A decade on ...

It is exactly ten years since the Lehman’s bankruptcy set off a chain reaction in the financial markets that prompted the biggest economic collapse since 1929. Perhaps if the regulatory authorities had been aware of the disruption that would follow in the wake of their decision to declare Lehman’s insolvent they would have thought twice about it. It proved to be the catalyst for the deepest global recession in 80 years and prompted the monetary authorities to step in to prop up the global financial system.

The prime cause of the bust was excess leverage that had built up in the banking system, aided and abetted by some irresponsible activity by banks and lax oversight by the regulatory authorities. Thanks to an unprecedented degree of monetary easing, the fallout from the crisis proved to be far less disruptive than the Great Depression of the 1930s but it nonetheless exposed the limits of the pre-2008 financial system. Despite all the hype suggesting that risk had been tamed, the opposite was true. Instead banks merely learned to hide risk using off-balance sheet vehicles, and when banks ceased to trust each other because they were not sure how much balance sheet risk their counterparties were exposed to, financial markets seized up.

It was evident during the meltdown that the motto of the London Stock Exchange “my word is my bond” counted for nothing. Trust evaporated faster than an ice cube in a heatwave. Whilst banks were clearly the catalyst of the crisis, I hold the view I expressed at the time that the whole episode reflected a systemic collapse in which regulators, central banks, governments and indeed private households all played a part. I was also initially puzzled as to why the authorities allowed Lehman’s to go to the wall when the Fed brokered a deal with JP Morgan after a similar fate befell Bear Stearns in March 2008. I rationalised it by suggesting that having acted as a backstop for the US financial system to that point, the authorities took the  view  that  they  could not continue  to  bail  out  failed  institutions  and thereby  continue  to promote  risk  taking. Which was fine, but a couple of days later they stepped in to bail out AIG.

It was nonetheless obvious on 15 September 2008, the day markets reopened after the Lehman’s announcement, that the risks to the economy had significantly risen. I noted on the day that  “On previous occasions when the US financial industry has suffered major shocks, the authorities have responded by implementing major legislative changes … We  might expect a similar legislative backlash in future with any legislation likely to focus on improving the transparency of banks' risk positions.” That proved to be an understatement. The Basel III legislation, unveiled in 2010, was a comprehensive overhaul of the financial sector which changed the way in which banks operated. The first element of this policy required banks to hold much more loss-absorbing capital, with a required minimum capital buffer of 7%-8.5%  compared to an effective pre-crisis buffer of 4%. A second element of the legislation focused on enhancing the consistency and comparability of banks’ risk weighted, assets to impose a much greater degree of uniformity thus enhancing transparency.

Although we will never fully know how successful the new legislation proves to be until it is tested in a crisis, regulators’ regular stress tests give grounds for optimism. Balance sheets have changed significantly in the past decade with a higher proportion of the asset base comprised of loans at the expense of trading securities whilst deposits make up a larger share of liabilities. But as the BIS has pointed out, a crucial area of banking resilience is profitability since this determines the extent to which banks can recover from losses. Although much progress has been made to weather-proof bank balance sheets, profitability – particularly in Europe – has not recovered. Admittedly, pre-2008 profit levels may be an inappropriate benchmark given the significant degree of risk required to generate them, but market pricing based on metrics such as price-to-book ratios suggest that investors are not very optimistic with regard to a profit recovery.

From an economic standpoint, economic prosperity is clearly growing more slowly than before the great recession. In the ten years to 2007, UK real household incomes grew at an annual average rate of 3%; over the period 2008 to 2017 the rate slowed to 0.8%. The experience across the euro zone has been similar, with average annual growth of 1.9% in the seven years prior to the crash but 0.2% in the decade thereafter.

A perception that living standards are not improving at the same pace as pre-2008 has resulted in a backlash against globalisation – a view that has been fuelled by the rise of China, which is viewed in some quarters as getting rich at the west’s expense.  Rising economic nationalism has placed limits on the EU’s ambition and although the single currency has survived intact, it survived a near-death experience in the wake of the Greek debt crisis and highlighted that a fixed exchange rate system needs much more than a single monetary policy to survive. Arguably, the problems in the EU coupled with a backlash against immigration gave rise to Brexit, whilst mounting concerns about the rise of China was the catalyst for the rise of Trump.

Just as many lessons were learned from the crash of 1929, so economic historians will have a field day with the Lehman’s bust. Perhaps the biggest lesson was that self-regulation does not work. The idea prevailing in the preceding 20 years that aligning incentives would ensure optimal market outcomes proved to be hopelessly naïve (as indeed many of us said all along). Few bankers are fans of the enhanced regulatory regime subsequently introduced but it is a necessary price to pay to ensure that 2008-style outcomes are not repeated. After all, the imposition of Glass-Steagall legislation in the US in 1933 successfully prevented banking crises until after it was repealed in 1999.

But one lesson has remained unlearned. Many believed that the Keynesian policy prescriptions which worked well in the 1930s, coupled with massive monetary easing, would help economies to recover relatively quickly. Although we got the monetary easing, governments have conducted a prolonged period of fiscal austerity after a brief stimulus. The economy has thus struggled to recover and financial markets are less dependent on the economic pickup than on the cheap liquidity provided by central banks. In that respect perhaps we will only know the extent to which we have fully recovered from the crash of 2008 when we see how markets and the economy cope with monetary tightening. The US seems to be doing fine on this front but Europe remains a long way behind.

It was twenty years ago today ...

It dawned on me this morning that it is twenty years since I packed myself off to Germany to start a new job. Two whole decades! As I reflect on where the time has gone, and why English football is in an even worse state than it was then, I am struck by how much simpler the world economy appeared back in 1996. The world's economic power was concentrated in Europe and the US, which meant that keeping track of the fundamental issues driving markets was a relatively simple task. European monetary union remained an aspiration for policymakers whose aim was to meet the qualification targets for entry into the single currency. Central and eastern European economies were still adjusting to the post-Communist world and were early converts to go-go capitalism which promised a massive rise in living standards. In Japan, we were awaiting a recovery following the bursting of the bubble economy in 1990, whilst southern and eastern Asian economies were regarded as a dynamic, but very unsophisticated.

How times have changed. Two market booms and busts later – the most recent being the most far-reaching since the Great Depression – the position of the US as a kick-ass superpower has changed. It is still the strongest military power in the world but its economic supremacy is no longer unchallenged. European monetary union did happen as promised, but as recent events have shown, it is far from a one-way ticket to prosperity. Many of the smaller nations in southern and central Europe are struggling under the weight of the massive rise in debt accumulated during the boom; we are still awaiting a solid Japanese recovery following 25 years of stagnation and Russia looks more like the old Soviet Union than the engaged partner the west hoped it would become. But the biggest change has been in the perception of Asia, particularly China, which is reclaiming its historical importance as a big player on the world stage.

Of all the events which have taken place over the past two decades, perhaps the most emblematic was the Lehman’s bankruptcy of 2008 which marked a seismic shift in the western world. This signalled an end to the fantasy world of debt-fuelled prosperity and the dawn of a day of reckoning. No longer would we be able to build our monetary Tower of Babel all the way to Heaven (to use Jens Weidmann’s analogy). We would have to be content with a smaller place with fewer floors (or should that be flaws?). As it turned out, the foundations  of our tower were pretty rotten and even now we are still digging them out, trying to construct a more sustainable structure.

In retrospect, we should have foreseen many of the problems which hit us, but most of us did not. As Martin Wolf noted in his book, “The Shifts and the Shocks”, we “lacked the imagination to anticipate a meltdown of the Western financial system.” Perhaps that is because we had created a system which had proved pretty robust to all that had been thrown at it and we simply became complacent. But an additional reason is that we failed to understand the significance of the change in the world economic order. Ben Bernanke argued as far back as 2005 that excess saving in surplus countries such as China was a contributory factor to the boom which preceded the western bust. It is not the whole story, but it indicates that the changed dynamics of the global system meant that western economies were potentially subject to forces which they had not been designed to withstand.

So whilst it may be overstretching it to argue that the 200 year dominance over the world economy enjoyed by the west is at an end, I have long believed that the high water mark of western capitalism was reached in summer 2007. As that particular tide begins to ebb, it will become ever more apparent how important the Asian economies will be to the global economic order. The US and Europe will no longer be in a position to decide for the rest of the world.

I noted some years ago that against this backdrop, Europe will have to be more outward looking; more open to hearing the voice of the electorate in order to shape its liberal democracy to cope with the demands of a 21st century world. Policymakers will have a key role to play in this debate, balancing the need to impose adjustment against the resistance of the electorate to the radical changes which are needed. The signs are not looking propitious. The stresses imposed by the euro zone debt crisis have exposed fault lines in the design of the single currency whilst the threat of Brexit may be the thin end of a wedge which exacerbates European divisions as populism rises up the political agenda.

We can be certain only that the old certainties no longer hold and for that reason it is pointless to try and predict what will happen in the next twenty years. Suffice to say that western policymakers have a lot of work to do to ensure that we will be in a position where we can feel as positive about our future in 2036 as we were in 1996. I would like to be optimistic about where Europe is headed. But until such times as we rediscover our sense of purpose, I suspect the years ahead will be politically and economically challenging.