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Economic and monetary challenges - Prospects of the EU economy and the Eurozone

Avoiding systemic crisis: Will prudential regulation and easy money suffice?

By White William R. - Previously, Economic Adviser and Head of the Monetary and Economic Department, Bank for International Settlements (BIS)


Post crisis policies have not lowered the probability of a global downturn. Indeed, seven years after the crisis began, vulnerabilities both old and new can easily be identified in each of the largest economies. Moreover, in a globalized world, vulnerabilities that materialize anywhere will have serious spill over effects everywhere. Should this happen, the associated social and political implications should not be underestimated.

How could we have arrived at this point? The simple answer is that both regulators and central banks have been guided by false analytical frameworks. They have assumed that the economy is not only understandable but also controllable. In reality, the economy is too complex and adaptable to be understood, much less tightly controlled. As a result, most official policies have proved ineffective in the pursuit of their respective objectives. Still more serious, they have generated unintended side effects that have made matters worse not better.

Consider the post crisis regulatory reforms designed to prevent future financial crises. On the face of it, there seem to be good outcomes: more and better capital and liquidity for banks, as well as increased regulatory focus on non-banks and systemic interactions. Yet, below the surface, problems lurk. Most of the regulatory measures proposed are only marginally stronger and more detailed versions of existing measures that failed to prevent the crisis in the first place. Moreover, institutions seem likely to continue successfully gaming the regulatory system as they have done for decades. The danger also remains that regulation will simply drive risky business further into the shadows, as with “shadow banking” before the crisis began. Finally, regulatory changes have sharply reduced the profits and potentially the viability of many of the banks that are still “too big to fail”.

A deeper problem is that regulation, focussed almost entirely on the prevention of future crises, has left the current crisis unresolved – especially in Europe. The level of nonperforming loans at European banks remains very high as does suspicion of wide spread “extend and pretend” lending to zombie customers. Combined with new “bail in” provisions, this has raised the cost of new capital significantly. This in turn has made financial institutions even more cautious about new lending, a development which has held back the European economic recovery. The fact that, after the Eurozone crisis began in 2010, regulators encouraged creditor banks to retreat from peripheral Eurozone countries also made the crisis worse.

Post crisis policies have not lowered the probability of a global downturn.

If criticisms can be made of post crisis regulatory policies, global monetary policies must be criticized even more. While unprecedented in scale and scope, they have failed to deliver “strong, sustainable and balanced growth”. Experimental and diverse measures across countries, smelling of panic, have led to cautious spending. In any event, easy money works largely through encouraging spending today rather than tomorrow. As tomorrow inevitably becomes today, it must lose its effectiveness.

These monetary policies have also had undesirable side effects on both the demand and supply side of the economy. As to demand, nonfinancial debt levels have risen from 210% to 250% of global GDP since the crisis began. In particular, the status of the emerging market economies has changed enormously. In 2008 they were relatively healthy and “part of the solution”. Today, however, they are “part of the problem” of debt headwinds, artificially high asset prices and domestic and international imbalances of many sorts. As to supply, easy money may have contributed to the decline in productivity growth in recent years. By encouraging lending to zombie companies, at the expense of new and innovative companies, easy money has truncated severely the Schumpeterian process of “creative destruction”.

With financial system problems unresolved, and with the real economy showing increasing weakness, the global economy remains vulnerable to a vicious downward spiral. Prudential regulation and easy money have not sufficed and must be complemented by other policies to increase both aggregate demand and supply. Governments alone can do this and they must, at long last, face up to their responsibilities.