Jan F Qvigstad: Could the financial crisis have been avoided?
Challenges to international cooperation and conflict
Speech by Mr Jan F Qvigstad, Deputy Governor of Norges Bank (Central Bank of Norway),
at a seminar on the financial crisis arranged by Prio, Oslo, 8 December 2009.
* * *
What happened?
Confidence between financial market participants collapsed in September last year following
the Lehman Brothers bankruptcy. The price of credit jumped up both in money and bond
markets. Equity prices declined, increasing the cost of raising new equity capital.
The authorities worldwide responded by supplying substantial liquidity to banks and central
bank key rates were reduced. In many countries, the authorities provided extraordinary loans
or took over banks to maintain confidence in institutions and market activity. In some
countries, the authorities have purchased securities to bring down long-term interest rates.
Stimulus has also been provided through increased public sector demand and government
budget deficits have grown to unprecedented levels in some countries.
The reaction of households and businesses was to increase saving and private sector
demand declined. Credit standards were tightened and risk premiums soared. The drop in
demand rapidly translated into a contraction in trade and output. In spring 2009, world trade
was around 20 per cent below the level prevailing one year earlier. In many countries, the
total value of goods and services production (GDP) declined over several consecutive
quarters. Countries that were heavily reliant on exports of manufactured goods were
particularly hard hit. Unemployment has increased sharply in countries not far from our own.
Given the high levels of available resources, there are prospects of lower than normal
interest rates among our main trading partners for some time ahead.
There are now signs that the stimulus measures are reviving growth, but production is still
lower than it was prior to the crisis. The challenge going forward will be to address the
problem of rising unemployment and high government debt in many countries.
Why did it happen?
When the Queen of England visited the London School of Economics in November last year,
she asked her host why no one had foreseen the financial crisis. In July this year, her
question was answered by a panel of 33 prominent economists from British universities,
government institutions and the business sector. The panel did not cite only a single cause,
but a web of causation.
An important factor behind the crisis can be found in global macroeconomic developments in
the years preceding the crisis. In the 2000s, China made its grand entry into global trade with
an attendant surge in production and income. This led to higher demand for inputs, and the
prices of oil and other raw materials increased. On the other hand, global consumer price
growth was pulled down by exports of cheap goods from China and other countries with low
production costs. Interest rates were lowered in many countries to prevent very low inflation
or deflation. In China, a large share of income was saved, either in the form of investment in
new production equipment or financial assets. The increased supply of financial savings
pushed down global long-term interest rates. Lower interest rates encouraged consumers
and businesses in other countries to borrow capital from China and other surplus countries.
The foreign debt of countries such as the US and UK accumulated rapidly in the years
leading up to the crisis.
Historically low interest rates prompted fund managers in Western countries to seek out new
alternatives in their search for high yields. New financial savings products were developed
and spread to investors around the world. It was often difficult, or even impossible, for
investors to value the risk underlying the products.
Yield potentials can also be increased by leveraging securities purchases. As long as prices
rise, the return on equity will increase with the degree of leveraging. On the other hand, the
risk of being left with debt, and little or no equity capital, increases when prices fall. In the
years ahead of the crisis, high debt leveraging still appeared to be an attractive proposition in
an environment of low credit risk and a glut of cheap credit. The result was a surge in debt
accumulation in the years preceding the crisis. Prices in securities and property markets
soared. The build-up of macroeconomic imbalances in the years prior to the crisis increased
vulnerabilities and the potential amplitude of a downswing. Many observers warned of the
risks associated with these developments but no one foresaw how the crisis would unfold,
when it would erupt, or its severity.
The global financial crisis has revealed weaknesses in the financial system. In retrospect, it
is clear that financial sector regulation was not adequate. Regulation was primarily designed
to ensure that individual banks had sufficient equity capital to protect lenders and depositors
against losses, rather than ensuring stability in the system as a whole. For example, there
were no requirements stipulating the size of liquid assets a bank must hold to weather
periods of failure in market funding. Nor were there any minimum requirements as to funding
stability. An example of the importance of these conditions is the collapse of the British bank
Northern Rock in September 2007. The bank had a residential mortgage portfolio that was
not particularly exposed to risk. The bank had, however, expanded rapidly over several
years, an expansion that was partly based on short-term market funding. When funding
markets failed, the bank promptly encountered liquidity problems and was compelled to turn
to the Bank of England for support. When it became known that the bank had sought
government support, depositors quickly lost confidence and the UK experienced its first bank
run since 1866. Many other banks that were considered to be solid under the applicable
regulation also encountered problems when financial market confidence evaporated.
Something worked: the IMF, G20 and WTO
The IMF is an organisation for international cooperation based on a system of mutual
assistance among member countries. The IMF provides loans to countries experiencing
balance of payments problems. The loans are financed by member countries. If the problems
stem from economic policy mismanagement, the loan will be subject to specific requirements
such as measures to correct policy.
When the crisis occurred, the IMF reacted swiftly to accommodate the increased need for
IMF services. The IMF's role as lender and interlocutor with the authorities in crisis-hit
countries probably helped to limit the crisis. The IMF provided support and assistance to
countries that were directly affected by the crisis and countries that were innocent
bystanders. The sharp increase in IMF lending reduced the financial resources of the
organization. Member countries have now increased their contributions to the IMF.
During the financial crisis, the G20 has played a prominent role in the international
coordination of economic policy. The group launched several important initiatives during the
crisis, which were subsequently placed under the responsibility of the IMF. All countries
stand to benefit from the establishment of international meeting places that the major
economies consider to be of interest. However, unlike the IMF, the G20 is not a
representative body for all countries. Even if the G20 account for a large share of global
output, most countries are not included, such as low-income countries and regions like most
of Africa, the Middle East and the Nordic countries. One possibility is to develop the G20
based on the IMF model where countries are represented through constituencies. Small
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countries like Norway, or at least the Nordic countries, could then be represented in a forum
for discussion of the policies of major economies.
In the wake of the Great Depression of the 1930s, protectionist measures were introduced in
many countries. Customs duties were increased to shield domestic industry. As a result,
world trade continued its decline over several years. So far, protectionist policies have been
avoided in the wake of the latest crisis, which makes it possible to reverse the sharp
contraction in world trade more rapidly and hence reinvigorate economic growth. One reason
why the mistakes of the 1930s have not been repeated this time may be that the World
Trade Organisation (WTO) was established in the interim. International trade agreements
concluded under the auspices of the WTO contribute to binding national governments and
prevent protectionist measures. By and large, this has worked well during the recent crisis.
Could the crisis have been avoided?
The macroeconomic forces that were unleashed in the years leading up to the financial crisis
were strong. It is unlikely that a single country could have stemmed the tide. China's
participation in international trade in goods added several hundred million persons to the
global workforce over a few years. This increased the room for strong, non-inflationary global
growth. China was not prepared, however, to liberalise its capital markets fully. The Chinese
government was not willing to allow its currency to float freely and the exchange rate against
the US dollar was managed. This disabled an important stabiliser and contributed increasing
world trade imbalances. Long-term interest rates remained low in spite of substantial
monetary policy tightening in the US between 2004 and 2006. International organisations
such as the BIS, OECD, IMF and others noted on more than one occasion that growing
imbalances in the world economy were a source of concern. But economic policy decisions
are the prerogative of national governments. Given the policy pursued by China, there were
probably limits to what monetary policy in Western countries could in reality achieve in terms
of rolling back these forces. Increased private saving in the US and other deficit countries
would probably have required monetary policy tightening sufficient to push up long-term
interest rates. Alternatively, a substantial increase in public sector saving would have been
necessary. Both alternatives would probably have led to an economic policy driven downturn.
It is demanding to pursue such a policy based on the proposition that a crisis might occur in
the future.
Improved financial regulation would probably have reduced the severity of the financial crisis.
Regulation and insurance have similar features: in most cases an annual premium must be
paid in the form of slightly lower growth. This occurs because capital is not allowed to flow
entirely freely to the highest yielding vehicles. In return, regulation can counter the build-up of
financial imbalances. This reduces the probability that a negative event will trigger a severe
financial crisis.
It is not optimal to be fully insured against crises because the insurance premium would be
too high. But the financial crisis demonstrated that the imbalances ahead of the crisis were
unsustainable and that they could have been reduced through regulatory improvements. The
reason that this did not occur may be that the risk had taken on the form of several
interwoven imbalances that no single authority had the power to correct.
Banking and financial market regulation will be enhanced in Norway and abroad. The Basel
Committee on Banking Supervision and the Financial Stability Board (FSB), as mandated by
the G20, will soon issue recommendations for strengthening regulation of banks' capital and
liquidity management. In the UK, the regulatory authorities have already drawn up new
banking regulation. A natural consequence of the financial crisis is that increased weight is
given to ensuring system-wide stability and not only the stability of individual banks. Other
important questions are whether systemically important banks should be subject to tighter
regulation and how to reduce the procyclicality of bank behaviour.
Recommendations from the Basel Committee and the FSB will be examined by national
authorities that will subsequently adopt new regulation. In a world with a global financial
market, there are limits to how far a single country go it alone. International coordination is
important for new regulations to have the intended effect. The crisis has opened a political
window for tighter regulation of the financial system, but it is uncertain how long the window
will remain open.
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