William White, former chief economist, Bank for International Settlements.
Mr White, could something similar to the collapse of Lehman Brothers and the unfolding crisis happen again?
Yes, it could happen again. And perhaps not in the far future. The basic problem remains: The massive accumulation of debt in all major economies. There is always the same pattern of too many bad loans over a long time with gradually declining credit standards. There were many steps taken after 2007 to keep things from getting out of control. But most of these steps had only short-term effects, such as the efforts to save the banking system with government support. These measures stopped things from getting worse, but they did not create a basis for improving the situation sustainably. The fundamental problem of the overleverage is not resolved. This problem must be tackled on the side of borrowers and on the side of lenders. But there were not many steps taken into that direction.
So, you do not see any progress regarding the reduction of debt?
There was some progress on the banking side, less for the real economy. Jamie Caruana, the Managing Director of the Bank for International Settlements (BIS), detailed in a speech that the level of private and public debt is now 30% higher than in the beginning of the financial crisis. What makes it even worse is the leakage of money into the emerging markets which has accelerated since 2007. For 20 years the relatively easy monetary conditions in the advanced countries should have led to an appreciation of emerging market currencies. But these countries have preferred to print money instead of accepting an appreciation of their currencies. This is just one more boom-and-bust-cycle to add to all the others we have seen before. They are coming time after time since the first “Greenspan Put” in 1987, when Alan Greenspan helped financial markets with easy money. It is more of the same.
What is the reason that these cycles are not broken by policy-makers?
The pain would be too great. The political will is not strong enough to implement the required reforms against vested interests. It is easier for politicians and central bankers to believe that more easy money is sufficient to solve the problem. Many think like Ben Bernanke who explains the Great Depression in the 1930s with a too restrictive US monetary policy. Bernanke thinks that the Fed can solve a credit crisis with more easy money. But this is exactly what got us into the situation in the first place. And it let, quite predictably, to the current crisis in the emerging markets.
Does that mean that further international co-operation would be needed?
The message of this year’s meeting in Jackson Hole was that countries with easy monetary policy do not need to take responsibility for its effect on other countries. This mirrors the situation in the Eurozone where all the blame lies with the debtor. But creditors have to take responsibility as they have decided to lend the money. The Fed now does not care how its monetary policy affects the emerging markets, since they say the emerging market countries can insulate themselves simply be letting their exchange rates rise. There is an element of truth to this, but the exchange rate movements required to do this might be very large and very disruptive. I think it is crazy that nobody gives guidance what would be good for the system as a whole, and points out the respective responsibilities of both debtors and creditors.
The Fed argues that its monetary stimulus helps to bring the economy back to trend growth. What is wrong with that?
That is what one hopes. But I doubt that we will get back on «trend growth» by simply pursuing the current policies. Relying on monetary stimulus is premised on the idea that more liquidity will not only keep everything from falling apart, but also will induce a form of spending that is going to be strong and sustainable. That is where I part company. To get strong and sustainable growth, we need other policies. First, countries which have enough room in their current account to do it, should do more macro stimulus. Considering the situation in Germany, it is not at all clear to me, why people are inclined to meet their debt ceilings even earlier than the law says they have to. A second instrument would be public and private investments. The infrastructure in many countries is in a terrible state. That would be really useful, something that will enhance growth. Third, an explicit reduction of debt is necessary. There is a lot of debt out there that will never be repaid. Banks need to write off this debt and then be recapitalized. Fourth, structural reforms need to be done. My work at the OECD led me to believe that here are a lot of low-hanging fruits which could pay off. But if a country is basically insolvent it is not in its interest to do reforms, because the creditors will reap most of the benefits. So you have to bring down the debt that it would be in the interest of the debtor to undertake reforms.
Are banks now better protected from a financial crisis?
Every fiat money system, in which banks can essentially create money by lending, can get easily out of hand. Some economists have suggested quite radical ways to deal with it. For example, to restrict banks to “narrow banking” or to back 100% of lending with reserves. But I do not see the political will for any radical solution. However, many useful measures were taken after the crisis. The provisions of Basel III, including liquidity requirements, counter-cyclical capital requirements and a leverage ratio, are good examples of this.
Would these measures be enough as protection?
We do not know. The capital requirements of Basel I in 1988 were set to meet the capital ratios at that time of most Western banks. It was only restrictive for the Japanese banks, which were very big at that time. But that were no analysis how much capital is really necessary to avoid a bank run in particular. Lehman had a risk-weighted capital ratio of 11% shortly before its collapse. There continues to be no analytical framework with Basel III to value if capital requirements are sufficient. In my view also the new capital requirements are still far too low.
But a too strict regulation could also be costly, right?
It is difficult to distinguish between properly and improperly valued loans. You want to reign in the excesses, but in a boom the optimism is first rational before it turns to be irrational. Good regulation can turn to dead-weight regulation. Also (ALSN 202.50 -1.46%) the shadow banking sprung up as an arbitrage to regulation. If you regulate banks more heavily, this means that you will rely on shadow banking much more. The problem with shadow banking is its inherently cyclical nature: It is based on collateral which becomes scarce in a crisis. But if you accept as a reality that booms repeatedly lead to busts, you need to act accordingly. Regulators need rules to act when there are danger signals in respect of rapid credit growth and sharp increases in property prices.
Were central bankers and regulators complacent before the financial crisis by their belief in their economic models?
Many believed in the accuracy of their models. But it was less the models, which led to more complacency. It was more the experience of the «Great Moderation» – that both the level and variance of inflation kept beeing low in the 20 years before even as economic growth strengthened– together with models which attributed this to the good work of central bankers. The models were saying: If you keep inflation expectations under control, a new crisis is impossible. But this low inflation came primarily from cheap production in China and other emerging markets, which had not been incorporated into their analytical framework. Thus, for many central bankers it was inconceivable when the crisis hit them. The reaction was first denial and then a policy of more of the same.
But the financial crisis changed the perspective of economists and central bankers?
The models have to be rethought. Everybody is talking now about macroprudential policies to keep systemic risk under control. But there is very little appetite to rethink the macroeconomic models. Paradigm shifts are always difficult. As the phrase goes, science advances one funeral at a time. People are so strongly linked to their beliefs that often no amount of cognitive dissonance will change them.