Over the past 30 years, the global financial system has evolved at an unprecedented pace (Knight et al (2004)). First, the regime shift to flexible exchange rates for the major currencies in the 1970s made spot and forward foreign exchange markets much more efficient signalling devices for transactors’ expectations of future events. Then, secondary and derivatives markets for government and other fixed income securities broadened and deepened. Flows of timely market information grew tremendously. As private transactors in the advanced countries learned how to decompose different types of risks, markets for new financial products expanded to allow economic agents to manage, hedge or lay off risks. The legal and informational framework that is essential for efficient financial markets was greatly extended and refined, and financial institutions and markets were liberalised and deregulated. Algorithms, most importantly the option pricing methodology developed in the early 1970s by Black, Scholes and Merton, opened the way to the creation of ever more complex financial products. And as a result of all these innovations, financial markets – at least in the industrial countries – have edged ever closer towards completeness, making them hugely more effective in allocating resources and risks across sectors and regions and over time.
The lower costs of financial intermediation, the greater scope for risk spreading, and reduced reliance on any individual institutional or market channels for intermediating savings have resulted in enormous efficiency gains and have instigated a vast increase in financial activity by households, businesses and governments. And they have created a global financial system that appears to have grown more robust to financial shocks emanating from individual countries. Indeed, this robustness is well illustrated by the fact that, over the past 10 years, global output growth has been significantly more stable, and global inflation has been significantly lower than during the two prior decades (Blinder and Reis (2005)).
But while this liberalised and globalised financial system has proved itself highly resilient, it has not been immune from generating financial imbalances that have led to dangerous situations and “close calls”. One only needs to think of the large number of systemic banking crises that have struck both industrial and emerging market countries since the early 1980s, the “dotcom” bubble of the late 1990s, the Russian and Argentine debt crises, and LTCM. In short, this breathtaking development of the global financial system has not – and probably cannot – overcome the innate tendency of both borrowers and lenders to alternate between periods of excessive exuberance and unjustified pessimism about future prospects (Rajan (2005)).
This conference is appropriately dedicated to the central banking and supervisory challenges that need to be confronted in maintaining and enhancing financial stability. So, let me turn to the issue I have been asked to address today. What challenges to financial stability do we face in the current global macroeconomic environment?
B. Current financial imbalances and the potential for instability
I think these challenges stem from the gradual build-up of what I shall call “financial imbalances” in times when macroeconomic performance otherwise looks quite solid.
I will define financial imbalances as “significant and persistent deviations of key financial variables from their longer-term trends”. This definition may not be very scientific, but it at least captures the reality that, building on market expectations, there are dynamic processes in financial markets that can cumulate over many periods, even though the financial variables in question are mean-reverting in the end. And these financial imbalances can, in turn, feed back onto real sector behaviour.
The analysis of such financial imbalances played little role in neo-Keynesian policy analysis. Although expectations about the future were central to Keynes’ theories of liquidity preference and the marginal efficiency of capital, neo-Keynesian policy prescriptions – right through to the mid-1980s – tended to focus on simple one-period optimisation of monetary and fiscal policies. But with the globalisation of financial markets, an older tradition of economic analysis has become relevant. This is the rich tradition that stresses the role of expectations in driving the ups and downs in the evolution of capitalist market economies, and it focuses on the dynamic processes by which financial imbalances can build over many periods. In particular, this approach puts a lot of emphasis on resource misallocations associated with excessive credit expansion and the build-up of debts over time that may ultimately prove impossible to service. Interestingly, the pre-World War II literature in this tradition raised the possibility that short-run (one-period) policy optimisation could sometimes exacerbate problems over time by encouraging still greater financial imbalances, in part through moral hazard. Therefore, a key role of policy is to act in a way that, over time, limits market excesses by providing market participants with as clear a view as possible of the objectives of economic policy and the broad direction in which policymakers expect the macroeconomy to evolve.
It is hard to escape the conclusion that the world today is characterised by an unusual, perhaps unprecedented, combination of financial imbalances, both domestic (internal) and international (external). The list of internal financial imbalances would have to begin with the level of policy interest rates. Real policy rates were effectively zero until very recently in the United States and remain below the “Wicksellian” long-term neutral rate. Real policy rates in continental Europe and Asia (ex Japan) generally remain around zero. The nominal policy interest rate in Japan has been zero for an even longer period, and “quantitative easing” has caused the balance sheet of the Bank of Japan to swell to over 30% of GDP. The long-term interest rates that are set by financial markets are also unusually low – what Federal Reserve Chairman Greenspan has referred to as a “conundrum”.
Moreover, accompanying these developments have been unusually low sovereign and corporate credit spreads, and unusually low measures of volatility in financial markets. Equally remarkable have been the financial imbalances associated with the decline over recent years in household financial saving rates in a number of industrial countries, effectively to zero in the United States and several other advanced economies. This trend has typically been accompanied by increases in household debt levels to record highs. In key large industrial countries, the present levels of structural fiscal deficits raise major questions about long-run fiscal sustainability. Finally, in most industrial countries, and many emerging market economies as well, housing prices have risen to record levels, as have the ratios of house prices to rents.
As to external financial imbalances, the current account deficit of the United States has been trending upwards as a percentage of GDP for over 20 years, and now stands at nearly 6% of GDP. Moreover, the net service account has finally shifted into negative territory, partly reflecting the fact that the United States, the world’s richest country, is now also its biggest international debtor.
To summarise, it is simply a fact that a large number of financial imbalances can be identified at the present time.
Before speculating on possible problems that might arise from these unusual developments, it is worth considering what might have caused them. I think a reasonable case can be made that the internal financial imbalances have their origins in three fundamental structural shifts – or regime shifts – that have taken place over the last two decades, affecting both industrial countries and emerging market economies. Moreover, I think a reasonable case can be made for the external imbalances being driven to some significant degree by the internal imbalances. Let me explain.
Starting with the industrial countries, the first noteworthy regime shift that has taken place since the late 1980s is the inexorable liberalisation and growing completeness of markets and institutions in the financial system that I referred to at the beginning of our talk. Credit is now available from many market sources as well as from financial intermediaries, and risk transfer can now be achieved in a myriad of sophisticated ways. Unquestionably, this process of liberalisation has brought many benefits. The intense competition among markets and institutions has increased choice and markedly reduced the costs of financial intermediation, bringing better returns to savers and reduced borrowing costs to users of credit. Yet, the empirical evidence also suggests another less welcome by-product. Credit spreads, asset prices, banks’ internal measures of risk, loan loss provisions, and the credit ratings generated by the handful of semi-official rating agencies, all tend to move markedly up or down in tandem with the cycles of economic activity. Moreover, this procyclicality of the financial system can interact with the real economy in a way that can amplify fluctuations in real economic activity, aggregate demand, prices and costs. More credit can lead to higher asset prices, which provide more collateral for more borrowing and spending, whether it is on fixed investment or consumer durables. Both these developments feed back to create higher expectations of future profits. It is not hard to see that such processes could become self-reinforcing, or even “irrationally exuberant”.
The second regime change has to do with the real sector of the economy. Liberalisation of markets for goods, services and factors of production at the global level – particularly in economies that were previously centrally planned – has constituted a massive, positive supply shock that has been profoundly disinflationary at the global level, and has even contributed to significant measured price deflation in some economies. In recent years, not only the prices of goods and services but wages and work practices have begun reacting to heightened international contestability almost everywhere around the globe.
The third regime change over the last two decades has been the sharpened focus of the monetary authorities, particularly but not exclusively in the industrial countries, on achieving and maintaining price stability in the form of low, stable and predictable inflation. We have long been aware of the merits of low inflation, but I think we are becoming increasingly aware of some associated complications arising from the other regime shifts I have just noted. With inflation under control, there might seem to be little or no need for monetary tightening, even when credit growth accelerates. But this also implies that there is little monetary resistance to slow down the procyclical tendencies that can arise in a liberalised financial system. Indeed, it could be argued that the “search for yield” in an environment of very low policy interest rates adds another powerful accelerator to this process.
I think forces such as these can help explain the unusual internal developments being observed in the industrial countries, but they also have relevance for emerging market countries. As easy monetary conditions in the industrial countries have been putting downward pressure on their exchange rates – particularly the dollar – over the past two years, they have put corresponding upward pressure on the exchange rates of emerging market economies, particularly in Asia. As emerging market countries have resisted these appreciation pressures, again in a generally disinflationary environment, the combination of massive interventions and difficulties in sterilising them has created easier monetary conditions in these countries as well. And lastly, as these foreign exchange reserves have been recycled back into the industrial countries, this financial accelerator has been given one further push. Thus, as in the years prior to the breakdown of the Bretton Woods fixed exchange rate system, it could be argued that we now have a global problem of excess liquidity.
As for the observation of external financial imbalances, it is again a fact that the countries with the biggest external current deficits (United States, United Kingdom, Australia, New Zealand) also tend to have the biggest internal saving, investment and fiscal imbalances; in particular, long-standing housing booms and very low household saving rates. Higher asset prices in such countries lead to higher perceptions of wealth and more spending; domestic absorption comes to exceed production and the external deficit rises. But the question must then revert to why some countries are more prone to internal financial imbalances than others. One possible answer is that these countries are also the furthest advanced in the area of financial liberalisation, with all its benefits but perhaps with all its associated dangers.
But this brings us to the third question. What harm might be done should any or all of these imbalances unwind? One possibility could be a sudden crisis in the financial system, though where and when an overextended system might fail is impossible to predict. I think another possibility is much more likely. If the overseas demand for US dollar assets were to slow markedly, for whatever reason, the US dollar would depreciate, world interest rates would rise, and the prices of a number of classes of financial and real assets would weaken. All these adjustments would likely be highly deflationary at the global level. In this case, an extended period of slow global growth could ensue, reinforced and lengthened by an erosion of the capital of financial institutions and other market participants that would sharply curtail their willingness to supply credit. We have observed such “headwinds” so many times in the past that even an economist would have to admit they are possible.
C. Possible policy responses
What can policy do to extricate us, at the least cost, from current exposures? This is a tricky question because, even if the probability of financial imbalances causing serious macro problems is small, the costs incurred should such problems emerge could be large. Moreover, the obvious recommendation of tighter policy interest rates to help restrain financial excesses could conflict with more traditional objectives of monetary policy, in particular keeping inflation at a low positive level.
Fortunately, there is one key country where no obvious conflicts constrain the move to tighter policy. In the United States, the measured increases in policy interest rates since the middle of last year are consistent with helping constrain both internal and external imbalances as well as reducing inflationary pressures. The other key policy element is implementation of a programme of fiscal measures that gives market participants confidence that the US fiscal deficit will be reduced to a sustainable level within a clear time frame. This combination of measures would give the best prospect of reducing the US current account deficit to a sustainable level without a disruptive amount of dollar depreciation, while holding US inflation to acceptable levels.
Elsewhere, particularly in Japan and continental Europe, policy interest rates should rise to more normal levels as the inflation outlook permits. Also important in these countries, and indeed in many emerging market economies including China, would be liberalisation of their services sectors (especially for non-tradables). This is very much required both to provide employment and to lower reliance on exports as a vehicle for growth. And, closely related to the preceding point, Asian and other emerging markets should allow their currencies to float up to encourage the production and consumption of non-tradables. In understanding these policy actions, closer cooperation at the international level, as well as stronger cooperation in each national jurisdiction between the monetary and financial supervisory authorities would be desirable.
Let me summarise. The global financial system of today is vastly more efficient and resilient to small or moderate shocks than it was 20 years ago, or even a decade ago. And keeping the financial system on an even keel no longer requires the direct, non-market interventions from central banks and regulators that seemed to be needed in those far-off days. But today’s complex, market-dominated financial system also creates more incentives than in the past for market participants to “reach for yield”, more capacity to expand leverage, more scope to act on the age-old destabilising sentiments of euphoria and gloom. In short, our financial system may be prone to new combinations of adverse “tail risks” that could feed back on the real economy. We may hope that the broadly positive global macroeconomic trends of the past two years will progress into the future. But I have argued that important financial imbalances are building despite the low measures of perceived risk. In these conditions, good risk management dictates that although one always hopes for the best it is wise to prepare actively for possible adverse outcomes. As Chairman Greenspan presciently remarked at the Jackson Hole Symposium 10 days ago, “history has not dealt kindly with the aftermath of protracted periods of low risk premiums” (Greenspan (2005)). What’s the bottom line of my luncheon talk? There is no free lunch. Times are good, but they may not “roll on” without encountering some potholes. Acting early to redress the major financial imbalances I have talked about could limit their potential adverse consequences. I, for one, believe this is food for thought.
Many thanks for your attention.
Bank for International Settlements (2005): 75th Annual Report, June.
Blinder, Alan and Ricardo Reis (2005): Understanding the Greenspan Standard, paper presented at the Federal Reserve Bank of Kansas City Symposium, The Greenspan era: lessons for the future, Jackson Hole, Wyoming, August.
Borio, Claudio (2005): The search for the elusive twin goals of monetary and financial stability, presentation for the conference on Financial stability – central banking and supervisory challenges at the International Monetary Fund, Washington, D.C., September.
Greenspan, Alan (2005): “Opening Remarks”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming, August.
Knight, Malcolm, Lawrence Schembri and James Powell (2004): “Reforming the global financial architecture: just tinkering around the edges?”, in David Vines and Christopher L. Gilbert (eds), The IMF and its critics: reform of global financial architecture, Cambridge, Cambridge University Press.
Rajan, Raghuram (2005): Has financial development made the world riskier?, paper presented at the Federal Reserve Bank of Kansas City symposium, Jackson Hole, Wyoming, August.