When excess global debt has been dealt with by creating even more debt; when the ‘hunt for yield’ continues apace; and when population ageing distorts asset prices, don’t conclude that the financial system has been brought to heel.
The zero interest rates and quantitative easing that followed the financial crisis made deleveraging easier in overly-indebted countries but encouraged huge increases in leverage elsewhere. In the event of another economic downswing, can enough countries increase leverage while others retrench? Probably not.
Countries with persistently extreme balance-of-payments positions may simply be a visible sign of a more widespread problem – a ‘hunt for yield’ in a world of structurally low interest rates and population ageing in which excessive risk-taking is a systemic problem.
Such a combination can lead to financial instability. As baby-boomers head into retirement, fewer workers have to support more retirees. Resources are increasingly allocated to the elderly: more spent on pensions and healthcare, less on education, and productivity-enhancing investments. This slows economic growth.
But an ageing population becomes risk averse, preferring ‘safe’ bonds, so pushing down their yields. Yet low returns force savers to save more to build a retirement nest egg – and that depresses rates further.
To meet pension demands, investors sometimes unwittingly end up taking more risk. This ‘hunt for yield’ weakens the financial system, encouraging exotic investments and illiquid markets.
Policymakers have not weaned the world off the risk-loving behaviour witnessed before the global financial crisis. Instead, monetary stimulus encouraged the hunt for yield.
What can be done? In the absence of a willing ‘consumer of last resort’, the world economy finds itself in a precarious position. Banks’ liquidity and capital buffers have been strengthened but reforms in other areas have simply not happened.
Reform should start with the hunt for yield by tackling the growing gap between retirement and life expectancy. However, increasing retirement ages or encouraging more immigration are politically awkward and boosting productivity has proved elusive.
The world has become even more dependent on dollar liquidity despite the US’s share of the global economy steadily falling. Enhanced financial stability requires either new sources of liquidity or – implausibly – the Federal Reserve to morph into a central bank for the world, not the US alone.
Inflation targeting needs reform. Central banks should aim not just for price stability but financial stability too.
Too often, creditor nations have walked away largely unharmed while debtor nations suffer painful economic adjustment. If creditors had to pick up more of the bill, governments and regulators might think more carefully about the consequences of unfettered capital outflows. A new Global Organization for Financial Flows could, if there was a sudden withdrawal of funds from a country, offer emergency short-term funding and rule on the relative cross-border responsibility of creditors and debtors.
Without such an organisation, countries may re-introduce capital controls.
If debt was the root cause of the global financial crisis, the situation today is, in some ways, even worse. Very few countries have managed to reduce their debts. For all the talk of post-financial crisis reform, it remains very much a work in progress.
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