The Global Financial crisis – What caused the build-up?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.comvox 

 

Five years have passed since the onset of the financial crisis and there is little agreement on the root causes or potential indicators of rising financial system stress.  Erlend Nier and Ouarda Merrouche address a number of these issues in a recent (25^th March) VOXEU communique called The global financial crisis – What caused the build-up?

 

Nier and Merrouche, IMF economists, summarize some of their recent research.  They start off asking a couple of questions: did central banks keep policy rates too low too long? Or were rising global imbalances the underlying cause of the crisis?  The answers to these questions are important to help contain and prevent the build-up of systemic risk.   

 

The authors noted the following results: net capital inflows can account for the differences between countries in the build-up of financial imbalances, the compression of the spread between long and short rates contributed to the rise in leverage and balance-sheet expansion, a weak supervisory and regulatory environment along with macroeconomic factors added to financial system stress and the relative importance of external imbalances relative to monetary policy.

 

Their research suggests that net capital inflows, rather than monetary policy stance, emerges as the key determinant of differences in the growth of financial imbalances across OECD countries over the pre-crisis period.

 

Capital flows along with weak regulation and supervision were the key drivers of the financial crisis.  The authors note that inadequate prudential policies failed to address systemic problems by over-reliance on wholesale funding.  The financial crisis corresponded with a sustained period of low interest rates globally, but the path of monetary policy (different across countries) was not a main contributor to the build-up of financial imbalances.  This suggests caution against a re-orientation of monetary policy frameworks in response to the crisis.

 

The lesson for policymakers and regulators is the need for effective macroprudential policy tools and effective/efficient regulation.   Otherwise, the use of the wrong policy options combined with over-regulation may result in rising systemic risk and increased contagion.

 

For more on this follow the link: http://www.voxeu.org/index.php?q=node/7774

Risks from Financial Repression

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Many advanced countries worldwide are experiencing a problem with surging levels of debt.  One of the tactics used to contain the surge of debt is called “financial repression”.  Given the recent global and European crises, there is expected to be resurgence in the use of this tactic for debt management.  In a recent VOXEU (26^th March) communique, “Financial repression: Then and now” authors Jacob Kirkegaard and Carmen Reinhart discuss how it is applied    

 

In the past, policymakers dealt with rising debt levels by a mix of strategies: economic growth, fiscal adjustment and austerity, explicit default or debt restructuring, surprise inflation and financial repression often accompanied by steady inflation.  Financial repression is defined as policies that allow governments to capture and under-pay domestic savers and investors.  These policies may include forced government lending from pension funds and financial institutions, interest-rate caps, capital controls and other policy options.  Countries will now focus on this strategy as one way to reduce the cost of the rising debt burden.  Countries will only use outright default or surprise inflation as a desperate measure or as a strategy of last resort.

 

This is why financial repression is now back as a policy option.  Financial repression in conjunction with steady inflation works in debt reduction by two methods: low nominal interest rates reduce debt servicing costs and negative real interest rates erode the debt-to-GDP ratio (tax on savers).  The repression tax rate (or rates) can be determined by financial regulations and inflation performance.

 

Currently, financial repression is represented in the context of macroprudential regulation.  The current financial regulatory measures are biased to keeping international capital out of emerging markets and in advanced countries.  Emerging market controls are meant to counter loose monetary policy in advanced countries and discourage hot money while regulatory changes create a captive audience for domestic debt.  This offers advanced and emerging economies common ground on tighter restrictions on international financial flows as the world is returning to a tightly regulated domestic financial markets.

 

One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail.  This reduces governments’ interest expenses for a given stock of debt and contributes to deficit reduction.  However, when this produces negative real rates and helps liquidate existing debt, it serves as a wealth transfer from creditors (savers/investors) to borrowers (governments).  The prevalence of a strong regulatory environment during the post WWII Bretton Woods arrangement helped to keep real interest rates negative or lower than levels that would prevail in an environment of greater capital mobility.  This allowed many of the advanced countries to use financial repression dramatically reduce accumulated debt burdens from WWII at a lower cost.  As countries emerge from the most recent crisis, low real rates are expected to persist as countries struggle for a sustainable recovery.        

 

Currently, many advanced countries have debt (public & private) levels that approach the post WWII levels.   Policymakers will be preoccupied with debt reduction, debt management, and generally trying to contain debt servicing costs.  The high level of unemployment will be further motivation for keeping rates low.  In this environment, financial repression (with dual aim of low rates and captive investor base) will regain renewed favor as many countries struggle with unsustainable levels of debt and a new regulatory environment with a new set of risks. 

 

For more on this follow the link:  www.voxeu.org

/index.php?q=node/776