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Some Lessons from the Financial Market Crisis *

2009; Wiley; Volume: 12; Issue: 3 Linguagem: Inglês

10.1111/j.1468-2362.2009.01250.x

1468-2362

Otmar Issing,

Global Financial Crisis and Policies

There is now widespread agreement that for the last two years the world has been confronted with a financial crisis of dimensions it has not seen since 1929. This crisis has called into doubt not only the soundness of the financial sector but also, at least for some, that of capitalism itself. Economics as a science has suffered in a similar way. The reputation of mainstream economics has been undermined, rightly or wrongly, by its failure to foresee the crisis and by its alleged ostracism of those who did give warning. The efficient markets hypothesis in particular is identified as having supported an unfounded belief in the robustness of the financial system. Those who believe Karl Marx's prophecy that capitalism is doomed to collapse because of its intrinsic contradictions should curb their excitement: the death of capitalism has been announced many times, but each time the alternative approaches its critics have propounded have been entirely discarded. However, supporters of the present system should not succumb to any illusions, either. The financial crisis has severely damaged trust, not only in the financial system but in the free market as such. It is doubtful that the current system could survive another crisis of dimensions approaching those of the current one were it to recur in the near future. In such a situation, it would not help that no viable alternative to our current system is at hand. The message is clear: a comprehensive overhaul of the financial system is needed, one which guarantees to the greatest extent possible that a crisis comparable to the recent one will not happen again, at least not for a long time. This message has to be taken seriously not only by those who are responsible for reforming the system, but also by those who are tempted to resist reform due to their own short-term-oriented, short-sighted self-interest. I am not arguing for regulations that would suffocate activities that are in the interest of society, nor am I arguing that regulators should try to prevent all ups and downs in the economy and in financial markets. The dynamics of markets produce swings around the trend and with them the inevitable risk of crises (see Kindleberger 1996). The challenge for policy-makers is not to undermine these dynamics and the creative destruction they bring, but rather to dampen their amplitude and as much as possible to prevent major crises. The causes of the crisis have been widely analysed, and there is no lack of proposals for reform. I will discuss the causes first.1 Since the end of the 1990s, interest rates have been low and liquidity has been high around the world, due in no small part to currency pegging in key regions. The increasing integration of China and other emerging markets into the world economy resulted in global downward pressure on traded goods prices. As it picked up speed, globalization limited the ability of businesses to increase prices and restrained wage growth in industrialized nations. The huge rise in liquidity consequently did not make itself felt in inflation and inflation expectations for quite a while. As a result, the strategy of 'inflation targeting', while ignoring money supply and credit volumes, did not encourage central banks to raise interest rates. However, the high level of liquidity did lead to rising asset prices around the world. The combination of high liquidity and low interest rates produced strong incentives to choose ever-riskier investments. As a result, risk premia shrank ever-smaller. This shrinkage in risk premia was accompanied by numerous financial innovations, most notably the widespread use of securitization – without, in some cases, the originators retaining any risk or signalling its retention policy to the market. These complex financial products were bought and sold worldwide, but they were particularly common in Europe. In Germany they were often purchased by government-owned financial institutions that had no viable business model of their own, and which sometimes misinterpreted risk premia in bond returns for arbitrage profits. The judgements issued by the rating agencies, which failed to perform sufficient due diligence or to use appropriate ratings models, further encouraged this behaviour. Further, transparency had largely been lost in markets worldwide. The limited transparency that had existed at the global level in the run-up to the crisis gradually almost disappeared until even the players themselves retained only a rudimentary understanding of their own transactions. To make matters worse, in numerous countries banks circumvented capital regulations by establishing new corporate entities to conduct their risky activities. Similarly, the real estate boom in the United States was fuelled by the politically leveraged government-sponsored enterprises Freddie Mac and Fannie Mae. The shocking failure of the oversight regime in these cases is all the more embarrassing as these activities were entirely legal. All these developments occurred against a backdrop of financial incentives that rewarded short-term success, through the sale of new financial products, with no reference to long-term risk. Finally, even though maintaining liquidity and protecting depositors are central mantras of banking regulation, the problem of 'market liquidity' was mostly neglected. Regulators and participants alike blithely assumed that it would always be possible to refinance short-term debt via the markets at any time. This assumption has now proven to be quite mistaken. All of these factors combined to produce a situation in which only a slight prod was needed to shake the entire (inverse) pyramid, and indeed nearly to bring it toppling down. This prod was delivered by the sub-prime crisis in the United States. From there, the ripples of the crisis spread to countries that either were predestined for it because their housing markets had been overheated for years, or that had investors with a high level of free cash flow. But it would be misleading and overly simplistic to blame the crisis entirely on the sub-prime troubles and the real estate markets. As important as this factor is, and as important as an end to the housing market crisis in the United States is for worldwide recovery, the sub-prime disaster was only the trigger. Risks were re-evaluated everywhere – spreads and risk premia rose abruptly, and the high volatility of these evaluations contributed to further insecurity. In the context of the complex and opaque network of financial institutions that had developed, and in the prevailing environment of high uncertainty, access to short-term refinancing in the markets was abruptly cut off. This caused a liquidity crisis beyond what had previously been imagined. With the collapse of their assets, banks' capital ratios were put under immense pressure, and the first institutions had to be taken over or 'rescued'. The crisis peaked with the collapse of Lehman Brothers in September 2008. Many countries have taken measures to combat the downturn, support the financial markets, save financial institutions and restructure their financial sectors. While on the one hand these actions have stabilized the situation, on the other hand they have also heightened expectations, if not in fact set the precedent, that in the future major financial institutions will always or almost always be bailed out with taxpayer money. It is therefore important to consider not just the causes of the current crisis when making proposals for reform, but also the experiences we have just had with crisis management. Establishing a regulatory regime that can credibly refuse to bail out a major financial institution in the future is the fundamental challenge for reform. There is wide agreement on at least the main elements that should be at the centre of financial reform. I discuss these elements below. Lack of transparency has been a major source of our current woes. We should not find this surprising: it causes information asymmetries and the misallocation of resources and risks. Complex financial products are an extreme example of this. One idea of how to increase transparency is through the use of a global risk map complemented by a credit register, which together would use statistics reported by banks to monitor the level of risk in the financial system.2 This 'intelligent transparency' would provide information to the macro-prudential supervisor on the distribution of risks in financial institutions and financial markets for the purpose of timely and appropriate measures to prevent the build-up of risk. Evident gaps in regulation must be closed. For example, banks should be supervised on a consolidated basis. More equity capital and less leverage also are conditions sine qua non for a stable financial system. Ideas for how to reduce or eliminate the procyclicality of Basel II have to be examined and implemented. Although hedge funds did not cause this crisis, they have the potential to aggravate an already critical situation and therefore should be included in the new regime of regulation and supervision. One of the clearest lessons of the current crisis is that there is a lack of effective macro-prudential supervision. It is true that the Bank for International Settlements (BIS) issued many warnings, and that the European Central Bank (ECB) constantly identified global imbalances and an alarming shrinkage of risk spreads. But a consistent, encompassing and data-based assessment of global financial trends was sorely needed, as were independent institutions with clear mandates and the proper incentives to recommend and implement corrective actions during the developments that led to the crisis. The recent de Larosière Group report on financial supervision in the EU proposes the creation of a European Systemic Risk Board (ESRB) with the ECB in a leading role. It also makes suggestions regarding the way in which the ESRB's monitoring should lead to regulatory action and in which macro- and micro-prudential supervision should be linked. On the one hand, it is encouraging that the EU Commission has adopted these proposals and that the EU Council of Ministers has in principle taken the same position. On the other hand, it is disappointing that resistance to the ECB's leading role has appeared without any convincing alternative being presented. If the ECB's role of receiving input from national supervisors and providing the analysis needed to support the ESRB is undermined, the success of this new arrangement will be endangered from the start. To deal with the problems of micro-prudential supervision in the EU, the de Larosière Report proposes to transform the Level 3 committees – the Committee of European Security Regulators, the Committee of European Banking Supervisors and the Committee of European Insurance and Occupational Pensions Supervisors – into European authorities, a solution which within a few years should evolve into an integrated European System of Financial Supervision. Ratings agencies have played a harmful role, accelerating and widening the crisis. A European ratings agency, either private or public, may well fail to materialize (and if it does it will not happen anytime soon), but the conflict of interest inherent in advising and rating for the same product and client must be resolved. Ratings agencies have to be supervised by a public authority and their rating performance must be made more transparent in order to foster competition among the ratings agencies. Global financial markets need global rules. Arbitrage exploiting differences in regulation and supervision between countries is a serious source of instability. It is true that there always will be financial centres that try to benefit from weaker rules. But it is unacceptable that in the midst of the crisis the risk is increasing that not even the biggest players – the United States, the United Kingdom and other countries in Europe – will agree on the principle of a level playing field: a shared set of rules governing market participants in their respective countries. In the end, transparency – the naming and shaming of governments and supervisors – might help to overcome the worst inefficiencies. Financial institutions that are not regulated and supervised properly would then have to pay higher risk premia for their deposits and debt issuance. Incentives fostering a short-term orientation in trading and other activities heavily contributed to the build-up of the bubble and its perverse distribution of risks. If the industry continues to take a purely defensive position, attempting to preserve the status quo, this will be very short-sighted of them. This attitude could provoke suboptimal administrative countermeasures such as caps on bankers' pay. There is a great risk that all the interventions by governments around the globe have created the expectation that in the future no major bank will be allowed to fail, and further that private savers, and more generally all bond holders, will be bailed out of risky investments that go bad. If this becomes the 'heritage' of the crisis, it would be a fatal deviation from the principles of the free-market system. Risk and uncertainty (in the Knightian sense) are unavoidable elements of life. The welfare of a society depends crucially on the way in which it handles the challenges they pose. A market system encourages entrepreneurs to take risks by promising rewards, but it also imposes losses for misjudgements. If the threat of losses and potential bankruptcy is removed or made not credible, institutions that are 'too big to fail' become incentivized to place risky bets: if they are correct, the institutions reap the gains; but if their bets turn out to be incorrect, taxpayers absorb the losses. This is the problem of moral hazard. Its result is irresponsible risk-taking – in essence, gambling. Therefore, the challenge the crisis has created is this: to deal effectively with the problem of moral hazard. This is neither easy nor possible without clear, binding rules that will be perceived as painful by at least some of the individual players. Those who predict the end of a free society and market economy as a consequence of such a binding framework have not understood the principles on which it is based, and are invited to read Adam Smith, who in his Wealth of Nations writes: But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed. The problem of 'too big to fail' is a manifestation of this regulatory challenge.3 If any bank becomes 'too big to fail', then the government of its home country and society as a whole can be taken hostage by its risky activities, a fact which in itself creates moral hazard. Allan Meltzer's dictum is apt and straightforward: 'If a bank is too big to fail, it is too big' (Meltzer 2009). Considering the dimensions of the problem of moral hazard, it is quite surprising that for an extended period of time authorities did not seem to care. Since the crisis arose, however, several proposals have been presented to deal with it.4 One possibility is to set quantitative limits on the size and activities of individual financial institutions. However, it is obvious that it would be very difficult to apply this principle in a reasonable way. More convincing is the proposal to impose strict capital and liquidity regulations on systematically important financial institutions. An elegant way to do this would be to increase the requirements gradually as the relevant institutions increase in size. Other proposals go in the direction of making systemically important institutions easier to close, thereby mitigating the risks for the whole system. Requiring banks to produce a 'shelf-bankruptcy' plan (Rajan 2009, p. 71) is an idea that is part of the new framework which the Obama administration wants to enact: '… we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bail outs and financial collapse' (Geithner and Summers 2009). Anil Kashyap likewise urges regulators to immediately implement what he calls a 'sound funeral plan' (Kashyap 2009). A number of proposals require institutions to issue ten-year subordinated notes equal to 10% of their total liabilities, or debt–equity swaps, in times of crisis. This would help not only with the 'too big to fail' problem, but also would provide other benefits such as serving to make financial institutions more resilient to potential shocks. Clearly, some combination of these proposals is entirely possible. 'Too connected to fail' refers to the fact that the collapse of certain highly leveraged financial institutions could be disastrous to a huge number of other players and thereby create risks for the entire system. The solution to this problem might be the creation of a two-tiered financial system, with one tier for highly regulated institutions with limited activities and a kind of implicit state guarantee, and the other for institutions licensed to take higher risks but also possessing no guarantee, either explicit or implicit, to be bailed out. Designing consistent rules and then implementing them is a tremendous challenge, much more difficult than simply pointing out the current problems. One of the major difficulties is coming up with a coherent set of regulations that all the major global players – in particular, the United States, and all members of the European Union – can agree on. But to give up in the face of this challenge or to just ignore it would simply lay the foundations for the next systemic crisis. During the 'great moderation', central banks (and central bankers) reached great heights of public approval. Inflation was low and stable worldwide, and robust growth prevailed. When the financial crisis broke out, central banks reacted quickly, reducing their interest rates to levels never before seen and adopting a number of 'unorthodox' measures to avoid the mistakes of 1929 and the subsequent years. These actions contained the crisis and laid the foundations for recovery, and in fact the reputation of central banks seems, if anything, to have been enhanced by the crisis. But this crisis might mark a watershed after which opinion could finally turn against central banks. Why? During the recent boom years, abundant liquidity and low interest rates created a situation of excessive risk-taking and asset price bubbles – bubbles enlarged by the use of sophisticated financial innovations. Under the strategy of inflation targeting, which was for years the dominant central bank doctrine, asset prices are relevant for the conduct of monetary policy only in so far as they have an influence on the inflation forecast, which is a forecast of consumer prices. This philosophy is exemplified in the 'Jackson Hole Consensus', which has been the prevailing regulatory approach to asset prices (Issing 2009, pp. 45–51): Central banks should not target asset prices. Central banks should not try to prick a bubble. Central banks should follow a 'mop-up strategy' after the burst of a bubble, which essentially means injecting enough liquidity to avoid a macroeconomic meltdown. These items were once uncontroversial. But in the wake of the current crisis, the big question is whether they are in fact adequate to serve as the guiding principles of central bank policy. It now seems clear that they are not, because they constitute a totally asymmetric approach: when asset prices go up, this is deemed irrelevant to monetary policy (as long as the forecast of consumer prices does not signal inflationary risks), but when a bubble bursts, central banks must come to the rescue. Implicitly or explicitly preannouncing this commitment to act as 'saviour' once bubbles burst, but not trying to counteract them as they develop, is asymmetric, creates moral hazard, and indeed is part of what creates the bubbles in the first place. Applying this approach consistently over a long period of time necessarily leads to a sequence of ever-bigger bubbles in, and subsequent collapses of, asset prices. Just consider this argument given in favour of the asymmetric approach during the 2005 Jackson Hole Conference: The 'mop up after' strategy received a severe real world stress test in 2000–2002, when the biggest bubble in history imploded, vaporizing some $8 trillion in wealth in the process. It is noteworthy, but insufficiently noted, that the ensuing recession was tiny and that not a single sizable bank failed. In fact, and even more amazingly, not a single sizable brokerage or investment bank failed either. Thus the fears that the 'mop up after' strategy might be overwhelmed by the speed and magnitude of the bursting of a giant bubble proved to be unfounded. Regarding Greenspan's legacy, then, we pose a simple rhetorical question. If the mopping up strategy worked this well after the mega-bubble burst in 2000, shouldn't we assume that it will also work well after other, presumably smaller, bubbles burst in the future? Our suggested answer is apparent. Is it now possible to deny that the 'solution' to the previous crisis prepared the ground for the next bubble and collapse? Is it surprising that the alleged 'biggest bubble' in history was followed by a crisis of even greater dimensions? Markets naturally tend to produce ups and downs. Overambitious attempts to fine-tune and stabilize the economy by aggressively fighting against downturns undermine the adjustment process, which is needed to correct the distortions that necessarily develop during an upswing. This fine-tuning thus increases the risk of a sequence of ever-bigger bubbles and subsequent bursts. At a time when the theory of business cycles was a major issue, Schumpeter raised a clear warning: … there was a further reason and that was the managing policy of the Federal Reserve System. The Federal Reserve System, following the call of business opportunity, in 1922 set about the task of regulating the pulse of business, in particular preventing downswings. In fact it had some measure of success. Small downswings were nipped in the bud; but adjustments were prevented, and when the great spring cleaning came, many more adjustments had to be made. Likewise, in his Prices and Production, Hayek argues that a major aspect of macroeconomic management is the need to let the adjustment process work over the cycle. Ill-conceived policies would finally increase the risk of a deeper crisis. The authorities succeeded, by means of an easy-money policy, inaugurated as soon as the symptoms of an impending reaction were noticed, in prolonging the boom for two years beyond what would otherwise have been its natural end. And when the crisis finally occurred, for almost two more years, deliberate attempts were made to prevent, by all conceivable means, the normal process of liquidation. It seems to me that these facts have had a far greater influence on the character of the depression than the developments up to 1927, which from all we know, might instead have led to a comparatively mild depression in and after 1927. Did we really need a crisis that brought the world to the brink of a financial meltdown to learn that the philosophy that was at the time seen as state of the art was in fact dangerously flawed? 'Given that the consequences of a systemic financial crisis can be quite substantial, the optimal monetary policy might at times choose to err on the side of caution, in order to reduce the probability for a crisis to a very small likelihood' (Issing 2003, p. 18). The financial crisis has destroyed both intellectually and empirically the foundations of the 'mop-up' approach. Now, we must conduct a thorough discussion as to the appropriate strategy of central banks with respect to asset prices. A solution might be a policy strategy that closely monitors monetary and credit developments as potential driving forces for consumer price inflation in the medium to long run. This strategy has an important additional effect: it may help limit the emergence of unsustainable trends in asset valuations. As long as money and credit remain broadly controlled, the scope for financing unsustainable runs in asset prices should also remain limited. Corresponding changes in asset prices also help to support the analysis of developments in money and credit. In the meantime, numerous empirical studies have shown that almost all asset price bubbles have been accompanied, if not also preceded, by strong growth of credit and/or money. One argument against this symmetrical approach is that the implicit costs in losses in output and employment would be too high. The experience of the present crisis makes this trade-off look rather different.5 However, this is not to say that in dealing with financial stability we do not need additional instruments in our toolbox. For example, anticyclical regulations for equity capital have to be discussed thoroughly. This raises the question of which institution should have the primary responsibility for financial stability. The ECB has pursued a monetary policy strategy much like that outlined above, one which has the advantage that it avoids the need to be specific about the mispricing of assets. Widening the time horizon of monetary analysis to the medium to long term functions as a kind of 'integrated risk management' that works symmetrically, leaning against both the 'head wind' (asset price declines) and the 'tail wind' (asset price increases). This is in contrast to the risk management approach that has been applied in practice – triggered more-or-less arbitrarily and considered only in cases of supposed risks of deflation or a general downturn of the economy. The ECB has never claimed to have found 'the' solution, but at least it has always acknowledged that the responsibilities of central banks extend beyond those delineated by the Jackson Hole Consensus. And with its strategy – which has been widely criticized for making exactly that claim – it has tried to give an outline of these additional responsibilities. The stability-oriented, two-pillared, symmetrical approach to asset prices therefore can be seen as the most modern approach to monetary policy. There are good arguments that central banks should play a greater role in preserving financial stability. Central banks are in close contact with all market participants and have oversight over the economy as well as access to the necessary data, expertise and resources. This is a strong argument to give the central bank a mandate for macro-prudential supervision (but not necessarily micro-prudential supervision). And indeed, this is exactly the proposal of the de Larosière Group: to give the ECB the leading role in the ESRB, whose task would be to pool and analyse all information relevant to financial stability. The role of the ESRB notwithstanding, the ECB, endowed with a mandate for macroeconomic supervision, should be responsible for identifying macroeconomic imbalances stemming from fiscal, housing, wage and other relevant national policies and for issuing warnings and recommendations addressed to national policy-makers. The ESRB would then complement such ECB warnings and recommendations in the field of supervisory/prudential policies. However, mere information and analysis are no substitute for the implementation of stability-oriented monetary policy. Avoiding activism and fine-tuning, and instead strictly following a medium-term strategy that closely monitors developments in money and credit is the proper approach for maintaining price stability. This leads us to the biggest risk for central banks: being captured by political interests. There is a natural tendency to overburden central banks, since they are regularly in contact with all market participants, and have an overview of all markets and huge pools of specialist talent on which to draw. With their more-or-less unavoidable use of unorthodox measures in their attempts to contain the recent crisis, central banks have already entered dangerous territory with the magnitude of the responsibilities they have assumed. A central bank should not be the entity that decides which sector – or worse, which company – gets or does not get credit. This is the task of financial markets, and if they are not functioning it is the responsibility of politicians, who are accountable to voters. There are also good reasons why central banks with responsibility for monetary policy should not be charged with micro-prudential supervision. The Report of the de Larosière Group presents arguments as to why the ECB should not be given this mandate. Most importantly, its being charged with micro-prudential supervision could undermine its independence. Not surprisingly, the present crisis has triggered debate about the entire framework of policies aimed at preserving financial stability. Central banks should be extremely cautious in seeking responsibilities beyond their present mandate, which is primarily the maintenance of price stability. It seems obvious that were they to seek further responsibilities, this might turn out to be a poisoned pill, for it is hard to believe that their independence would survive. As a final consequence, the period of low inflation we have just experienced might turn out to be transitory.