The inadequacy of the communiqué from the G20 summit, which made it clear that the high-level talking shop in Toronto had failed to deliver a unified global stance on preventing double-dip recession, has prompted fears that we are now entering the next phase of the banking and financial crisis.
The G20’s inability to agree on a global approach to resolving developed world indebtedness and economic failings prompted the Nobel laureate Paul Krugman to publish an impassioned plea for continued fiscal stimulus in the New York Times. Krugman is convinced that “policy [outside the USA] is paralyzed by fear of invisible bond vigilantes.”
However, Krugman is a voice in the wilderness when set against the resolve of most European governments. And markets are febrile. In jittery trading ahead of a crucial repayment by Europe's banks of a €442bn emergency loans from the European Central Bank, the rates at which banks lend to each other soared as rumours swirled that some banks—especially Greek and Spanish ones—are finding it impossible to raise funds in the wholesale markets. However, the fears subsided a bit when banks borrowed less than feared.
Perhaps the most depressing note, however, came last Tuesday, when the Bank for International Settlements, the central bankers’ central bank, unveiled its latest prognosis. The BIS takes the exact opposite view to Krugman. It said further fiscal stimulus is out of the question for over-leveraged economies and is urging governments to get real and lose no time in facing up to the problem of their own indebtedness.
In a speech at the BIS's annual general meeting in Basel, BIS general manager Jaime Caruana said:
“Global growth can no longer be sustained by fiscal expansion in the advanced world. Structural budget deficits in many countries are just too high: even at today's very low long-term interest rates, public debt-to-GDP ratios are on unsustainable trajectories.”
Caruana also raised the specter of a further round of crisis-related losses at banks which he accused of being less than honest about toxic loans on their balance sheets. Banks' use of “extend and pretend” and “delay and pray” has left us extremely vulnerable to a rerun of the systemic crisis of 2008-09, said Caruana. The difference is, having used up their ammunition in 2008-09, national governments' have nothin left to throw at future bank collapses. Caruana said:
"Unlike then, we have hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries."
Caruana is prescribing four not-so-easy steps to cure the crisis:
- Advanced economies must start reining in their budget deficits now. To facilitate the process, there should be greater exchange rate flexibility which would boost domestic demand in emerging market countries and support global growth at a critical juncture.
- There should be a timely winding down of the exceptional central bank and government support measures for the banking industry. If the banks are not weaned off this support, it will create moral hazard, undermine private sector financial intermediation, and generate new, hidden risks.
- Banks must fundamentally change their behaviour, incentive structures, and attitudes to risk. Rather than squandering money on dividends and obscene pay packages, banks must preserve capital to reduce leverage and reduce dependency on short term borrowings. They urgently need to find more stable funding sources, lengthen the maturity of their liabilities and learn to manage interest-rate risk.
- There must be international agreement on financial regulation reform, with systemic risk awareness embedded in regulation and supervision. Macroprudential and macroeconomic policies should reinforce each other to prevent future bouts of irrational exuberance.
None of these is going to be that easy. In each case, powereful vested interest groups would have to be separated from things which they hold dear (for example: bankers from their bonuses).
The approach also requires an ideological victory over the neo-Keynesians. The likes of Krugman still wield a huge amount of clout, and are adamant that fiscal stimuli must be maintained at all costs—amid apocalpytic warnings that, if they are not, we’re all going to hell in a handcart.
Further reading the battle of ideas over financial and economic reform and curing the banking and financial crisis
- G20 reform agenda knocked sideways by Obama, by Ian Fraser [blog post]
- Trust, Fear and a Dead Economist, by Todd Buchholz
- Roubini's 10-part prescription for a more stable financial future, by Ian Fraser [blog post]
Tags: Bank for International Settlements , banking , capital adequacy , central banks , economic recovery , financial crisis , fiscal stimulus , G20 , regulation , US