Is financial stability enough?

As regulators and policymakers continue to examine new rules for the financial services, stock markets are booming and bank bonuses are being paid out anew. A happy new year, or should we be worried that, without corrective action, another financial crisis could strike in the months or years ahead?

Since the late 1990s, financial stability issues have received increasing attention. The Asian crisis of 1997, the failure of the LTCM hedge fund in 1998, and the global downturn at the end of the 1990s all involved dangerous amounts of speculation and threats to the efficient functioning of financial markets. As a result, many central banks set up separate financial stability departments, Financial Stability Reports proliferated, and the activities of the Financial Stability Forum received increasing attention.

The current crisis has further sharpened the policy focus on financial safeguards. This is not surprising. It is commonly believed that the crisis had its origins in the market for sub-prime mortgages in the United States and then spread globally via such other financial markets as those for asset-backed securities. Further, the extraordinary efforts made by governments to liquefy financial markets again and to recapitalise financial institutions continue to dominate headlines and affect perceptions about underlying causes. The recently upgraded status of the Financial Stability Board by international political leaders and the extension of its membership to include all G20 countries attest to the fact that financial issues are being treated ever more seriously.

And so they should be, since a wellfunctioning financial system is a necessary condition for a vibrant market-driven economy. Without an adequate system for allocating savings and ensuring payments, economic progress is likely to be limited. This has been the rationale for public sector interventions to regulate and otherwise support the banking system for a century or more.

However, the proliferation of financial markets and the relative decline of intermediated credit in recent years have turned the focus to underlying systemic questions. Indeed, we now know that surface indicators of good financial health can be seriously misleading. If market participants are hit by the same shocks, are similarly vulnerable and react similarly as well, the implications for the financial system as a whole and the real economy it underpins can be devastating.

So, financial stability is necessary. However, similar to the earlier failure of price stability to deliver macroeconomic stability, financial stability is also not sufficient to achieve that objective. While “booms” similar to the one we had lived through since the 1990s are ultimately driven by an excess of credit, the imbalances to which they give rise go well beyond unjustified asset price increases and a potentially weakened financial sector. One particular contributor to the severity of the “bust” is debt. In fact, in Japan through the 1990s and beyond, it was not the weakened banking sector that forestalled recovery, but the efforts of the Japanese corporate sector to reduce debt after the excesses of the 1980s. A similar challenge may now be in store for the US, UK and a number of other countries, as consumers and businesses reflect on the state of their balance sheets.

But even this broader set of balancesheet effects fails to account fully for the imbalances generated by excessive credit growth. Perhaps most important is a misallocation of real resources, which then weighs heavily on the economy during the subsequent downturn. In a number of economies, not least the US, the combination of consumption and housing investment rose to unprecedented levels as a proportion of GDP. In China, there was a corresponding upsurge in capital investment. These two developments combined suggest that Asia is now all geared up to produce export goods that the traditional purchasers can no longer afford to buy. And to add to the difficulties ahead, it seems clear that, during the boom, there was a buildup of excess global capacity in a whole range of industries–cars and trucks, banking, wholesale distribution, construction and steel, among many others.

It will take a significant amount of time for the underlying resources (labour and capital) to be either written off or shifted into more profitable and sustainable endeavours. During that time, aggregate production potential will be diminished and structural unemployment will rise. Credit-driven “boom and bust” cycles touch all parts of the economy. This has institutional implications. If the problem extends well beyond the stability of the financial sector, then oversight and prevention should more appropriately be entrusted to those used to thinking in macroeconomic terms.

In current circumstances this probably means central banks rather than traditional financial sector regulators, although the latter would clearly have an important role to play as well. Indeed, there seems to be a growing consensus that regulatory instruments–like countercyclical capital requirements and provisioning–could directly mitigate the tendency to excessive credit increases and financial leverage during cyclical upswings. However, this consensus should not preclude the complementary use of monetary policy as well. Low interest rates encourage borrowing for risk-taking in the search for higher returns, and feed speculation and leverage in turn. Indeed, given the high economic costs associated with these cycles and the known shortcomings of both regulatory and monetary policies, a judicious combination of all instruments of control at our disposal would seem a perfectly sensible strategy.

The increasing recognition that credit cycles have implications for both the demand side and the supply side of the global economy reveals an important role for the OECD. The organisation has spent decades working on structural issues and how demand and supply side forces interact. These analytical insights are now helping the OECD to make a material contribution to two of the most important policy issues of our time, issues being debated in the G20 and elsewhere. How can we best get out of the current crisis, and how can we prevent or mitigate the effects of such crises in the future?

©OECD Observer No 276-277 December 2009-January 2010

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