Seeking sustainability within the economy
01 Feb 2010
The financial crisis in 2008 was in large part born of massive inflows of capital from the emerging markets seeking a safe haven in the United States.
Swiss Re: What do you believe were the key lessons learnt from the financial crisis?
Bengt Holmström: One of the lessons is just that when we innovate, we run risks of making mistakes, even major ones. The US built an entirely new, huge market-based banking system – a shadow banking system – in the last fifteen years. It was thought to be safe, but it resulted in the first bank run in the US in 70 years. The innovations in structured financial products and the enormous growth in shadow banking was a response to a huge demand for safe assets stemming from global imbalances. We learned to our surprise that global financial markets could not keep up the pace of growth in trade. We thought it would be the other way around.
Another lesson we learnt was that, as secure as the underlying assets are, a little bit of adverse selection in a complex chain of intermediation is capable of freezing the market. If you don’t know the risks of your counterparty is, it paralyses your ability to trade assets.
We also learnt that the tail risk – the risk from a deep crisis – is always with the government. But much of the risk that now fell on government could be and must be shared much more effectively by the private sector. That is an opportunity for insurance companies.
On the other hand, a good lesson that was learned is that the government has the capacity to stall a bank run if it is innovative and creative enough. We were very fortunate to have Ben Bernanke as chairman of the Federal Reserve at the time, because he has thought about these problems more than anybody, so he was the right person was in the right place at the right time. As a result, the actions taken by the biggest and most important government were on the whole good.
He took a trial and error approach to fixing the crisis. The Fed came up with at least 12 new interventions, from TARP to TALF to PPIP and more. They went into the CDS markets, and the asset-backed seurities markets. They tried buying up toxic assets, then they injected equity into the banks. And of course they first lowered interest rates quickly before they undertook quantitative easing. They were hugely innovative and when one thing didn’t work they tried something else. Whatever it takes was the motto. That has calmed the markets.
With the information we have right now they have been very successful. It’s no exaggeration to say that the actions of the central bankers prevented a repeat of the Great Depression.
Swiss Re: What was at the core of the crisis?
Bengt Holmström: The crisis was had its seeds in the massive inflows of capital from the emerging markets seeking a safe haven in the United States. Billions of dollars were flowing into the US, looking for low risk avenues of investment. At the same time, the United States government was providing immense subsidies to its housing industry to increase the housing stock and expand home ownership to low income families. The massive supply of investment capital combined with an artificial demand for housing created an enormous housing price bubble.
Indeed the supply of capital was so large it could not be absorbed by the traditional banking sector. Instead it flowed into the shadow banking sector – the world of investment banks, hedge funds, and government sponsored enterprises such as Fannie Mae and Freddie Mac. This part of the banking system was responsible for almost all of the growth in financial intermediation seen over the past decade. Without shadow banking we would not have had as big a bubble, but the system brought great benefits, too. There is no way going back and we should not try to do it. Just strengthen the system with better regulations.
The shadow banking sector is financed through wholesale, short-term (often overnight) funds, and it is hugely leveraged. The repo markets are at the heart of it, and it was the repo markets that were at the core of the market meltdown when liquidity dried up following the collapse of Lehman Brothers. When Lehman Brothers collapsed, some USD2 trillion was withdrawn from this market almost overnight, and there was no way that the broker-dealers could access this kind of money without selling assets and deleveraging.
Swiss Re: What are some of the lessons for regulators?
Bengt Holmström: The crisis revealed that the banking sector retained much of the riskier tranches of their business, while selling off the safer bits. As a result, systemic risk was concentrated in the shadow banking system and in the off-balance sheet entities of commercial banks.
In the final reckoning, systemic risk will always sit with the government. But in order to avoid a similarly costly build up of risk, regulators should seek ways to distribute the systemic risk by identifying it and charging it to the system – as deposit insurance does. Because of the way the shadow banking system operates, this is easier said than done. Nonetheless, until we find a way to do so, the remarkable period of calm that banking has enjoyed over the past 70 years may not return.
Swiss Re: There are large economic support programmes everywhere, costing a lot of money and causing large debts, particularly for the next generation. Can we say that the US is bankrupt? How do you see this problem in the context of the recent financial crisis?
Bengt Holmström: The US is certainly not bankrupt, and I would not agree that the amounts of money that have been nominally spent will actually be spent. If history is any guide, central banks actually make a lot of money on some of these schemes.
When there is a panic and people are so uncertain about counter-party risks that markets freeze, the government is the only one with credible assets, so how can it not make money? It may not make money if it feels it needs to support the system and overpay for assets. But if the government was a private entity with the same credibility the crisis is a real opportunity to make money.
The government should have bundled the toxic assets and insured the the tail risk of the bundles to eliminate adverse selection. That is what it should have done, but the political opposition was so strong that the Fed couldn’t get it done. In my opinion the mindset out there is not right, not in Congress and not in the general public. People think “this is all Wall Street’s fault”. Time is spent finding those who are guilty, it’s about putting people in jail or whatever.
But that can come later. We have plenty of time to figure out who was a crook, but we don’t have as much time to figure out what went wrong with the system and what are the right regulatory reforms. Like an plane crash, when you are looking at the causes of a crash you have to look at everything, the mechanics of the plane, the weather, plance scheduling and the like, before you can conclude that the fault was with the captain, which in this case was Wall Street. It is deeply misguided to start by finding out who is guilty before looking at problems in the system.
Swiss Re: As an economist, you learn that everything is about growth. Is that still the case? Given the sustainability imperative, is the growth model an old model? Do we need to rethink the way we do things from first principles?
Bengt Holmström: Wow, that is such a big question. If you really look at the big picture of the world, it is hard to believe that growth would stop. It is in our genes, so to speak, to improve on things, do better and be better. On the other hand there certainly have been long periods when growth has stalled, even for hundreds of years. This could happen again, just like the crisis happened just when we thought it never will.
Much of the growth that we have seen is of course attributable to the fact that activities that were outside the market and went unmeasured are now part of GDP. We now measure many more things than we used to do. At the same time, many things contribute to the quality of life but remains unmeasured.
As the world of national accounting gets more sophisticated, more gets measured, but how much is real is another question entirely. How do you value clean air for instance? Terrorism, as another example, how do you measure the issues that are raised by terrorism? Perhaps trillions of dollars have been lost in welfare, perhaps growth has actually been negative because of the rise in terrorism over the last decade. So if you price the goods that are not currently priced but have value we may already be experiencing stagnancy.
So growth as we think about it is a narrow concept. And it may be that we will be moving in economics in the direction of a broader definition of growth.
Let me say emphatically though that I don’t think the market economy is drastically threatened in any way. We’ve had 70 years without banking panics in the US, and that is a huge achievement. Now we need to figure out how to create a more robust financial system for the global economy. It is going to be a tough challenge, but I’m confident that it can be done – probably by expanding and improving on the shadow banking system that caused the current crisis. That’s how innovation works.
Bengt Holmström, NORIS 2009, Interview by Sven Schulz
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