By Karen Shaw Petrou
At its October meeting, the IMF’s economists pronounced that global economic prospects are “benign,” with financial risks well within acceptable bounds, at least for now. But, as Martin Wolf said the following Friday in the Financial Times, the meeting’s mood was anything but calm and confident. Why?
Perhaps it’s due to the decline of the liberal financial elite and the discontent this breeds over generous cocktails. However, the real reason global central bankers and finance ministers are worried is that they should be.
Every hypothesis on which post-crisis monetary and regulatory policy is founded has had demonstrable, dangerous unintended effects. On their own – and let alone with a systemic spark – these consequences create a vicious negative feedback loop with the accelerant of economic inequality making a financial crisis still more likely.
The New Abnormal
Textbook macroeconomic statistics may look sound and financial systems are far better capitalized. But IMF data buried in the October report show all too clearly that there’s a vicious negative feedback loop underway beneath the sugar-coating. It works like this:
- Unconventional monetary policy stokes inequality because of distorted financial-asset valuations and sluggish employment gains that are also inequitably distributed. Even if QE is not an inequality driver, as some contend, it could create problems in any central-bank with the unwinding of at least $19 trillion now held on central-bank books, destabilize financial markets or worse. Notably, the IMF is far less sanguine about easy unwinds than the FRB, ECB, or Bank of Japan.
- In concert with QE, ultra-low rates and post-crisis rules limit the capacity of traditional banks to fund equality-generating employment growth. Traditional financial intermediation is increasingly replaced by marketplace finance with uncertain inclusion, growth, and resilience capacity. The combination of higher return on capital due to QE combines with lower growth, due in part to financial policy, heightens economic inequality as Piketty’s formula predicts.
- Inequality on its own or in concert with other systemic risks stokes the next financial crisis due to high levels of consumer indebtedness and weak non-financial sector resilience in concert with increasingly irrelevant interbank and central-bank stabilization mechanisms, as a forthcoming blog post will show. The IMF report shows chillingly how quickly crisis sparks could come from geopolitical risk, illiquidity, over leverage or financial-sector risks outside the reach of bank regulation (e.g., cyber-security attacks that incapacitate a CCP).
- Now, we start all over again a whole lot worse off than in 2007 due to structural asymmetries built into finance during the post-crisis period and still greater economic inequality created by the next financial crisis.
And, just in case you thought all the post-crisis reforms mean that at the least a failing giant financial company can be resolved without endangering prosperity or forcing taxpayer bail-outs, think again – the IMF report is deeply pessimistic about the ability of regulators to handle a cross-border, complex resolution.
Does the IMF Have an Answer?
Not really. The IMF’s latest report readily and woefully acknowledges the transformation of global finance, drawing in detail a frightening picture of growing risk across equity and bond markets that on their own could light new systemic fires and the ways in which inequality stokes them. Solutions and why they won’t work are:
1) Fiscal policies that promote equality: The IMF issued a blog urging what I would call accommodative fiscal policy in concert with more talk about inequality. Nice thought, but these are at best unlikely in the U.S. and other industrialized countries struggling with deficits and growing demands from higher-income households and corporations for tax relief.
2) Macroprudential Policy: The IMF thinks these horizontal prudential standards will control structural risks such as growing consumer indebtedness. But, they won’t work because, as the Fund elsewhere acknowledges, finance doesn’t depend on banks and regulators in many countries (e.g., the U.S.) and has little ability to put the regulatory brakes on non-banks. The financial-market risks the IMF so convincingly portrays are often also outside direct regulatory control or could only be reached if regulators concede on the need to redesign certain post-crisis prudential rules.
3) Big-Bank Business Models: The IMF tells big banks to redesign their business models, with the Fund report for the first time naming the largest banks in the world that in its view will have non-viable charters as soon as 2019. What these banks actually should do is not made clear beyond IMF injunctions that balance sheets be cleaned up as fast as possible. The IMF may well be wary of recommending new big-bank business models not only because business advice is far from its forte, but also because another global body, the Basel Committee, despairs of the viability of most bank charters under the concerted onslaught of financial-technology and other “shadow” firms. Big-bank business models now are the way they are not because big banks want to fail, but because the combination of legacy costs, market forces, and financial policy make them this way.
What to do?
First, step away from efforts to create a grand, unified body of complex rules to recognize how badly many of the post-crisis standards are being implemented and how many unintended effects are already evident.
Second, go back to basics and either ensure effective cross-border resolution or redesign financial regulation to contain cross-border contagion risk.
Finally, understand how all of the new rules, in concert with the inequality they help to stoke, undermine effective monetary-policy transmission, a challenge exacerbated when unconventional monetary policy makes inequality even worse.
Specific solutions beyond these principles? This blog is dedicated to this question and offers solutions wherever solid research suggests them and our political judgment tells us they might happen. More to come.