John Gieve: Seven lessons from the last three years
Speech by Sir John Gieve, Deputy Governor of the Bank of England, at the London School
of Economics, London, 19 February 2009.
* * *
Introduction
As you know I am about to leave the Bank of England after three years as the Deputy
Governor responsible for its work on financial stability and as a member of the Monetary
Policy Committee.
It has been a game of two halves. The first 18 months from January 2006 to July 2007 were
the tail end of the Great Stability, a period of nearly 15 years of continuous growth, low
inflation, and falling unemployment. They were guided by and reinforced a wide consensus
that economics had discovered the right way to manage the economy and that the UK was a
good model of how to put it into effect.
The second 18 months have seen an extraordinary reversal: with turmoil in financial markets,
the credit crunch, and the onset of a severe global recession calling into question nearly
every part of that consensus.
The immediate challenge is to limit the depth and duration of the recession and bring the
economy back onto a sustainable path with low but positive inflation. But we have just set out
our analysis of the economy in our February Inflation Report and Charlie Bean explained the
policy options we face in a speech earlier this week. So I will focus today on some wider
implications of the last few years for the way we conduct economic and financial policy.
In doing so I am well aware that we are not yet at the end of the story. We don't know how
deep and prolonged this recession will be or how soon and completely financial markets will
recover. So it is too early to reach settled conclusions on causes or cures. So I offer this as
an interim report: seven lessons I have drawn from my experience of the last three years.
A settled consensus
But let me set out first the position as it appeared in 2006.
For much of my life, the design of economic policy has been at the centre of both political
and academic contention. In the UK, over the twenty years following the breakdown of the
Bretton Woods arrangements, we tried everything from prices and incomes policies to
several varieties of monetary targets and finally fixed exchange rates and they all came to a
sticky end. But the approach we adopted after our ejection from the ERM was guided by
modern monetary economics and set us on a course which gathered growing support across
the political spectrum and in markets.
Macroeconomic policy
The new consensus was based in Britain on the experience of repeated bouts of inflation and
the three painful recessions which had been required to bring it under control. That
experience hammered home the lesson that there was no trade off between inflation and
growth. The best that macro policy could aim for was stable and low inflation which would
provide a platform for sustainable growth at a rate which would be determined in large part
by the microeconomic policies which could affect the productivity and dynamism of the
economy.
The right instrument to maintain that low inflation environment was monetary policy. And to
ensure that interest rates were used to that end, and thus to condition public and market
expectations, the decisions should be taken by an independent Central Bank pursuing an
explicit inflation target and informed by modern macroeconomics.
Fiscal policy
In macro terms, fiscal policy was put on auto pilot. Discretionary changes in the
government's tax and spending plans were thought to require too much time to agree and
take their effect to be of any practical use in stabilising the economy. And economists worried
that fiscal measures would prove largely impotent in any case - households and companies
would "look through" any cut in taxes today, which they expected to be financed by an
increase in taxes tomorrow.
So monetary and fiscal policy worked in tandem. Monetary policymakers relied on the
government to balance the books over the cycle so that the inflation target would remain
credible. And the government relied on monetary policymakers to stabilise the economy, so
that fiscal policy could focus on other aims: encouraging innovation, growth and employment;
redistributing income and investing in the public services.
A single regulator
Alongside this macro framework, there was a consensus that industry and commerce was
best left to the market with market failures and externalities controlled by independent
regulators, like OFGEM, OFCOM and OFWAT, rather than through ownership. In the case of
the financial services sector, responsibility was given to the FSA and banking supervision
moved out of the Bank. The new FSA inherited from the Bank an approach to prudential
supervision in particular which was based as far as possible on principles rather than a
detailed rule book .
There were positive and negative reasons for that move. The positive were that a single
financial regulator would be more effective at a time when the lines between banking,
insurance and securities dealing were breaking down. It was efficient for the firms to have
just one regulator to deal with and good for the regulator to be able to look at all aspects of
their business. On the negative side there was a worry that responsibility for supervision
even of banks could unbalance the Bank and distract it from its monetary role. So while the
Bank retained a role in promoting financial stability and monitoring the vulnerabilities in the
system as a whole, it was not given any statutory objectives or powers in the new legislation.
This piece of the UK system was controversial in some quarters but it definitely topped the
international best buy tables in 2006. The IMF called it a model for others and a succession
of governments visited London to learn from it. The Chairman of the FSA was invited by the
US Treasury Secretary to address the heads of the US regulatory bodies. And the Mayor of
New York City and a US Senator commissioned a report which concluded that the US
needed to learn from London's approach to regulation if it was to arrest New York's decline
as a global financial centre.1 In short the separation of the three authorities, each with a clear
remit and the independence to pursue it, was seen as a good model for a modern economy
(Chart 1).
Revisiting the Great Stability
And it worked! We should not underestimate the achievement of the next decade. As
recently as fifteen years ago, low and stable inflation still seemed an unattainable goal. But,
research published by the Bank around the time I joined found that:
"the post-1992 inflation-targeting regime has been characterised, to date,
by the most stable macroeconomic environment in recorded UK history"2
As Chart 2 shows, volatility of both output and inflation hit new lows. Similar gains were
achieved overseas, although the break in macroeconomic performance appears to have
happened earlier in the United States.
In the UK we did indeed avoid the sort of cyclical booms in output, income and employment
we had seen in the 70s, 80s and 90s (Chart 3). Even with the benefit of hindsight, it is hard to
demonstrate that the economy was running significantly above capacity in the last few years.
The flow of migrants eased capacity constraints in the labour market and the surveys of
capacity utilisation rang no alarm bells (Chart 4). Indeed when I arrived on the MPC, some
members were arguing that we needed to cut rates again following a year in which
unemployment had increased and house prices appeared to have achieved the mythical "soft
landing" after a relatively light touch on the interest rate tiller.
And while the expansion of low cost producers in Asia had been a helpful tailwind, the
system seemed to have dealt with some big shocks, like the East Asian Crisis and the
bursting of the Dotcom bubble. So most commentators concluded that a good policy
framework had played its part.
The last 18 months have shown that the reduced volatility of growth and inflation did not tell
the whole story. There may not have been a boom in activity in the West but there certainly
was in many emerging markets. And rising savings there, channelled a huge flow of funds
into the world's financial markets, depressing risk-free interest rates. After the
postmillennium collapse in the world's stock markets this was compounded by a coordinated
loosening of monetary policy. Cheap money supported an increase in leverage in the
financial sector (Chart 5). And banks became increasingly dependent on funding from
wholesale markets rather than their traditional deposit base. In the real economy, asset
prices rose and household balance sheets in particular became stretched.
Fast forward to the present day and the neat separation of powers and responsibilities
between policymakers has evaporated (Chart 6). Monetary policymakers are beginning to
explore unconventional tools to arrest the economic decline as nominal interest rates
approach the lower bound. Fiscal policy has returned as a major tool of macroeconomic
management as well as an essential support to the banking sector. And the Bank and the
Treasury have been drawn deeper into the financial stability realm. A substantial share of the
British banking system is now owned by the UK taxpayer.
Are these just temporary changes to deal with an exceptional crisis or were there some more
structural flaws in the original design and the consensus that underpinned it? I would draw
out seven lessons. (Chart 6)
Lesson 1: The limitations of private-sector risk management
One weakness in the system was the failure of banks and many other investors to
appreciate, price and manage risk.3
It was not that banks were blind to the froth in financial markets. For example, we published
analyses of the vulnerabilities in our Financial Stability Reviews in 2006 and 2007 and
highlighted the declining price of risk, the build up of global imbalances, the growing
dependence of banks on wholesale funding, and the risk that structured credit markets could
seize up in a downturn. When we took that message to Chief Executives of banks in London
and New York, they generally accepted the analysis and agreed that a correction was bound
to come. However, almost to a man (and they were all men), they took comfort from the
sophistication of their risk management systems and hedging strategies. They were
confident they could ride out the storm.
But as it turned out their systems were preparing them for a shower not for a hurricane. The
limitations of their risk models were cruelly exposed in August 2007. One CFO remarked last
year "We were seeing things that were 25-standard deviation moves, several days in a row",
which in plain English means that according to their models, the outright impossible was
happening on a daily basis. According to the Value at Risk (VaR) benchmark for example -
which measures the amount an institution stands to lose on its portfolio given an abnormal
movement in market prices - there shouldn't have been a big problem But that was partly
because recent experience grossly underestimated what the truly abnormal really was.
Updating these models to take account of the volatility in asset prices seen over the past 18
months suggests measured risk increases by a half and in some cases doubles (Chart 7).
Many of the models depended on relatively short runs of data - one year for many, ten years
at most. So the long period of stability reduced the projected losses from a future downturn
(Chart 8).
But the problem goes deeper than just choosing the right sample period to estimate these
VaR models. Using a longer back-run of data to re-classify August 2007 as an extremely
improbable 5 standard deviation event rather than an effectively impossible 25 standard
deviation event rather misses the point. The longer the build up of imbalances went on, and
the larger they became, the smaller the chance that the bubble could burst without a
correction. The events of August 2007 were not a bolt from the blue, an unpredictable
random disaster, but the culmination of several years of developments in financial markets
But inadequate models are not the only reason for being wary of putting too much weight on
risk management by individual firms. There is also the vital question of incentives.
Chuck Prince, the ex-chief of Citi, has been widely condemned for saying: "as long as the
music is playing, you've got to get up and dance." But in a provocative way he was doing little
more than state the obvious. Firms are expected to maximise profits and if they won't seize
the opportunities someone else will. Sit out the dance, and you risk getting swallowed by a
competitor.
In many ways the ideal risk management system for a single bank is one which lets it dance
until the music stops but then to get to the exits before its competitors - to take the profits
when they are available and to close out risks as near as possible to the downturn (or even
better profit from their competitors' remaining exposures). It is noticeable that the investment
banks which did best in 2007 were not those which had stepped back from the new markets
well in advance but those which reacted most quickly and cohesively when the trouble
started in the summer of 07.
Of course other banks need to learn from their example and improve their own information
and control systems. But in a competition someone always has to come last and what
matters for the authorities is how much the weakest will be damaged and how far that
damage will spread through the system. What we saw in the autumn was that even the most
successful investment banks were put at risk by the failure of the weaker ones.
So one lesson we have learned from this crisis is that we cannot leave risk management to
the banks. Not only may they get it wrong but their risk systems, like their marketing, are
directed at their competitive advantage and they are not motivated or in a position to look
after the system as a whole.
Lesson 2: Establish more effective crisis management
As Adair Turner set out very clearly in his recent speech, the events of the last year and a
half have revealed a number of particular gaps in the international regulatory regime. For
example, it gave too little weight to off-balance sheet exposures - the SIVs and conduits in
the shadow banking system which were holding huge portfolios of what turned out to be toxic
assets. The risks of losses on trading books were underestimated as were the risks in the
growing dependence of many banks on brittle wholesale funding markets. I am confident that
the G20 summit will endorse a practical set of measures agreed in the Financial Stability
Forum and the Basel Committee to tackle these points.
But we need also to beware of the dangers of over regulation. Some commentators seem
attracted to turning our banks into nationalised utilities. Certainly international capital markets
have complicated policy making but that is not a sufficient reason for dismantling one of our
most successful sectors. Moreover nationalisation has been tried in many countries and its
record is poor. It may reduce the risk of shocks but generally only at a heavy cost in
misallocation of resources (and usually a continuing drain on the public purse). In my view it
should only be a very last resort. The aim of the game should be to manage the system so
that society can enjoy the gains of a flourishing financial sector - the efficient allocation of
resources and transfer of risk - whilst minimising the threats to economic stability. So we
need to have effective systems not just for preventing crises but for dealing with bank failures
if and when they happen.
The collapse of securitisation markets in August 2007 and the failure of Northern Rock
revealed gaps in the UK's arrangements, With the benefit of hindsight, the main problem was
not the handling of the initial rescue - although the tripartite's footwork may have owed more
to John Sergeant than Fred Astaire. But I don't think anyone believes now that the business
could have been saved. It was in terminal difficulties and it was right to rescue it and protect
depositors. The bigger problem was that, having stepped in, the authorities were hamstrung
by the inadequacy of the legal powers to resolve it quickly and cleanly.
We have learned from that autumn's experience. Since then we have found imaginative
ways to provide the market with the liquidity it needs (through the Special Liquidity Scheme,
long term repos, and now the discount window), we led the world in recapitalising banks in
the autumn and we have resolved the banks which could not survive swiftly and effectively
both through private sector solutions and through the use of statutory measures.
I am delighted that tomorrow the first parts of the new Banking Act come into effect and give
the Bank of England new powers to resolve failing banks and protect depositors.
At the heart of the Act is the creation of a Special Resolution Regime for UK banks and
building societies. The FSA will have the power to trigger this regime before an institution
becomes insolvent. And once a bank is in the regime, the Bank will have the powers to
arrange for it to be wound up , drawing on a new bank-specific insolvency-procedure, or to
transfer the whole or part of the bank to a commercial purchaser, if necessary via a
temporary bridge bank owned by the Bank. If none of these options is sufficient to protect
financial stability, there will be the option of temporary public sector ownership. In the course
of the legislative process, we have identified and enacted wide ranging protections for netting
and set off and creditors generally to ensure that no one is made worse off by the resolution
than they would have been if the bank had gone into a simple administration.
The Act also puts the Bank's financial stability objective onto a statutory footing and
formalises the Bank's role in overseeing those payment systems that are essential to the
smooth running of the economy.
Giving these responsibilities to the Bank is the right choice because they build on the role the
Bank already has as LOLR in crisis handling (which nearly always involves a crisis of
liquidity). More generally it provides a statutory basis for the Bank's second core purpose -
financial stability - which was not mentioned in the 1998 Act and appeared something of an
orphan in the Bank when supervision moved to the FSA. Over the last 18 months of course
that has changed and the Bank is now closely involved with the FSA in monitoring and
intervening in banks and markets facing stress, as well as reviewing the risks to financial
stability more widely and playing a role in forming international policy through bodies like the
G20 and the FSF.
In effect the Bank has become a second pair of eyes alongside the FSA watching the health
of the financial system. The FSA, as the regulator, is informed by "bottom up" knowledge of
the position of individual institutions; the Bank is informed by a top down view drawing on its
own engagement in many markets and on its analysis of the wider economy. We come
together to monitor institutions when they become vulnerable.
Some argue that we should go further and move prudential supervision - at least of the main
banks - back into the Bank. That would certainly be workable - we have done something like
it before - and there could be changes in the euro zone which might add to the attractions of
a move in that direction.
However, it is important not to underestimate the costs of the transition and the new
boundary issues it would create. The cultures and staffing of the Bank and the FSA have
changed a great deal since 1997 and would not be easy to reshape. And there are genuine
costs for firms and supervisors in split responsibilities for different parts of complex groups.
Personally, I am not convinced there is a clearly superior arrangement to the revised
arrangements we have now put in place. It is not clear that any country has done much
better than the others despite the differences in regulatory structure. Perhaps Canada has
the best claim and that has a system similar in many respects to the UK's.
Whatever the boundaries, in a crisis like today's I am sure that cooperation between the
regulator, Central Bank, and Finance Ministry would be essential. I am pleased therefore that
the new legislation makes clear the duty of the Bank to cooperate with the FSA and
Treasury.
Lesson 3: Tighten international coordination
If the tripartite arrangements at home needed to be improved, cross border coordination
needs to be transformed if we are to avoid a drift back into a network of national and regional
financial enclaves.
The failure of Lehmans was a fully fledged disaster for the world economy. And a number of
other cases, from the failure of the Icelandic banks to Fortis, Dexia and IKB, have shown how
difficult it is to manage failures of international banks .
Yet the fact is that most of the key players in the world's financial markets have developed
into large and complex multinational firms. Their business is not separated into national units.
Some core functions - such as risk-management and liquidity management - will be
centralised, and performed at the head-office. Activity at each hub cannot be viewed in
isolation: a multinational may raise deposits in one country to fund loans in another. And the
ultimate buffer against unexpected losses - capital - is fluid across borders in pursuit of
profit.
One response is to call for global regulators to deal with global institutions. That of course
means pooling national sovereignty over a key issue of economic policy. And it could also
require a global fiscal authority with deep pockets to whom the regulator could turn should
one of these institutions fall into distress. The task of persuading the US and China to hand
over the regulation of their largest banks to a supranational regulator would make even the
greatest diplomat quail.
Another conclusion is that such multinationals pose too great a risk to stability and should be
subject to greater control by host authorities in each jurisdiction with the creation of separate
pools of capital and liquidity in each country. But that retreat from globalisation would also
have a cost in inefficiency and restraints on the flows of capital between countries. We
should not forget that the last decade of free financial markets has been a time of great
progress across the developing world in Asia, Eastern Europe and South America.
But the process of building up national controls is already underway in many countries
including even the UK which has long been one of the most open economies for capital and
ownership. It will continue unless we can convince each other that much better structures for
cooperation and coordination are in place. That is an acute problem within the EU where the
single market is based on a common passport. But dealing with the European problem is not
the main priority since most of the biggest banks in the world are based elsewhere.
I don't think we should give up on this international agenda. The package of economic
measures that were rolled out late last year - from coordinated cuts in interest rates, to
provision of dollar liquidity and measures to support banks - showed the power and
possibility of coordinated action. The programme of work on the regulatory implications of the
crisis which has been coordinated by the FSF and will go in April to the G20 Summit
demonstrates a wide accord on the main regulatory issues.
But we need more progress on implementation as well as policy. In particular we need much
stronger cross border crisis planning - a subject on which I have been chairing a group
under the FSF. This has been bedevilled, in practice, by the sheer lack of information and
time to consult widely in the heat of a crisis. That we can do something about.
I hope we will agree two things to put to the G20 summit - a statement of principles on how
countries should cooperate in planning for and handling crises in cross border institutions
and a programme to put in place better arrangements for information sharing and cross
border dialogue on the largest banks in the world. Building on the core international colleges
of supervisors we would aim in peacetime to establish a shared information base among the
relevant authorities and jointly to think through the implications of failure for different
countries. That would at least give us the basis for considering a coordinated solution in
wartime. In time we should also try to establish greater harmony on national resolution
regimes which is on the Basel Committee's agenda.
Lesson 4: Develop a new generation of macroeconomic models
So far I have concentrated on lessons for financial policy but this recession has also set
some challenges for the economics profession and cast doubts on the macroeconomic
modelling.
In truth, much of my critique of the models that financial institutions use to calibrate risk could
equally be levelled at the workhorse DSGE models that most economists and central
bankers use to describe and forecast macroeconomic developments.
These have a number of attractive features. It is built on sound economic principles of
forward-looking optimising agents, which is useful for carrying out academic though
experiments. Unfortunately, such models also have some big drawbacks.
First, having introduced uncertainty into the picture by making agents forward looking, they
then assume the problem away. Risk doesn't matter: agents are assumed to make decisions
today based on the path they believe the economy will take in the future, not the full range of
possible paths it might take. And those beliefs about the future are based on absolute faith in
the ability of the policymaker to stabilise inflation and the economy over the medium term.
They therefore beg some important questions for policy makers - how do we sustain and
build confidence in our policy and what happens if it falters?
Second these models generally assume that the path of the economy is one of equilibrium
disturbed by a sequence of more or less random shocks to which it responds in short order
to return to the equilibrium path. For economists using these models a critical question is
always what shocks have led to the starting position i.e. how far from equilibrium are we and
for what reason. Those starting assumptions will then condition the path back to trend growth
and target inflation over the medium term.
In truth, these "shocks" reflect not only events and surprises in the real world but the
limitations of the model itself. In particular, the models cannot deal easily with self reinforcing
movements away from equilibrium. What at first glance can look like a series of unrelated
unexplained disturbances to the variables in the model, could actually reflect some common
economic impulse that is not captured by the model. Whether those shocks die away, persist
or even build - and therefore how misleading the forecasts that the model produces are - will
depend on what's missing from the model.
In fact the areas of the economy which the current generation of models do not cover well
include the areas where the imbalances were building up in recent years. The treatment of
financial markets and their interaction with the real economy is little more than a side-show.
Banks are typically absent altogether. Yet experience has shown that financial markets are
particularly prone to these self-reinforcing movements away from equilibrium. We have seen
in the last few months alone many examples of that. For example we have seen coordinated
sales of assets depressing prices, leading to write-downs on portfolios throughout the
system, which in turn have triggered a further wave of selling.
These features generally prevented these models from "joining up the dots" in the last
upswing and from capturing the impact of tightening credit conditions in the downswing.
I should emphasise that the MPC is not a slave to any one model. The current Governor
reminds us frequently that:
"It is vital never to confuse the world with a model. The whole point of a model is to abstract
from a wider range of factors in order to think clearly about one particular issue."4
Over the last couple of years, for example, we have drawn on a range of models to capture
the impact of credit markets. The MPC bases its forecasts on all the evidence. And most
forecasts have a lot of added judgement in them. But our main macro model sets a baseline
for our discussions and forces us to quantify and integrate different judgements. It is difficult
to see how the committee could reach a consensus on a forecast (albeit with a probability
distribution around the central projection) without a model of some sort.
All models are simplifications and all models have difficulty identifying turning points. But we
badly need some new thinking to make them better. Putting banks into the models would be
a good place to start. The model of the banking sector which is being developed in the
Financial Stability wing of the Bank will make a good contribution to that.
Lesson 5: Mopping up after the bust is not a good strategy
The world's central banks have tended to follow similar strategies. So much so that an
American economist, John Taylor, was able to neatly summarise how monetary policy is set
with a very simple rule. He found that movements in interest rates around their long-run level
could be explained by just the level of inflation relative to its target, and imbalances between
the level of demand in the economy and the capacity of the economy to produce output.
Asset prices and stock imbalances of the kind we have seen on the balance sheets of banks,
households and companies are conspicuous by their absence in the Taylor Rule. Whether
policymakers actually slavishly follow the Taylor Rule, or it simply represents a good
description of how we behave is largely immaterial. Either way, the default position of
policymakers has been that interest rates should not be used to choke off a boom in financial
markets. That non-interventionist doctrine was based on two key judgements.
First, that the costs of leaning against imbalances in financial markets were high. It was
believed that policymakers would find it difficult to differentiate between movements in asset
prices that could be justified by fundamentals and those which reflected bubbles. The central
bank which frequently responded to movements in asset prices would often as not be doing
so mistakenly. By the time that the central bank was confident that asset prices were
unsustainable it would typically be too late to act. An increase in interest rates late in the day
could prove counter-productive: the bubble might well have burst by the time the change in
policy had filtered into aggregate demand. Even when an imbalance could be identified early
enough to do something about it, the increase in interest rates required to choke off the
imbalance would have serious side-effects.
Much of this will be familiar to all policymakers, no matter what field they work in. It is a
"counsel of despair". Understanding how developments in financial markets pose risks to the
system and the wider economy is a formidable task. But it is one we should embrace, rather
than shy away from. It is the final leg of the argument that is key: how much higher would
interest rates have had to have been in order to have contain the boom in financial markets.
Some commentators have made much of the Bank's decision to cut interest rates by 25
basis points in the summer of 2005. But to pretend that all this could have been avoided had
interest rates been 25 basis points higher over the last couple of years seems to me pure
wishful thinking. Likewise, the idea that had rates been a little higher at the tail-end of the
boom in late 2006 and early 2007 the crash could have been averted is a flight of fancy.
Interest rates would have had to have been significantly higher for an extended period of
time, perhaps as far back as 2002/3. Growth would have been weaker. Inflation would have
undershot the target by even more than it did. Sterling would likely have risen, putting our
export sector under particular strain. Which leaves us with the question: is that a price worth
paying in order to avoid the fall-out when a bubble eventually bursts? And that leads us to
the second judgement that underpinned the non-intervention doctrine.
Prior to the latest crisis at least, many policymakers believed that the costs of allowing a
bubble in financial markets to run its course were relatively small. Interest rates could always
be