Treasury Secretary Martin Parkinson last night delivered a speech to London’s Chatham House in which he joined the chorus of crisis-worriers over the low volatility in global markets, reminded of the limits of monetary policy, endorsed macroprudential measures and encouraged the G20 to adopt Australia’s infrastructure growth agenda. It was a good speech that makes one wonder why APRA is not more obviously and openly engaged in macroprudential measures (or might suggest that they are coming). I’ve excerpted a goodly section below.
It is all too easy to look back at how the Global Financial Crisis unfolded and, with the benefit of hindsight, see where the vulnerabilities in the global economy were that resulted in the Crisis and the subsequent Great Recession.
That being said, it’s hardly the case that we were completely unaware of the pressure points in the lead up to the Crisis. There was certainly commentary on global imbalances—reflecting factors such as the inevitabilities of global demographic changes and a ‘re-emerging’ Asia resuming its place as an economic powerhouse—as well as discussion about the macroeconomic and structural policy choices facing key economies. Some of these issues were very much in the G20 agenda in the early-to-mid 2000s – for example demography, which was a key issue when Australia last hosted the G20 in 2006, back prior to the participation of Leaders in the G20 process.
While there was awareness of pressure points and vulnerabilities, even the emergence of key systemic risks, the so-called Great Moderation largely lulled investors — and many policymakers alike — into thinking that volatility would remain low, spurring a search for yield and higher leverage. This is a pattern we’ve seen in periods preceding other financial crises, and indeed some of these risk characteristics are evident now (albeit not involving leverage).
While the risks and vulnerabilities were perhaps clearer at the macro level, what remained obscured was how the search for yield was being intermediated. There were clear cases of mispricing of risks, with the US housing boom the prime example.
But it was not merely the existence of asset-price bubbles in the lead up to the Crisis that was the sole source of the problem. Accurate assessment of the real risks from these bubbles was made vastly more complicated by the increasingly complex and often opaque inter-linkages between the macroeconomy and the financial sector. The complexity of financial instruments also contributed, as a situation evolved where investors did not fully understand the nature of the instruments they were buying and selling, despite devouring them whole.5 As some of these instruments had direct ties to the real economy, there was a fundamental misunderstanding of the risks that had built up between the real economy and the financial sector.
The increasingly obscure linkages between the real and financial world made the nature and sustainability of growth somewhat ambiguous.
The fruits of this complacency can be seen in a number of structural weaknesses in the fiscal and structural policy settings of some of the world’s major economies during the 2000s. For example, with a few notable exceptions such as Germany, countries within the euro area were content to simply discuss structural reform during the good times, and do little to safeguard fiscal sustainability. Similarly in the United States, despite the jobless recovery of the 2000-01 recession, the wider economy performed comparatively well, breeding a degree of lassitude in policymakers’ willingness to tackle fiscal sustainability issues – something that to various extents is also true of other Anglophone economies.
Arguably, many emerging economies were in better shape in the lead up to the Global Financial Crisis, not least because their own crisis experiences during the 1990s induced difficult reforms. But even in many of these economies, reforms necessary for rebalancing growth were avoided.
Collectively, this risk taking by private agents — fuelled by complacency about the fallout from growth prospects and volatility — combined with government complacency over prudent policy settings, morphed into higher public debt in many countries as private losses were absorbed by the state. This manifested in a sovereign debt crisis in countries that could not borrow in their own currency.
The Crisis was unprecedented, at least in terms of living memory, as was the policy response.6 The depth and severity of the downturn required extraordinary effort from monetary and fiscal policy.
But the circumstances in the lead up to the Crisis also mattered for monetary policy. Even though there were secular influences — imported disinflation from emerging economies — that were fundamentally changing the relationship between aggregate prices and output in the US, the Great Moderation precipitated policy rates in the US that left the Federal Reserve less room to move in response to an exceptional crisis.
While policies of least regret were implemented at great speed in response to the Crisis, it was inevitable that this unprecedented response would cast a long shadow into the future. And the legacy is still with us through extremely accommodative monetary policy that is depressing yields on risky assets, and high levels of public indebtedness. As this legacy shapes the challenges ahead, I would like to unpack both of these a bit more.
The current global economic conjuncture is one where monetary policy in the major advanced economies continues to remain extremely accommodative. Although the US Fed is ‘taking its foot off the accelerator’ so to speak, monetary conditions remain very accommodative, while the European Central Bank and the Bank of Japan continue to be on an easing trajectory.
We must acknowledge though that the policies pursued by the world’s major central banks no doubt prevented a worse crisis, despite the risks we find ourselves discussing now.
The overarching objective of expansionary monetary policy has been to stimulate greater risk-taking among consumers and businesses. Indeed, it was expected that while such policies might encourage undesirable risk taking behaviour — such as excessive speculation in financial markets — they would also encourage good risk taking, such as business investment in the productive capacity of the economy.
In this regard, and without knowing the counterfactual, monetary easing does indeed appear to have triggered risk-taking behaviour as intended. Nowhere is this more evident than in high-yield debt markets for corporate paper (Chart 1).
Chart 1: Corporate bond yield spreads
Source: Bloomberg
Note: Data as at 22 July 2014Moreover, investors seem to have a favourable perception of risks in the future. The low level of implied volatility being observed today suggests there’s a low demand for protection from sharp market corrections; rather, markets seem to be more concerned about ‘missing out’ on gains. Further evidence of this appetite for risk can be seen in the limited enduring reaction to recent geopolitical events, such as the crisis in Ukraine and events in Iraq, or the recent worries over the Portuguese banking system (Chart 2).
Chart 2: VIX and MOVE index
Source: Bloomberg
Note: Data as at 22 July 2014The problem, however, is that the yield-seeking behaviour is raising the potential costs associated with extremely easy monetary policy. On the one hand, ongoing accommodative monetary settings are likely to continue to stoke risk-taking behaviour; while on the other hand, premature withdrawal of stimulus may undermine the recovery and increase corporate default rates with obvious flow-on impacts to asset markets and the real economy. As several Central Bank Governors have pointed out, prudential responses will need to play a key role.
In addition to monetary stimulus, the Financial Crisis generated regulatory responses in an effort to prevent this sort of crisis from occurring again. Of course, on the matter of regulatory response we must ask the question: has the horse already bolted before we could close the gate? Further, the follow-up measures to prevent a future crisis have naturally proceeded at a slower pace, due to a lack of urgency in solving a problem that will inevitably occur sometime in the future.
And it is natural that these questions arise, for it’s a tricky balancing act. A lack of thoroughness will do nothing to avert a similar crisis in the future, which — let us be clear — is inevitable in an increasingly complex and integrated world. But similarly, we cannot be too heavy-handed as such a severe approach may reduce risk taking too much or may breed the very complacency that contributed to the Crisis.
For this reason, Australia has sought to focus the G20 financial regulation agenda on substantially completing reforms that directly address the flaws that were exposed by the crisis.7 By focussing the agenda, we hope to reduce the ever present risk of regulatory over-reach that stems from the tendency of policymakers to try to pin down every risk, rather than the most critical ones. This is the point at which stability and growth trade-offs can be harmful – where the cost of regulation can outweigh the benefits.
But it is my view that the most effective salve to these concerns is for the global economy to return to sustained growth. This is necessary to generate sufficient corporate earnings and maintain low default rates that justify the increasingly elevated valuations across a range of equity and credit markets.
Finally, moving from the monetary and financial issues to public finances, the aftermath of the Financial Crisis has led to a rapid accumulation of government debt in many economies around the world. This reflects both the operation of automatic stabilisers from the sharp deterioration in economic growth, as well as the sizeable fiscal stimuli and government needed in some countries to support the banking sector.
As I have already mentioned, the Crisis had no modern precedent in its intensity, forcing authorities to take extraordinary measures to stabilise their economies. The issue with fiscal stimulus is that authorities need to strike a precarious balance between optimising the benefits of expenditure against the risks associated with growing public-debt levels potentially undermining investor confidence – particularly as future interest rate rises will increase the fiscal burden of debt servicing costs.
In some countries with lower debt to GDP ratios, fiscal policy has arguably been too tight, holding back their recovery and harming growth elsewhere through spillovers.
This being said, as we look forward, it’s more fruitful now to focus on ensuring the composition of fiscal policy is optimised for achieving sustainable growth. There is concern that our responses to the Global Financial Crisis have left us far less equipped to respond to future crises than we were in 2008-09.
The task ahead
And we must not forget there are a number of longer-term challenges that will put pressure on public finances in the future.
One major challenge I’d like to touch on that is being faced by advanced economies, as well as some emerging ones, is an ageing population — as mentioned already, something we stressed when Australia last hosted the G20 in 2006.
As their population ages, the dependency ratio — that is, the ratio of people requiring support relative to the working-age population — will increase to previously unexperienced levels in most of these countries. This changing demographic structure will also have a dampening effect on future potential growth. The extensive social safety nets in place in most advanced economies are costly to run and costs are projected to increase rapidly over the coming decades. Meanwhile, as living standards rise, citizens of many emerging economies will, rightly, expect greater social safety nets from their states. As a result, in the absence of corrective measures, governments around the world are likely to see growing pressure on public finances.
As the full impact of these challenges will not be felt for another decade or so, responding to them requires a high degree of political maturity and the right incentive structure.
With the output gap that remains compared to where global output might have been if the pre-crisis trend had continued (Chart 3) and the challenges that we face, we have a sizeable hole to fill. And that gap is noticeably larger than the initial decline in GDP in 2009.
Chart 3: Global economic output
Source: IMF World Economic Outlook databases, various and Treasury calculations.
Note: Counterfactual growth is taken to be the entirety of the April 2008 WEO projections.I know Larry Summers and others have noted, the pre-Crisis growth trajectory was buoyed by successive bubbles in key economies8 and meanwhile Robert Gordon and others note that the pace of potential growth may be slowing in key economies.9
However, notwithstanding these views, let me contend that with better policy settings, the pre-Crisis trajectory might have been sustainable and the counterfactual growth path — or at least something higher than the current trajectory — might have been achievable.
This is the exact motivation for the Sydney growth ambition.
Ultimately, sustainable global growth will be determined by productive capacity. This is why it’s important we make up lost ground not only by expediting the recovery but also by trying to lift the productive capacity of our economies. The Sydney growth ambition set by G20 Finance Ministers and Central Bank Governors in February this year aims to do just this.
So, how do we get there?
Monetary policy needs to continue to play a supportive role. Of course, there is a certain point at which the build-up of undesirable risks becomes a concern. In such instances, there is a need to consider what other tools are available. As monetary policy is a blunt instrument, prudential tools can be employed where necessary and appropriate.10
Rather than thinking about the limits of monetary policy, the key here is that monetary policy must be supportive of the real economy — but it can only do so much. Monetary policy easing, generally speaking, is designed firstly to stabilise the economy and then help cement a recovery by encouraging businesses to invest and employ. Instead, we continue to see business investment — critical for strong and sustainable growth — remaining anaemic. And, as already discussed, we are now in a situation where we need to take the pressure off monetary policy.
Without giving away the punchline, I would like to refer to ECB President Mario Draghi’s recent observation:
“I would even say that structural reforms are fundamental to reap the benefits of our recent monetary policy decisions. Our recent monetary policy decisions expand bank credit, but for firms or companies to access this credit they must be in the condition to work. If it takes nine months to open a business – and then once it is open, it is overwhelmed by taxation – it makes it very hard for this business to ask for credit.” 11
There is no shortage of analysis available on the types of structural reforms countries should undertake, ranging from blue-sky ‘if we could start from scratch’ recommendations to those that tinker on the margins.
The types of reforms in mind when the Sydney growth ambition was agreed are certainly ambitious, but they are also realistic and achievable reforms.
For example, the OECD estimates that moving towards more appropriate regulatory and competition policy could lead to sizeable impacts on productivity and investment. Estimates suggest that a 10 per cent reduction in the level of product market regulations (as measured by the OECD’s PMR index) could boost GDP by 1 to 1.5 per cent.12 This 10 per cent reduction in PMR, incidentally, corresponds to the intensity of reforms made by those OECD countries that have undertaken significant product market liberalisation over the past decade. This highlights that ambitious but achievable reforms can get us a long way to the 2 per cent ambition.
