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Lessons from the global financial crisis -Martin Wolf | Insights Vol 13 ...

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Lessons from the global financial crisis


The big lesson of history is that crises repeat themselves, that times of euphoria are when the conditions for crises emerge and that when the crisis hits, it is too late.
(Pages 5-13 of the printed journal) By Martin Wolf

The first indication that a significant financial crisis was about to hit the world came in August 2007. At the time of delivery of the Corden lecture, in October 2012, more than five years had already passed. Yet the crisis was still alive, particularly inside the eurozone, as it is at the time of writing, in late March 2013, though the indicators of extreme stress had calmed since the summer of 2012. In the affected high-income economies, nothing like a normal cyclical recovery had occurred. The crisis undoubtedly cast a long shadow. While it is far too early to know what its full significance might be, it is already clear that it is a watershed moment in the history of the world economy. As Dorothy says in The Wizard of Oz, "Toto, I've a feeling we're not in Kansas any more." In this lecture, I address three questions raised by the crisis. The first is: what has happened? The second is: why did this happen? The last is: what are some important lessons from what has happened? On none of these topics is the discussion comprehensive. It cannot be. But it does try to address some of the bigger issues raised by this important economic event.

What has happened?


From the summer of 2007, we watched a global financial crisis that affected economies that, in aggregate, amount to at least half of the world economy. Inside this broader event, we watched an intense regional crisis inside the eurozone. The same forces that drove the eurozone crisis also drove the wider global one. But the challenge of finding a satisfactory resolution has proved even harder within this defective currency union. The economic collapse in the affected economies proved both large and enduring. In the six largest advanced economies, plus the eurozone, the picture is remarkable and disturbing. First, the recessions were the deepest since the 1930s. Second, the recoveries have been exceptionally weak: only two economies, those of the US and Germany, were larger in the fourth quarter of 2012 than they had been in the first quarter of 2008 and even these two were only slightly bigger. The other economies were still below their

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Lessons from the global financial crisis -Martin Wolf | Insights Vol 13 ...

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starting point. Third, the economies of the eurozone, as a whole, particularly of France and the UK, stagnated from late 2010 or early 2011to the end of 2012, as fiscal austerity tightened. Finally, Italy's economy shrank rapidly from mid-2011. By the fourth quarter of 2012, it was nearly 8 per cent smaller than it had been in the first quarter of 2008. The "Great Recession", as it has been called, triggered a no less extraordinary rescue effort. The authorities responded with de facto nationalisation of the liabilities of the core financial system, via explicit guarantees, recapitalisation of financial institutions, traditional lender-of-last-resort operations, on an enormous scale, and direct interventions in what turned out to be a badly damaged credit system. At the same time, monetary policy was eased dramatically, with both short-term interest rates brought down to their lowest-ever sustained level and extremely rapid expansions of the balance sheets of the central banks (see Figure 1). Finally, in a number of important advanced economies, notably the UK and US, fiscal deficits reached levels and the rise of public debt reached rates previously only experienced during world wars. In the UK, for example, short-term interest rates became much the lowest since the Bank of England was founded, more than three centuries ago, while the increase in public debt has been surpassed only by what happened during the Napoleonic Wars and the First and Second World Wars. Figure 1: Central bank intervention interest rates

Among the six largest high-income economies, the biggest increases in public debt, relative to gross domestic product, occurred in the UK, US and Japan (see Figure 2). In the first two, this was largely because of the devastating impact of the financial crisis on fiscal receipts and GDP, relative to prior expectations. In the case of Japan, it was rather because of the large deficits the country had been running, prior to the crisis, as well as the depth of the recession. Germany and Italy managed the rise in debt relatively well, though Italy was in a difficult position because of the already high level of its fiscal debt, prior to the crisis. France has fallen somewhere in between. Figure 2: Net public debt (as a share of GDP)

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Yet, despite these enormous fiscal deficits, long-term interest rates fell to extraordinarily low levels. In the US, UK and Germany, they fell to below 2 per cent. In Japan, they fell to below 1 per cent. Again, in the UK, for which data exists on yields on long-term bonds since the early eighteenth century, the rates of interest on long-term government bonds had no historical precedent. The obvious question is how huge fiscal deficits can be compatible with such extraordinarily sustained low interest rates. The immediate explanation is that markets expected short-term interest rates to remain low for a long time. The underlying explanation, however, is that the economy is in a Keynesian "liquidity trap", with chronic ex ante excess savings and short-term interest rates up against the zero bound. The best example of this condition, by far, is Japan, where short-term interest rates have been close to zero since the late 1990s and long-term interest rates are, at the time of writing, little more than 0.5 per cent, despite extraordinarily high and rising levels of public debt. The global crisis had, as an important component, the crisis in the eurozone that became visible in the course of 2009. The currency union experienced a rolling wave of financial and sovereign debt crises that hit, in succession, Greece, Portugal, Ireland, Spain, Italy and Cyprus, with more, certainly, to come. The symptoms of these crises have been elevated yields on government debt and difficulties in funding banks. The two phenomena are closely related, since banks rely on governments for support, in extremis, while governments rely on banks for funding, also in extremis. The relationship is therefore rather like that of two drunks trying to hold each other up. But, as governments in vulnerable countries found it increasingly difficult to fund themselves, other than from their own banks, they could not offer credible support for their banks. At the same time, as cross-border private finance dried up, the banks became more dependent on their hard-pressed governments for support. Even the willingness of the European Central Bank to act as a lender-of-last-resort to troubled banks proved insufficient, in the cases of Greece, Ireland, Portugal and Cyprus, because banks in these countries started to run out of adequate supplies of acceptable collateral. Official rescue programs were launched in these cases, under the auspices of the so-called "troika" the European Commission, the European Central Bank (ECB) and the International Monetary Fund. But, behind these, stand the creditworthy governments of the European Union, above all, Germany, which fund the 500bn European Stability Mechanism (and its predecessors, the European Financial Stability Facility and European Financial Stabilisation Mechanism), used to back such programs. Meanwhile, the ECB, under president Mario Draghi, helped relieve the pressure by announcing its Long-Term Refinancing Operation, in aid of troubled banks, in late 2011, and its Outright Monetary Transactions, in support of the debt markets of troubled governments, in the summer of 2012. Unfortunately, while bond yields finally fell in affected countries, their economies went into very deep recessions, the results including very high unemployment, particularly in Greece and Spain, as they

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tried to restore lost external competitiveness, a very slow process. Not surprisingly, the political stresses on both sides of the creditor-debtor divide have proved to be extremely powerful: the former consider the latter soft-headed; and the latter consider the former hard-hearted. The atmosphere is increasingly poisonous, with dire implications for European integration in the long run. This, then, turned out to be a huge and long-running crisis that has, correspondingly, raised important questions about the future of the West, the stability of the market economy and the proper conduct of macroeconomic policy before and during crises. It has changed our world.

Why did this happen?


So why did this happen? The financial crisis is the result of two economic processes: a long-term leverage cycle in high-income countries, characterised by financial sector liberalisation, which began in the 1970s and accelerated in the 1980s and 1990s; and the emergence of huge macroeconomic imbalances in the world economy, particularly after the Asian financial crisis of 1997 and 1998, with enormous concomitant flows of excess savings from the emerging countries to a limited number of high-income countries, particularly the US. The eurozone was partly the victim of these global forces. But more important was the fact that both huge imbalances and the financial liberalisation occurred inside the eurozone, too, with the same dire results as globally. Figure 3 provides an important indicator of the global savings glut: the declining real rate of interest on safe securities since the mid-1980s. In theory, in an integrated global capital market, there should be a single real rate of interest on such securities. Fortunately, the evidence supports this hypothesis: the real interest rate on the UK's index-linked government bonds, which have been issued since the 1980s, coincides quite closely with that on US Treasury Inflation-Protected Securities (which have been issued more recently), since the early 2000s. Using this measure, we see that real interest rates fell dramatically from the time of the Asian financial crisis, from close to 4 per cent to around 2 per cent. That is what one would expect when a huge adverse shock persuaded the governments of East Asian emerging countries to prevent their countries from continuing to be net importers of foreign capital, on a large scale. Figure 3: Yields on index-linked government bonds

In the terminology of Hyman Minsky, the fall in real rates of interest on safe securities and subsequent upward shift in the price of long-term real assets, above all, of housing,

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was the "displacement event" the event that triggered what ultimately became a huge and devastating financial bubble. Thus, the enduring decline in real interest rates triggered a rise in the price of long-lived real assets real equity prices (which peaked in 2000) and house prices (which peaked just before the global financial crisis). Of the two, the latter was the more economically significant, since rising real house prices generated a credit boom, which, in turn, generated still higher house prices, rising construction activity and lower household savings rates (see Figure 4 for house prices and Figures 5 and 6 for the rise and fall of leverage and borrowing in the US, by far the most important economy to be heavily affected by the financial crisis). These interconnected bubbles burst, devastatingly, in 2007 and 2008. At the same time, as one would expect, the crisis was associated with a still bigger ex ante savings surplus: so the real interest rate on safe securities fell to zero. This is a clear indicator that the economies of the western world had fallen into a contained depression. Figure 4: Real house prices

Figure 5: US private debt (over GDP)

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Figure 6: US private sector gross borrowing over GDP

A crucial element in the emergence of the savings glut and consequent fall in the global real rate of interest on safe securities was the emergence of the global imbalances. Between 1996 and a decade later, these imbalances grew roughly six times, relative to global output. The big surplus regions were east Asia, particularly China, the oil exporters and Germany and Japan. Meanwhile, the big deficit regions were the US and "peripheral Europe" western, southern and parts of eastern Europe. The latter all fell into crisis

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after 2007. This was not an accident. These economies had managed to import the excess savings of the surplus regions by generating what turned out to be unsustainable credit and spending booms. These booms collapsed in the crisis, pushing much of the world economy into deep recession. The huge surplus savings of the emerging economies were, in turn, not the result of purely private decision-making. In substantial part, they reflected conscious policy, particularly the decision to intervene in currency markets, to keep currencies competitive. The result was massive accumulations of foreign currency reserves, particularly by China and other developing countries (see Figure 7). These, then, were, in important measure, official capital outflows. Inevitably, domestic monetary, fiscal and structural policies were, consciously or not, designed to reinforce such surpluses via a combination of sterilisation of the currency intervention, financial repression and outright fiscal stringency. Figure 7: Global foreign currency reserves ($bn)

The pattern inside the eurozone was not dissimilar to that in the world as a whole. Again, huge imbalances emerged within the eurozone (see Figures 8 and 9). In the end, all of the eurozone's capital-importing countries were hit by crises, as cross-border finance suddenly dried up, financial bubbles burst, asset prices collapsed, fiscal deficits exploded and, finally, fiscal austerity was adopted (or imposed). With both private and public sectors trying to move towards financial balance, or surplus, these countries' external balance had to shift into surplus, as Figure 8 forecasts. As that happened, the entire eurozone slowly shifted towards surplus, thereby imposing strong contractionary forces on the rest of the world. The conventional wisdom inside the eurozone was that fiscal irresponsibility caused the crises. This is false, except in the case of Greece and, solely because of its high legacy debt from the 1990s, Italy. The other crisis-hit economies had excellent (Ireland and Spain) or at least tolerable (Portugal) fiscal positions prior to the crisis. The explosion in public sector indebtedness was a consequence of the crisis, not a cause, in these cases dramatically so in the cases of Ireland and Spain (see Figure 10). Figure 8: Eurozone imbalances on current account (as per cent of Eurozone GDP)

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Figure 9: Current account balances inside the Eurozone (1997-2007 averages, per cent of GDP)

Figure 10: Net public debt of crisis-hit Eurozone countries (as share of GDP)

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In brief, the opening of the world economy to free movement of capital, the attempt by emerging economies to protect themselves from the consequences, as they had experienced them, in the crises of the 1990s, the helter-skelter liberalisation of financial markets and the willingness of the monetary and financial authorities in important economies to ignore the growing imbalances, domestic and external, combined to produce a huge crisis. Moreover, in the case of the eurozone, these imbalances interacted with a regime that was not only rigid but was also unsupported by almost all the insurance mechanisms characteristic of a modern federation, other than a central bank. This proved to be extremely fragile.

What are the lessons?


The high-income economies have a long slog ahead of them. The US seems likely to recover first, partly because it has done more to fix its financial system, but as much because it has gone through more adjustment than European countries: real house prices are back where they started; and substantial deleveraging has also occurred. The eurozone crisis is likely to be far longer lasting. This is partly because the system as a whole is dysfunctional. It is also because the ECB has no will to generate rising nominal demand, unlike the Federal Reserve. It is, again, also because the adjustments in the vulnerable countries are going to be painful and, inevitably, long term. Whether, in the end, the eurozone survives in its present form is, to say the least, debatable. The economics say "no". The politics say "yes". It is a case of an irresistible force meeting an immoveable object. Whatever the ultimate economic outcome, we already know the wave of crises has been immensely costly for the afflicted economies. So what lessons should we learn if we want to reduce the chances of further crises on this scale. Let us consider three questions. Can we prevent crises altogether? Can we make the financial system more robust? Can we lower the economic costs of crises?

Can we prevent crises?


The answer to the first question is: almost certainly not. But that does not mean we are unable to do better. The evidence from history is clear: financial crises are an inherent feature of dynamic market economies. Economists were extraordinarily foolish, if not willfully ignorant, when they imagined that achieving low and stable inflation would also

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stabilise the economy. We now know that the opposite is true. The "great moderation", as the period of relative macroeconomic stability in western high-income countries that preceded the great recession came to be called, was a hubristic notion, at best, and utter folly, at worst. The truth is the opposite. Times of stable prosperity are precisely the time when people feel comfortable about taking on risk. The simplest way to take on risk is to increase leverage. This is what our bank-based financial system is designed to do. But the rise of derivatives has dramatically increased the system's ability to embed leverage in the economy. Inevitably, as suggested above, the rise in leverage sharply increases the vulnerability of the economy to shocks, particularly to adverse shifts in the prices of assets used as collateral in the leverage process. Thus, the scale of the crisis was, in good part, the result of mistakes in view of the risks, in macroeconomic policy and in understanding of what was happening in the financial system. These mistakes were reinforced, in the case of the eurozone, by a failure to realise that the very process which made the first decade look so good the convergence of interest rates and the associated cross-border capital flows was making the system more vulnerable to a sudden shift in risk appetite. When that shift occurred, the eurozone's capital-importing countries experienced what was, in effect, a "sudden stop", similar to that experienced by emerging economies in previous crises. The big lesson of history is that crises repeat themselves, that times of euphoria are when the conditions for crises emerge and that when the crisis hits, it is too late. So policymakers must be aware of the dangers, at all times, and lean against the winds of overconfidence that bring them. Will that work? Probably not. It is too easy to think that "this time is different".

Can we make the financial system more robust?


If we cannot prevent crises, can we make the financial system more robust? The answer: yes. Indeed, we need to do so, though, in truth, the sources of overconfidence are all too likely to undermine our efforts here, too. But the general ideas are clear. The financial system has to become less closely interconnected. Institutions also need to be easier to resolve, without government support. This means much more equity capital perhaps as much as five to ten times as much as is now the norm, bringing leverage down from 30 to one to four or five to one. To the extent that capital is not raised in this way, it means ring-fencing of retail from investment banking, to make it easier to ensure continuity of service from the former and to make it more credible that governments will not rescue the latter. Finally, it means changing incentives, to ensure that employees and managers are judged over a long period of performance and share fully in losses. Paying such employees in bail-in-able debt that must be held for many years is one way to achieve this outcome. Finally, accounting must be changed to ensure that hypothetical gains are not treated as today's profits. One way of achieving this is through generous provisioning against potential losses.

Can we lower the economic costs of crises?


Lowering the economic costs is the easiest part, at least in theory. The key requirement is a forceful fiscal and monetary response, along with a rapid reconstruction of the financial system and accelerated recognition of the debt that has clearly become unserviceable, even at the post-crisis low level of interest rates. This sort of aggressive policy response is at least relatively easy for countries that possess strong initial fiscal positions (which is why debt needs to be driven to very low levels in a boom) and, above all, their own central banks, particularly countries that issue reserve currencies. Such countries will be able to run the very low interest rates they will need for a very long time. But low interest rates and even quantitative easing are insufficient when short-term interest rates are at, or close to, zero. This is why fiscal expansion is also necessary. The fiscal stimulus should, if possible, be used to generate additional high-quality assets, thereby ensuring that valuable assets match additional liabilities. This will be relatively easy to manage during a long-lasting recession, which is what tends to follow fiscal crises, since that gives time to plan additional investment. But it will also be important to address obstacles to private investment, particularly if, as now seems to be the case in some important high-income economies, non-financial corporate sectors are running what seem to be structural financial surpluses. Also crucial will be policies that bring about shifts in the global imbalances: crisis-hit countries will need to offset private and public austerity with reduced current account deficits or even large surpluses. The position of countries in a currency union is far more difficult. They are not fully

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sovereign. They may be driven into austerity by inability to finance their debt. The central bank can help by agreeing to purchase their debt, to keep interest rates down. But the highly independent ECB will do so only on condition that countries meet the agreed goals of tough plans for fiscal stabilisation. This would eliminate much of the potential benefits of the ECB's commitment to keep rates down. This is made worse by the unwillingness of either the ECB or solvent governments to use their freedom of manoeuvre to generate reasonable growth in nominal incomes. Thus the vulnerable countries are forced to adopt austerity at home without any reasonable external offset. The result is sure to be long-run recessions.

Conclusion
The financial crisis is a huge event, with deep roots in a malfunctioning global economy. It has created huge policy challenges and given us important lessons. A long dead friend of mine once said to me: "It is not true we don't learn from history. We do. Then we forget." Maybe the lessons this time will be deeply enough engraved to ensure we do learn. But I am no optimist. I expect we will soon forget, once again. Top ^

An updated version of the Corden Lecture delivered at the University of Melbourne on 17 October 2012.

Martin Wolf, CBE, is Associate Editor and Chief Economics Commentator, Financial Times, London.

D iscl aimer In s ig h t s is p u b lis h e d b y t h e U n ive rs it y o f Me lb o u r n e fo r t h e Fa cu lt y o f Bu s in e s s a n d E co n o mics . O p in io n s p u b lis h e d a re n o t n e ce s s a rily t h o s e o f t h e p u b lis h e r, p rin t e rs o r e d it o rs . Th e U n ive rs it y o f Me lb o u rn e d o e s n o t a cce p t re s p o n s ib ilit y fo r t h e a ccu ra cy o f in fo rma t io n co n t a in e d in t h is jo u rn a l. No p a rt o f t h is jo u rn a l ma y b e re p ro d u ce d w it h o u t t h e p e rmis s io n o f t h e e d it o rs . U n ive rs it y o f Me lb o u r n e , 2 0 1 1 .

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