The latest research of the McKinsey Global Institute (MGI) suggests that unless increases in labor productivity compensate for an aging workforce, the next 50 years will see a nearly 40 percent drop in GDP growth rates and a roughly 20 percent drop in the growth rate of per capita income around the world. Globally, the potential for diminished growth varies considerably among countries.
A useful precedent can be found with the monetarist revolution (Weingast & Wittman, 2008). In the 1960 and 1970s, monetarist proposed monetary targeting rules arguing that monetary policy matters rather than fiscal policy (their Kenyanesian opponents argued the opposite), and that stabilizing the money supply would serve to stabilize employment and output. In other words, monetary targeting rules were celebrated for their economic properties and not their political properties.
The reason why policy-makers adopted monetary targeting regimes in the 1970s, however, was because in the oil price shock era monetary targeting rules turned out to be a useful political device to fend off political pressures to inflate.
In the political implementation of monetary targeting rules, their political properties prevailed. And so it went with macro political economy. The message that filtered through to policy-makers and central bankers was that money cannot systematically raise employment and output. Moreover, political attempts to stimulate employment and output are futile and damaging, all they do is create inflation. For this reason, policy-makers themselves are better off delegating monetary policy to an independent central bank. Macro political economy thus made a successful case for the depoliticization of monetary policy.
In history the initial steps in opening up the global economy were made in the 1950s and 1970s as the desire to avoid the economic and political mistakes of the interwar period led to the gradual dismantling of trade barriers. Some of this was done within specific geographies notably with the formation of the European Coal and Steel Community in 1951, the forerunner of the European Union. The question is now what role monetary policy will play in EU. Is is simply to say that Monetary policy always has redistributional consequences. Because monetary policy is such a powerful toll of redistribution, and likely to get dragged into the distributional conflict over the split of the GDP.
After the Great Depression and World War II, the financial system in many countries was tightly controlled. In the United States, the United Kingdom, and elsewhere this was partly to encourage the holding of public debt, which had been such an important part of paying for the war effort. From the 1950s, however, interest rates were liberalized, and a broader array of financial instruments became available. By 1970s which marked the beginning of a wave of deregulation, capital flows into developing countries also became increasingly liberalized.
Until recently, high income countries were thought to have become less vulnerable to severe banking crises that have lasting negative effects on growth. Between 1970 and 2011, 80 percent of G20 nations experienced at least one systemic banking crisis. As mentioned, in Speech by Vitor Constancio, VP of ECB, at Warwick Economic Summit “monetary policy cannot cope with two different objectives and the need for macro-prudential policy has become more acute with the realisation that advanced economies are very likely faced with a prolonged period of low real and nominal growth.” The trend for lower GDP and productivity growth and for ever lower real interest rates has continued for quite some time. For instance, the U.S. annual productivity growth was 2.36% from 1890 to 1972. Then it declined to 1.67% from 1972 to 2004 and to 1.33% from 2004 to 2013. However, this development cannot be explained by the absence of structural reforms, as often done by economists in relation to other countries.
Across advanced economies, Germany currently stands out as a nation where sound fiscal policies are publicly supported. However, even Germany has built up large public debts, while letting its banking system sink into crisis, during the last three decades. It was German and French governments that initially backed efforts to weaken Europe´s stability and growth pact in the early 2000s.
Its hard to to know how much debt any government can safely issue before risk premiums start rising in dangerous manner. But, if debt levels continue to drift upwards, then eventually all nations will reach their debt capacity, and at that point every nation would be on a a path to crisis.
The crisis experience suggests that, in times of extreme market tensions, even a sound initial fiscal position may not offer absolute protection from spillovers
When crises occur, central banks and governments step in to ensure the system is stable. They lower interest rates, bail out institutions and they increase fiscal spending. Low interest rates reduce incentives to cut budget deficits. Business and households with mortgages are key actors who pressure governments to cut deficit, hoping to reduce interest rates. This practical lessons was major factor behind Bill Clinton´s steps to reduce the deficit during his first term in office. The astonishing nature of monetary policy becomes clear once you understand that essentially the same apply to fiscal policy.
One of Clintons priorities was to reduce the budget deficit using a combination of cuts in spending and increases in taxes. President Clinton was worried, however, that by itself, such a fiscal contraction would lead to a decrease in demand and trigger another recession. The right strategy was to combine a fiscal contraction so as to get rid of the deficit, with a monetary expansion to make sure that demand and output remained high. What triggered the recession was not, as in 1990-1991, a decrease in consumption demand but a sharp decline in investment demand.
Lower interest rates also buttress the lobbies that call for more spending. Given high levels of leverage, it is no surprise that, in the aftermath of crises, companies and households try to rebuild their equity capital. This drives up savings rates, and lowers interest rates. It becomes then reasonable to argue there is no better time for governments to invest in the future, as well as support demand, since the costs of such support are small compared to the benefits.
Private sector-led financial development can also play an important role in sustaining economic growth and improving welfare. However, the lessons from developing countries is there are advantages from keeping regulation tighter and capital requirements higher. This was the lesson drawn, for example, from the experience in 1982 in Chile and from 1997-1998 in Korea and other Asian countries. But the financial sector in those places is smaller and less powerful than in today´s rich countries. Its much hard to do in countries where finance has a great deal of political power and cultural prestige, and where leverage is already high.
Models of the political monetized economies are politically vulnerable for two reason. The first consists of the incentive to fund government spending with increases in the money supply, the second, of the incentive to inflate to increase employment and output. First, political pressures for government spending can translate into an excessive use of the money printing press. The second source of political vulnerability consists of sticky prices, or contracts denominated in nominal currency that are not inflation indexed and cannot be quickly adjusted.
Political business cycle (the time-consistency problem and opportunistic and partisan political business cycles) depends on the time horizon of the party in office. The promise of economic voting is after all that voters would be able to use economic conditions as a measure of the success or failure of governments, the anticipation of being thus measured would induce politicians to improve economic conditions on their watch. But, once growth resumes, the case for financial sector reform seems less pressing. Banks, however, often have multiple contracts. Unfortunately, the dynamics of this system are not entirely stable. The high cultural prestige of finance, combined with the government´s need to sell debt, means that financial sector executives continue to run fiscal policy. This contributes to the fact that once the crisis is over, the regulatory system relaxes, and new risks build up. Financial development or the move from public choice to political economy transforms the political economy of finance.
Experience over the past decade suggests we have built a global financial system in which there is an incentive to build up unsustainable and dangerous levels of both private and public debt. Jorda, et al (2014) show in a historical overview spanning 140 years that the link between loose monetary conditions and booms in mortgage lending and house prices has become stronger post-WW2. A large housing bubble preceded the 2008 crisis in the hardest-hit countries (the US, the UK, Ireland, Spain, Portugal, and Italy).
The strong rise in aggregate private debt over GDP in many Western economies in the second half of the 20th century has been mainly driven by a sharp increase in mortgage debt. Mortgage credit has risen dramatically as a share of banks’ balance sheets from about one third at the beginning of the 20th century to about two thirds today.
In the wake of the Global Financial Crisis, Ireland faced its worst banking crisis after the bursting of the property bubble. The property boom, fuelled by domestic and cross-border banking credit, did not only lead to unsustainable residential and commercial real estate prices but also to massive new construction. Not only macro factors, but also a weak supervisory approach played an important role.
To restore the capital base of the Irish banking system, the Irish government provided up to € 64 bn to the banks (amounting to about 40 per cent of GDP). The Irish taxpayers have been brave in shouldering the full costs of re-capitalising the Irish banking system. In the depths of financial crisis, the taxpayers are the main losers from such crisis, but advanced countries have managed to postpone costs by issuing public sector debts, so ultimately it is future generations who pay for the damage caused by financial sector excess risk-taking.
There was considerable volatility in the public finances around the time of the contentious intervention in the banking system, but since 2012 the deficit has followed a gradual falling trend, against a backdrop of ongoing austerity and, more recently, a rebound in economic output. Strengthening activity and a recovery in the labour market have underpinned a marked upturn in government revenue and in nominal GDP, both of which have helped to bear down on the headline fiscal deficit (in absolute terms and as a share of GDP). The Central Statistics Office (CSO) data suggest that the public finances remained on track last year to achieve the government’s latest estimate (in its 2015 budget) of a deficit of 3.7% of GDP in 2014, down from 5.7% in 2013 (The Economist Intelligence Unit 2015:Special report Where next for the euro zone?). This CBI-CEPR-IMF Conference paper provides a high-level overview of the crisis management by the Irish authorities and lessons from its Recovery from the Bank-Sovereign Loop.
As Friedrich Hayek warned back in the 1930s, the consequences of such a process of misplaced investment take time to resolve, owing to the subsequent oversupply of specific capital (in this case, of the housing stock). The housing bubble was the financial panic that gripped capital markets worldwide after the collapse of Lehman Brothers. The panic was sharp and severe, requiring central banks to play their fundamental role as lenders of last resort.
2012 when those political failures came close to ripping apart the euro, ECB´s Draghi stepped into the breach. Just 20 words from him were enough to simultaneously shock and soothe the markets threatening the currency´s destruction.
“The ECB Governing Council is ready to do whatever it takes to preserve the euro”, he told delegates at a London investors conference. “And believe me, it will be enough”
Properly managed sovereign debt is helpful to financial development because it provides a relatively low risk and liquid asset for both individuals and firms. It can also play an important role in stabilizing the macroeconomy when and if it enables the the government to increase its budget deficit as the financial system comes under pressure and credit conditions tighten.
To allow national fiscal stabilizers to work, governments must be able to borrow at an affordable cost in times of economic stress. A strong fiscal framework is indispensable to achieve this, and protects countries from contagion. Governments need to assess whether and how to go on opening up their economies and integrating them into the world economy.
There is a robust debate about how much growth is actually desirable, Yet without growth, the world is a poorer place—and fulfilling social and debt commitments becomes harder. So there is a strong case for sharing more sovereignty in this area – for building a genuine economic union. This means governing together. In this case, the European Stability Mechanism (ESM) would become an effective vehicle for risk sharing and cut the bank-sovereign loop.
It is also clear that our monetary union is still incomplete. This was the diagnosis offered two years ago by the so-called “Four Presidents” (the European council president in close collaboration with the presidents of the European Commission, the European Central Bank, and the Eurogroup).
In the euro area, stability and prosperity anywhere depend on countries thriving everywhere. And, though important progress has been made in some areas, unfinished business remains in others. A key part of the solution is to improve private risk-sharing by deepening financial integration. Indeed, the less public risk-sharing we want, the more private risk-sharing we need. A banking union for the euro area should be catalytic in encouraging deeper integration of the banking sector. But risk-sharing is also about deepening capital markets, especially for equity, which is why we also need to advance quickly with a capital markets union. Limiting the potential for servere financial crisis through well-designed regulation is a sensible goal and an important lesson from the Great Depression.
Financial Stability depends on working together of EU rules and well-aligned national authorities.
Monetary policy operation always has some fiscal implication, and for the Central Bank what matters first and foremost is that monetary policy is effective. Usually, these fiscal implications are dealt with easily within a one-country framework, between the central bank and the treasury. But in the euro area, there is no European treasury, and each national treasury gives an implicit or explicit indemnity to its own central bank, but not the euro system as a whole. The US Treasury has argued that its recent bailouts were profitable for US taxpayers, because they managed to get back more than what they directly gave out.
Indeed, it required new leaders to break the panic in both institutions – Haruhiko Kuroda at the BOJ and Mario Draghi at the ECB – finally to set monetary policy right. Yet, The Bank of Japan and the ECB were, characteristically, the slowest to react, keeping their policy rates higher for longer, and not undertaking QE and other extraordinary liquidity measures until late in the day. So, too, did the Bank of England, though it was too a bit slower to react.
The good news is that, even near the zero lower bound (ZLB), monetary policy works. QE raises equity prices; lowers long-term interest rates; causes currencies to depreciate; and eases credit crunches, even when interest rates are near zero
Now, the expected announcement by Mr Draghi, will bring the bank closer into line with the US Federal Reserve and the Bank of England, which adopted QE in the wake of the global financial crisis. But QE has split the central bank’s 25-strong governing council, with both German members voicing their opposition in recent weeks. Today, Germany´s new demands reflect its role as a large creditor to other EU nations.
Under the securities markets programme, the ECB’s first bond buying scheme, the national central banks shared responsibility for losses and profits according to the ECB’s capital key, which reflects member states’ economic size. That made Germany, the region’s powerhouse, the biggest potential loser — and winner. To appease QE’s German opponents, which include the chancellor Angela Merkel herself, Mr Draghi is expected on 22nd Jan 2015 to say that bonds bought will remain with national central banks, so losses will not be spread among eurozone members.
The ECB´s governing council includes representatives from each central bank of the euro-zone nations to ensure price stability, and to supporting economic activity in Europe. The ECB decisions are being taken by the ECB´s Governing Council with a euro area focus, and the decisions are meant to affect monetary and financial conditions across the whole euro area.
Given the very different circumstances and risks faced by different member states, it is also important that the rules allow sufficient flexibility to recognise national financial stability responsibilities. And that they are applied by national authorities that have responsibility for financial stability.
Capital Markets Union:
Monetary policy is focused on maintaining price stability over the medium term and its accommodative stance contributes to supporting economic activity. However, in order to increase investment activity, boost job creation and raise productivity growth, other policy areas need to contribute decisively.
In particular, the determined implementation of product and labour market reforms as well as actions to improve the business environment for firms needs to gain momentum in several countries.
Turning to the issue of Capital Markets Union, in a speech on Tuesday to a conference organised by the City of London Corporation and Open Europe, Jon Cunliffe discusses how the European Union has achieved and should continue to achieve a balance between developing a single market for financial services and the need for financial stability. Jon sets out how the establishment of a Capital Markets Union can help to further the objective of encouraging the free movement of capital in the EU by promoting the development of market-based financing.
He notes that the regulatory framework for openness and for managing the financial stability risk around the single market in financial services in the EU was built on the principles of common rules – with force of law – commonly applied and on mutual recognition.
This is key, because to be confident of maintaining financial stability in a single market with free movement of capital, each member state needs to be confident in the strength and in the application of prudential regulation in other member states.
The benefits of Capital Markets Union could be very large. Indeed, One reason the American economy recovered from the recession faster than Europe’s was that it “had an active capital market to help provide finance for businesses at the time when its banks were under strain. However, the American private placement market (a form of direct lending typically between institutional investors and midsize firms) is almost three times bigger than that in the European Union, and debt securities markets, including the market for corporate and government bonds, are three times larger in the United States.
Bankers in London, (which has the largest, most internationally active and most complex financial sector in the EU) and Europe have long called for the region to shift from a bank-lending economy to one driven by capital markets. The political and economic events taking place in Greece and across Europe are shaking confidence in the future of the euro zone, and the spotlight has been focused on where the economic future of Europe lies.
Sir Jon, who has specific responsibility within the Bank for the supervision and oversight of Financial Market Infrastructures recommends that the objectives should be: first, to put European savings to better use by deepening and diversifying the sources of finance available to business and offering more investment choices and portfolio diversification to savers. Companies must seize the opportunity to accelerate productivity growth and the value-creation potential it holds.
The focus on productivity needs to go hand in hand with improving skills. As the new wave of innovation hits, jobs are becoming more skilled. Thus, Innovation has become the central driver of national economic wellbeing and competitiveness
Second, to enable greater risk sharing across the EU by creating deeper cross-border markets. And third, to create resilience by ensuring that if the banking system is damaged, there is an effective alternative channel of finance to the real economy. Reforms will be needed to both supply and demand to achieve those Capital Markets Union objectives. On the supply side, measures will be needed that enable household and corporate savings to flow to vehicles that will invest in capital markets, and investors will need to be encouraged to allocate capital across borders, reducing their “home bias”.
On the demand side, Cunliffe suggests that more diverse forms of borrowing will be needed and could include forms of finance in which investors directly acquire assets, such as equity and corporate bonds, and indirect forms of finance in which banks and markets work together through securitisation markets to lend to the real economy.
Domestic demand should also be further supported by ECB´s monetary policy measures, the ongoing improvements in financial conditions and the progress made in fiscal consolidation and structural reforms. Furthermore, demand for exports should benefit from the global recovery.
The move toward embracing deeper capital markets also mirrors a widely held sentiment in financial circles that regulators and policy makers should shift their focus from regulating the markets to encouraging their growth.
A more integrated capital market would provide deeper equity markets that could enable a wider range of corporates to issue equity. As equity provides the most efficient forms of risk-sharing, Sir Jon suggests that this area should be a priority for CMU.