CAMBRIDGE, UK (Project community) – After the global financial crisis of 2008, governments and central banks in advanced economies swore that they would never again allow the banking system to hold political hostages, let alone threaten economic and social well-being.
Thirteen years later, they only partially fulfilled that promise. Another chunk of finances is now risking spoiling a permanent, inclusive, and sustainable recovery from the terrible COVID-19 shock.
The story of the 2008 crisis has been told many times. Blinded by how financial innovations, including securitization, enabled the sharing and dicing of risk, the public sector stepped back to give finance more room to do its magic. Some countries went even further than a “light” approach to banking regulation and supervision and fought hard to become larger global banking centers, regardless of the size of their real economies.
In all of this, unnoticed, the financial world was exposed to dangerous overshoot dynamics previously seen in other major innovations such as the steam engine and fiber optics.
In any event, easy and cheap access to activities that were previously largely banned led to an exuberant first round of overproduction and overconsumption.
Indeed, Wall Street’s credit and leverage factories were in full swing, flooding the housing market and other sectors with new financial products that offered little protection. In order to ensure quick acceptance, the lenders first relaxed their standards – among other things by offering so-called NINJA mortgages (no income, no job, no assets), which did not require any proof of creditworthiness of the borrower – and then engaged in oversized trade among themselves.
When governments and central banks realized what was going on, it was too late. To use the formulation of the American economist Herbert Stein, what was unsustainable turned out to be unsustainable. The financial implosion that followed threatened to spark a global depression, forcing policymakers to rescue those whose reckless behavior had caused the problem.
Of course, political decision-makers have also taken measures to “reduce risk” for banks. They increased capital buffers, increased on-site surveillance and prohibited certain activities. But while governments and central banks have managed to reduce the systemic risk emanating from the banking system, they have not understood and monitored closely enough what happened to that risk.
The vacuum created was soon filled by the unsupervised and regulated non-banking sector. This means that the financial sector has continued to grow significantly both in absolute terms and in relation to the national economies. Central banks got into an unhealthy co-dependency with the markets, lost political flexibility and risked the longer-term credibility that is critical to their effectiveness. Assets under management and margin debt rose to record levels, as did debt and the Federal Reserve’s balance sheet.
Given the size, it is not surprising that central banks in particular are proceeding very cautiously these days for fear of disrupting financial markets in such a way as to undermine the post-pandemic economic recovery. On a highway of the financial sector, on which too many participants drive too fast – some carelessly – we already had three near-accidents with the government bond market, private investors this year
Hedge funds stuck in a corner and an over-indebted family office that inflicted $ 10 billion in losses on a handful of banks.
Thanks to some luck and unofficial crisis prevention measures, each of these events did not result in a major collapse in the entire financial system.
Central banks’ long-standing codependency with the financial sector appears to have led policy makers to believe that they had no choice but to isolate the sector from the harsh reality of the pandemic. This resulted in an even more impressive divide between Wall Street and Main Street and gave another worrying boost to wealth inequality.
In the 12 months to April 2021, the billionaires’ combined wealth will increase Forbes the magazine’s annual global list elevated by a record $ 5 trillion to $ 13 trillion. And the billionaire population in the world grew by nearly 700 year-over-year, reaching an all-time high of more than 2,700.
It is time to act now to reduce risk taking
Policy makers would be unwise to hope for only the best – some kind of financial one God from the machine in which a strong and rapid economic recovery offsets the huge increases in debt, indebtedness and asset valuation. Instead, act now to mitigate the financial sector’s excessive risk taking. This should include the containment and reduction of margin debt; Enforcement of stricter eligibility criteria for broker dealers; Improving the assessment, supervision and regulation of non-banking institutions; and reducing the tax benefits of currently privileged investment income.
These steps, both individually and collectively, are not in themselves a panacea for an ongoing and growing problem. But that’s no excuse for further delays. The longer policymakers allow the current momentum to grow, the greater the threat to economic and social well-being and the greater the risk that – wrongly and despite a decade of promises – another crisis will break out in the same sector as last time .
Mohamed A. El-Erian, President of the University of Cambridge’s Queens’ College, is a past chairman of President Barack Obama’s Global Development Council. He is the author of “The Only Game in Town: Central Banks, Instability and Avoiding Another Breakdown”.