Ten years ago, as the global economy slipped ever-closer to a total meltdown, regulators were slow to recognize the severity of the problem because they were looking in the wrong direction.
The transcripts from the US Federal Reserve’s policy-making committee meeting that took place on September 16, just as the financial giant, Lehman Brothers, was allowed to fail include 129 mentions of “inflation,” and just five of “recession.” Not surprisingly, given their narrow focus on inflation, they voted to take no action to support the economy, just days before it began to go into free-fall.
We will never know how much the Federal Reserve’s obsession with inflation cost the global economy—not just through that delayed response, but also due to the previous decades of focusing on low inflation rather than jobs and growth.
In retrospect, the Fed’s lack of awareness of the wider economy in 2008 seems crazy. And yet, we are running the risk of doing something very similar today. As stock markets continue to a historically long bull market, we’re partying like it’s 2007, even as both Canadian and global economies edge into ever-more dangerous territory. And we simply don’t have the tools to respond when the next crisis hits.
Why are we acting like the 2008 financial crisis was a blip, when it should have been a wake-up call to transform our financial and economic systems?
During the immediate aftermath of the crisis, of course, governments and central bankers did take bold action. They experimented with quite radical policies, particularly in the US and in Europe, including massive bail-outs, quantitative easing, and even negative interest rates. Yet, these changes were largely framed as exceptional—temporary aberrations rather than a sign that the tools needed to manage the global economy had changed for good.
Some more sustained efforts to reform the regulatory system have been successful. Big banks are better capitalized now than they were before the 2008 crisis and regulators have more power. But dig a bit deeper and it is remarkable how many things remain unchanged. The same big three credit rating agencies whose misleading evaluations helped to blow up the system still account for over 96% of all ratings. Big American financial institutions are using loopholes to move their riskier derivatives portfolios offshore where they aren’t regulated. And the real-estate market, which was at the heart of the last major crisis, is a ticking time bomb as interest rates slowly climb back up to more normal levels.
What happened to the big talk of reform that we heard in the early days of the crisis? Policymakers discussed much higher leverage ratios (which would restrain the riskiness of banks’ financial bets), the comprehensive regulation of derivatives, and a financial transactions tax that would make it more costly for big investment firms to make very short-term, often destabilizing, financial bets.
But in the end, the reforms that were made were tweaks rather than major changes. Governments around the world failed to introduce the kinds of wide-ranging reforms needed to prevent and manage the major financial meltdown. When the next economic crisis hits (and yes, there is always another one), our central banks—and our governments—will face much higher levels of debt, far less room to lower interest rates, and few new tools to respond.
Who is to blame for this current dangerous situation, and our woeful lack of preparedness?
CIBC’s CEO, Victor Dodig, recently blamed central banks for the current instabilities in the global financial system—suggesting that they kept interest rates too low too long, creating distortions in housing markets and in the emerging market economies who borrowed cheaply and are now having to pay more than they can afford. Dodig is right to suggest that these are serious warning signs that the economy may be in trouble soon. But he’s pointing a finger in the wrong direction when it comes to allocating blame.
Central banks only kept rates this low because it was the only tool at their disposal to keep the economy going. The real blame rests with the many western governments, including Canada’s Conservatives, who didn’t have the political guts to do what was needed to reform the global economy. These governments flirted briefly with stimulus and discussions of more systematic reform, and then shifted all too rapidly to a package of austerity and a few minor reforms.
The heavy lifting for supporting a still-ailing economy was left to the central banks—who found themselves keeping rates low far longer than they had ever anticipated.
Higher rates without any government action to support the economy would only have made things worse, sooner. What we needed then, and still need now, is more systematic economic reform of the kind that was only briefly discussed and then ignored after the 2008 crisis.
It may well be too late to do much more before the next economic crisis hits. We just have to hope that the next crisis produces some more creative thinking and, above all, some braver political action to reform the global economy for the long haul.
This blog post originally appeared in the Ottawa Citizen on September 20, 2018.