Markets Insight

June 10, 2014 6:07 am

Déjà vu: echoes of pre-crisis world mount

But missing credit bubble indicates next crash is not imminent

An occupational hazard of observing markets is a recurring sense of déjà vu. Even so, 2014 is proving a vintage year for echoes of the pre-crisis world.

First, we have the return of the Great Moderation, that period of eerie stability before 2007 which economists and central bankers hailed as the harbinger of a new era of non-inflationary growth. Today market volatility has again collapsed across all asset classes. Ten-year US Treasuries, the global bond market benchmark, have been trading in a relatively narrow range all year.

Note, next, that the Bank of England’s latest systemic risk survey shows that the perceived probabilities of a high-impact event in the UK financial system over both the short and medium term continue to fall, setting new lows since the survey began in 2008. This brings back memories of the last Banking Banana Skins survey produced by the Centre for the Study of Financial Innovation before the crisis, which revealed that the financial community’s biggest worry at the time was over-regulation. Risk management featured low on the list of concerns.

Structured product alert

Then there is the return of structured products with embedded leverage such as collateralised loan obligations. CLO issuance in 2013 reached $82bn, a mere 15 per cent below its peak in 2006.

At the same time, global leveraged loan issuance for leveraged buyouts and other highly borrowed transactions saw record volumes last year, rising 55 per cent from 2012 to $1.6tn. The credit risk premium in the US bond market is very low by historic standards, while the quality of bond issuance and covenant protection has deteriorated. Credit risk is clearly underpriced.

Before concluding that we are once again on the road to perdition, though, it is important to recognise the echoes that are not present. With the odd exception such as the London housing market, residential and commercial property so often at the heart of financial crises – are not seriously overheating in the G7 economies.

Nor is there any sign of a credit bubble. The credit channel in much of the developed world is still broken. And the difference between actual and trend private sector credit growth measured relative to gross domestic product shows a significant negative credit gap in the G7 countries. Since the credit to GDP ratio is used by the Basel III capital regime for setting banks’ counter-cyclical capital buffers, this would point to a relaxation rather than a tightening of policy. We also know there has been significant deleveraging in the banking system.

This leads to a question. If the banks are not pumping out credit and inflating bubbles, why are lending standards falling? One potentially ominous answer might be that there is increased competition for the banks from the shadow banking system and that official data fail to capture the full extent of the lending activity now taking place.

While there may be something in that, a simpler explanation is that the banks are also in competition with the capital markets. And these markets are awash with excess savings. As well as the huge surpluses of savings over investment currently being generated in Asia, the eurozone has emerged as a net saver since the crisis. Taken in conjunction with the bond buying programmes of the central banks, this has caused a further round of yield compression as financial institutions search for yield with a diminishing regard for risk.

Seeds of next crisis

The implication is that while a financial crisis is not imminent, the seeds of one are being sown in the way described by Hyman Minsky, the great theorist of capital market instability. The bubbles will come in due course. And an interesting take on potential vulnerabilities comes from the Institute of International Finance, a club of leading global banks. The IIF argues that as well as monitoring the credit to GDP ratio, it makes sense to look at the asset to GDP ratio.

Using this metric, it finds that the asset to GDP ratio shows a large positive deviation of 9 percentage points from its long-term trend in the G7. This highlights the risk that unless growth accelerates significantly in the future, economic growth may not create sufficient resources to service the developed world’s huge pool of assets, whose value will therefore have to correct at some point.

The decline in secondary market liquidity due to the reduction in the banks’ market making capacity since the crisis could, the IIF warns, magnify a bond market correction, making it disorderly and contagious. Volatility would return with a vengeance.

The IIF’s warning feeds into existing concerns about the impending normalisation of monetary policy and of central bank balance sheets in the US and UK. The only (faintly) reassuring thing about this particular systemic risk is that macroprudential policy makers are well aware of it.

The writer is an FT columnist

Copyright The Financial Times Limited 2014.

The Great Credit Mistake

Adair Turner

JUN 6, 2014

Newsart for The Great Credit Mistake

LONDONBefore the financial crisis erupted in 2008, private credit in most developed economies grew faster than GDP. Then credit growth collapsed. Whether that fall reflected low demand for credit or constrained supply may seem like a technical issue. But the answer holds important implications for policymaking and prospects for economic growth. And the official answer is probably wrong.

The prevailing view has usually stressed supply constraints and the policies needed to fix them. An impaired banking system, it is argued, starves businesses, particularly small and medium-size enterprises (SMEs), of the funds they need to expand. In September 2008, US President George W. Bush wanted to “free up banks to resume the flow of credit to American families and businesses.”

The stress tests and recapitalizations of US banks in 2009 were subsequently hailed as crucial to the recovery of both the banking system and the economy. By contrast, the European Central Bank’s inadequately tough stress tests in 2010 were widely panned for leaving eurozone banks too weak to provide adequate credit.

In the United Kingdom, banks have been criticized for not lending the reserves created by quantitative easing to the real economy, leading the Bank of England to introduce its “funding for lending scheme in 2012. In the eurozone, it is hoped that this year’s asset quality review (AQR) and stress tests will finally dispel concerns about bank solvency and free up credit supply.

A “credit crunch” – particularly in trade finance – was certainly a key reason why the financial crisis generated a real economy recession. Taxpayer-funded bank rescues, higher bank capital requirements, and ultra-easy monetary policy have all been vital to overcome credit supply constraints. But there is strong evidence that once the immediate crisis was over, lack of demand for credit played a far larger role than restricted supply in impeding economic growth.

That argument is persuasively made by Atif Mian and Amir Sufi in House of Debt, an important new book that analyzes US data on a county-by-county basis. Mian and Sufi show that the recession was caused by a collapse of household consumption, and that consumption fell most in those counties where pre-crisis borrowing and post-crisis real-estate prices left households facing the largest relative losses in net wealth.

It was in those US counties, too, that local businesses cut employment most aggressively. For SMEs, a shortage of customers, not a shortage of credit, constrained borrowing, employment, and output. And the customers were absent because the pre-crisis credit boom had left them over-leveraged.

In the UK, many business surveys from 2009-2012 told the same story. Poor customer demand was ranked well ahead of credit availability as a constraint on growth.

Economic growth can indeed continue to be severely depressed by a debt overhang even when credit supply is unrestricted and cheap. Many Japanese companies were left overleveraged by the boom and bust in credit and real estate in the 1980s and early 1990s. By the late 1990s, the Japanese banking system was offering companies loans at near-zero interest rates. But, rather than borrow to invest, firms cut investment to pay down debt, driving two decades of stagnation and deflation.

Since 2011, the ECB’s analysis of weak eurozone growth has stressed the negative impact of an impaired and fragmented financial system, with high sovereign-bond yields and funding costs for banks resulting in prohibitive lending terms in the peripheral countries. Major progress in fixing these problems has already been achieved.

The ECB’s latest Monthly Bulletin documents this, citing multiple indicators of improved credit availability and pricing. Nonetheless, the rate of decline in private-sector loans has accelerated over the last year – from -0.6% to -2% – and low demand is acknowledged to be the main driver of depressed credit growth. Simultaneous private deleveraging and fiscal consolidation are restricting eurozone growth far more than remaining restrictions on credit supply.

Despite the ECB’s own evidence, however, the policy focus remains on fixing the credit-supply problem, through the AQR and stress tests, and through the ECB’s own version of a funding for lending scheme, announced on June 5. That reflects a recurring tendency in official policy debates, particularly in the eurozone, to concentrate on fixable problems to the exclusion of more difficult issues.

Fixing impaired banking systems after a crisis is both essential and achievable. Moreover, even when public rescue costs are inevitable, they are typically small change compared to the economic harm wrought by the financial crisis and post-crisis recession. By contrast, a large debt overhang may be intractable unless policy orthodoxies are challenged.

Japan offset private deleveraging in the 1990s by running massive public deficits. The US has pulled out of recession faster than the eurozone, not only – or even primarily – because it fixed its banking system faster, but because it pursued more stimulative fiscal policies.

But fiscal stimulus is constrained within the eurozone, where member countries no longer issue their own currency and “sovereigndebt therefore carries a default risk. Aggressive monetary expansion through quantitative easing is also far more complicated and politically contentious in a currency area with no federal debt for the central bank to buy. To survive and thrive, the eurozone will need to become more centralized, with some common fiscal revenues, expenditures, and debts.

Of course, this scenario implies immensely difficult political choices. But the starting point for debate must be realism about the nature and severity of the problems facing the eurozone. If eurozone policy assumes that fixing the banks will fix the economy, the next ten years in Europe could look like the 1990s in Japan.

Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Can the Great Recession ever be repaired?

Gavyn Davies

Jun 08 16:42 

The US employment report on Friday was notable because it showed that the number of jobs in the American economy now exceeds the high point reached in January 2008 for the first time since the Great Recession. Another important signal that the economy is returning to normal, it might be claimed.

But a period of more than six years with zero growth in jobs in the American economy is anything but normal. According to the Economic Policy Institute in Washington, the US would need to create an extra 6.9 million jobs before the labour market could really be said to be back to normal, in the sense that all those who want employment would be fully satisfied.

The same point can be made about the path for real GDP in almost every developed economy since 2007. While several economies have now returned to their previous peak levels of output, very few have approached the previous long term trendlines which had been established for decades before that. For the developed economies as a whole, output remains about 12 per cent below these trendlines.

Because this level of output has never actually been attained in the real world, there is little sense of tangible loss about this, notably in the political sphere. Nevertheless, the opportunity cost could still be enormous.

The case for believing that the trendlines can indeed be re-attained is that this has always happened after recessions in the past, at least in the US, though it has sometimes taken many years, especially in the wake of financial crashes. The optimists say that none of the growth fundamentals in the system – the state of technological knowledge, the available labour force, and the amount of fixed investment that is profitable to deploy – has been permanently destroyed by the Great Recession. Therefore, they say, it is incumbent upon policy makers to try to re-attain the trendlines, rather than simply accepting the loss. Many central bankers, especially in the US and the UK, strongly believe this.

A more pessimistic view is that the Great Recession has resulted in a permanent (or at least very long lasting) loss of economic capacity, in which case it would be inflationary to attempt to re-attain previous trendlines. On this view, the global economy has now locked on to a different path, with its effective capacity being much lower than previous trends might imply. The latest estimates of capacity published by the IMF and OECD, who should be able to do this sort of work better than most, clearly imply this (see graph above).

An interesting paper released this week by Lawrence Ball at Johns Hopkins University examines the loss of capacity on a country-by-country basis. He does this by extrapolating the IMF/OECD estimates of potential GDP made prior to the Great Recession into the 2008-15 period, and then compares these with the latest published estimates. The difference between these two paths for potential GDP provide an estimate of the lost capacity due to the Great Recession. The results are truly alarming:

As the table shows, most of the decline in output relative to trend in 2013 is attributed to a drop in potential output (7.2 per cent). The US and the core euro area countries perform relatively well in the league table, while the UK and the stressed euro area economies perform badly.

Only about 2.6 per cent of the overall output loss in 2013 is attributed to an “output gap”, or a fall in output relative to potential. This segment is the only part that can rapidly be repaired by expansionary macro-economic policy, which in the current environment means monetary policy, since fiscal policy is still being tightened in most countries. The future growth rate in potential GDP has also dropped by 0.7 per cent a year in the developed economies, so the problem will keep getting worse from now on.

On the latest IMF/OECD forecasts, the output gap will drop to only 1.5 per cent by 2015, which implies that there will be little work left for monetary policy to do by then.

Lawrence Ball’s most interesting result is that there is a very strong association between the actual loss of output since 2007, and the loss in potential output. Those countries which best avoided the recession (eg Switzerland, Germany and Australia) have had the smallest loss of potential GDP, while those which suffered the deepest recession (mainly the stressed group within the euro area) have lost the most in potential GDP.

Ball concludes that “hysteresis effects” have been at work, implying that a demand shortfall in 2008-09 has had permanent effects on potential GDP via reduced labour participation, lower capital spending and reduced innovation and economic dynamism [1].

While Ball clearly believes that the direction of causation runs from the demand side to the supply side, it has to be admitted that these results are observationally equivalent to the opposite conclusion. It is possible that those countries which suffered the largest supply shocks then experienced the largest drop in output, even though there was no prior shortfall in demand. It seems to me far more difficult to make the argument work this way round, but economists should be humble about how much they really know about the causes of recessions [2].

Can anything be now done to reverse these losses in capacity? It is becoming increasingly clear that monetary policy alone will not work. Before too long, financial market bubbles will prevent that.

Some economists believe that the repair can only be accomplished with a much more active role for fiscal policy [3]. Although it is certainly a huge stretch to believe, even in hindsight, that the herculean losses in output since 2007 could all have been prevented by expansionary fiscal policy, the right type of fiscal policy reforms (tax cuts, infrastructure spending, work incentives and capital spending inducements) could now have benefits on both the supply and demand sides.

Those in charge of fiscal and monetary policy are barely, if at all, addressing these problems in their public pronouncements. In fact, a de facto consensus appears to be developing that the losses in potential GDP should be accepted as an unfortunate fact of life. It is a recipe for too easily accepting the second best.



[1] See also Robert Hall’s highly relevant work on this.

[2] See Noah Smith, Tim Harford and John Cochrane this week for cautionary notes on the pretence of knowledge in this area, with a riposte from Simon Wren Lewis.

[3] See Ball, DeLong and Summers, for example.