Senior Fellow, Institute for New Economic Thinking; former Chairman, U.K. Financial Services Authority; and former Chairman, Financial Stability Board Standing Committee on Supervisory and Regulatory Cooperation.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Chairman Turner: Yes. A lot. The pre-crisis orthodoxy defined central banks to a very significant extent as having one primary objective – low and stable inflation (with some countries in addition including a broad employment mandate) – and one policy tool, the policy interest rate. I think that this definition involving a very small set of objectives and one policy tool was fundamentally mistaken.
We now know, or should have learned from 2008 and the years before, that the growth of credit and leverage within an economy is a matter of prime importance. Crucially, you can have long swings in which there is a build-up in leverage that will not show up in an overheating of inflation, so that the inflation targeting objective doesn’t signal the appropriate policy reaction. And, this buildup of leverage cannot be controlled by the interest rate alone.
Central banks still hanker for the pre-crisis clarity of “one objective, one instrument.” This was intellectually elegant and provided a strong base for central bank independence within a framework of accountability. However, I think it was a delusion. We have to accept that central banks as macroprudential regulators will in future have to be in the business of managing the credit cycle. This means having points of view both on the quantity of credit created and (to a degree) on the allocation of credit between broad categories of sectors within the economy.
Where should we be looking now for financial stability risks given this experience?
Chairman Turner: At the moment, I am less worried about financial stability risks narrowly defined than about the overall macroeconomic risks of a still-unresolved debt overhang.
By “financial stability risks narrowly defined,” I mean those risks that could produce chaotic failures of major institutions such as banks or could in other ways produce unexpected short-term turbulence in financial markets that would threaten the stability of the financial system or the solvency of systemically important institutions.
With respect to financial stability defined in those terms, I think we have made very significant progress since 2008 in terms of increasing the capital and liquidity requirements of banks, and particularly of systemically important banks. We also are beginning to get a grip on some of the issues having to do with the derivatives market and improving the resolvability of systemically important institutions. Consequently, while I hope this isn’t just a failure of foresight, I am far less worried than we should have been before 2007/08 that we will suddenly face a rapidly developing crisis in the way that we did from 2007 onwards.
I am, however, very worried that we really don't have an answer about what to do with the accumulated debt stock in the world. According to the 2014 Geneva Report and to the recent McKinsey Global Institute report, the total level of leverage in the world has simply continued to increase since 2008. We have not really achieved any deleveraging at all. Instead, we have simply shifted debt around, whether from the private to the public sector or from one country to another. So, that is my overall concern.
Returning to financial stability narrowly defined, to the extent I am concerned there, it’s because the longer we run with very low and, indeed in some cases now, negative interest rates (both short term and long term), the greater must be the incentives for all sorts of fancy highly leveraged financial speculations, carry trades, etc. These continue to be very difficult for financial regulators to spot. So, my worry would be that the sustained period of low interest rates must be producing very high levels of leveraged activity in some areas of the economy. I think we’re seeing that with the return of exuberance in some buy-out markets and CLO [Collateralized Loan Obligation] structures, etc. At the moment, I am not too worried about them, but I work on the basis that there are some things going on which we only imperfectly understand. Certainly, that is where we need to keep a very strong eye on developments.
What do we need to do to preserve the benefits of global finance?
Chairman Turner: I am less worried than other people about undoing the benefits of global finance because I think that some of the benefits of global finance were overstated.
The simplistic argument in favor of global financial innovations and integration is essentially an application of a simplistic economic theory of complete markets – namely, the more we have complete and free markets the more that capital will find its most efficient allocation, the more that risk and return will be distributed to those best placed to manage it, etc.
I think the crisis of 2008 was – in addition to being the crisis of particular institutions – a crisis of the intellectual theory that applied complete and free markets to the financial markets as well as, say, to the market for restaurants or the market for bananas or the market for automobiles. The fundamental point is that the market for finance is different, so many of the propositions in favor of free and complete markets that are powerful in other sectors of the economy are much less powerful in finance.
Specifically therefore, I think that some of the things that we accepted before the crisis – for instance, that banks should be free to operate globally as single legal entities if they wish, and to move liquidity around the world according to their own profit-maximizing objectives – were mistaken.
I think that we know from the theory and the empirics of capital flows that there is a hierarchy of capital flows. Foreign direct investment is clearly positive for growth: equity portfolio investment is probably net beneficial, and various categories of long-term debt more likely than not are a plus. But I do not think that short-term debt flows (and, in particular, short-term debt capital flows intermediated by banks that are able to move liquidity around the world rapidly) are necessarily good for the economy. I think this view is what comes out of the work of Hélène Rey that was presented at the 2013 Jackson Hole Economic Symposium or from the work of the 2009 report of the group from the Committee on the Global Financial System chaired by Rakesh Mohan.
So, in response to this financial crisis, we have now introduced some, as it were, “sand in the wheels” of global financial integration, such as by requiring the subsidiarization within each country of significant bank operations, rather than operations through branches. We also have economies and authorities willing to apply forms of prudential or tax or other constraints on hot-money capital inflows in the upswing of the cycle. That does not worry me, and overall I am not convinced that any of the regulatory responses introduced since the crisis are getting in the way of useful global financial integration.
Mr. Turner is the author of Between Debt and the Devil: Money, Credit, and Fixing Global Finance, to be published by the Princeton University Press later this year.