3. Financial Policy

Yanis Varoufakis

The most common explanations of the 2008 crisis (growing trade imbalances, financialisation, etc.) are themselves symptoms of an underlying global macro dynamic that has been unfolding since the 1940s: the transformation of the United States from an hegemonic economy whose surplus was used to stabilise Europe and Japan, to a deficit economy whose hegemony grew as a result of stabilising global aggregate demand via its growing twin deficits. To see this, we need to go back to the 1944 Bretton Woods Conference. The US administration understood that the only way of avoiding a post-war depression was to recycle America's surpluses to Europe and Japan, and thus generate abroad the demand that would be met by American factories when the war ended.

The result was the project of dollarising Europe, founding the European Union as a cartel of heavy industry, and building up Japan, within a global currency union (the Bretton Woods system) and its underlying philosophy whereby money was co-owned by those who had it and the global community that backed it. The system featured fixed exchange rates anchored to the dollar, almost constant interest rates, banks operating under severe capital controls, and American-led management of global aggregate demand. This brought the United States a Golden Age of low unemployment, low inflation, high growth, and diminished inequality.

In the late 1960s however, the foundation of Bretton Woods was disintegrating. By 1968, America had lost its surpluses, slipped into a burgeoning twin deficit and could, therefore, no longer stabilise the global system. This, combined with banks' attempt to free themselves from their constraints, created the offshore, unregulated Eurodollar market that became the basis for financialisation after Bretton Woods was jettisoned on 15 August 1971, when President Nixon announced the ejection of Europe and Japan from the dollar zone.

Washington was unwilling to reduce its deficits by imposing austerity (that would shrink US capacity to project power worldwide), and in fact boosted the deficits. America absorbed exports from Germany, Japan and, later China, ushering in the second phase of post-war growth (1980-2008). Expanding American deficits were financed by around 70 percent of the profits of European, Japanese and Chinese exporters seeking refuge and higher returns. Three developments aided this: lower US wage growth than in Europe and Japan boosting returns to foreign capital; 20 percent+ interest rates; and dollarised financialisation that occasioned self-reinforcing financial paper gains. By the mid-1980s, the United States was absorbing a large portion of global surplus industrial products while Wall Street provided credit to American consumers (whose wages stagnated), channelled direct investment into US corporations; and financed the purchase of US Treasury Bills (i.e. funded American government deficits).

When, after 1991, an additional two billion workers entered the global workforce from China, India and the former Soviet bloc, producing new output that boosted the already imbalanced trade flows, capitalism entered a new phase - globalisation. In globalisation's wake, the EU created its common currency, because, like all cartels, it had to keep the prices of its main oligopolistic industries stable across the single market. To do this, it was necessary to fix exchange rates within its jurisdiction, similar to the Bretton Woods era. However, from 1972 to the early-1990s each EU attempt to fix European exchange rates failed spectacularly. Eventually, the EU decided to establish a single currency, within the supportive (although grossly imbalanced) environment of global stability that the US-anchored global surplus recycling mechanism maintained. To get around the political hurdles presented by the Bundesbank's reluctance to sacrifice the mark, we ended up with the ECB supplying a single currency to the banks of nineteen countries, whose governments would have to salvage these banks during the crisis, without a central bank that could support them.

Meanwhile, Wall Street, and UK, French and German banks were taking advantage of their position in the US-anchored global recycling system to grow on the back of the net profits flowing into the United States. This added energy to the recycling scheme, as it fuelled an ever-accelerating level of demand within the United States, Europe and Asia. It also brought about the decoupling of financial capital flows from the underlying trade flows. To illustrate this, recall Germany’s position in August 2007. German net export income from the United States was USD 5 billion. Germany's national accounts registered this surplus as well as a counter-balancing outflow of capital from Germany to the United States. However, the national accounts do not show that from the early 1990s until 2007, German banks were buying into lucrative dollar denominated derivatives with dollars they were borrowing from Wall Street. In August 2007, the price of these derivatives began to fall, underlying debts were going bad, and Wall Street institutions faced large margin calls. German bankers needed dollars in a hurry when their US counterparts began to call in their dollar debts, but no one would buy the toxic derivatives they had purchased. From one moment to the next, German banks swimming in oceans of paper profit found themselves in desperate need of dollars they did not have. Could Germany's bankers not borrow dollars from Germany's exporters to meet their dollar obligations? They could, but how would the USD 5 billion the latter had earned during that August help when the German bankers' outstanding debt to Wall Street the Americans were now calling in exceeded USD 1000 billion?

Politicians intervened to shift the losses away from those who created them. In Europe, the dominant narrative on what went wrong had no basis in macroeconomics and was thus allowed to obscure the reality that the eurosystem had been designed not to have any shock absorbers to absorb the shockwave from Wall Street. Consequently, one nation was turned against another by a political class determined to disguise a crisis caused by an alliance of Northern and Southern bankers and other rent-seeking oligarchs as a clash caused by the profligate Southerners, or as a crisis of over-generous social welfare systems.

While America's trade deficit returned to its pre-crisis levels within a couple of years, it was no longer enough to stabilise global demand. The pre-crisis mechanism which converted the US trade deficit into fixed capital investments around the world has broken down. The Central Banks tried to make amends with QE-induced liquidity. But that only pushed up asset prices in the West, giving US corporations an opportunity to buy back their shares while saving their own profits in offshore accounts. Where monies did flow, in the Emerging Markets, investment grew but was vulnerable both to the deflationary forces from European austerity and to the expectation of tapering and higher long-term interest rates in the United States. Perhaps the only pillar of global demand was China, although its capacity to maintain that boost was circumscribed by the constant threat of its credit bubble bursting.

In short. Wall Street's pre-2008 capacity to continue 'closing' the global recycling loop vanished - and has not been replaced yet. America's banks can no longer harness the United States' twin deficits for the purposes of financing enough demand within America to keep the net exports of the rest of the world going. This is why the world today remains in the grip of the same crisis that began in 2008.

NAEC Conference “10 Years after the failure of Lehman Brothers: What have we learned?”, OECD, 13-14 September 2018, http://www.oecd.org/naec/10-years-after-the-crisis/

Erdem Başçı

Long term interest rates are currently at historically low levels in all of the G7 countries. They have tended to fall in both nominal and real terms since early 1980s. Especially after the Global Financial Crisis (GFC) which hit in 2008, interest rates have fallen to zero or even negative levels in many cases. The big question is whether this situation in permanent or temporary. Since nobody knows the answer for sure, a certain degree of prudence is justified as to the pace and the eventual extent of debt accumulation at these very attractive rates.

It is therefore not surprising that after the GFC the prudential standards have been tightened to some extent across the globe. Part of the tightening is the naturally elevated prudence of the private sector to a recently realised risk, part of it is due to tighter prudential standards for microeconomic stability reasons (micro-prudential regulation) or macroeconomic stability reasons (macro-prudential regulation).

In an economic model with one representative consumer, there would be no need to use loan-to-income restriction as a prudential tool, simply because the single consumer would not be demanding any consumer loans whatsoever in equilibrium. The model becomes not only more realistic but also much more interesting once we allow heterogeneity across consumer types. A useful macroeconomic model with a banking sector would need to have at least two types of consumers. One would be the ‘patient’ type, who lends, the other the ‘impatient’ type, who borrows. Even in such a simple-looking version, the results become strikingly different from those of a representative consumer model.

The first obvious result from such a model with heterogeneity is that at any point in time, the impatient consumers would find the market interest rate ‘too low’ and would become borrowers. If there is a banking sector in the model, as debtors they would be placed on the left-hand side of the balance sheets of the banks. The patient part of the population would find the market interest rate ‘sufficiently high’ and would become lenders. As depositors they would be placed on the right-hand side of the balance sheets.

We could also consider another split, between “I don’t know” what the consequences of my financial decision might be, and “I don’t care”. The former can be dealt with via financial education, while microprudential financial regulation is used to tackle "I don’t care.”

The presence of prudential regulation can therefore be attributed in part to the existence of heterogeneous behaviour, and the mere existence of prudential regulation points to the need for incorporating heterogeneity into our economic models.

The question then arises of what form this regulation should take. One of the most effectively used macroprudential policy instrument after the financial crisis has been to impose a loan-to-income restriction on consumer loans, for example, a mortgage shouldn’t be more than a few times the income, or total monthly debt repayments shouldn’t be more than a certain fraction of the income. This makes sense not only for prudential reasons, but also for social sustainability reasons.

Imposing such constraints may exclude potential borrowers from being able to take out additional loans even if interest rates are very low, and even very low levels of real interest rates will not be able to stimulate consumer credit. Yet, the demand for money will continue to grow even at negative interest rates mainly due to transaction demand (money needed for daily transactions) and precautionary demand (keeping some money just in case it might be needed); despite the fact that the demand for money as an asset class will go down sharply. Therefore under the prudential regulation hypothesis (PRH) there is a possibility of sustaining a monetary equilibrium with very low, possibly even negative, interest rates.

Negative real interest rates would not be consistent with attempts other than the PRH to explain the low real interest rates that we currently observe in many countries. Neither the (global) savings glut hypothesis (SGH) of Bernanke, nor the secular stagnation hypothesis (SSH) of Summers would be consistent with negative real rates. The SGH would fail mainly because the subjective interest rate of even the most patient consumer would likely be positive, albeit small. The SSH would fail because the marginal product of capital would remain positive, albeit lower, compared to the past.

If loan-to-income regulation is the most relevant binding constraint for consumer indebtedness, for banks the equivalent is the leverage ratio restriction (LRR) or bank capital requirements. The LRR requires the banks to hold a minimum amount of equity capital as a fraction of their total balance sheet size. This constraint will always be binding as long as bank profitability is sufficiently high. Therefore it will also be a hard constraint on the lending ability of the banking sector, hence their production of money. Macroeconomic models which ignore the effects of LRR on the banking sector will probably overestimate the impacts of monetary and fiscal policies on aggregate demand. The recent stagnant growth of broad money aggregates in all of the G7 countries needs to be studied from this angle.

Before the GFC, both monetary and prudential policies eased gradually over three decades. After the GFC, monetary easing continued but was accompanied with a justifiable degree of tightening in prudential policies. Ten years after the GFC, the big question is whether monetary policy can be normalised and what that ‘new normal’ would look like, in particular, if negative interest rates would be a permanent feature of the new normal. I argue that they could, together with stagnant growth in broad money aggregates. Even a modest degree of prudential regulation in the financial system may give rise to these two results. In fact a necessary condition for observing negative interest rates in the equilibrium of an economic model is to incorporate prudential regulations as constraints on borrowing. My main message here is that prudential policy matters a lot and should not be ignored by economists.

BIS Papers N° 86: “Macroprudential policy” https://www.bis.org/publ/bppdf/bispap86.pdf

“10 Years after the failure of Lehman Brothers: What have we learned?” NAEC Conference, OECD, 13-14 September 2018, http://www.oecd.org/naec/10-years-after-the-crisis/

Olivier Blanchard

Before the Great Financial Crisis, macroeconomic paradigms largely ignored the possibility of financial developments as drivers of economic performance. In macroeconomic models, the role of the financial system was often reduced to the determination of a yield curve and stock prices, based mostly on the expectation hypothesis with fixed term premiums. Fluctuations were seen as regular random shocks. This does not fit the financial crisis, where the best metaphor is plate tectonics and earthquakes.

Financial crises are characterised by non-linearities and positive feedback whereby shocks are strongly amplified rather than damped as they propagate. And rather than returning to the status quo when the shock ends, financial crises are followed by long periods of depressed output. Another non-linearity comes from the interaction between public debt and the banking system, a mechanism known as “doom loops”. This played a central role early in the euro crisis. Higher public debt leads to worries about public debt restructuring, decreasing the value of the bonds held by financial institutions, leading in turn to a decrease in their capital, worries about their health, and the expectation that the state may have to bail them out and be itself in trouble as a result.

In contrast to the standard pre-crisis view, non-linearities like this can amplify initial shocks, potentially leading to implosive paths, and strong policy challenges. We are in an environment of low nominal and real interest rates, and may be for the foreseeable future. An environment that forces a rethink not only of monetary, but also of fiscal and financial policies. So far, the focus has been primarily on monetary policy. The binding lower bound on short term nominal interest rates (zero, or slightly negative) limited the scope of monetary policy to sustain demand during the recovery. The limits of monetary policy imply a larger role for other policies, in particular fiscal policy. If the interest rate is below the growth rate, could this be a signal that the economy is dynamically inefficient, in which case larger public debt is actually not only feasible, but also desirable? If the economy is dynamically efficient, but the safe rate is below the growth rate, can the state still issue debt without ever paying it back? If it can, should it?

Low interest rates also have implications for financial regulation and macro prudential policy. It has been argued that a combination of human nature, leading to search for yield, and of agency issues, lead to more risk taking when interest rates are low. Also, by inflating asset values and reducing debt service costs, low rates may also lead to high leverage.

Given the limits to monetary policy, and neutral interest rates below growth rates, fiscal policy will inevitably play a much more active role in stabilisation. However, fiscal policy faces a highly unusual environment. Debt levels relative to GDP are high by historical standards, but interest rates on government debt are low, and in many countries, they are expected to remain lower than growth rates for some time to come. As a consequence, levels of government debt service relative to GDP are low by historical standards.

These evolutions raise two issues. The first is how fiscal policy can be used as a stabilisation tool. Another issue is the complexity of “multipliers”, i.e. the effects of fiscal policy on demand and output, of their dependence on the specific type of fiscal adjustment and the economic environment.

Automatic stabilisers can be made more potent and effective with policy effort. And with the interest rate likely to remain below the growth rate for some time to come, the usual discussion of debt sustainability must be re-examined. At a minimum, debt consolidation can take place more slowly and there are additional arguments for debt-financed increased public investment.

Based on recent experience, a large fraction of instability in advanced economies over the next decades is likely to be associated with financial instability. This raises the issues of crisis prevention and crisis resolution. Some believe that policymakers need stronger tools for responding to financial strains, others that the moral hazard associated with the excessive availability of bailout funds was an important contributor to the excessive risk taking that led to the crisis. To a substantial extent, crises have their roots not in conscious risk taking by financial institutions, but in events that they do not anticipate, and so cannot be changed by altering incentives. Moreover, the provision of liquidity to combat runs may not represent a moral hazard cost because it need not be socially costly. The US government made a profit on the TARP programme of support for financial institutions.

For crisis prevention, the efficacy of capital regulation and stress tests, and the desirability of time varying regulatory policies to promote stability are central issues. However, claims that the system would weather a storm far worse than 2008 without any large institution needing to raise capital probably say more about stress test methodologies than they do about banking system robustness. A major policy error made in the 2008 crisis was the failure of regulatory authorities in the United States to force the raising of capital or at least the reduction of dividend payments and stock repurchases in the spring and summer of 2008, even as markets were seriously concerned about the health of the financial system.

While regulatory policies that are more responsive to changes in firms’ economic capital are desirable, time-varying capital requirements or leverage limits may not be. It is difficult to identify bubbles or excessive credit booms ex ante and even more difficult to confidently identify them far enough ahead of their bursting to make countercyclical policy worthwhile. These considerations suggest financial stability benefits of higher and constant capital ratios, rather than lower and cyclically sensitive ones.

One of the most interesting findings of research since the crisis is that, leaving aside the risk that some activity shifts to the shadow banking sector (which thus needs to be regulated as well) higher capital ratios have limited effects on either the cost of funds for banks or on bank lending. Higher capital ratios than the current regulatory ratios may therefore be appropriate. For the best mix between financial regulation and macro prudential policy, having higher and constant capital ratios rather than lower and varying ones is likely to be more conducive to the maintenance of financial stability.

NAEC seminar “Rethinking macroeconomic policy”, OECD, 5 July 2018 http://www.oecd.org/naec/events/rethinking-macroeconomic-policy.htm

“Rethinking Stabilization Policy. Back to the Future”, Olivier Blanchard. Lawrence Summers, NBER Working Paper No. 24179, December 2017 http://www.nber.org/papers/w24179

Ann Pettifor

High levels of unemployment or under-employment, falling incomes, housing crises, and obscene levels of inequality have led to the rise of counter-movements in all the leading economies. Karl Polanyi foresaw this in the 1940s, in The Great Transformation: “No sooner will today’s utopians have institutionalised their ideal of a global economy, apparently detached from political, social, and cultural relations, than powerful counter-movements—from the right no less than the left—would be mobilised”. The current economic disorder that is helping to fuel populism is largely caused by the lack of transparency, and the intangibility of the international financial system. Widespread ignorance of the workings of the great public good that is our monetary system has made society vulnerable. If democracies are to make finance the servant to the real economy, the public must gain greater understanding of the monetary system.

Ignorance of the workings of the system is compounded by the fact that many economists chose to ignore it, until as Olivier Blanchard says, the crisis forced macroeconomists to (re)discover the role and the complexity of the financial sector, and the danger of financial crises. These economists chose to ignore reality because of the failings of the traditional approach to finance. In 1961 the newly-created OECD, encouraged by ‘classical’ economists proposed to turbocharge the economy. They championed an unsustainable and delusional new target for something they named “growth”, 50 percent over the decade. They also pushed policies for financial liberalisation, although it would take several decades for these changes to be fully implemented. These policies led to a series of credit booms – regarded as ‘infinite booms’ by for example, traders in sub-prime mortgages and collateralised debt obligations. The situation was one of “all competition and no control”, both as regards demand-side measures, such as limits on loans-to-value ratios, and supply-side actions, including lending and interest rate ceilings, reserve and capital requirements, and supervisory guidance. Policy and regulation require boundaries, but finance capital abhors boundaries. The result is an international monetary system run by the equivalent of the Sorcerer’s Apprentice. In the absence of the Sorcerer – regulatory democracy – financial risk-takers and fraudsters have, since 1971, periodically crashed the global economy and ruined the lives of millions of people. There is no such thing as effective global regulation. Global financiers want to be free to use the magic of money creation to flood the global economy with ‘easy’ money, and just as frequently to starve economies of any affordable finance.

If we want to strengthen democracy, then we must subordinate bankers to their role as servants of the economy. Capital control over both inflows and outflows is a vital tool for doing so. In other words, if we really want to ‘take back control’ we will have to bring offshore capital back onshore. That is the only way to restore order to the domestic economy, but also to the global economy.

Monetary relationships must be carefully managed – by public, not private authority. Loans must primarily be deployed for productive employment and income-generating activity. Speculation leads to capital gains that can rise exponentially. But speculation can also lead to catastrophic losses. Loans for rent-seeking and speculation, gambling or betting, must be made inadmissible.

Money lent must not be burdened by high, unpayable real rates of interest. Rates of interest for short- and long-term, in real terms, safe and risky – must, again, be managed by public, not private authority if they are to be sustainable and repayable, and if debt is not to lead to systemic failure. Keynes explained how that could be done with his Liquidity Preference Theory according to which interest is the reward for giving up liquidity and rates are lower on short-term securities because investors are not sacrificing liquidity for as long as with other securities.

Both the domestic and international system are socially constructed, man-made systems. Just as they were built by society, so they can be transformed by society, as happened during the ‘golden age’ of economics from 1945 -71. The good news is that if well-managed, the social relationships that make up our monetary system are potentially infinite, unlike natural resources or human capital. A publicly-backed monetary system can provide for all of society’s needs, including the very costly requirement to transform the economy away from fossil fuels. Under a sound monetary system, there need never be a shortage of finance.

The very real possibility of using public awareness, understanding, and political will to restore such a system is why I see a ‘horizon of hope’ for a world that appears to be heading towards another dark age.

NAEC workshop on financial markets, OECD, 20 October 2017, https://oecdtv.webtv-solution.com/4106/or/committee_on_financial_markets_naec_workshop.html

The Production of Money: How to Break the Power of Bankers, Ann Pettifor, Verso Books, 2017

“The Production of Money”, LSE, 8 February, 2017 http://www.lse.ac.uk/Events/2017/02/20170208t1830vOT/The-Production-of-Money

John Vickers

Regulatory reform of the financial system has gone in in the right direction. Structural reform got started in the United Kingdom by way of ring-fencing, which is a good thing to do, but it's not happening anywhere else, and that is disappointing. We need to go a lot further in terms of beefing up the equity capital in banks and other financial institutions. However, the official word globally and in the United Kingdom is that there is no need, where we've got to is just fine. It's a long way short of fine.

It's strange that people in the financial sector, in the banks themselves, and the regulatory community, with some exceptions, share a consensus that we've done very well, we've got to a good place. On the other hand, in the opinion of economists outside that group, again with some exceptions, we're not even halfway there. For such a big public policy question as how safe to make the banks, a question that is so important for how the market economy works, it is worrying to have these different expert groups such a long way apart. I feel that the economists have the best of this argument.

There is some very low cost, even free, insurance to be had by over time by gradually building up equity buffers, and then the odds of another severe crisis would be reduced. You can never say never, but if and when the next crisis hits, we'd be in a better place to withstand it. The question here is the proportion of shareholder-funded equity, how large a multiple of shareholder equity capital should the banks be allowed to grow to. Even after all the reform efforts, big banks, or the very biggest perhaps, can still go highly leveraged, but the academic view is that this is too much.

The issue is to decide what are the costs and benefits. Do we have a safer system, better incentives, better decision-making in place for when the next crisis hits? Are we better placed to absorb the losses, pay the costs? For society as a whole, it's not so clear what those costs are, provided you phase them in over a good length of time. One of the lessons of the crisis for economists is we need to think much more carefully about how the system is regulated and run, and it should be the main spirit of thinking about the financial system.

When I chaired the UK Independent Commission on Banking, we faced a dilemma on this issue. We felt that the baseline global regulation was not strong enough, but we were making recommendations just for the United Kingdom, and there's a limit to how far one country, even a sizeable one like the United Kingdom, can go above the global baseline. So our recommendation concerned British retail banks, and with retail there is less of a risk of all the banks migrating somewhere else. We wanted quite a significant chunk over and above the proposed global baseline, and at the same time, we would have said that the global baseline itself should have been much higher. But of course we didn't have a say in that decision.

When you line up the costs and benefits and do the analysis, I think the official view is left a bit stranded. The weight of evidence is that we have not gone far enough. Today, the economy generally is a better state than it was in the years immediately following the crisis, so there is an opportunity to go further and build it up. It could be done. There are political reasons why it's difficult, but there are no technical obstacles to doing it.

Now that we're ten years on from the financial crisis, people talk about the pendulum swinging back. It may be so when we should be pushing forward. I'm not saying, and I don't think anyone is saying, there's a bigger crisis just around the corner. I am saying though that we're in a reasonably calm situation at the moment, even if debt issues are building up in the world economy, so let's take this opportunity, let's build on the progress that has been made to go a number of steps further.

In the years immediately after the crisis, you had a firm line taken in the United Kingdom and with the then administration in the United States and in Switzerland. It's not entirely a coincidence that the Swiss had two enormous banks in relation to the size of the Swiss economy, just as we in the United Kingdom had some huge banks in relation to our economy. The too-big-to-fail issue is particularly prominent in economies like ours, but the banks say that where we've got to is just fine. They would point to the new resolution regimes that bail-in debt to say they can lower the estimate of how much equity capital is needed.

I think that's the wrong approach. I like the bail-in debt resolution regimes, where instead of the taxpayer bailing out the bank, the bank’s creditors and shareholders recapitalise the bank by converting some of its debt into common shares. But I see bail-in as a complement, an add-on, not a reason to lower the equity capital requirements.

It would be awful if we had a repeat of the crisis, and in some ways, I think that we are even worse off, or could be even worse off, than last time. Monetary policy is at the limits, you can't do that again because we've already fired all the ammunition if you like. And the political consequences of the rise of populism in various places that we've seen have a lot to do with the financial crisis. If you had another problem in the financial system well within living memory, it could be calamitous, not just in economic terms but in society and politics more generally. The stakes are very high and it's important therefore that this issue gets more prominence; that we have the policy debate and let the best argument win. I think the evidence points to a need for more equity capital, but I'm not at the table with those who decide.

NAEC Financial markets workshop, OECD, 20 October 2017, https://oecdtv.webtv-solution.com/4106/or/committee_on_financial_markets_naec_workshop.html

John Vickers on reform of financial markets since the 2008 crisis https://youtu.be/JOXbbd_kHX4

Adair Turner

“Monetary finance” means running a fiscal deficit (or a higher deficit than would otherwise be the case) which is not financed by the issue of interest-bearing debt, but by an increase in the monetary base. Milton Friedman described this as “helicopter money”, with the government printing dollar bills and then using them to make a lump-sum payment to citizens. Today it could involve either a tax cut or a public expenditure increase which would not otherwise occur. It could be one-off or repeated. It would typically involve the creation of additional deposit rather than paper money, initially in the government’s own current accounts, and then transferred into private deposit accounts either as a tax cut or through additional public expenditure. The money could be “created” in a number of ways, but the choice between them has no substantive economic consequences. In all cases the consolidated balance sheet of the government and central bank together is the same; the monetary base of irredeemable non-interest-bearing money is increased; and the government is thus able to cut taxes or increase expenditure without incurring any future liability to pay more interest, or to redeem the capital value of the money created.

Technically, and excluding the impact of political dynamics, money finance deficits can always stimulate aggregate nominal demand, and will always do so more certainly and more powerfully than either debt financed fiscal deficits or pure quantitative easing operations. The scale of the resulting stimulus to nominal demand can be managed, and adjusted over time through the use of available policy tools. If therefore there exist circumstances in which economies might face a deficiency of aggregate nominal demand, money financed fiscal deficits are, in technical terms, a feasible and at times optimal policy option. However, if monetary finance is accepted as legal and technically feasible, biases in the political system may create incentives for its excessive use. In democracies, electoral cycles create incentives for governments to reduce taxes or increase public expenditures in the run-up to the election, or to avoid necessary fiscal consolidation. If money financed deficits were an available option, they might appear a costless way out of this constraint. While non-democratic political systems might in principle be free of such incentives, in many cases they depend for their stability on clientele patronage systems which are most easily lubricated by money creation.

In response to these biases, and to the macroeconomic harm which excessive monetary finance has produced in many economies, modern economic policy has gravitated to the consensus that the only way to contain the dangers of monetary finance is to prohibit it entirely. The central issue therefore is political, whether we can design political economy rules, responsibilities and relationships which can allow us to obtain the technically possible benefits of money finance while constraining the dangers of excessive mis-use.

We could place the use of monetary finance within the constraints of central bank independence and of inflation targeting, and preserve the legally defined self-denying ordinance which prevents politicians from enjoying discretion to implement inflationary policies. It would not however be acceptable for the central bank to determine the precise allocation of the fiscal resources thereby created; this should be done by the government. The guiding principle should be that the specific measures implemented should be credibly one-off. Tax cuts and specific investment programmes might meet this criterion, but increases in ongoing entitlement programmes which are difficult to reduce later would not.

One counter argument is that the effectiveness of monetary finance might be offset by anticipation of an “inflation tax” that would depress demand so that monetary financed deficits might be no more stimulative than deficits financed by debt. However, a money financed deficit will always stimulate nominal demand, while a debt financed deficit might not do so in some circumstances, so that the stimulative impact of a money financed deficit is always greater than or equal to that of a debt financed one. This is the case both where the economy is already at full employment/full potential output and where an increase in nominal demand can therefore only produce an increase in inflation; and in the case with underemployment/below full potential output, where an increase in nominal demand could produce some increase in real output as well as an inflationary effect.

Another question relates to the private sector asset counterpart to a consolidated public sector non-interest-bearing liability. The impact of money financed deficits will only differ fundamentally from debt-financed deficits if the additional monetary base created is permanently non-interest-bearing. But who would willingly hold non-interest-bearing money? The answer is that while no household or company needs to hold non-interest-bearing money once market interest rates have returned to significantly positive levels, monetary finance is only fully effective if the commercial banks are required to hold non-interest-bearing reserves at the central bank. If instead the central bank paid interest on these reserves, the difference between money financed deficits and debt financed deficits would be very significantly reduced. But if the commercial banks are required to hold non-interest-bearing reserves, while companies and households earn interest on their deposits at commercial banks, this is equivalent to imposing a tax on commercial bank credit intermediation.

Although money finance should only be used in extreme circumstances and as a one-off exercise, it is possible that secular stagnation with negative real long-term interest rates would mean using money to finance part of a fiscal deficit year after year because this would better than other options such as running debt financed fiscal deficits, meaning that public debt levels as percent of GDP either rise continuously or stabilise at a high level only sustainable if interest rates remain very low for ever.

To conclude, there is a technical case for using monetary finance in some circumstances. But before using it, we should address the political issue of how to ensure it will only be used in appropriate circumstances and appropriately moderate quantities.

NAEC seminar “Between debt and the devil”, OECD, 20 May 2016 http://www.oecd.org/naec/events/between-debt-and-the-devil.htm

“The Case for Monetary Finance”, IMF, November 5–6, 2015 https://www.imf.org/external/np/res/seminars/2015/arc/pdf/adair.pdf

“Monetary Finance: Mechanics & Complications” INET, May, 2016 https://www.ineteconomics.org/perspectives/blog/monetary-finance-mechanics-complications

“Why a future tax on bank credit intermediation does not offset the stimulative effect of money financed deficits”, INET, August 2016 https://www.ineteconomics.org/research/research-papers/why-a-future-tax-on-bank-credit-intermediation-does-not-offset-the-stimulative-effect-of-money-finance-deficits

Willem Buiter

Few lessons have been learnt from the global financial crisis (GFC) and expressed in legal, regulatory and other institutional reforms, and some were the wrong lessons. We may know more about the observable drivers of financial crisis risk, but not enough to make it likely that we will see the next crisis coming. We still cannot confidently identify asset bubbles, so the bubbles that will precede the next financial crash will not have been identified by those in a position to act. On a global scale, the lack of progress in sorting out the distribution of capital requirements across a multinational financial institution is worrying. There is still “cognitive” regulatory capture whereby regulators internalise the objectives, interests and perception of reality of those they are meant to regulate and supervise in the public interest.

There have been attempts to address the perverse incentives through remuneration structures that involve deferred compensation, and banks are better capitalised now. That is good news, but banks still hold too little capital relative to their debt obligations and other sources of leverage, while systemically important non-bank financial intermediaries remain undercapitalised and have probably increased their share of total financial intermediation because of tighter regulation of banks. Banks can still hold their own domestic-currency-denominated sovereign debt with zero capital requirements and without any concentration or exposure limit. In the Eurozone, this strengthens the doom loop between barely solvent sovereigns and barely solvent banks.

In a number of countries, retail banking activities have been ring-fenced. It is difficult to see what problem this is the solution to. Lending to households and SMEs is also very risky, so there is no good case for separating the ‘responsible’ retail banking activities from the ‘casino’ activities of investment banks and other financial intermediaries. There is, however a need for macroprudential instruments to reduce the likelihood of financial and credit booms and bubbles, or the magnitude of the inevitable bust, to acceptable levels. Policy rates, the exchange rate and the size and composition of the central bank balance sheet are not sufficient. This requires countercyclical capital requirements; countercyclical liquidity requirements; countercyclical loan-to-value, loan-to-income or debt-service-to-income ratios; countercyclical margin requirements for equity etc. The cycle is the financial cycle, which may differ from the business cycle.

The operations of central banks should be rethought too. Many central banks have come out of the GFC with greatly enhanced supervisory and regulatory roles, but traditional central bank operational independence for monetary policy cannot be extended to these enhanced functions. The crisis reminded us that the primary responsibility of the central bank is financial stability. But central banks during the GFC created moral hazard and engaged in inappropriate quasi-fiscal activities by not heeding the third of Bagehot’s guideposts for an effective lender of last resort (LLR): lend freely; lend against collateral that would be good during normal times and if held to maturity; and lend at a penalty rate. Moreover, the Dodd-Frank Act weakens the future ability of the Fed to act as LLR by restricting its ability to provide idiosyncratic support to financial institutions. In addition, the Federal Deposit Insurance Corporation can no longer issue blanket guarantees of bank debt as it did in October 2008, and the US Treasury will not be able to repeat its guarantee of money market funds, as it did in September 2008.

Today’s debt burdens have not yet become un-financeable debt service burdens, but when neutral interest rates and credit risk spreads normalise, debt service burdens are likely to become unmanageable for many debtors. It is true that, for domestic-currency-denominated, nominal debt, a shift from the private sector to the public sector reduces the risk of default. There are however political and economic constraints on the ability of the sovereign to raise taxes (and to cut public spending) to cover these debts. In the Eurozone moreover, governments do not have the ultimate control of monetary issuance by their national central banks unless they are willing to leave the monetary union.

As well as the need for an LLR, the crisis reminded us of the need for a market maker of last resort (MMLR) given the significant amount of financial intermediation through the financial and capital markets. The LLR provides funding liquidity and the MMLR provides market liquidity. The GFC likewise made clear the need for a global LLR/MMLR. The IMF does not have the resources to do this and the greatest achievement of the Fed during the GFC was that it became the de facto global LLR, through the use of the liquidity swap lines (reciprocal currency arrangements). This prevented a complete financial collapse in Europe, but it is unfortunate that no swap lines were made available to the central banks of the “fragile five” (Brazil, India, Indonesia, South Africa and Turkey).

Conventional monetary policy space is likely to be very limited (especially outside the United States) when the next financial crisis and recession hit. Lack of fiscal space will likely restrict the scope for public spending increases and/or tax cuts if the resulting fiscal deficits cannot be monetised. The lack of fiscal space will become acute when neutral interest rates and credit risk spreads normalise. Helicopter money drops are the only effective way to stimulate demand when the economy is in a liquidity trap and there is limited fiscal space for debt-financed fiscal stimuli. We are not well positioned to deliver here.

Limited and selective learning has taken place by policy makers and by monetary, supervisory and regulators. Some of the lessons drawn have lowered the ability of the central bank to act effectively as LLR/MMLR. The banking sector may be slightly more resilient. It is not enough, however, to prevent another major financial crisis or even to postpone it by much. Nor is it enough to mitigate the impact on the real economy.

“10 Years after the failure of Lehman Brothers: What have we learned?” NAEC Conference, OECD, 13-14 September 2018, http://www.oecd.org/naec/10-years-after-the-crisis/

Anat Admati

Developed economies rely on chains of commitments between individuals and businesses of all sizes to enable consumption and investments and to share risks. Intermediaries such as banks and institutional investors are often important participants in these chains, making loans to individuals and businesses, investing their own and other people’s money in the financial claims of large corporations. Financial firms also create and facilitate trade in asset-backed securities representing claims on baskets of assets, and in derivative securities whose payoffs depend on the realisation of certain events.

Central banks and governments play a critical role in the financial system. Government bonds trade alongside other securities in financial markets. Central banks lend to financial institutions, and increasingly participate directly in the markets by buying or accepting as collateral not only government bonds but also mortgage securities and corporate bonds. By setting the terms of the loans they make and determining which assets to purchase and at what quantities, central banks and governments impact the allocation and pricing of financial claims, effectively choosing winners and losers. How others in the economy are affected by government and central bank actions can depend critically on decisions made by financial intermediaries and other corporations, for example whether they use funds to make payouts to shareholders or invest in employees’ welfare or otherwise.

Excessive borrowing by households and financial institutions, combined with ineffective regulations, were key causes of the 2007-2009 financial crisis. Many troubled banks received massive support from governments and central banks during and since the crisis, and they benefitted from the rescue of others (such as the insurance company AIG or the Greek government). The lingering weakness of banks and households lengthened the post-crisis recession.

Many claim that reforms have made the financial system much safer, but in fact the system has not changed substantially in the last decade, and it remains too fragile, opaque and distorted. Policymakers failed to learn the lessons of the financial crisis and the new rules are complex, poorly designed and inadequate, exposing the public to unnecessary risk. Perhaps the most glaring regulatory failure in the run-up to the financial crisis in 2008 and through the last decade that included highly profitable years for the banking sector, was allowing them to deplete their ability to absorb losses by making payouts to shareholders (in the form of dividends and share buybacks) rather than retain these and reinvest these profits on behalf of their shareholders and to be better prepared for economic shocks. Cash paid out to shareholders is no longer available to repay depositors and other creditors. When governments and central banks rescue banks, the shareholders and managers who had benefitted from the prior gains effectively pass on some of the losses to innocent taxpayers.

The distorted incentives of heavily indebted corporations are not unique to banking. Making payouts to shareholders, continuing to borrow, and selling assets (or laying off employees) instead of retaining profits and raising new equity can benefit managers and shareholders by shifting costs, risks and losses to others. A “leverage ratchet” dynamics makes corporate borrowing addictive and inefficient. This problem is particularly relevant for banks, whose love of borrowing is due to their naturally high level of indebtedness (in the process of taking deposits) and is further enabled and encouraged by explicit and implicit guarantees. Unless regulators intervene, and with supports from central banks, dysfunctional “zombie” banks may persist for extended periods of time, hiding their weaknesses and gambling for resurrection.

Corporate tax codes in most jurisdictions, which subsidise debt relative to equity, are among the key reasons corporations borrow excessively. These tax subsidies have no good rationale or justification. They are as perverse as subsidising a polluting technology when clean and otherwise equally costly alternatives are available. The persistence of bad and harmful policies is no excuse for allowing it to continue. Abolishing distortive debt subsidies is long overdue.

We find counterproductive debt subsidies in other parts of the economy. For example, some nations, such as the United States and the Netherlands, provide tax and other subsidies to mortgage debt, which encourages excessive borrowing to invest in real estate and distorts household decisions and housing markets. If home ownership is worthy of public subsidies, governments can find ways to subsidise equity rather than debt funding of homes. Similarly, the student debt crisis in the United States reflects counterproductive policies in the name of supporting higher education. The policy creates heavy and harsh debt burdens, subsidises for-profit colleges, including those providing sub-par education, and raises the cost of higher education.

When borrowers default or become insolvent, they may file for bankruptcy. The legal processes that ensue vary in different jurisdictions and for different borrowers, and they can be complicated, lengthy and costly. Cross-border resolution of large multinational financial institutions is virtually intractable, a problem that has been known for decades yet remains largely unsolved. Worse, some bankruptcy provisions, such as broad “safe haven” exemptions to derivatives and repo (sale and repurchase) agreements favour some creditors, mostly from within the financial system, over others, and ultimately encourage fragility. Finally, distortions in the setting and implementation of accounting rules, auditing, and credit ratings further increase the opacity of the financial system.

Fuelled by persistently low interest rates and by yield-chasing investors willing to overlook risks, corporations have binged on debt in recent years, planting the seeds of a debt crisis before the onslaught of Covid-19. The disruptions caused by the pandemic led numerous affected individuals and businesses to financial distress and the inability to fulfil all the promises they had made. Governments and central banks stepped in to prevent some defaults or delay harsh consequences, for example by mandating temporary freezes on foreclosures and evictions, providing unemployment benefits, cash grants, and loans. Central banks have poured trillions into financial institutions and asset purchase programmes.

These actions have propped up financial markets, but also created distortions and added to the high mountain of debt, which will have to be dealt with at some point. Similar to the financial crisis of 2007-2009, the extraordinary interventions favour investors and corporations and do not reach many parts of the economy that are most in need, creating disconnect between financial markets and the rest of the economy and exacerbating income and wealth inequality. Despite the risk of massive losses from the slowdown of the economy, many banks are still allowed to make payouts to shareholders and harm the public.

Recklessness in finance goes beyond excessive borrowing and includes many cases of fraud, money laundering and other law evasion, only some of which are periodically revealed. Large fines, with no major consequences for individuals who could have done more to prevent wrongdoings, fail to prevent repeated scandals. We must re-examine the workings of our justice systems in a corporate context.

In some parts of our lives, such as aviation safety, complex systems operate remarkably safely, including across national borders. In the financial sector, however, recklessness persists because of political economy forces and the benefit that many who collectively control the system derive from its fragility. Covid-19 might serve as a wake-up call.

The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (with Martin Hellwig), Princeton University Press, March 2013 http://bankersnewclothes.com/

“The Leverage Ratchet Effect” (with Peter DeMarzo, Martin Hellwig and Paul Pfleiderer), Journal of Finance, 2018, 145-198. https://admati.people.stanford.edu/publications/leverage-ratchet-effect

“The Parade of Bankers’ New Clothes Continues: 34 Flawed Claims Debunked” (with Martin Hellwig), revised August, 2019. https://admati.people.stanford.edu/publications/parade-bankers-new-clothes-continues-34-flawed-claims-debunked

“The Missed Opportunity and Challenge of Capital Regulation”, National Institute Economic Review, February 2016, 235: R4-14. https://admati.people.stanford.edu/publications/missed-opportunity-and-challenge-capital-regulation

“It Takes a Village to Maintain a Dangerous Financial System”, Just Financial Markets? Finance in a Just Society, Lisa Herzog, editor, Oxford University Press, 2017. https://admati.people.stanford.edu/publications/it-takes-village-maintain-dangerous-financial-system

Michael Jacobs

The coronavirus crisis has raised government deficits and debt to levels not seen since the Second World War. As they closed their economies down to control the public health risk, governments in all developed countries have been forced into unprecedented increases in spending. Resources have been poured into health systems; radical measures taken to keep companies afloat and workers in jobs; welfare payments have spiralled as unemployment has risen. At the same time the closedown of economic activity has caused tax revenues to collapse.

The OECD’s Economic Outlook in June 2020 reported that in the first three months of the crisis public debt-to-GDP ratios rose by 10% or more in almost all OECD countries. The report forecasts debt-to-GDP levels in 2021 of over 100% in the United States, United Kingdom and the Euro area as a whole, with Japan’s reaching around 250%. These ratios reflect not just much higher budget deficits, but lower GDP.

For many years, the orthodox economic view has been that deficits and debt levels of these kinds are extremely damaging to medium-term growth, and so to be avoided at almost all costs. Following the 2008 financial crisis, this view led to the implementation across Europe of severe austerity policies, including the socially devastating measures imposed on its peripheral members by the Eurozone.

This view had two main origins. Theoretically, it followed from the ‘crowding out’ thesis, which argued that high government borrowing required high interest rates to fund it in the short term and higher taxes in the long, both of which would deter private sector investment and spending. Empirically, it was bolstered by a famous 2010 paper by Reinhart and Rogoff, which claimed a consistent historical and cross-country pattern that debt-to-GDP ratios over 90% were associated with significantly lower growth rates.

The empirical basis of this paper was subsequently discredited, and the crowding out thesis had long been challenged by the Keynesian observation that in a recession there is insufficient private sector investment to be deterred, and public borrowing is the only way to sustain aggregate demand. But intellectual and policy inertia is powerful, and some version of the orthodox view persists in many commentaries about the current crisis. The question is being asked: how will we pay for all this extra public spending? Will we need a return to austerity to bring deficit and debt levels down to affordable levels?

There is now wide consensus among macroeconomists that the answer to this is no. This is for four crucial reasons.

First, since public borrowing is always partly a question of intergenerational equity (with current spending paid for out of future income), the severity of current economic conditions makes a critical difference to the calculus. We are now entering the most severe global recession at least since the 1930s, and in many countries perhaps for centuries. By the end of 2020 the OECD forecasts unemployment at over 10% on average across the OECD and the Euro area, with higher rates if second outbreaks of the coronavirus occur. In these circumstances current public spending will not be enough – new stimulus packages will be required to create jobs through public works and training schemes, infrastructure investment, subsidies to key sectors and probably tax cuts. If this is not done the long-term ‘scarring’ effects of business failures and unemployment will be even more severe than already being experienced. The idea that such measures should not be implemented in order to save future generations from higher debt levels is patently absurd. ‘Future generations’ are today’s young people, who will suffer most from high and lasting unemployment. The cost-benefit calculus is clearly on the side of even higher deficits now.

This is particularly true, second, because in these deep recessionary conditions it is only through public spending that growth will resume, and it is only through growth that debt levels will eventually fall. Household spending, corporate investment and global trade are projected to pick up only slowly and uncertainly over the next few years, and in these circumstances only government spending can fill the gap in aggregate demand. As the experience of austerity after 2010 demonstrated, too early a withdrawal of government spending leads to slower growth, and therefore to more slowly-falling debt. Austerity in recession is self-defeating.

Third, the level of interest rates at which many governments can currently borrow makes the cost-benefit calculus completely different from previous periods. What matters to future generations is not the ratio of debt to GDP itself, but the cost of servicing that debt. At low interest rates – in some countries governments can now borrow at negative real rates for 20 years ahead – the cost of servicing debt is extremely low. This means that the return on investment required to justify current expenditure is much lower than in the past. As long as the nominal interest rate is below the nominal growth rate of the economy, debt to GDP will gradually stabilise and then decline (provided the government’s primary budget balance remains stable). These are not the conditions in which the previous orthodoxy was developed, when interest rates were assumed to exceed GDP growth rates, and almost always did.

Fourth, central banks are now much more involved in buying government debt than in the past. The expansion of quantitative easing (QE) during this crisis has seen central banks buy up large quantities of government debt, and their continuing willingness to do so is an important reason that interest rates are projected to stay low. The prevailing assumption behind QE since the financial crisis has been that at some point in the future central banks will sell the debt back into the market, but almost no such ‘unwinding’ had occurred before the current crisis struck, and the new wave of asset purchases has made the prospect recede even further. But it doesn’t matter. Central banks can hold government debt indefinitely, if necessary. So long as today’s low inflationary expectations persist, there is no reason why they should not do so.

So there is no need for a return to austerity, or for governments to seek to pay back their newly-raised debts in a short period of time. We shall simply have to get used to sustained high debt-to-GDP ratios, in some cases over 100%, and to accept that they are worth the cost. This will be the new macroeconomic normal.

Or more accurately, it will be a return to an old normal. After the Second World War, national debt was even higher than today. In the United States it peaked at 113% of GDP in 1945, in the United Kingdom  250%. These levels were reached because governments in both countries took it for granted that winning the war was more important than the cost of future debt. So instead of a return to austerity after the war, the immediate post-war period saw an expansion of public expenditure on health, housing and welfare services. These contributed to growth, as well as to a reduction in inequalities (which also contributed to growth), and there was almost no demand for the debt to be repaid quickly. It took 15 years for US public debt to return to its pre-war level, and thirty years for UK public debt to return to 50% of GDP (in 1975). In both countries in this period the central bank bought up significant portions of the debt and kept it on its own balance sheet.

After the financial crash a popular economic metaphor was that the national economy is like a household. It must live within its means, and pay back its debts. But the metaphor was wrong then, and it is even less applicable today. Today the appropriate metaphor is that the coronavirus crisis is like a war. During times of war, governments spend what it takes to defeat the enemy, and borrow from their central banks to do so. They then pay the debt back over a long period, relying on investment and growth (and some inflation). Today we must do the same. For it is not just a war against the coronavirus that we face today. We also face a climate and environmental emergency. This demands much higher levels of investment in low-carbon infrastructure, industrial transformation and nature restoration. As governments contemplate the new phase of the current crisis, they have a huge opportunity to tackle mass unemployment and recession through spending on green recovery measures. Anxiety about the levels of government debt that will result should not prevent them.

Martin Wolf

© The Financial Times, 28 April 2020

This time it is capital markets, rather than banks, that have to reform.

The scale of the financial disarray reflects in part the size of the economic shock. It is also a reminder of what the late Hyman Minsky taught us: debt causes fragility. Since the global financial crisis, indebtedness has continued to rise. In particular, the indebtedness of non-financial companies rose by 13 percentage points between September 2008 and December 2019, relative to global output. The indebtedness of governments, which assumed much of the post-financial crisis burden, rose by 30 percentage points. This shift on to the shoulders of governments will now happen again, on a huge scale.

IMF’s April 2020 Global Financial Stability Report gives a clear overview of the fragilities. Significant risks arise from asset managers as forced sellers of assets, leveraged parts of the nonfinancial corporate sector, some emerging countries, and even some banks. While the latter are not the centre of this story, reasons for concern remain, despite past strengthening. This shock, the report states, is likely to be even more severe than envisaged in the IMF’s stress tests. Banks remain highly leveraged institutions, especially if we use market valuations of assets. As the report notes: “Median market-adjusted capitalisation is now higher than in 2008 only in the US.” The chances that banks will need more capital is not small.

Yet it is capital markets that lie at the heart of this saga. Specific stories are revealing. The Bank for International Settlements has studied one weird episode in mid-March when markets for benchmark government bonds experienced extraordinary turbulence. This happened because of the forced selling of Treasury securities by investors seeking “to exploit small yield differences through the use of leverage”. This is the type of “long-short strategy” made infamous by the failure of Long-Term Capital Management in 1998. It is also a strategy vulnerable to rising volatility and declining market liquidity. These cause mark-to-market losses. Then, as margin is called in, investors are forced to sell assets to redeem loans.

Another story elucidated by the BIS tells of emerging economies. An important recent development has been the rising use of local currency bonds to finance government spending. But when the prices of these bonds fell in the crisis, so did exchange rates, increasing the losses borne by foreign investors. These exchange-rate collapses worsen the solvency of domestic borrowers (notably businesses) with debts denominated in foreign currency. The inability to borrow in domestic currency used to be called “original sin”. This has not gone, argue the BIS’s Augustin Carstens and Hyun Song Shin. It has just “shifted from borrowers to lenders”.

Yet another significant capital-market issue is the role of private equity and other high-leverage strategies in increasing expected returns, but also the risks, in corporate finance. Such approaches are almost perfectly designed to reduce resilience in periods of economic and financial stress. Governments and central banks have now been forced to bail them out, just as they were forced to bail out banks in the financial crisis. This will reinforce “heads, I win; tails, you lose” strategies. So vast is the size of central bank and government rescues that moral hazard must be pervasive.

The crisis has revealed much fragility. It has also demonstrated yet again the uncomfortably symbiotic relationship between the financial sector and the state. In the short run, we must try to get through this crisis with as little damage as possible. But we must also learn from it for the future.

A systematic evaluation of the frailties of capital markets, comparable to what was done with banks after the financial crisis, is now essential. One issue is how emerging economies reduce the impact of the new version of “original sin”. Another is what to do about private sector leverage and the way in which risk ends up on governments’ balance sheets. I think of this as trying to run capitalism with the least possible risk-bearing capital. It makes little sense. This creates a microeconomic task - eliminating incentives for the private sector to fund itself so heavily via debt; and a macroeconomic one - reducing reliance on debt to generate aggregate demand.

The big question now is whether the essential systems that keep our societies running are adequately resilient. The answer is no. This is the sort of question the OECD’s New Approaches to Economic Challenges Unit has dared to address. Inevitably, it has created much controversy. Yet it is admirable that an international organisation is daring to do so at all. The crisis has shown us why. We cannot afford complacency. We need to reassess the resilience of our economic, social and health arrangements. A focus on finance must be an important part of this effort.

Mathilde Mesnard and Robert Patalano

The global financial system remains inherently fragile and vulnerable to endogeneous evolutions as well as to shocks aring from within the financial system itself, as in 2008, or from outside, as with the Covid-19-triggered crisis. In such a complex adaptative system as the financial system, there are tipping points that create radical and sudden changes in behaviours, leading to instability or crisis, that will in turn be amplified due to negative spillovers and feedback loops between institutions and markets, and within and across borders that extend beyond national regulatory perimeters. Despite collective efforts by many OECD countries to implement a comprehensive suite of G20 financial reforms, Covid has illustrated new faultlines that have arisen in part due to unintended consequences, from concentrations to regulatory arbitrage and market fragmentation.

Sources of current financial vulnerability include the rise of global corporate debt in both advanced and emerging market economies, resulting from low interest rates and abundant liquidity. High levels of leverage increase firms’ vulnerability to shocks, the more so in a low growth environment. Moreover, the current stock of outstanding corporate bonds has lower overall credit quality, higher payback requirements, longer maturities and inferior covenant protection. These characteristics could amplify the negative effects of any downturn on the non-financial sector and the overall economy.

A particular concern is linked to the rebound in the issuance of leveraged loans and collateralised loan obligations, now well over USD 2 trillion globally, and largely issued without financial covenants that typically protect leveraged lenders from excessive losses. Furthermore, a significant amount of speculative bonds and leveraged loans are held in open-ended investment funds. Unexpected sharp redemptions of funds in levels beyond liquidity buffers of such funds cause portfolio managers to sell these less-liquid assets to raise cash, and such forced asset sales propagate stress to other debt investors. The combination of corporate leverage and liquidity transformation of funds adds to systemic fragility during periods of stress.

Another potential source of crisis is the level of sovereign debt. Given the surge in sovereign borrowing needs in response to the pandemic, redemptions will increase substantially, exposing issuers to refinancing risks in the future. Moreover, despite efforts to strengthen banking systems, bank equity valuations have fallen to historically low levels amid the Covid crisis, as weak banking sector performance and weak asset quality in many countries considerably deteriorated in 2020.

In the longer term, there are also implications of climate change for market resilience and financial stability, with both physical risks related to the actual or expected economic costs of a continuation in climate change, and transition risks related to an adjustment towards a low-carbon economy. The manifestation of physical risks could lead to large losses, particularly in industries where exposure to fires, floods, and storms is more detrimental to performance. Growing physical risks will likely have an increasingly large impact on the stability of the financial system, unless countermeasures – both environmental and financial – are taken. A disorderly transition to a low carbon economy, for example in the form of an abrupt change in public policy not anticipated by market participants, could result in a sharp fall in asset prices as so-called stranded assets associated with fossil fuels are devalued, which could destabilise the financial system.

Improving market resilience and policy certainty is vital to help mitigate the unexpected and anticipated impacts from physical and transition risks, and financial markets are already moving in this direction. Sustainable finance, through environmental, social and governance (ESG) investing and green markets, is providing a wealth of information that can help market participants and regulators better assess the potential climate risks and take mitigating actions. Amid this progress, the current state of sustainable finance related to ESG and green finance is such that much greater transparency, consistency, and comparability of metrics and methodologies are needed to ensure that investors, from central banks to retail funds, have reliable market tools to help reduce fossil fuels and pivot toward renewable investments to facilitate an effective transition to low-carbon economies.

Physical and transition risks might combine, amplifying their overall effect on financial stability, with concentrated exposures in certain financial institutions. Climate-related risks may thus affect financial system resilience and give rise to abrupt increases in risk premia across a wide range of assets. The breadth and magnitude of climate-related risks might make these changes more pernicious than in the case of other economic risks. Moreover, the interaction of climate-related risks with other macroeconomic vulnerabilities could increase risks to financial stability. Therefore, it is critical that more in-depth steps are taken by financial authorities, related to stress testing of portfolios, more climate-friendly reserve managerment portfolios, and even consideration of greening of the financial system through collateral and monetary policy frameworks within existing central bank mandates.

In summary, as the NAEC Initiative has highlighted, there are currently many endogeneous sources of vulnerabilities within the global financial markets, as well as many already materialised or highly probable external shocks. Governments have made significant and globally coordinated efforts to address the consequences of the Covid crisis, in addition to efforts over the past decade to improve the resilience of the global financial system. Yet, this economic shock has illustrated that additional policy measures, based on new ways of considering systemic risks – be they pandemics or climate change – are urgently needed to ensure a resilient financial system that can set the foundation for sustainable and inclusive economic growth. We need to think the unthinkable when it comes to policy measures to deal with catastrophic tail risks, as Covid has demonstrated.

Boffo, R., C. Marshall and R. Patalano (2020), “ESG: The Environmental Pillar” forthcoming.

NGFS (2019), “A call for action: Climate change as a source of financial risk.”

Patalano, R. and C. Roulet (2020), “Structural developments in global financial intermediation: The rise of debt and non-bank credit intermediation”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 44, OECD Publishing, Paris, https://doi.org/10.1787/daa87f13-en.

Roulet, C (2020), “Covid-19: Stress simulations of corporate debt.” forthcoming

Roulet C. and Patalano, R (2020), “Covid-19: Non-performing loan losses and bank asset disposal strategies” forthcoming.

OECD (2019), Business and Finance Outlook: Trust in Business, Chapter 1.

OECD (2020), Business and Finance Outlook: Sustainable and Resilient Finance, forthcoming.

Alan Kirman

Economists have argued for two centuries now that if people are left to their own devices, the invisible hand will lead to a socially satisfactory state. Rough periods will occur of course, so one should just take appropriate measures to “get things back to normal”. This faith is not justified by history. We have navigated from crisis to crisis, and leaving individuals and firms to their own devices does not produce the nirvana that many claim. The world has organised itself in a way that puts a high premium on short-run “efficiency” and “just in time” supply chains. The idea that one might want to have reserve capacities “just in case” has been dismissed and we are now paying heavily for that.

There is nothing unprecedented about today’s crisis, notwithstanding claims that this is an entirely new situation for which we could not have been prepared. And that despite high profile figures such as Bill Gates arguing in a 2015 TED talk entitled “The Next Outbreak: We are not Ready” that we should not simply react to each crisis as it occurred but should be “playing epidemic and crisis games” the way the military play war games.

The structure of our system is conducive to its fragility, with short-term individualistic incentives within a framework that is increasingly interconnected and interdependent. As Andy Haldane’s prophetic comparison in 2009 put it:

“Seizures in the electricity grid, degradation of ecosystems, the spread of epidemics and the disintegration of the financial system – each is essentially a different branch of the same network family tree”.

Ben Bernanke argued that:

“The best approach for dealing with this uncertainty is to make sure that the system is fundamentally resilient and that we have as many fail-safes and back-up arrangements as possible.”

Such observations soon faded from memory, and when the pandemic hit, few reactions from governments questioned the existing economic framework. President Emmanuel Macron was an exception:

“This pandemic reveals that there are goods and services that must be placed outside the laws of the market.”

This admission by someone regarded as a disciple of universal deregulation suggests that the “neo-liberal consensus” is being questioned, though impacts on economic policy remain to be seen.

The question is are we prepared to accept that our system will evolve through reactions to successive crises, or is it possible to analyse the nature of crises, to avoid having simply to react to each in turn? Although we have not created Bill Gates’ powerful army of experts, many people thought deeply about major systemic disruptions. The OECD, for example, created the New Approaches to Economic Challenges (NAEC) initiative in 2012 to draw lessons from the 2008 crisis. NAEC emphasises the need to look at the world as a complex adaptive system whose behaviour is governed by the interaction between its components.

Economists now recognise the need to integrate the financial sector more effectively into macroeconomic policy thinking and NAEC contributors from fields as diverse as statistical physics and central banking have made proposals on how to do this. Contrary to conventional wisdom, becoming more connected has not made the financial network more robust. Macro characteristics such as robustness, radical uncertainty, or emergence cannot be deduced from even a detailed knowledge of the individual components. These characteristics call for simulations and computational models rather than analytical models which provide exact “solutions”.

NAEC also focuses on another system characteristic, resilience, with Igor Linkov from the U.S. Corps of Army Engineers, as part of its mission to protect populations from major disasters. Linkov’s work highlights the trade-offs between resilience and efficiency that the Covid-19 crisis has highlighted. Cutting hospital beds or relying on one supplier of protective equipment may have made health systems “more efficient”, but we now see the price to be paid. Resilience is now one of the most frequently used words when the current pandemic is being discussed, yet had we taken it seriously the effects of the pandemic would have been much less severe.

Thinking systemically suggests that modern crises can soon lose their identities, with a health crisis becoming an economic crisis. The same is true for epidemics. Nobel Prize winner Angus Deaton explained the epidemic of “Deaths of Despair” from opioid addiction, alcoholism and stagnating wages as in fact the product of several epidemics each intimately related to the others (see Chapter 17). Likewise, Joshua Epstein, professor of epidemiology at NYU, views the current pandemic as a product of two epidemics, the disease itself and fear of the disease. One could add a third epidemic, as financial markets participants who were neither infected nor fearful are impacted by the first two epidemics through changes in stock market indices.

This highlights the importance of narratives. Nobel Laureate Bob Shiller emphasises that stories do not just explain economic policy, but also shape it. In the social media age, many narratives are based on widely shared fake news, but we should not confuse rapidity of diffusion with depth of impact. Analysis by David Chavalarias at the Paris Complexity Institute of millions of tweets and retweets during the French presidential campaign shows that fake news reinforces existing prejudices but does not convert those who are not sympathetic to it to begin with. Today, “getting back to normal” would resonate with those sympathetic to the narrative that has dominated economic policymaking over the last decades. These forces of inertia and vested interests resistant to change will quickly forget that the system cannot simply be put back on the rails and left to run as before, leaving us even worse prepared for the next disaster than for this one.

The encouraging return in the current crisis of expert opinion, notably from epidemiologists’, highlights how economists have been paid little attention, despite the economic consequences of the pandemic. But if economists react to each crisis by immediately forecasting outcomes, their poor accuracy in the past may lead to them being ignored (or may cause misinformed panic). Much better to admit that with so much radical uncertainty, as John Kay and Mervyn King point out in their new book entitled Radical Uncertainty, “we simply don’t know”.

Rethinking the Financial Network, speech given by Andrew G Haldane, Chief Economist, Bank of England, at the Financial Student Association, Amsterdam, 28 April 2009 https://www.bankofengland.co.uk/speech/2009/rethinking-the-financial-network

Is Ben Bernanke Having Fun Yet? Profile of Ben Bernanke by Sewell Chan, New York Times, May 15, 2010 https://archive.nytimes.com/www.nytimes.com/2010/05/16/business/16ben.html

National televised speech on Covid-19 by President Emmanuel Macron, 12 March 2020

Agent Zero and Integrative Economics, presentation by Joshua M. Epstein, Professor of Epidemiology, New York University School of Global Public Health, at the NAEC conference on Integrative Economics, OECD, 5 March 2020 https://www.oecd.org/naec/integrative-economics/

NAEC seminar “Narrative economics”, Robert J. Shiller, OECD, 10 September 2019 http://www.oecd.org/naec/events/narrative-economics.htm

NAEC seminar “How Twitter is changing politics” David Chavalarias, Director of The Institute of Complex Systems, OECD, 22 November 2017, https://oecdtv.webtv-solution.com/4047/or/general_secretariat_naec_seminar_on_social_media.html

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