A decade after the global financial crisis the global economy seems (finally) to be enjoying a robust recovery. Economic growth is widespread and includes increased expenditures on investment, a sign that business firms expect continuing demand for their products. With the crisis finally behind us, we can revisit it to reassess its causes and the response. We can also ask whether our ability to respond to another crisis is adequate.
Reappraisals of the roots of the crisis have focused on the fragility of the financial sector, and the consequences of inadequate capital and liquidity shortfalls. Low interest rates due in part to foreign savings contributed to a rise in housing prices in the U.S., and the extension of mortgage loans to borrowers who sought to profit from further price increases. Bankers were willing to extend credit in part because they could pass along any risk through the sale of mortgage-backed securities, in some cases to financial firms in Europe. Credit booms in the housing sector also occurred in other countries, most notably Ireland and Spain.
But by 2007 as interest rates and the price of servicing the debt rose, housing prices stalled and mortgage borrowers who expected capital gains began to exit the market. The mortgage-backed securities lost their value, which led to a chain of liquidations of positions that pushed their prices further down. In the summer of 2008 the federal government was forced to take over the government-sponsored agencies, the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), that were active in the secondary market for mortgage securities. The failure of Lehman Brothers in September 2008 signaled a financial collapse that quickly spread to Europe.
In the aftermath of the crisis there was a wave of new rules in the financial sector. National bank regulators acting together at the Basel Committee on Banking Supervision revised capital adequacy ratios. In the U.S. the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted to overhaul and update our regulatory rules and institutions. The bill consolidated government supervisory agencies, extended their reach and introduced new tools, including a mechanism to allow the orderly closure of financial companies that have failed. The Consumer Financial Protection Bureau (CFPB) was established to prevent the predatory mortgage and other lending practices that had contributed to the crisis.
While national leaders were criticized at the time for an initially fumbling response, Daniel Drezner of the Fletcher School at Tufts University appraised the macroeconomic and financial policies undertaken at the time of the crisis and concluded that the system “worked,” i.e., the policy measures undertaken adverted a much worse outcome. The leaders of the Group of 20 nations (the successor to the Group of 7) agreed to increase government spending and to expand the resources of the International Monetary Fund to allow it to lend to a range of countries. Just as importantly, they also agreed to refrain from implementing trade barriers or engaging in competitive exchange rate depreciations. The Federal Reserve, aware of the central role of the dollar, instituted swap agreements with foreign central banks that enabled them to assist their banks with dollar obligations.
Ten years later, is the global economy safe from another financial meltdown? If one did occur, could we respond as aggressively? Because of the slow recovery, credit growth does not seem excessive—with the significant exception of China. Global stock markets, on the other hand, continue to set new records. The U.S. cyclically adjusted price earnings ratio has reached a level only seen in 1929 and during the “tech bubble,” leading inevitably to explanations of why this time the valuation is justified. Bitcoin, supposedly a new form of currency, continues to draw investors with a scarce understanding of what they are purchasing, and many are doing so by borrowing on their credit cards. A collapse in prices could lead to an unraveling of positions and a new round of liquidations that could extend into other financial markets.
Unfortunately, central banks will have limited room to respond. While the Federal Reserve is increasing the Federal Funds rate, it currently stands at only 1.50%. But even this is higher than the Bank of England’s target rate of 0.5% or the European Central Bank’s 0.0%. Central banks could return to quantitative easing operations but they would be beginning with much larger balance sheets than they had in 2008. A fiscal stimulus would be effective in the event of an economic contraction, but the U.S. has just enacted tax cuts that are expected to add $1.5 trillion to the federal debt. How would financial markets respond if a new downturn lowered tax revenues further as the government sought to increase spending?
Moreover, the financial sector in advanced economies is just as large as it was before the crisis. The size of financial sectors has been cited as a cause of concern by economists at the Bank for International Settlements and also a team at the IMF. The latter paper finds: “The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.” There seems little doubt that we reached that point years ago.
There also seems to be no recognition of the fragility of the financial sector, and the threat it can pose. The success of governments in preventing a recurrence of the Great Depression precluded a public accounting of the causes of the crisis and the dangers of financial excess. A recent column in The Economist concluded:
“The success of the response to the downturn helped avoid some of the disasters of the 1930s. But it also left the fundamentals of the system that produced the crisis unchanged. Ten years on, the hopes of radical reform are all but dashed. The sad upshot is that the global economy may have the opportunity to relearn the lessons of the past rather sooner than hoped.”
If such a disaster occurs, it is difficult to imagine how the current administration in the U.S. would respond. There is no sense of common purpose or even an acknowledgement of the global interdependence of economies. Economic nationalism during a period of volatility will surely set off a round of tit-for-tat responses that in the end would leave no country better off.
In the meantime the financial sector enjoys continuing growth in earnings and the U.S. Congress is preparing to loosen some of the Dodd-Frank banking restrictions. But, as Martin Wolf of the Financial Times has warned, “The world at the beginning of 2018 presents a contrast between its depressing politics and its improving economics.” Markets can and do change rapidly,and there are many potential sources of disruption. And the greatest danger is always the one you do not see coming.
