Central banks have learned the lessons of the 2008 crisis, but may not have fully overcome the risks that caused it, according to Yale University’s Andrew Metrick.
Metrick, a professor of finance at Yale, says thinking at central banks has “advanced significantly” since 2008, “but that does not mean they are on top of [the risks]”.
Looking back at the experience of the Great Depression, Metrick notes a misguided approach to monetary policy was at the heart of that crisis. Though economists realised their mistake relatively quickly, it was several decades before authorities fully implemented improved monetary policy tools.
A similar learning process may be under way now for macro-prudential tools. “We’re still really in the early stages,” Metrick says. “Hopefully, we will be faster than we were on the monetary policy side, but we’re still in the process of doing that with macro-prudential tools, even though great strides have been made in understanding.”
Metrick warns there may be some ongoing vulnerabilities. One such area is international co-operation. “The global political environment is moving away from the type of co-operative activity that is absolutely essential to both prevent and fight any kind of global panic,” Metrick says.
Hello, I’m Dan Hinge, news editor at Central Banking, and this is CB on Air.
Last week we looked at how the 2008 crisis impacted the way central banks do their jobs. This time we’re going to turn to some of the lessons of the crisis, and whether we have properly learned them yet.
To talk it over, we have Andrew Metrick, Janet Yellen professor at Yale University. Andrew, welcome back.
Andrew Metrick: Hello.
DH: So let’s start at the start; what do you see as the main factors behind the 2008 crisis?
AM: I would say there are two main factors behind the crisis and they are both largely macro factors. One is the very large global demand that we had for money-like safe assets. Ben Bernanke talked about this in the mid-2000s as the global savings glut, and that is one aspect of it. Emerging market economies were growing much richer, the oil producing nations had significant savings they were sitting on, and in addition to that, the rich countries of the world were putting their cash into ever larger institutional pools.
All of these pools of cash – from the emerging markets, the oil-producing nations, from the rich countries’ institutional pools – had a demand for at least part of their portfolio to be safe. And what they would traditionally do when they wanted to be safe was to try to own either US government or agency securities, or those of other wealthy nations.
At the same time that the world was growing richer, the supply of these assets was, somewhat paradoxically, falling. In the United States, in fact, we were running budget surpluses in the late 1990s and the total supply of Treasury securities was falling. This increased demand and the reduced supply together created a very large incentive for the financial system to manufacture substitutes for safe government debt. And it is indeed those manufactured substitutes that were gobbled up by all these different sources over the first few years of the 21st century.
This happened in some sense in the shadows. In the shadows both because it was outside of the regulated part of the banking system, but also because it wasn’t something that central banks or other regulators thought they should be paying attention to, or needed to pay attention to. And thus we saw a very large build-up of securities that most market participants did not feel that they needed to, or were ever going to need to, expend a lot of resources on evaluating. You see something you think is very safe, a very small desk, a very small group of people can manage it.
So that’s on the demand for safe assets. On the other side, on the beliefs side, it had been a very long time since we had had a full-blown financial crisis, and there was a certain amount of complacency throughout advanced economies that made it such that when people evaluated the underlying risks in some of these assets they perceived to be safe – the classic example being something like triple-A mortgage-backed securities – what was backing them was housing, housing mostly in the United States, and the general view was, “well yeah, that can fall a little bit, but it’s not going to fall 30% – it’s not going to fall so much that it will create real problems in these underlying safe assets”.
That’s a natural human tendency. It’s what [Carmen] Reinhart and [Kenneth] Rogoff call “this time is different” – to believe that the world really has changed, and we haven’t had a good financial crisis in a long time and these assets can’t really fall all that much.
Those two things put together, which in my view are both macro forces, are the primary couplet that led us to the brink of the financial crisis, and while there were other things, and you will hear often blame placed on governments, or blame placed on bankers, or just greed in general – I’m not saying those things didn’t exist – but the macro factors overwhelmed those things. And so, going forward, we really have to widen our aperture a little bit, in trying to look at both of these sides if we want to be preventing and managing the next financial crisis.
DH: And to what extent are you confident that central banks are now on top of those macro risks?
AM: I think that the thinking in central banks has significantly advanced from 10 years ago, but that does not mean they are on top of them. I would say 10 years ago we weren’t paying attention to them largely as a group – we weren’t paying attention to them at all. It wasn’t the type of problem – everyone understands the possibility of froth in a housing market, that was understood as a general rule, but the way that would then make its way through the financial system, through the variety of instruments that we had created to simulate a safe asset, that was not understood at all. And watching those markets, that wasn’t done.
Now, when I speak with senior central bankers, I feel certainly they get it and they understand that. But we are still in the early days of designing the tools that would make that work. An analogy there would be prior to the Great Depression there was really deep confusion about what we would nowadays call monetary policy. And what we believed back then, which was basically the gold standard, turned out to be really more the problem. It was the source of the contagion around the world in the Great Depression.
We did learn that a bit from our Great Depression experience, and there was a much greater understanding of monetary policy in general, but it took a very long time before central banks cracked the code of what it took to have a reliable, stable monetary policy that was credible to market participants, and to develop the tools to do that.
So we’re still really in the early stages. Hopefully we will be faster than we were on the monetary policy side, but we’re still in the process of doing that with macro-prudential tools, even though great strides have been made in understanding.
DH: We’ll return to the macro-prudential tools in a later episode. For now, would you say there are remaining blind spots. One thing that occurs to me is international co-operation is still somewhat limited, and potentially is even going backwards at the moment.
AM: So I would agree that international co-operation is perhaps the biggest challenge that we face going forward. I wouldn’t label it a ‘blind spot’ – people see it, they know that it’s a problem. But we have challenges, and those challenges are the global political environment is moving away from the type of co-operative activity that is absolutely essential to both prevent and fight any kind of global panic.
At the same time there has just been stalling in understanding what exactly we should do. In some cases the reaction, the feeling, is we need more ring-fencing, which I believe is the opposite direction to what we should be going in.
So there are challenges, some of those challenges are intellectual ones, because it is hard for me to argue for what I think is right since I am not certain of it, and other people may have very strong views and political reasons to make them, and it is difficult for folks on the other side to win an argument if they can’t marshal sufficient evidence to do so.
So I don’t think it is a blind spot, but I think I would agree that the international co-operation side is the biggest challenge we have in going forward.
DH: If you had to distil the crisis down into one key lesson, assuming that’s possible, what would that be?
AM: Well on the side of fighting the crisis, I think that the one key lesson is that in the middle of a crisis, we collectively worry too much about moral hazard. We are too worried about creating a situation that would appear to make the next crisis more likely, or that seems to not adequately punish people for past behaviour.
In the midst of a crisis is the wrong time to write new rules to punish whoever you think is deserving of that punishment. It scares people, and it can make panics worse. And the main example of that of course is what happened in Cyprus, but there are many other smaller micro-examples during the crisis. I think in general we have too much of a moral hazard-fundamentalism approach to the way we fight crises, and not enough of a sense of real urgency during the crisis that you must end the panic before you completely lose control of it.
DH: Thanks very much.