house-price collapses in several high-income countries and an inflationary global commodity price boom. Just as striking are the many huge uncertainties. Will the recent surge in commodity prices prove to be a short-term bubble or long-lasting? Will US households cut back sharply on consumption, which ran at 70 per cent of gross domestic product between 2003 and 2007? Can the deleveraging of the US and other high-income countries occur smoothly, without high inflation? How much more bad debt is still to emerge? Will emerging economies suffer such big inflationary surges that they will be forced to abandon intervention in currency markets? If so, will long-term interest rates jump in the US? Are emerging economies more vulnerable to the slowdown in US imports than many now believe? When will financial markets recover? Are equity markets adequately assessing the risks ahead?

The divergence in possible outcomes is so large that nobody can credibly claim to know what lies ahead. The combination of a massive re-rating of risk with global inflationary pressure is unprecedented and still quite scary.

The third big question is what policies we need right now. The BIS view is that the right bias in monetary policy is towards being "much less accommodating". Better, it suggests, a sharp global slowdown than a big inflationary upsurge. I agree. But, as it also stresses, in today's varying circumstances, one monetary policy cannot fit all. Each central bank must assess domestic conditions. This is itself a good reason for larger emerging countries to abandon exchange-rate pegs.

Yet the report does dare to raise a telling question about the US Federal Reserve's policy of judging what to do in terms of "insurance" against unpleasant outcomes. The danger with this approach is that, if the extreme outcomes are unlikely, Fed monetary policy is likely to be seriously wrong much of the time. The BIS also stresses the need for policymakers and private actors to recognise reality: "If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off."

The fourth and biggest question concerns the lessons we need to learn. Some instability is a normal part of a capitalist economy. But I do not accept that the huge bubbles in equities and housing over the past decade are normal. Moreover, even if normal, they cannot fall within any definition of desirability.

The most interesting part of the BIS analysis of the lessons is that it focuses not on what is new - the paraphernalia of the modern financial system - but on what is old - "the inherent procyclicality of the financial system and excessive credit growth". The important point here is that fiddling with details of the regulatory regime or tightening supervision of individual institutions is not the heart of the matter. What matters is the operation of the system as a whole.

This is why the BIS takes such a strong stance on the need to tighten monetary policy when credit growth soars and asset prices explode, even if that temporarily reduces inflation below target levels. This, argues the BIS, would be a more symmetrical use of policy instruments. It is also why the report stresses "macroprudential" policies. These would focus not on the misbehaviour of specific institutions but rather on systemic risks, such as their shared exposure to common shocks and possible adverse interactions among and between institutions and markets.

The aim is clear: it is neither to prevent institutions from going bust nor to eliminate the cycle of boom and bust. The former is undesirable and the latter impossible. The aim is to reduce the frequency and severity of crises. It is not enough to say that we can clear up afterwards. That is too complacent and too one-sided.

We do not have all the answers. But, to its great credit, the BIS has at least defined the right questions.

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