John Gieve: The financial cycle and the UK economy
Speech by Sir John Gieve, Deputy Governor of the Bank of England, at the London Stock
Exchange, London, 18 July 2008.
* * *
Introduction
These are troubled times for both the City and the economy more widely. After 15 years of
unbroken growth and low inflation, the prospect for the rest of this year is uncomfortable:
inflation will continue to rise sharply while growth tails off and unemployment picks up. And
the downturn is particularly pronounced in the banking sector. While the acute concerns
about funding that emerged last summer have ebbed a little since March, worries about
future losses, profitability, and even the viability of some business models, have been
growing on both sides of the Atlantic, leading to sharp falls in most equity prices and, in the
UK, to difficulties in bank rights issues.
This morning I want to say a little about the challenges this sets the MPC in the short term
but also to address some of the longer term lessons of the credit crunch.
Global imbalances and the credit crunch
One of the striking aspects of this downturn is that it started - at least in Europe - in the
financial sector. The level of defaults on lending to households and companies is still very
low. The credit squeeze here has not been, initially at least, a response to losses at home
but driven by the dramatic loss of liquidity in financial markets (Chart 1) which was set off by
the US sub-prime downturn.
One puzzle has been why that problem in one part of one country's housing market has
triggered such global turmoil. Of course the US is not just any country. But while the numbers
may look large in absolute terms, even if sub-prime losses reach $500 billion as the IMF
have suggested1, they will be quite modest relative to the size of the whole banking system.
The answer is that sub-prime provided only the initial spark and the fire fed on much broader
weaknesses in the financial sector, which in turn had been allowed to develop by imbalances
in the global economy.
The most striking feature of the world economy in the last decade has been the explosive
growth of China and other emerging economies. For example, since China joined the WTO
in 2001, its imports and exports have expanded on average by 25% each year, more than
twice the growth in world trade over that period.
But these countries have been reluctant to rely, in net terms at least, on foreign capital either
because of their own previous currency crises or their observation of the painful adjustment
experienced by others. Foreign direct investment has been permitted to allow the transfer of
technology and expertise but these capital flows have been re-exported through
accumulation of foreign reserves. Some countries have preferred to maximise their
production of tradeables by undervaluing their real exchange rates through fixed or
heavilymanaged nominal exchange rates to the US dollar. As the absolute sizes of their economies
have increased, so have their current account surpluses and the scale of their foreign
reserve accumulation is now massive. Global foreign exchange reserves have increased
from just under $2 trillion in early 2000 to over $7 trillion in May 2008 and are forecast to
grow by $1 trillion in 2008 alone (Chart 2).
The vast excess savings of these economies needed somewhere to go. The gainers were in
the West where the asset and financial markets were most developed. The inflow brought
greater liquidity to markets and helped to create the conditions for widespread underpricing
of risk. The counterpart to the excess savings in the East became expansion of credit, the
growth of consumption and a boom in asset prices in the West. Looked at in a global
perspective, the dramatic increases in wealth and living standards in emerging economies
have been a great step forward. But the growth pattern has been unbalanced and we are
now having to handle the inevitable correction.
In that sense, the innovation that led to the exponential growth of new structured credit
markets in recent years was not just a product of new technology and more aggressive risk
taking in Western financial markets; it was also a flawed response to these wider imbalances
in the global economy.
Sources of procyclicality
But weaknesses in modern credit markets, and the "originate to distribute" model of banking,
have certainly been a good part of the problem. The development of new markets and credit
instruments has tended to amplify the financial cycle - they have been pro-cyclical in the
jargon - and has introduced or strengthened the misalignment of incentives and flawed
measures of risk.
Of course financial markets have always tended to develop a strong cycle. There is a natural
feedback between asset prices and credit availability. When credit supply increases,
households and companies who were previously credit constrained find it easier to borrow.
Their increased ability to buy assets bids up prices. And these higher-priced assets can be
used as collateral to secure loans. So as asset prices rise, so does collateral, thereby
increasing the willingness of banks to supply credit.
But in recent years this has been reinforced by some structural and regulatory changes. The
growth of credit risk transfer through securitisation has tended to increase the proportion of
banks' balance sheets that come under mark-to-market accounting. Even gradual changes in
the values of the underlying loans have tended to appear as abrupt changes in banks'
trading and treasury books. When liquidity was abundant, asset values were high and
marked-to-market profits were high. Now that liquidity is scarce and asset values lower,
mark-to-market losses and write-downs are high.
The widespread use of credit ratings in valuing assets and managing counterparty credit risk
has also had an impact. Credit rating agencies try to rate through the cycle. And for
corporate ratings they may well succeed. But for some structured finance products, such as
re-securitisations of sub-prime backed securities they (like many others) misjudged the
impact of a downturn in the cycle and the non linearity of returns. As a result, there have
been wholesale downgrades of the credit ratings of structured securities over the past 12
months. The problem for the financial system is that these ratings are often hard-wired into
decision making. Certain classes of investors are forced to sell assets when they lose a AAA
or investment grade rating.
Remuneration structures have also amplified risk taking in the upswing. Two features of
remuneration in the financial industry are that they are asymmetric (there is unlimited upside
for high performance but a floor on the downside) and tend to be based on short-term
targets. The asymmetry in reward creates an incentive to gamble and short-term
performance targets encourage traders to follow rather than counter a deviation from
longrun fundamentals. Even where the incentives were paid in options linked to the medium-term
performance of the employer, the apparent rewards have been highly cyclical.
In addition, regulation can also encourage procyclical risk taking. Basel I, for example,
encouraged the growth of securitisation and the "originate to distribute" model of banking
because holding the low risk elements of a loan portfolio in the banking book were relatively
heavily capital-weighted. Basel II contains more carefully calibrated capital risk-weights and
is a considerable improvement over Basel I. But the risk measures are drawn from the
market and share some procyclical features. Weights increase as credit risk rises so
riskweighted assets will seem relatively low during tranquil economic times and relatively high
during periods of stress. While there may be scope within Pillar II to address this, it is too
early to know whether that can be used effectively.
The combination of these market and regulatory effects have amplified risk taking during the
boom and is now constraining risk appetite as financial conditions have deteriorated.
Policy responses
Since the crisis broke last summer, regulators, governments and central banks have come
together in the Financial Stability Forum (FSF) to analyse what has gone wrong and agree
an international response. Its recommendations have been approved by the IMF and the G8
and include a range of measures to fill particular gaps or put right particular faults in the
regulatory system by:
• strengthening prudential oversight of capital, liquidity and risk management;
implementing Basle II and requiring more capital against, for example,
off-balancesheet vehicles, securitisations and tail risk;
• enhancing transparency and valuation particularly for complex structured
financial products and off-balance sheet vehicles;
• changing the role and uses of rating agencies, including by distinguishing ratings
of corporates and structured products;
• strengthening the authorities' responsiveness to risk; and
increasing the robustness of arrangements for dealing with financial stress;
•
ensuring central banks' operational frameworks are flexible enough to deal with
extraordinary situations in money markets and mechanisms for dealing with weak or
failing banks are put in place.
More generally we are discussing in the FSF how the authorities can go further in moderating
the financial cycle.
Of course monetary policy can play a role in this. One goal of monetary policy is to stabilise
the economy in the face of shocks and central banks have always looked at credit and
money growth as important indicators of the state of the economy. The rapid growth of credit
in 2006 for example was one factor leading the MPC to start raising interest rates. However
central banks have been wary of putting a lot of weight on disciplining financial markets by
changing interest rates. Famously Alan Greenspan asked "But how do we know when
irrational exuberance has unduly escalated asset values, which then become subject to
unexpected and prolonged contractions..?"
There are two good reasons for care. First policy has to be appropriate for the whole
economy; the interest rates which would be needed to have a significant effect, say, on the
growth of house prices in recent years might have been far too high for other industries.
Secondly central bankers have been cautious to put much weight on their own assessments
of when an increase in asset prices is becoming unsustainable. If they get the judgement
wrong, they risk slowing growth needlessly and bring inflation persistently below target.
Even if central bankers put more weight in future on their judgements of excesses in financial
markets, it seems highly desirable also to make the regulatory system more counter-cyclical.
A number of proposals have recently been put forward, which would have the effect of
directly increasing a bank's capital requirements during an economic upturn and allow room
for capital requirements to fall in a downturn. For instance Professors Goodhart and Persaud
have put forward a scheme linking a bank's capital to the growth in its assets. Another
possibility is to learn from the Spanish system of requiring banks to set aside general
provisions against their loan book in good times which can be a cushion against losses in the
downturn. There are some drawbacks to each of these particular proposals but we are
discussing the best approach both with the FSA and with our international colleagues in the
FSF.
Current challenges for the MPC
Making sure we do set in place capital and liquidity regimes which dampen the next cyclical
upswing in financial markets is important. More immediately, we also have to deal with the
present conjuncture and I want to finish this talk with some reflections on that.
If the sharp credit squeeze was the only challenge we faced, the Monetary Policy Committee
would be expected to continue reducing rates to mitigate the risks of an excessive fall in
demand and in inflation in the medium term. But of course we do face another simultaneous
shock, the sharp rise in commodity prices, which is driving up inflation across the world. And
that raises the question whether we should be raising rates rather than reducing them.
Moreover recently each month seems to have brought more worrying news on both fronts.
The cost shock
In the May Inflation Report, the Committee forecast a pickup in inflation to well over 3 per
cent, above target and driven in large part by the huge rises we have seen in energy and
food prices (Chart 3). Since those projections were put together, oil prices have risen a
further 20% and food prices by a further 5%. And the Consumer Price Index has risen faster
than we were expecting, reaching 3.8% in June. We are a little behind the US where inflation
now stands at 5% or the Euro area where it has reached 4% but the gap is expected to
continue to narrow. The peak monthly rate will depend on the exact timing of energy price
rises but we are expecting inflation to be well over 4% for much of the rest of the year.
Of course, not all prices are rising so quickly. The prices of clothing and footwear fell by
almost 8% over the past year. And the price of durable goods like plasma TVs has been
falling even faster. But it is the rising cost of regularly purchased essential goods, like food
and petrol, which attract most attention and probably drive people's inflation expectations,
which have continued to drift up.
This increase reflects in large measure a rise in world prices for commodities which we
cannot avoid, but we must ensure that it is only a temporary spike and that inflation returns to
target when this year's increases fall out of the index in a year's time. Above all that means
ensuring that the higher rate of inflation does not become embedded in the expectations and
behaviour of wage and price setters. The fact is that when their relative prices rise we cannot
avoid a transfer to the producers of oil and other commodities, because they are difficult to
substitute out of. That transfer is bound to hit real wages one way or another but the more
that is resisted and nominal wages are pushed up, the greater the cost is likely to be in
unemployment and slower growth.
We have no direct lever on public expectations. We need not just to assert our determination
to bring inflation back to target but ensure that our words are credible. So, in setting interest
rates we need not just to assess the balance between supply and demand pressures in the
economy which will set the context for price and wage decisions in the medium term, but also
ensure that our decisions are understood and seen to respond to the economic
developments in inflation and output that people are experiencing.
It is clear that with inflation rising well above target we need a period of slower growth to
create a margin of spare capacity. The questions we discuss and reconsider each month are
how big a margin is necessary and what level of interest rates is needed to bring it about.
The Credit Crunch
On the scale of the necessary output gap, for example, we need to take account of the
supply effects of the doubling of oil prices and the impact of migration. On the other side we
need to judge how sharp a slowdown is already in train.
In deciding the necessary level of interest rates we need not just to focus on the level of
Bank Rate. We need also to take account of the impact of the turmoil in the banking sector
which is now leading to a fierce squeeze on credit especially in the housing market but not
just there. The increase in bank margins over safe rates have offset the cuts we have made
to Bank Rate since last summer and the tightening of other conditions have introduced some
quantity restrictions which are not fully captured in price. Our credit conditions survey
suggests that this squeeze may intensify in the coming months.
Timely sources of data suggest that the economy is already slowing fast. The CIPS survey
balances are now pointing to a contraction in activity in manufacturing, construction and
services (Chart 4). House prices and transaction numbers are falling rapidly with direct
effects on house builders and related services. And while there are winners as well as losers
from lower house prices, there are signs that the housing market is affecting consumer
confidence. More broadly, there are signs that the tightening of credit conditions is beginning
to affect both consumption and investment. Most importantly, the sharp increases in
commodity prices are squeezing real take-home pay which is bound to impact on
consumption at some point.
Conclusion
I began this speech by highlighting how the recent events in financial markets have been
facilitated by the integration of emerging economies into the global economy. Of course, I
could make an even closer link with rising commodity prices. The rapid expansion in activity
in these economies has inevitably put pressure on the global price of energy and other raw
materials, whose supply is relatively fixed at least in the short run. That is showing up in
rising inflation world wide (Chart 5).
So is it right to conclude, as some have, that the path of inflation is determined abroad?
Certainly commodity prices have an effect in the short run. But it is domestic monetary policy
- the decisions that the Monetary Policy Committee take each month, together with the
overarching framework that defines our target - that determines the path UK inflation in the
medium-run. The MPC will continue to assess the balance between the risks of higher
inflation from the commodity cost shock and the downside risks to output (and to inflation in
the medium term) from the credit crunch. But I can assure you that we will do whatever it
takes to bring inflation back to target in the medium term.
Chart 1: Financial Market Liquidity Chart 2: EME holdings of FX reserves
Liquidity index
Per cent US$tr
1.0
40 6
0.8
US$ (RHS)
0.6
35 Annual percentage change (LHS)
5
0.4
30
0.2
+ 25 4
0.0
0.2 20
3
0.4
15
0.6
10 2
0.8
5
1.0
1
1.2
0
90 92 94 96 98 00 02 04 06 08
-5 0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Chart 3: Brent Oil Prices Chart 4: Survey-based measures of activity
Construction Index: 50 = no change
Nominal
US dollars (2008) per barrel
Services
70
Real
140
Manufacturing
65
120
60
100
55
80
50
60
45
40
40
20
35
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
1960 1968 1976 1984 1992 2000 2008
Source: CIPS
Chart 5: Global inflation
EMEs Per cent
UK
9
US
8
Euro Area
7
6
5
4
3
2
1
0