Long read.......but I think worth it.
How to stop the next bubble
The financial crisis has shown that markets are bubble-prone and that laissez-faire regulation doesn’t work. The authorities need to get a grip if we are to avoid a mega-bubble. But we may need an even deeper crisis for that to happen
Mark Hannam
Jonathan Ford
John Gieve
Anatole Kaletsky
George Soros
Martin Wolf
JONATHAN FORD (CHAIR): I want to start by asking where we are in the crisis. Is it over? George Soros, you have said that this is the worst crisis we have been through for 60 years. Presumably you still believe that there is worse to come?
GEORGE SOROS: There is now a widespread belief that the crisis is over. I think, on the contrary, that the effect on the real economy is yet to be felt. The measures taken by the authorities will not bring recovery. There are four reasons for this. First, the fall in house prices in the US is only halfway over and in Britain it has hardly begun. Second, consumers have been slow to adjust their spending habits, but this is about to happen. Third, the financial system is severely wounded, and even though banks have been remarkably successful at raising more equity, they will cut back on lending and this will feed through to capital spending and business activity. Finally, and most important, there is a threat of inflation at the same time as a slowdown. The rise in energy and food prices will turn the slowdown into a recession.
ANATOLE KALETSKY: I agree with George that the threat of inflation is potentially the most alarming new factor in this crisis, but I would challenge the other three points. The worst is over in the real economy in the US, although not yet in Britain and Europe. US house prices do not have much further to fall, and consumer spending will hold up. While there are, indeed, several trillion dollars of consumer spending to come out of the system, the impact may be quite comfortably spread over many years. And while the financial system has been wounded, the bank writedowns—in the US at least—have already gone beyond what is plausible in terms of likely losses. There is one shoe that has yet to drop: the continental European banks, which have not recognised the losses to the same extent.
JOHN GIEVE: We are coming through the first acute liquidity shock to the banking system, and although there are still lots of risks, we expect confidence gradually to return. But the end of that phase does not mean the end of the downturn. In Britain, where things have held up so far, what started as a very marked turndown in the commercial property market is now spreading into the housing market, and we expect a downturn in economic activity over the rest of this year. So the worst is definitely not over in that sense.
MARTIN WOLF: The whole risk adjustment process has still not worked its way through. Credit spreads in the inter-bank markets, commercial paper markets and so forth remain wide, and so banks remain reluctant to lend to one another. I am closer to George than I am to Anatole on the US housing market. And looking at the world as a whole, the US shock is combined with two others: inflation and energy prices, particularly for Europe and emerging Asia. It is hard to imagine that this won’t have a significant negative effect. The appreciation of the euro is shifting the US current account deficit to Europe. That is creating large stresses within the eurozone in terms of divergences of competitiveness between Germany and southern Europe. Meanwhile, because of inflation fears, the European Central Bank (ECB) will do nothing to help Europe in a difficult world situation. That will lead to a bigger slowdown than we now expect. China and India are suffering from weaker US demand, and will not be able to respond easily because inflation has become a big problem there too. Energy prices also act as a big tax on these economies. If you add these things together, we are heading for a significant global slowdown—if not a global recession—which will last some time.
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FORD: I think we should turn to the regulatory aspect. John, I want to bring you in as a representative of the “authorities,” and ask whether you are to blame for allowing this bubble to expand so far that we are now worrying about a multi-year downturn for the economy?
GIEVE: Well, the authorities always take the blame if things go wrong. There are a number of different charges. One is about the handling of Northern Rock last August and September. We did save the Rock, but the view is that we were slow, and could have handled it better.
FORD: But what about the earlier period when the bubble was blowing up?
GIEVE: Looking back to where we were this time last year, I think most people, including the Bank of England, were saying that a correction was inevitable. But at that point we didn’t know how big and painful it would be. Now we can see that more of the rise in asset prices was cyclical than most people had thought. That does raise issues for monetary policy and also regulation; in particular, whether our regulatory regimes are sufficiently countercyclical—should banks be compelled to set aside more in the good times so that they can absorb losses in the bad? In the monetary context, the debate is about what weight to give to asset prices, and in the regulatory context, what you can do to flatten the top of the cycle.
WOLF: It seems pretty shameful for people who earn vast sums of money in the markets to turn around and say, “It’s the fault of the regulators who didn’t stop us from doing it.” Nonetheless, we have to look at the authorities too. And there are two main lines. One is: it’s Greenspan’s fault—monetary policy was far too loose for too long, particularly after the last bubble burst, and this created the conditions for the next; and the second is that the regulatory regime was not tough enough. There is some truth in both points, but they are exaggerated. I can’t believe there is any monetary policy you could imagine that would stop the house price bubbles we have seen. When house prices are going to rise, or people expect them to rise, by 10 or 12 per cent a year, an additional 1 per cent on the interest rate is not going to stop people from buying houses. Of course, we could have said that to buy a house, no one may borrow more than three times their income and that everybody has to have a down-payment of at least 50 per cent of the property price. But I suspect that any government that tried to introduce regulations like that, or comparable regulations to stop bankers from doing deals, would have been swept from power.
MARK HANNAM: Over the last few years, central banks or regulators have had two jobs; one is to do with monetary policy, the other with financial stability. The Bank of England’s new structure reflects those dual responsibilities. Until recently, it looked as if the monetary policy side had been spectacularly successful because we had a long period of strong growth and low inflation. Now, one could argue that this was made possible by globalisation—cheap labour in Asia and so on—but the central banks, the Bank of England, the ECB, the Fed took credit for it. One result is that they became overconfident about their success and took their eye off financial stability.
Monetary policy is a bit like preventative healthcare. It is all about giving people advice and steering for two years in the future, it is all about adjusting the tiller a little bit here, a little bit there, warning people about price levels and so forth. Financial stability is more like emergency care; when someone calls for an ambulance you don’t sit and have a discussion about moral hazard. You get going and rescue the system. But some central bankers tried approaching the financial crisis in the same way that they deal with monetary policy—“We will meet in three weeks and look at some economic data.”
Take an example: the Bank of England launched a liquidity facility this year that allows banks to shift some assets off their balance sheets by swapping them for government bonds. This could have been thought of last year. The fact that it took several months to develop this strategy makes the central bankers and regulators look reactive. It’s as if they hadn’t prepared for what might happen. Does John think that is a fair criticism?
GIEVE: There was a lot of debate about whether the Bank reacted quickly enough last summer and early autumn. But we are now several months on, and all the central banks have adapted their operations to provide liquidity to the banking system. I find it quite unconvincing to think that if we had introduced the liquidity facility on slightly different terms in September we would now be looking at a very different picture. The central banks did what was needed to deal with this period of acute liquidity worries. I do not think that doing it quicker would have seen it go away.
KALETSKY: But John, I can’t resist raising one issue which might have gone differently if the tactics and the footwork had been quicker, namely Northern Rock. If, back in August, the Bank of England had been prepared to advance liquidity on the same basis that you are advancing it today, in other words if the Bank had acted back in August the way the ECB did, the run on Northern Rock might not have occurred. After all, the ECB has been refinancing the entire Spanish mortgage market, which is probably at least as vulnerable to a house price correction as the Rock was, and has thereby avoided anything like Northern Rock in Spain, or indeed in Denmark or other European countries. Isn’t this a fair criticism: that if you were going to end up supporting banks in the way you did in April, you might as well have done it back in August or September and avoided a lot of trouble?
GIEVE: When Northern Rock first approached us, they were looking for help for a few weeks until they could fund themselves by selling off more securitised mortgages. Their whole funding structure was based on securitisation. But the securitisation market is still closed, so it’s hard to see how Northern Rock would have refinanced its balance sheet over that period.
KALETSKY: In Spain the securitisation market is also closed. The ECB has been continuously refinancing the mortgage banks there for the last nine months, and will continue to do so as long as it takes to reopen markets.
GIEVE: I don’t think the sort of things that Europe did in August and September would have provided Northern Rock with anything like the funds that it needed. And there have been bank failures in the euro area. Although the amount of liquidity the ECB provided looks huge, the eurozone is a much bigger economy than ours, and there’s little evidence that the Spanish have been disproportionate users of it. I am not criticising the ECB, I think they have done well, but I want to come back to the bigger picture. It is clear, ten months in to this crisis, that we are not dealing with a squall that might have blown over if central banks had offered a bit of liquidity support on slightly different terms. We are talking about something much bigger. The same markets are closed or sticky in Europe, the US and in Britain. So tactical questions are not at the heart of this.
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