The Global Financial Crisis: Lessons Learned, Lessons Already Forgotten? Alexander K. Swoboda

1. The Global Financial Crisis: Lessons Learned, Lessons Already Forgotten?Alexander K. Swoboda Presentation prepared for the Panel on China and the Global Financial Crisis; Implications and Future Perspectives Shanghai, May 27 2013

2. Outline • The Crisis: global, pervasive, lingering • A different financial system? • A major threat to international financial (and economic) stability: Exit in a still fragile financial sytem • What, if anything, have we learned?

3. I. The Crisis: global, pervasive, lingering • After the great moderation, the crisis came as a shock. Some had begun believing that the moderation was due to 70% policy (especially monetary) skill, 20% improved structure and 10% luck. (vs. 1/3,1/3,(1/3). • Its propagation revealed that financial system had become increasingly global, interconnected geographically and across markets but, at the same time, increasingly complex and opaque. • It also confirmed that regulation was highly pro-cyclical: it tended to amplify rather than dampen macro shocks and credit cycles. • And it led to questioning the benefits of financial innovation/integration, sometimes sensibly, sometimes in populist unhelpful fashion. In a deeper sense, it became a crisis of confidence and trust in finance, its organization and public policy.

4. II. A different financial system? • The post-crisis financial system: what has changed? • More concentrated rather than less • More fragmented (cf. Eurozone) • From private to public debt, from bank to sovereign doom loop • Some progress in regulatory policy • Attention paid to procyclicality / macroprudential policy • Some moves towards coordination (e.g towards a single supervisory mechanism in the Eurozone but well short of a true banking union), etc. • Move towards simple non risk weighted leverage ratios and some progress on anti-cyclical buffers • But fundamental problems remain: • Too big to fail – too large to save: little progress • Lack of fiscal space in short run and consolidation in medium to long run

5. III. Exit in a fragile financial system • The more highly leveraged a financial system, the more interconnected and the more opaque, the more fragile that system . (Fragmentation / interconnectedness paradox). • With no action on the fiscal front, with macroprudential still far away, monetary policy is overburdened and conflicted. The exit from QE and UCMP becomes particularly delicate. • Worse, any interest rate spike, whatever its source threatens a financial crisis. • The current system is still fragile and leverage is increasing. So are lending and margin chains making the management of counterparty risk at a system level problematic. The “we are fully hedged” syndrome.

6. III. Exit in a fragile financial system (continued) • There is evidence that (i) intermediation chains in the shadow banking system are increasing again (cf. securitization and collateral chains), which combined with a search for yield, threaten to provoke asset price collapses if a shock decreases the value of assets in those chains and leads to a rolling sequence of margin calls. • Some hints: • Stocks purchased on margin on the NY stock exchange • End March 2013: USD 379.5 billion • July 2007 record: USD 381.4 billion • Three figures from the 2013 U.S. Financial Stability Oversight Council

11. III. Exit in a fragile financial system (continued) • The dilemma is that you are damned if you do and damned if you don’t: • If interest rates are not raised, leverage and thus fragility increase, making any future tightening more costly and threatening to stability • It also makes the system more fragile to any shock to interest rates whether policy induced or resulting from increased risk aversion or what have you • Not to mention the hysteresis effects of persistent low interest rates, including effect on pension fund balance sheets and possibly solvency • If interest rates are raised or rise “too fast” the sensitivity of the system to any spike in rates may be so high that a crisis ensues

12. IV. What, if anything, have we (or should we have) learned? • Crisis has brought a number of central issues to the fore: • Pro-cyclicality of credit cycles, of leverage and of much regulation • Complexity and opaqueness (risk management issues) • Too big to fail • Policy inaction or delay (kicking the can down the road) • Instrument shortage: Obstfeld’s trilemma and the burden on monetary policy. • We know what we need to do, why don’t we do it? • A political economy or politics problem • It’s never a good time to reform • Distributional issues including political power

13. What, if anything, have we (or should we have) learned? (concluded) • Some simple lessons for policy: • Ask of every regulation whether it is pro or anti-cyclical. Contingent rules important; discretionary policy too often leads to inaction • Regulations should be as simple and few as possible. This means concentrating on essentials. (Haldane). Dodd-Frank! • Too big to fail: cf. Richard Fischer, too small to fail • Act quickly (related to but not equal to big bang vs gradualism) • Attack problems at source (not only Tinbergen principle but also Mundell’s assignment prescription) to avoid unwanted side effects and instabilities

14. What, if anything, have we (or should we have) learned? (concluded) • All this is easier said than done especially in a world that is getting more integrated and interconnected but where many distortions subsist. With greater factor mobility the overall cost of such distortions is likely to increase—and so may the likelihood of financial instability. And, more fundamentally, there is no easy recipe to resolve the tension between increasingly interconnected financial markets and a fragmented policy and political world.