Ignazio Visco: The financial crisis and economists' forecasts
Commencement address by Mr Ignazio Visco, Deputy Director General of the Bank of Italy,
to the students of the Master in Public Economics at the Faculty of Economics, La Sapienza
University, Rome, 4 March 2009.
While I alone am responsible for the views put forward in this paper, I wish to thank Fabio Busetti, Michele
Caivano, Eugenio Gaiotti, Alberto Locarno, Sergio Nicoletti Altimari, Patrizio Pagano, Fabio Panetta and Stefano
Siviero for discussions on its various parts and for their practical assistance.
The original speech, which contains various links to the documents mentioned, can be found on the Bank of
Italy's website.
* * *
1. Introduction
It is perhaps early to draw lessons from the crisis that has hit the global economy. The crisis
appears severe and widespread, its effects far-reaching and long-lasting. Measures of
various kinds have been taken or are in the process of being taken regarding monetary
policy, the use of public resources and the revision of rules and institutions on which the
proper functioning of the markets and the operation of financial intermediaries depend. The
present is undoubtedly a period of maximum efforts on the part of economic policy and
overall political action, efforts that are directly proportional to the seriousness of the crisis.
But this is also a moment in which the interpretative models used in analyzing our economies
start being reconsidered and attempts are being made at identifying the reasons underlying
the failures of markets, economic policies and economists' forecasts. Besides, this is also
necessary in order to better define interventions - global, substantial, focused and lasting -
aimed at overcoming the crisis and, as far as possible, preventing, with the design of new
rules, new institutions and new policies, such serious instability from occurring again. If
overcoming the crisis will be arduous and complex, the process of revising the theoretical
and quantitative frameworks of analysis, and the domestic and supranational guidelines and
instruments of economic and financial policy will be equally difficult and laborious.
To begin, one can and certainly must ask how seriously economic analysis, together with
forecasting models, has failed, but also why economic policy, in its various forms, has been
so late to respond to the alarms of economists' analyses and forecasts. This is the subject I
should like to address briefly in what follows, while anticipating an obvious answer: if
economic policy bears serious responsibilities, economic analysis and forecasting models
have also shown important limitations that must be addressed.
2. Origins of the crisis and the economists' diagnosis
Until two years ago the world economy had known an exceptionally long period of rapid
expansion, with much smaller GDP growth rate fluctuations than in preceding periods,
accompanied by low and stable inflation in practically all the main areas of the globe. Thanks
also to the high economic growth rates of large emerging countries, consensus forecasts
were for continuing and relatively stable growth. That confidence was gradually eroded by
the events that occurred between the summer of 2007 and the autumn of last year and
collapsed rapidly in the last few months, giving way to a pronounced and generalized
increase in the volatility of markets and economic activity and widespread uncertainty about
the future.
As is well known, the first signs of the crisis we are passing through were the difficulties
encountered by intermediaries that had invested massively in "structured" financial products,
linked to the performance of mortgage loans (and hence of the prices of the underlying real
estate) granted in the United States to borrowers with low credit ratings (so-called subprime
borrowers). The crisis spread rapidly to other segments of the financial market and, in the
last few months, to the real economy. The seat of infection was set in fact in a broader
context of fragility of the international financial and economic system. The problems that
emerged in 2007 in the markets of structured products linked to subprime mortgages
triggered the crisis, but the conditions for it to take hold and spread rapidly had gradually
accumulated over time. The pre-existent elements of fragility and potential instability had
already been partly identified and indicated as possible sources of danger.
Economic, demographic and technological changes
Great changes have taken place in the last twenty years, in terms of the integration of
economies and markets, demographic movements and technological and financial
innovation. The growth in world trade of goods and services was extremely rapid, as was that
in foreign direct investment. The emerging Asian economies now account for more than a
quarter of world exports, twice the level in 1990. In little more than a decade, direct
investment rose from 10 per cent of world GDP in 1995 to 25 per cent, with the advanced
and emerging economies recording similar increases. Financial integration increased
remarkably: in 2007 the ratio of foreign financial assets and liabilities to GDP was equal to
300 per cent in the advanced economies, compared with 140 per cent in 1995, when the
prevailing expectations were for rapid growth in both the emerging and developing countries,
in conjunction with the progressive removal of the constraints on the mobility of capital.
Globalization has obviously brought a large increase in countries' interdependence and
accordingly in the probability of cross-border transmission of real and financial shocks. At the
same time the greater risk diversification associated with the increase in the global exposure
of financial portfolios should have produced, at least in principle, a smaller exposure to
perturbations of a local nature.
As regards demography, the very rapid population growth in the developing economies has
begun to be matched by a progressive ageing of the population in the industrial countries
and in some of the large emerging economies as well (especially China). The increase in life
expectancy has gone hand in hand with the reduction in births, causing a sharp rise in
oldage dependency ratios (of the elderly in relation to the population of working age), which is
set to continue in the coming decades. This has led to a downward trend for public pensions
and an increase in supplementary pension schemes offered by pension funds, insurance
companies and other institutional investors. In the meantime households' direct exposure to
financial risk has grown: in 2008 in the three largest euro-area countries the proportion of
households' financial assets administered by these intermediaries has reached about one
third, up by about 10 percentage points since 1995.
Lastly, the development of new information and communication technologies has had a
growing impact on every sector of the economy, and society in general. This has had
important effects on productivity and economic growth, and on all the building blocks of the
financial system, from payment system infrastructure to intermediaries, and from markets to
investment instruments. In particular, the securitization of banks' assets expanded
considerably, together with the supply of so-called structured financial instruments (ABSs,
CDOs, etc.) whose valuation is generally rather complex. The traditional model of credit
intermediation thus gave way, especially in the United States, to a system in which loans
granted were rapidly transformed into other financial products having these loans as
collateral and sold on the market: the so-called originate-to-distribute model. These
instruments - intended in principle to reduce risk, by redistributing it among a multitude of
investors, free up capital and hence boost banks' ability to lend - helped to finance the "new
economy", in parallel with the spread of new technologies. At the same time they made it
possible to reduce the cost of loans, above all as a result of the compression of illiquidity
premiums.
The complexity of structured instruments was coupled, however, with a lack of transparency,
in particular as regards their valuation (in which a crucial role was played by rating agencies,
without any particular control by regulatory authorities or information providers), by means of
statistical models and often carried out on the basis of incomplete and insufficient data. We
can now say - unfortunately well into the financial crisis - that opportunistic behaviour by
managers, fueled by a distorted system of incentives, especially with reference to executive
compensation, led to the creation of unnecessarily complex and opaque financial assets,
with the effect of preventing a correct assessment of creditworthiness and often causing
excessive risk-taking.
The unsustainable growth of external imbalances
In this context more and more in recent years the model of growth of the world economy was
based on a growing imbalance between a steadily declining US saving rate (negative for the
household sector) and highly positive rates for China and other emerging countries (as well
as Japan). This led to large external deficits for the United States and huge surpluses for the
rapidly growing countries, which served to finance the twin (budget and external current
account) deficits of the United States. This was soon recognized since the unsustainability of
growing current account imbalances was evident, even though variations in the value of
financial assets and liabilities contributed to reducing the explosive expansion of the
country's net external position (Figure 1). The risks associated with such a growth model, in
which the rapid expansion of the world's largest economy was financed with capital from the
rest of the world, including, somewhat paradoxically, emerging and developing countries, had
been stressed repeatedly and from many sides, although there was no lack of less alarmed
observers and analyses suggesting that what appeared to be fundamental imbalances in the
external accounts were the result of sustainable developments. At all events, the analyses
produced by government and international institutions regularly pointed to the possibility that
those imbalances might give rise to rapid and disorderly adjustments, with sudden
realignments of the external value of the dollar and abrupt falls in US domestic demand, as
the main threat to stable growth of the world economy.
In the end, the financial crisis was not provoked by a flight from the dollar but by the slump in
the US housing market and the consequent depreciation of structured financial products.
This initial spark found ideal tinder in the general vulnerability, and the crisis spread like
wildfire, encountering no particular obstacles. For that matter, the US trade deficit was
nothing but the counter-item to the insufficiency of saving, above all by American
households, over-indebted and holding assets consisting largely of long-overvalued real
estate that was itself used as collateral for financial derivatives. The sharp drop in demand in
the United States is apparently being accompanied by an effective adjustment of these
disequilibria, an exceedingly abrupt correction imposed by the crisis. However, for this
adjustment to be carried through and the imbalances definitively rectified, there must be an
expansion of final demand, consumer demand in particular, in the countries that are running
large external current account surpluses. It is too early to conclude that this will actually be
the outcome of the measures now being taken, but economic analysis had correctly
discerned the dangers of the disequilibria and the inevitability of an adjustment - the longer
postponed, the more traumatic.
Although they were discussed in a number of forums for international coordination, the
corrective measures needed to remedy matters were never undertaken resolutely enough.
The increase in final demand led by the US expansion was accompanied by the
extraordinarily rapid growth of economic activity and exports in the large emerging
economies (accentuated by policies that impeded exchange rate adjustments) and
unprecedented strains in the markets for raw materials. In recent years, given the low price
elasticity of energy demand and supply, this resulted in an equally extraordinary rise in
energy prices and the steady increase in the trade surplus of oil-producing countries (Figure
1). This was an additional factor of global payments disequilibria and a source of finance for
final demand in the United States.
Monetary policy and financial and real asset prices
In the absence of worrisome inflationary tensions, for over a decade monetary policies were
kept very expansive. Low nominal and real interest rates ushered in not only the long period
of exceptionally rapid and stable growth of global output but also a powerful expansion of
monetary and credit aggregates. This was accompanied by a sharp increase in the liquidity
of markets, which in its turn was connected with financial innovation and the strong growth of
such institutional investors as pension funds and hedge funds. The upshot was a large,
across-the-board reduction in risk premiums, which fell to extremely low levels by historical
standards, in all markets (shares, corporate bonds, real estate). The most benevolent
interpretations saw this as evidence that the world economy had entered a new phase, the
"Great Moderation," marked by rapid growth without significant fluctuations and by orderly
price movements, anchored to low average levels of inflation. The advent of that phase, it
was argued, was the result of economic policies effectively oriented to macroeconomic
stability, and in particular of monetary policies credibly directed to containing inflationary
pressures and preserving the value of money. The result, ran the argument, was a stable,
certain outlook, conditions propitious to private initiative and hence to economic growth.
This interpretation (based on "good policy", the standard term used in the literature, as well
as on the supposed effects of positive structural changes with the spread of new
technologies) was disputed by other analysts. These asserted that the protracted, orderly
growth and modest fluctuations was actually the product of exceptionally favourable
circumstances, in particular the absence of the sort of violent, repeated, adverse shocks that
had marked previous periods ("good luck"). Sooner or later, they argued, in an environment
that in a number of ways had not changed radically from the previous decades, this largely
expansive monetary policy, by encouraging and in practice financing high risk-taking, would
bring about the conditions for abrupt corrections as soon as risk perception and propensity
changed. This danger was signalled by a good many observers, and starting in 2004 there
were particular warnings that too casual an attitude towards risk-taking might be followed by
a disorderly, traumatic reaction in the opposite direction. In the light of events, the optimistic
interpretation of world economic trends in recent decades was clearly indulgent. While there
is no denying the contribution of good policy, and especially its impact on medium-term
inflation expectations, it is now evident that it would probably have been wiser to take greater
precautions against the possibility of an erroneous, falsely reassuring reading of events.
On a number of occasions the fall in risk premiums pushed bond, stock and real-estate
prices up to levels that were clearly unjustified by the fundamentals. The consensus view, in
the framework generally known as "flexible inflation targeting" (which authoritative
commentators have used, broadly, also to describe the policy of the Federal Reserve), is that
monetary policymakers need not worry about countering speculative bubbles in asset prices.
What matters is that they take them into account in their forecasts of the variables that are
factors in determining the general level of prices, such as inflation expectations and the
deviation of final demand from the "potential" level of economic activity (i.e. that
corresponding to full use of productive resources). The sole tool at policymakers' disposal
(the interest rate) should accordingly be deployed in order to attain just one objective, namely
flexibly preserving the value of money, since it cannot aim simultaneously at curbing the rise
in the prices of financial and real assets. Obviously, in memory of lessons from long ago, in
order to avoid the depressive effects of the bursting of an asset bubble monetary policy must
react swiftly to cut interest rates and expand liquidity.
Actually, the impact of asset prices on the spending and investment decisions of households
and firms also depends on their relative indebtedness, and all the more so insofar as the
latter depends on the collateral represented by their capital goods (for households, mostly
residential property). This applies above all to the anglo-saxon economies, and it is a
potential factor of non-linear amplification of the effects of changes in real and financial asset
values. In this case monetary policy, even under flexible inflation targeting, could be called
on directly to counter very large variations in those prices, especially considering that a
tightening of bank credit becomes more likely as the level of indebtedness increases. In the
long run, holding policy interest rates steady while share or house prices are soaring, in a
context of heavy and growing household and corporate debt, could further fuel a speculative
bubble that will eventually burst, at a potentially very severe cost to the economy as a whole.
Yet this, in practice, was the policy followed for decades by the Fed and the Bank of
England, vis-à-vis both the stock market boom of the late 1990s (Figures 2, 3) and the
housing boom (Figures 4, 5, 6). Admittedly, in the former case this benign neglect during the
boom and the drastic lowering of interest rates during the subsequent market downswing had
relatively limited consequences (especially by contrast with Japan's disheartening "lost
decade" of deflation starting in the early 1990s). The case of house prices, however, is
seemingly quite different. On the one hand the rise in prices, though strong and sustained
(likely exceeding the levels justified by fundamentals), was probably less "explosive" in the
United States than in some other countries, such as the United Kingdom and Sweden (but
also Spain and the Netherlands) when gauged by the Federal Housing Finance Agency
index (but equally so if measured by the Case-Shiller index).1 On the other hand, however,
the devastating repercussions on US financial markets and intermediaries (transmitted
worldwide through structured financial products) stemmed precisely from the interaction with
the levels of debt of American households, spurred by the possibility that rising house prices
offered for mortgage equity withdrawal. In many cases their debt came to exceed their home
equity.
In this way, the expansion of liquidity and so of credit was accompanied by the ratcheting up
of financial leverage, prompted among other things by the emergence of new business
models. In his re-examination of the Depression in 1933, Irving Fisher noted: "Easy money is
the great cause of overborrowing. When an investor thinks he can make over 100 per cent
per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or
speculate with borrowed
money. This was a prime cause leading to the over-indebtedness of
1929. Inventions and technological improvements created wonderful investment
opportunities, and so caused big debts" (Fisher, 1933, p. 348; emphasis added). In Fisher's
view, that is, depressions stem from excessive debt exposures (inevitably accompanied, one
might add, by excessive risk-taking); sooner or later, a correction is inevitable. Once the
correction gets under way, the impellent necessity of rapidly reducing excessive leverage
exacerbates the fall in asset prices, which is the more violent, the larger the original bubble.
And the price collapse, in turn, amplifies financial leverage, making the de-leveraging all the
more painful. This danger had long been known to economists.
3. From economists' diagnosis to pre-crisis policies
If economic analysis had effectively pointed out some of the looming dangers, the potential
sources of infection and the mechanisms of propagation, then why was economic policy
action for so long hesitant, sluggish, lacking in international coordination? To some extent
this may have been due to the generic nature of the alarms sounded by economists, their
failure to pinpoint the origins and course of development of the crisis, or the very reiteration
of warnings when their fears did not materialize, giving policymakers the idea that the risks
were vague and remote. But we can also find causes not only in connection with economic
analysis but also within the policy decision-making process itself.
In the first place, until the crisis was full-blown and the spectre was raised of dramatic, dire
developments in the financial markets, there was a lack of international coordination and an
inability to take measures to counter the increasingly rapid build-up of balance-of-payments
disequilibria and the effects of a disproportionate rise in international liquidity. There was
undoubtedly awareness of the paradox of industrialized countries being increasingly financed
by the current account surpluses of developing countries. It was clear that for an unusually
long time this had determined particularly low levels of interest rates and volatility in the
prices of financial instruments. And with US monetary policy maintaining an expansionary
stance (too) long after the brief recession of 2001-02, this had transmitted to the Chinese
economy, given the prevailing exchange rate system, an impetus whose signs could be seen
globally in the spiralling prices of raw materials. All of this was discussed repeatedly at
academic conferences, central bank workshops, international consultations and official
meetings of ministers and central bank governors. But only the sense of extreme urgency
that spread last autumn following the failure of Lehman Brothers made it possible to begin to
shape a coordinated response. In the future, it will be necessary to intensify efforts in this
direction, including by finding appropriate ways of translating into action, in more binding
forms, the interventions decided by the institutions responsible for overseeing the
international economy.
The reassuring, understandable belief that a new world had emerged - one of Great
Moderation - perhaps also led to overestimation of the economy's ability to absorb shocks.
This belief was reinforced by the apparent ease and limited costs with which the global
economy overcame the difficulties that loomed large at times in the course of recent years,
from the financial crises of the countries of South-East Asia and Russia to the collapse of
LTCM, the deflation of the stock market bubble in 2000-01 and the shock caused by the
terrorist attacks of 11 September 2001. In particular, the bursting of the so-called dot-com
bubble had seemed to be controlled with ease; given the seriousness of the concerns
expressed beforehand and looking back on the modest scale of the damage and the
remarkable effectiveness of the countermeasures adopted, the conclusion was drawn that
the evolution of that crisis had confirmed both the advent of the Great Moderation and the
merits of good policy.
However, as already observed, there was much debate then, and there still is today, about
whether monetary policy should not pay more attention to financial and real asset price
trends and to the pro-cyclical growth of credit and leverage, and in some instances respond
decisively to seemingly "excessive" movements. Aside from the difficulty of defining what
excessive means in practice, it is certainly useful to examine the factors that determine
particularly large swings in these prices, just as it is necessary to shed light on the factors
that tend to threaten financial stability and disproportionately amplify cyclical fluctuations.
Many of these factors probably originate not so much in behaviour as in rules and incentives
existing in the markets. In the case, for example, of the mortgage loans that triggered the
current crisis due to excessive borrowing, two factors surely played a crucial role: (1) the
assumption that the continuous rise in house prices would lower the amount of debt in
relation to the value of the underlying asset over time, and (2) the possibility of obtaining
mortgages with loan-to-value ratios of 100 per cent and more. In these cases, and as has
long been acknowledged (for example, with reference to the sharp rise in house prices in the
United Kingdom recorded in the early 2000s), it is obvious that it is necessary to resort not so
much to monetary policy but to prudential instruments, with limits on the value of collateral
that can be used in taking out a loan. The question is why steps of this kind were not taken,
quite apart from the failure to use monetary policy (naturally as a possible second-best
instrument).
In the same way, it is legitimate to wonder whether confidence in the ability of financial
markets to regulate themselves was not excessive. What role was played, in particular, by
the waiving of stricter supervision in many sectors of financial intermediation? This, even
disregarding the strength of lobbies and instances of excessive proximity between the
supervisors and the supervised. In any event, it is clear that the consequences of a change
of trend in the perception and concentration of risks were seriously underestimated,
notwithstanding the many analyses and signals that had become available in recent years.
Excessive deregulation of the financial sphere was also accompanied, as recalled earlier, by
an unprecedented development of financial innovation. There was an enormous increase in
the supply of complex instruments for hedging risk, structured products often very difficult to
value if not using mathematical-statistical techniques whose application presupposed at least
three conditions: (1) the availability of the basic information necessary to determine the
quality of the products (securities or loans) underlying these instruments (in other words, the
likelihood of the loans and bonds being honoured); (2) the validity, essentially over time and
in the real world, of the arbitrage principle; and (3) a sufficiently high degree of liquidity in the
markets. It is certainly open to doubt whether much thought was given to the soundness of
these basic hypotheses, either by the regulators or by bankers and investors.
Much remains to be done then, in the process of reviewing the rules and institutions
responsible - including at supranational level - for the proper functioning of the markets, the
prudent management of financial intermediaries and the valuation of investment and
riskhedging instruments. The path of economic and financial development of the modern
economies is, however, littered with episodes of excess, speculative bubbles and failures
linked to highly imprudent if not criminal practices. If, on one level, the challenge lies in not
falling into the opposite excess of exaggerated and obsessive regulation (bearing in mind
that the hedging of risk, when properly identified and where possible, is right and proper), on
another level I believe we must be aware of our position between the rock of market failures
and the whirlpool of policy failures. The thesis I find most convincing is that the area where
most errors were made, precisely because there was enough evidence at a macroeconomic
level to act in time, was in the lack (beyond the declarations and press releases at G7
meetings), of sufficiently decisive policy reactions to the external imbalances that began to
expand rapidly from the second half of the 1990s. Essentially these disequilibria reflected
continuous and sustained growth in final demand, especially consumption demand, in the
leading economic region of the planet, financed by over-borrowing, primarily from abroad;
growth, in short, without the accumulation of savings.
To conclude on policies and to support my previous point, I believe that aside from a logical
interpretation of what provoked the current crisis, it is useful to propose a chronological
reconstruction of the sequence of events that have marked the last ten to fifteen years. I
propose the following summary, which admittedly is perhaps a little too USA-centric:
1. The revolution in the new information and communication technologies halted the
progressive decline of productivity growth in the United States, which returned to
markedly high rates of expansion in the second half of the 1990s.
2. During the same period, following the financial crises that hit the countries of
SouthEast Asia and Russia (1997-98) and the collapse of LTCM (autumn 1998), the
Federal Reserve's policy remained essentially accommodating, with a strong
expansion of liquidity also to counter the so-called millennium bug.
3. The "new economy" euphoria, beyond being compatible with objective interpretations
of the increases in productivity linked to the introduction and spread of the new
technologies, was reflected in US household consumption, with a rapid rise in debt
and a sustained decline in savings, but with financial positions basically in balance
thanks to the increase in net wealth due to capital gains, in part the result of soaring
share prices during the dot-com bubble.
4. The powerful expansion in US final demand and imports was gradually accompanied
by growth in the exports and output of the major emerging economies such as China
and India, which had previously lagged behind, and an upwards trend in US inflation,
dealt with by a tightening of monetary policy at the beginning of 2000.
5.
Monetary tightening ended by bursting, late, the dot-com bubble in 2000-01. The
recessionary effects of this were compounded by those of the severe shock of the
September 2001 terrorist attacks.
6. Amid fears of recession and deflationary conditions of the kind that had prevailed in
the previous decade in Japan, the Federal Reserve's response was again very
accommodating. A drastic reduction in interest rates was accompanied by a strongly
expansionary budgetary policy, which remained in place also in relation to the war
operations in the Middle East.
7. Monetary policy also remained expansionary for a long time, facilitating a return to
sustained growth in household consumption, not countering the trend towards a zero
saving rate, and giving free rein to financial innovation, in conditions of abundant
liquidity, especially with the repackaging in 2004-06 of mortgages - in a context of
constantly rising house prices - into structured products that opened up new
investment possibilities to banks.
8.
The growing US current account deficit was accompanied by ever-larger surpluses in
emerging countries and Japan, with a significant build-up of official reserves, in a
context of a relatively sluggish rise in domestic consumption demand and saving
rates even higher than the nonetheless elevated rates of investment. The
oilproducing countries also recorded sharply higher trade surpluses, reflecting the rise
in oil prices due to the expansion of global demand.
9. The increase in international liquidity connected with the growing payments
imbalances and the Fed's accommodating monetary policy - which contributed, given
the limited flexibility of emerging countries' currencies and the Chinese renminbi in
particular, to the global economic expansion - led to a prolonged period, from 2004 to
2007, of low price volatility in financial markets and low nominal yields. This was also
due to the large volume of investment in fixed income securities by international
investors and countries that had accumulated high levels of reserves by running large
and rising current account surpluses.
10.
The upshot was the search by investors - including international banks and banks of
other countries and financial vehicles they controlled - for investments with higher
risk-return profiles and the attendant supply of structured financial instruments
backed mainly, although not exclusively, by home mortgages granted with
loan-tovalue ratios exceeding even 100 per cent on the false premise that house prices
could only increase.
11.
The strong expansion of global demand engendered inflationary pressures, to which
the monetary policy authorities