The Lost Lesson of the Financial Crisis

Mohamed A. El-Erian
. A man walks past BNP Paribas bank

LONDON – Ten years ago this month, the French bank BNP Paribas decided to limit investors’ access to the money they had deposited in three funds. It was the first loud signal of the financial stress that would, a year later, send the global economy into a tailspin. Yet the massive economic and financial dislocations that would come to a boil in late 2008 and continue through early 2009 – which brought the world to the brink of a devastating multi-year depression – took policymakers in advanced economies completely by surprise. They had clearly not paid enough attention to the lessons of crises in the emerging world.
Anyone who has experienced or studied developing-country financial crises will be painfully aware of their defining features. For starters, as the late Rüdiger Dornbusch argued, financial crises can take a long time to develop, but once they erupt, they tend to spread rapidly, widely, violently, and (seemingly) indiscriminately.
In this process of cascading failures, overall financial conditions quickly flip from feast to famine. Private credit factories that seemed indestructible are brought to their knees, and central banks and governments are confronted with tough, inherently uncertain policy choices.

Moreover, policymakers also have to account for the risk of a “sudden stop” to economic activity, which can devastate employment, trade, and investment.
Marshaling a sufficiently comprehensive response to extreme financial stress becomes even more difficult, if not enough was done during the good times to ensure sustainable and inclusive growth. It becomes harder still when politicians are actively playing the blame game. In the end, the sociopolitical and institutional effects of a crisis can far outlast the economic and financial ones.
All of these lessons would have been useful to advanced-economy policymakers ten years ago.

When BNP Paribas froze $2.2 billion worth of funds on August 9, 2007, it should have been obvious that more financial stress would be forthcoming. But policymakers drew the wrong conclusions, primarily for two reasons.
First, it took some time for policymakers to come to grips with the extent of the financial system’s latent instability, which had accumulated under their watch. Second, most policymakers in the advanced world were too dismissive of the idea that they had anything to learn from emerging countries’ experiences.
Unfortunately, these problems are yet to be fully resolved. In fact, there is a growing risk that politicians – many of whom are distracted and sidestepping their economic-governance responsibilities – may be missing the biggest historical insight of all: the importance of an economy’s underlying growth model.
Indeed, advanced-country politicians today still seem to be ignoring the limitations of an economic model that relies excessively on finance to create sustainable, inclusive growth.

Though those limitations have been laid bare over the last ten years, policymakers did not strengthen adequately the growth model on which their economies depend. Instead, they often acted as if the crisis was merely a cyclical – albeit dramatic – shock, and assumed that the economy would bounce back in a V-like fashion, as it had typically done after a recession.
Because policymakers were initially captivated by cyclical thinking, they did not regard the financial crisis as a secular or epochal event. The result was that they purposely designed their policy responses to be “timely, targeted, and temporary.” Eventually, it became clear that the problem required a much broader, longer-term structural solution. But by that time, the political window of opportunity for bold actions had essentially closed.
Consequently, advanced economies took too long returning to pre-crisis GDP levels, and were unable to unleash their considerable growth potential. Worse, the growth that they did achieve in the years after the crisis was not inclusive; instead, the excessively wide income, wealth, and opportunity gaps in many advanced economies endured.
The longer this pattern persisted, the more advanced economies’ future growth prospects suffered. And what was previously unthinkable – both financially and politically – started to become possible, even likely.
A decade after the start of the crisis, advanced economies still have not decisively pivoted away from a growth model that is overly reliant on liquidity and leverage – first from private financial institutions, and then from central banks. They have yet to make sufficient investments in infrastructure, education, and human capital more generally. They have not addressed anti-growth distortions that undermine the efficacy of tax systems, financial intermediation, and trade. And they have failed to keep up with technology, taking advantage of the potential benefits of big data, machine learning, artificial intelligence, and new forms of mobility, while managing effectively the related risks.
Policymakers in the advanced world lagged in internalizing the relevant insights from emerging economies. But they now have the evidence and analytical capability to do so. It is in their power to avert more disappointments, tap into sources of sustainable growth, and tackle today’s alarming levels of inequality. The ball is in the political class’s court.

Over $9tn of bonds trade with negative yields     
How central banks created the most curious legacy of the financial crisis
by: Eric Platt
Sub-zero commission
Central banks’ response to the financial crisis turned the normal rules of the bond market upside down. Bondholders typically expect to be paid interest to make up for the risk they might not be paid back. Yet trillions of dollars of debt is trading at prices so high that the yield is negative; buyers of the bonds who hold them to maturity are guaranteed to lose money.

Led by the US Federal Reserve, central banks have themselves become huge buyers of bonds, driving up prices and pushing yields below zero. This policy of quantitative easing was meant to reduce interest rates for business and personal borrowers, stimulate growth, buoy inflation and force money managers out of safe haven investments.

From less than $1tn in 2007, the Federal Reserve’s balance sheet has more than quadrupled in size. As the financial crisis spread to Europe and Japan, the European Central Bank, Bank of Japan and Bank of England joined in the expansion. All told, the balance sheets of the four central banks have surpassed $14tn. With the Swiss National Bank and Sweden’s Riksbank, that figure climbs to $15tn and accounts for a fifth of the six countries’ total government debt.

Along with central bank interest rate cuts — including setting unprecedented negative rates in Europe and Japan — the bond-buying programmes explain why $9tn still trades with a negative yield, and why sub-zero rates are a reality that investors likely have to contend with for years to come.

Goldman’s sketchy case to buy (and then sell) bitcoin
Technical note about the cryptocurrency says plenty about modern financial markets

by: Dan McCrum
        © Reuters

Attracting attention in parts of the web this week were headlines that captured the strange place on the fringes of modern banking where astrology, finance and computer games intersect.

A Goldman Sachs analyst had predicted the price of bitcoin — currently above $4,000 — would surge in a frenzy of speculation, before going on to halve.

Unpicking the story finds layers of greed, nonsense and warped logic, not least the contradictory claims made in favour of so-called cryptocurrencies. But deeper than that, it exposes what happens when attention is focused on the price of an asset to the exclusion of all else.

Start with the basis of the Goldman idea, a piece of so-called technical analysis in a set of charts to watch. An often mocked niche pursuit, such analysis might best be described as traders scrawling on charts.

The underlying idea is that buyers and sellers react to events in predictable ways that show up as patterns in the movement of prices. So as an investment case becomes popular, for instance that Unilever stock or platinum futures, are cheap, the price starts to rise, attracting attention and money which pushes prices higher in a form of market momentum.

There is some sense in looking at a chart, if only because many people do and data providers have automated much of the scrawling. If a lot of investors think it worth noting when the line representing the 30-day moving average for a share price crosses the path of the 100-day equivalent, the event can start to attract importance.

Such analysis is also taken much further, with shapes on a chart matched against a library of past doodles used to track the ebb and flow of momentum. Resistance levels, Bollinger bands, even a pattern resembling what some call a vomiting camel, and Elliot waves are brandished as reason to believe how a price will move, with decimal point accuracy for an extra sheen of rigour.

As per the Goldman trading desk, discussing the possibility of trend exhaustion that could take bitcoin back to about $2,200: “Once a full five-wave sequence is in place, the market should in theory enter a corrective phase. This can last at least one-third of the time it took to complete the preceding advance and retrace at least 38.2 per cent of the entire move.”

Invocation of invisible market forces seen through their effects is only a few steps removed from a horoscope. Sagittarius is rising, sell gold.

Bitcoin’s existential crisis Play video

Technical analysis may be all that cryptocurrencies such as bitcoin and its many rivals deserve, however, because the arguments in favour of them are largely self-referential: it must have value because the price has gone up a lot.

Prices rise for reasons good and bad, however. Consider the effect of a recent so-called forking event for bitcoin, an attempt by parts of the community that maintain it to push through an eightfold increase in the network’s maximum capacity to deal with transaction data.

Rather than replacing bitcoin, the attempt has created a parallel new currency, bitcoin Cash, handed out to some but not all owners of the original, depending on the policy of different cryptocurrency exchanges. The value of the new digital coins created by the software tweak is in theory about $5bn, were it possible to swap them for hard currency.

Creating new bitcoin from nothing would appear to go against one of the core arguments for its use as a currency, that a cryptographic formula limits the number of coins that can exist, unlike a central bank that simply wills money into existence.

Since the fork, the price of classic bitcoin has instead zoomed upwards, betraying a sort of video game logic. Congratulations, the quest is complete, all players receive bonus currency. It also comes as initial coin offerings proliferate, where cryptocurrencies supposedly worth millions of dollars are exchanged for digital tokens.

Which is why the trading note is so apt. It begins with a familiar regulatory invocation, that the Goldman Sachs trading desk “may have a position in the products mentioned that is inconsistent with the views expressed in this material”, then goes on to suggest the price of bitcoin may both rise and fall.

In this bold new world of finance, everyone gets to have everything both ways.

Cleaning Up China With a Mountain of Debt

China chooses a greener—and more indebted—future

By Nathaniel Taplin

China dreams of a greener future, and is borrowing heavily to get there.

An annual health check on China’s economy by the International Monetary Fund out Tuesday highlighted a worrisome trend: China’s real fiscal deficit, including borrowing by semi-official entities such as local government financing vehicles, known as LGFVs, hit 12.4% of GDP in 2016, more than a third higher than the equivalent figure in 2012.

China’s official budget deficit is only 3%-4% of GDP, but most investing is done at the local level through a constantly evolving set of off-balance sheet entities like LGFVs, public-private partnerships, and so-called industrial funds.

The role of these often highly leveraged institutions in supporting growth is rising. As manufacturing and property investment has slowed, infrastructure has been used to fill the gap. Infrastructure spending hit 27% of total investment in mid-2017, up from just 22% in mid-2011. Over the same period, which also saw the massive blowout in the IMF’s broader fiscal deficit measure, manufacturing and housing investment fell nearly 10 percentage points to just 44% of the total in July.

The Dongxing Lake Reservoir in Liaocheng, Shandong province. Infrastructure funding in China is increasingly heading into environmental protection and water management. Photo: SIPA Asia/Zuma Press

This infrastructure funding, which used to go mostly into new roads and the oversupplied electric-power sector, is increasingly heading into environmental protection and water management, which China desperately needs.

Although such projects may support growth in the long run by keeping the population healthy—they aren’t typically big moneymakers. A water-conservation and treatment project in the northern megacity of Tianjin evaluated by the Asian Development Bank in 2010 had an internal rate of return of only 5%-8%, according to the bank’s estimate. With average bank and shadow bank lending rates running at around 5% and 7% respectively, that doesn’t leave much room for error. A paper by four Oxford University professors in 2016 found that more than half of infrastructure projects in China over the previous five years were uneconomic.

China needs better water works and cleaner air to safeguard its citizens’ health and long-run economic potential. But as debt-funded infrastructure plays an increasingly important role in China’s postcrisis growth strategy, the future is looking greener—but not less risky.