Financial Stability in Abnormal Times

Kenneth Rogoff

Despite improvements in the financial system since the 2008 crisis, the piecemeal reforms that have been enacted fall far short of what is needed. And an inexorably growing financial system, combined with an increasingly toxic political environment, means that the next major financial crisis may come sooner than you think.

CAMBRIDGE – A decade on from the 2008 global financial crisis, policymakers constantly assure us that the system is much safer today. The giant banks at the core of the meltdown have scaled back their risky bets, and everyone – investors, consumers, and central bankers – is still on high alert. Regulators have worked hard to ensure greater transparency and accountability in the banking industry. But are we really all that safe?

Normally, one would say “yes.” The kind of full-blown systemic global financial crisis that erupted a decade ago is not like a typical septennial recession. The much lower frequency of systemic crises reflects two realities: policymakers respond with reforms to prevent their recurrence, and it normally takes investors, consumers, and politicians a long time to forget the last one.

Unfortunately, we don’t live in normal times. Crisis management cannot be run on autopilot, and the safety of the financial system depends critically on the competence of the people managing it. The good news is that key central banks still, by and large, have excellent staff and leadership. The bad news is that crisis management involves the entire government, not just the monetary authority. And here there is ample room for doubt.

To be sure, if the next crisis is exactly like the last one, any policymaker can simply follow the playbook created in 2008, and the response probably will be at least as effective. But what if the next crisis is completely different, resulting from say, a severe cyberattack, or an unexpectedly rapid rise in global real interest rates, which rocks fragile markets for high-risk debt? Can anyone honestly say that US President Donald Trump’s administration has the skill and experience to deal with a major collapse? It is hard to know, because the only real crisis the United States has experienced so far during Trump’s presidency is, well, Trump’s presidency.

US Federal Reserve chair Jay Powell and his team are first-rate, but who will be the other adults in the room if an externally generated financial crisis threatens? The Fed cannot begin to do everything on its own; it needs both political and financial support from the rest of the government. In fact, the Fed has less room for maneuver than it had in 2008, because the 2010 Dodd-Frank financial reforms sharply restricted its ability to bail out private institutions, even if the entire system might otherwise collapse. Will a gridlocked Congress deliver? Or perhaps Steven Mnuchin, who produced Hollywood movies prior to becoming US Treasury Secretary, can use insights from his acting role in the 2016 movie “Rules Don’t Apply.”

Europe has issues that are similar, or worse. With populism fueling deep distrust and divisions, financial resilience is almost certainly far lower than it was a decade ago. Just look at the United Kingdom, the other major global financial center, where the political elite have taken the country to the edge of the Brexit cliff. Can they really be expected to handle competently a financial crisis that requires tough political decisions and agile thinking? The UK is fortunate to have very good staff in its Treasury as well as its central bank, but even the brightest boffins can do only so much if politicians don’t give them cover.

Meanwhile, across the English Channel, deep division over eurozone burden sharing will make it difficult to implement a cogent policy for dealing with a bout of severe stress. A significant rise in global real interest rates, for example, could wreak havoc in the eurozone’s balkanized debt markets.

But won’t it be another 20-40 years before the next big financial crisis, leaving plenty of time to get ready? One hopes so, but it is far from certain. Even if regulations have been successful in containing risks to banks, it is likely that major sources of risk have simply migrated to the less regulated shadow financial system. What we know for sure is that the global financial system continues to expand, with global debt now pushing $200 trillion. Better financial regulation may have helped contain the corresponding growth in risk, but it is not necessarily shrinking.

For example, although big banks do seem to have less risk “on the books,” regulators must work hard to monitor risky debt that has migrated to the shadow financial system and can inflate quite quickly, as we learned the hard way in 2008. Regulators are quick to point to banks’ higher buffers of “liquid” assets to fight runs on deposit and debt-rollover problems. Unfortunately, assets that are “liquid” in normal times often turn out to be highly illiquid in a crisis.

Policymakers are right to say there have been improvements in the system since 2008. But the piecemeal reforms that have been enacted fall far short of what is most necessary: requiring banks to raise a larger share of their funding through equity issuance (or by reinvesting dividends), as economists Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute have argued. Unfortunately, an inexorably growing financial system, combined with an increasingly toxic political environment, means that the next major financial crisis may come sooner than you think.

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