The Fi­nan­cial Cri­sis Ten Years On: Is the Re­pair Job Fin­ished?

The global fi­nan­cial cat­a­clysm of 2008 hit at a con­flu­ence of po­lit­i­cal and geopo­lit­i­cal trans­for­ma­tion; a new Amer­i­can pres­i­dent was elected less than two months af­ter the cri­sis hit and ten days later, the G20 lead­ers met for the first time in Wash­ingto

Policy - - Contents - Kevin Lynch

As an­niver­saries go, it is hardly one to cher­ish—a decade ago, September 15, 2008 to be pre­cise, Lehman Broth­ers filed for bank­ruptcy. In so do­ing, it trig­gered the worst fi­nan­cial cri­sis of our life­times.

Much has been writ­ten about how a bunch of lousy U.S. mort­gages—col­lat­er­al­ized, pack­aged and lever­aged be­yond com­pre­hen­sion—brought the global econ­omy to the brink of an­other great de­pres­sion. There were lots of vil­lains and blame to go around,

with reg­u­la­tory fail­ures in the United States, Great Bri­tain and the E.U. clearly rec­og­nized as en­ablers of the cri­sis. And, while it started as a cri­sis in fi­nan­cial mar­kets, it ended up caus­ing in­cred­i­ble de­struc­tion to economies, so­ci­eties, and in­di­vid­u­als, not to men­tion trust in the cap­i­tal­ist sys­tem it­self. Amer­i­can es­ti­mates of the costs are stag­ger­ing: an unimag­in­able $13-$22 tril­lion of lost out­put, lost in­comes, lost jobs, lost wealth, lost homes and gov­ern­ment debt.

So, we are now 10 years on. The global econ­omy is ex­pe­ri­enc­ing syn­chro­nized and strong growth for the first time since the fi­nan­cial cri­sis. Af­ter ex­tra­or­di­nary con­ven­tional and un­con­ven­tional pol­icy eas­ing by the Or­gan­i­sa­tion for Eco­nomic Co­op­er­a­tion and De­vel­op­ment (OECD) area cen­tral banks, mon­e­tary nor­mal­iza­tion has be­gun, slowly, in the U.S. and Canada, with the U.K., E.U. and Ja­pan yet to take this step. Gov­ern­ments, cen­tral banks, international in­sti­tu­tions and reg­u­la­tors have ex­pended enor­mous ef­forts to re­form fi­nan­cial sys­tems, to re­build sys­temic trust and to re­boot economies dev­as­tated by the cri­sis and the en­su­ing global re­ces­sion. So, is it “mis­sion ac­com­plished”, to ap­pro­pri­ate a favourite phrase of Amer­i­can pres­i­dents? It all de­pends on how you de­fine the mis­sion.

De­cry­ing the dan­gers of pol­icy com­pla­cency at Davos this year, International Mon­e­tary Fund Man­ag­ing Di­rec­tor Chris­tine La­garde used a metaphor at­trib­uted to Pres­i­dent Kennedy: “The time to re­pair the roof is when the sun is shin­ing.” The IMF chief warned that we are en­joy­ing a cycli­cal eco­nomic burst, not a new higher-growth nor­mal, and we still face a longish list of struc­tural growth in­hibitors, eco­nomic and so­cial vul­ner­a­bil­i­ties and geopo­lit­i­cal risks. These in­clude: poor pro­duc­tiv­ity; ex­ces­sive in­equal­i­ties; ris­ing pro­tec­tion­ism; de­clin­ing international co­or­di­na­tion; grow­ing trust deficits be­tween the gov­ern­ing and the gov­erned and fi­nan­cial fragili­ties. The broader re­pair job, then, is cer­tainly not com­plete, and fi­nan­cial sec­tor sta­bil­ity does not ex­ist in iso­la­tion. So, not­with­stand­ing the chal­lenges in the broader eco­nomic con­text, are we done yet with the fi­nan­cial sec­tor re­pair job? Again, it de­pends.

We learned a lot from the post-mortems of what hap­pened, both within and across na­tional fi­nan­cial sys­tems. We un­der­stand much bet­ter which reg­u­la­tions were in­ef­fec­tive and why, and what were the cri­sis am­pli­fiers and shock ab­sorbers. To a cer­tain ex­tent, it was re­learn­ing the ba­sic prin­ci­ples of fi­nance: ad­e­quate buf­fers for sol­vency, suf­fi­cient firm and sys­tem liq­uid­ity, the need for trans­parency to prop­erly eval­u­ate risks, the dan­gers of ex­ces­sive lever­age, and clear ac­count­abil­ity for bal­ance sheets and risks within fi­nan­cial in­sti­tu­tions and by reg­u­la­tors. Per­haps most im­por­tantly, we learned the hard way how in­cred­i­bly in­ter­con­nected and glob­al­ized the fi­nan­cial sys­tem had be­come while reg­u­la­tion and over­sight re­mained pre­dom­i­nantly na­tional.

By 2007, many fi­nan­cial sys­tems— par­tic­u­larly in the U.S., the U.K. and the Euro­zone—had badly lost sight of these ba­sics and their reg­u­la­tory sys­tems were not im­pos­ing suit­able an­chors. Canada and its fi­nan­cial sys­tem largely avoided the worst of these ex­cesses, but still felt the punch of the global re­ces­sion.

The size and com­plex­ity of the re­pair job ne­ces­si­tated the cre­ation of new and re­vi­tal­ized re­me­dial mech­a­nisms. In 2009, the G20 at the lead­ers’ level proved its worth at its sec­ond postcri­sis gath­er­ing in Lon­don. The Fi­nan­cial Sta­bil­ity Board came into be­ing, the IMF found new pur­pose, new na­tional reg­u­la­tory agen­cies were es­tab­lished, the Basel Com­mit­tee was given a new man­date and cen­tral bankers be­came the new guardians of the uni­verse. To­gether, they have re-es­tab­lished and mod­ern­ized the core fi­nance prin­ci­ples but through a hugely com­plex set of pre­scrip­tive reg­u­la­tions, with grow­ing dif­fer­ences across coun­tries in their specifics as time goes on.

The reg­u­la­tory pol­icy chal­lenge for gov­ern­ments is to learn from the past while not at­tempt­ing to nav­i­gate the fu­ture us­ing the rearview mir­ror. The busi­ness chal­lenge for fi­nan­cial in­sti­tu­tions is to adapt ef­fi­ciently to the new reg­u­la­tory regime while not tak­ing on too many new risks to raise re­turns.

Amer­i­can es­ti­mates of the costs are stag­ger­ing: an unimag­in­able $13-$22 tril­lion of lost out­put, lost in­comes, lost jobs, lost wealth, lost homes and gov­ern­ment debt.

The reg­u­la­tory pol­icy chal­lenge for gov­ern­ments is to learn from the past while not at­tempt­ing to nav­i­gate the fu­ture us­ing the rearview mir­ror.

What was lost in the great global fi­nan­cial cri­sis was the pub­lic trust in the fi­nan­cial sys­tem in many Western coun­tries and the per­cep­tion of the supremacy of the western mar­ket cap­i­tal­ism model in the eyes of many Asian coun­tries. The for­mer may be more pos­si­ble to re­gain than the lat­ter.

One les­son, shaped by my ex­pe­ri­ences as deputy min­is­ter of Fi­nance in the run-up to the global fi­nan­cial cri­sis and as clerk of the Privy Coun­cil in its af­ter­math, is the value of reg­u­la­tory prin­ci­ples over ex­ces­sive re­liance on pre­scrip­tion, par­tic­u­larly in any pe­riod of sub­stan­tial change, and ac­count­abil­ity for hold­ing true to those prin­ci­ples.

In the de­sign of reg­u­la­tory sys­tems,

sim­plic­ity usu­ally wins out over com­plex­ity if the ob­jec­tive is to clearly con­vey the de­sired ex ante be­hav­iours to a dis­persed and het­eroge­nous group of mar­ket par­tic­i­pants. Be­yond this, the value of skilled reg­u­la­tors and su­per­vi­sors, who are open to reg­u­lar in­ter­ac­tion be­tween the reg­u­la­tors and the reg­u­lated and in­clined to co­or­di­nate across bor­ders, is too of­ten un­der-es­ti­mated rel­a­tive to the ad­di­tion of more rules. Fi­nally, it is im­por­tant to build re­siliency into sys­tems from a for­ward-look­ing per­spec­tive not one of hind­sight. This, in turn, high­lights the value of so­phis­ti­cated tech­nol­ogy and mar­ket fore­sight mech­a­nisms for fi­nan­cial sec­tor pol­icy mak­ers in a world of pro­found change mov­ing at a fran­tic pace.

What would such a fore­sight lens cap­ture to­day that might re­shape reg­u­la­tory pol­icy think­ing? The struc­ture of our economies is very dif­fer­ent than it was at the time of the fi­nan­cial cri­sis, trans­formed by tech­no­log­i­cal change on steroids and the de­mo­graph­ics of ag­ing so­ci­eties. In­con­ceiv­able even a decade ago, we are in the midst of a geopo­lit­i­cal tsunami with the rise of pro­tec­tion­ism, pop­ulism, and na­tion­al­ism, com­bined with a sharp de­cline in trust in in­sti­tu­tions. Per­va­sive glob­al­iza­tion and sus­tained rapid growth in Asia mean that we are now in a mul­ti­po­lar world where China, the sec­ond largest econ­omy, is as­sert­ing its place to be a global reg­u­la­tory rule-maker.

Within the di­rect am­bit of fi­nan­cial ser­vices, fin­tech is dis­in­ter­me­di­at­ing fi­nan­cial func­tions, E-com­merce is do­ing the same for re­tail and lo­gis­tics, and dis­trib­uted ledgers and cryp­tocur­ren­cies are chal­leng­ing clear­ing sys­tems. Mas­sive data vaults com­bined with data an­a­lyt­ics en­hanced by ar­ti­fi­cial in­tel­li­gence will likely blur the line among fi­nan­cial in­sti­tu­tions, fin­techs and in­fotechs, while the re­cent con­tro­ver­sies in­volv­ing Facebook serve to high­light the po­ten­tial risks in­her­ent in the in­fotech busi­ness model of data in­ter­me­di­a­tion. Data pri­vacy, data se­cu­rity (cy­ber­at­tacks), data rights and data us­age are rapidly emerg­ing is­sues that may re­quire new reg­u­la­tory mea­sures, new mod­els of fi­nan­cial sec­tor co­op­er­a­tion and pos­si­bly new pub­lic-pri­vate part­ner­ships on se­cu­rity. The World Eco­nomic Fo­rum’s Bal­anc­ing Fi­nan­cial Sec­tor Sta­bil­ity, In­no­va­tion and Growth Ini­tia­tive is ex­plor­ing new ap­proaches by the fi­nan­cial ser­vices sec­tor to re­spond to cy­ber­se­cu­rity and data us­age risks and con­cerns. At the macroe­co­nomic level, while solid and syn­chro­nized global growth has fi­nally been achieved, it has been pro­pelled by mas­sive fis­cal (most re­cently U.S. tax re­form) and mon­e­tary stim­u­lus. With de­clin­ing po­ten­tial growth in many Western coun­tries, in­clud­ing Canada and the U.S. (es­ti­mates sug­gest Cana­dian po­ten­tial growth post-2020 around 1.75 per cent, and U.S. po­ten­tial growth be­low 2 per cent), much of this stim­u­lus will trans­late into higher in­fla­tion and ex­ac­er­bate la­tent fi­nan­cial fragili­ties. These fi­nan­cial fragili­ties in­clude global debt lev­els at over 230 per cent of global GDP—well above pre-cri­sis lev­els—and ris­ing debt in­ter­est costs for firms, house­holds and gov­ern­ments as mon­e­tary nor­mal­iza­tion picks up pace.

In­deed, there is some risk of “ir­ra­tional ex­u­ber­ance” in look­ing at to­day’s con­junc­ture. Ian Brem­mer cer­tainly thinks so. At Davos this year, the CEO of the Eura­sia Group char­ac­ter­ized to­day’s con­text as: “Let’s be hon­est: 2018 doesn’t feel very good. Yes, mar­kets are soaring and the econ­omy isn’t bad, but cit­i­zens are di­vided, gov­ern­ments aren’t do­ing much gov­ern­ing, and the global or­der is un­rav­el­ling.”

Fur­ther, as Larry Sum­mers has stressed, we have an ag­ing ex­pan­sion but a thread­bare pol­icy tool­kit—av­er­age mon­e­tary eas­ing in past U.S. re­ces­sions was 500 ba­sis points whereas U.S. in­ter­est rates to­day are less than half of that, and U.S. gov­ern­ment debt ra­tios are head­ing above 100 per cent of GDP de­spite an econ­omy at full em­ploy­ment. Sim­ply put, it will take sus­tained mon­e­tary nor­mal­iza­tion and fis­cal con­sol­i­da­tion to re­stock the tool­kit as well as struc­tural pol­icy re­forms to de-age the ex­pan­sion.

The un­der­ly­ing prob­lem for gov­ern­ments is the de­clin­ing stock of pub­lic “trust cap­i­tal” and the in­creas­ing pace of eco­nomic and so­ci­etal dis­lo­ca­tions. Gov­ern­ments still op­er­ate in a Gov 2.0 con­text in a world be­ing re­shaped by Tech 4.0 and pub­lic con­fi­dence can be a ca­su­alty of that gap. How do pol­icy and reg­u­la­tion keep pace with the speed and scale of change?

Global fi­nan­cial or­der re­quires es­tab­lish­ing and en­forc­ing clear and ef­fec­tive rules of the game for how the fi­nan­cial sys­tem will work in a highly in­ter­con­nected, mul­ti­po­lar world that is in the midst of a tech­no­log­i­cal revo­lu­tion.

The Wash­ing­ton Con­sen­sus, which pro­vided that frame­work for many years in a very dif­fer­ent global con­text, is no more. The ini­tial G20 meet­ings of lead­ers in late 2008 and early 2009 pro­vided a road map out of a cri­sis that has largely taken us to this point but its hall­marks of co­op­er­a­tion and co­or­di­na­tion are fray­ing. If a new con­sen­sus is to be found, will it be driven by rein­vig­o­rated Western lead­er­ship (a G6 con­sen­sus?) by the new world­view of China (a Bei­jing con­sen­sus?) or from else­where?

Fi­nan­cial fragili­ties in­clude global debt lev­els at over 230 per cent of global GDP—well above pre-cri­sis lev­els—and ris­ing debt in­ter­est costs for firms, house­holds and gov­ern­ments as mon­e­tary nor­mal­iza­tion picks up pace.

Con­tribut­ing writer Kevin Lynch is Vice Chair, BMO Fi­nan­cial Group and for­mer Clerk of the Privy Coun­cil and Head of the Pub­lic Ser­vice dur­ing the fi­nan­cial cri­sis of 2008-09.

PINGNews Flickr photo

Ten years af­ter the fi­nan­cial cri­sis of 2008-09, the af­ter­shocks con­tinue.

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