Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, has delivered a fantastic speech entitled More painkillers, please? Why more finance is the wrong medicine or our growth problem, which argues that the world’s authorities need to stop trying to juice their economies via finance-led growth, since this will only worsen imbalances, create boom and bust cycles in asset markets, and ultimately lower productivity, growth and living standards.
Below are the key extracts:
Finance-led growth emerged as the dominant political strategy in the 1980s. That meant financial deregulation was high on the agenda to foster financial development, and monetary policy was used to counter financial turmoil.
In fact, monetary policy created a high degree of stability during the spell known as the “Great Moderation”, which ran from the 1980s until 2007…
Given this experience [of the GFC], a doctor treating a patient with these symptoms would stop prescribing painkillers. But as it turned out, the monetary “medication” actually started to be expanded in 2008. First via ultra-low interest rates, then through quantitative easing, followed, more recently, by even more monetary measures aimed at kick-starting inflation and the economy.
The liquidity provided stabilised the financial system, but it also inflated asset prices. The aftermath of the expansionary monetary policymaking before the crisis should serve as a reminder not to make the same mistake twice. Providing an endless flow of liquidity as a kind of painkiller does nothing to tackle the root cause of the economic challenges we are facing.
The second painkiller frequently administered to support financial development in the pre-crisis era was deregulation and a “light touch” in regulation and supervision. The idea behind this approach was that lenience would fuel increased investment. Unfortunately, it inflated the credit bubble…
In sum, these policies did not constitute a sustainable lifestyle, nor did they deliver a systematic cure. Rather, they turned out to be painkillers. So the big question I’m asking myself is this: should we carry on treating the symptoms by taking more and more painkillers – or should we look for a fundamental change of lifestyle that might cure the underlying problems?..
Put differently, do we need to treat the global economy with more monetary and financial stimulus? And, more fundamentally, do we need more finance to fix our economy?
For over three decades, the simple answer was “the more, the better”. And scientific evidence supported this intuition. Studies showed that financial development corresponded strongly with economic growth. Politically, there was a clear preference for finance-led growth. Thus, deregulation was high on the agenda.
I won’t remind you where all this led. We just need to remember the tremendous costs for banks and for society at large that followed the burst of the last credit bubble.
Moreover, recent scientific evidence based on historical data reveals that there is indeed such a thing as too much finance. Financial depth starts having a negative effect on output growth when credit to the private sector reaches 100 per cent of GDP. Most advanced countries far exceeded this level prior to the financial crisis – and continue to do so.
Thus, the diagnosis for advanced economies like the EU und the US is that increasing financial intermediation is beneficial, but only up to a point. This point has been exceeded in most developed economies…
What’s the takeaway from all this? It’s that more finance is not the solution to our current problems.
Sticking to the simple “more finance, more growth” trajectory isn’t a sustainable solution. That would run the risk of focusing on what is currently our most pressing problem – lifting growth expectations – at the expense of our long-term – and fundamental – goal of achieving a stable financial system. And by doing that, we would also sacrifice sustainable growth.
Most doctors would probably agree that a sophisticated course of treatment aimed at the patient’s long-term wellbeing is better than a box of painkillers every week. But ask them what exactly they would prescribe, and the result will probably be rather like asking several economists for macroeconomic policy advice. You might end up with more treatment plans than you have doctors – or patients for that matter.
What we need is less, and better finance – finance that serves the real economy and sustainable development. How do we achieve that? There are several angles to that question, but the ones I would like to emphasise are financial regulation and supervision, and monetary policy.
As I said earlier, providing a flow of liquidity as a monetary painkiller does nothing to tackle the root causes of the economic challenges we are facing. In the absence of economic progress on the structural front, monetary easing is not the key to a sustainable economy. It does, however, affect financial stability, given that it can fuel bubbles. Therefore, we need to look for an exit strategy. It is important for central banks to think hard about how they intend to achieve an exit as soon as economic conditions make it viable to do so…
The bottom line is this: we must not lapse back into bad old habits when we’re finalising, implementing and enforcing the reforms aimed at restoring financial stability. Financial intermediation is important for our advanced economies. But if it’s not or insufficiently regulated, it can do more harm than good. That should be borne in mind in each and every decision we take…
Conclusion:
Esteemed colleagues
We are facing two challenges simultaneously: to reanimate economic growth, and to build a sustainable financial system that is fit for the 21st century.
I am convinced that our policies need to set their sights on a long-term solution – a lasting cure, if you will, not an endless supply of painkillers. We should not turn a blind eye to the short-term challenges we face, of course. But what we must do is refrain from solutions that encourage excessive indebtedness. Finance will be an important ingredient in the cure for growth – but it will need to be of a better quality, not a greater quantity.
A copy of this speech should be delivered to Coalition politicians and the RBA, who still seem to believe that juicing private debt and the housing bubble is the Australian economy’s best path to rebalancing after the mining boom.
