Presenting, one of the best accounts of how the current crisis came about that we’ve read to date.
It comes courtesy of Benoît Cœuré, member of the executive board of the ECB, and should be required reading for every player in financial markets, if not every technocrat the world over.
Featured therein: the role played by the shortage of safe assets worldwide, global imbalances, the effects and consequences of falling yields and capital inflows over the last two decades — not to mention the lessons drawn from the Asian financial crisis and the mysterious nature of what “global liquidity” is in the first place.
Accordingly, Cœuré begins with a logical starting point: 1997 — the point Asia arguably really began attracting almost half of the total capital inflow heading into developing countries — marking the peak of the so-called Asian miracle (a factor also discussed by Richard Duncan in his must-read book the Dollar Crisis, which pretty much predicted the whole crisis as well as how it would come to play out).
As Cœuré notes these regional inflows led not just to dramatic increases in the rate of growth, but also in asset prices, whilst disincentivising what would otherwise have been natural moves to draw investment through improvements in transparency and corporate governance. Huge amounts of leverage ensued, pushing asset prices to what became in hindsight clearly unsustainable levels. When markets corrected, the Asian Financial crisis emerged.
But the Asian Financial Crisis was only the beginning. As Cœuré explains:
The shortage of liquidity created by the crisis changed risk sentiment, thereby increasing the global demand for safe assets. With the US dollar still reigning supreme, the United States became a hub for the recycling of the liquidity that was available globally .
All of a sudden, capital was flowing uphill, from emerging to advanced economies, a puzzle famously known as the “Lucas paradox”.
Clearly, however, the surge in capital flows to the US was mainly driven by the desire of the official sector in emerging-market and oil-exporting economies to increase their war chests of reserves and insure against global shocks, and not by utility-maximising decisions of their private sector.
Nevertheless, those inflows contributed to the decline in long-term interest rates and increased risk appetite in many of the advanced economies. The self-reinforcing interaction between risk appetite and liquidity came back with a vengeance. Of course, one should not neglect the domestic inefficiencies in advanced economies that allowed the financial crisis to occur in the first place. That said, the global dimension of the underlying forces is striking.
All of which arguably set the scene for the second round of the Asian Financial Crisis, though this time it would be the developed world edition.
As Cœuré points out, it was the backdrop of depressed yields (generated by the mass capital inflows discussed above) which created the conditions that so readily distorted the incentives of the lender-borrower relationship. In other words, banks didn’t rush into subprime loans because they were greedy and evil, but rather because the conditions they found themselves in made it the most logical course of action.
Banks, essentially, acted as they would always have been expected to act — in line with the incentives at hand. It was the incentives themselves which had been compromised thanks to the massive capital inflows experienced by developed markets in the preceding years.
Which brings us to the Euro crisis, and the role that skewed incentives have also played here:
The ensuing sovereign debt crisis in the euro area can be seen – at least to some extent – through the lens of global liquidity and its cycles. In an environment of abundant liquidity and high risk appetite, sovereign yields in the euro area converged at very low levels. Government bond spreads did not reflect differences in macroeconomic fundamentals. This distorted incentives, both in the public and the private sectors. Sovereigns over-borrowed and put off necessary reforms. In some Member States it was the private sector that took on excessive debt, fuelling unsustainable real estate bubbles which, when they burst, pulled the banking system down and then affected public finances. In other words, abundant liquidity undermined market discipline, which could otherwise have become an important pillar of macroeconomic and fiscal discipline in the euro area.
A fact which leads nicely to today’s shortage of safe assets and its impact on global liquidity:
Financial crises, but also economic downturns in general, trigger a rise in global risk aversion. This in turn induces a flight to safety by global investors, resulting in an excess global demand for safe assets. As an illustration, think of the current nominal yield on some short-term sovereign debt, which is close to zero and has even turned negative in some constituencies. The consequent shortage of safe assets globally, however, is a significant impediment to the functioning of the global financial system. How can we, as policy-makers, address this recurrent problem?
What’s the solution to this vicious liquidity circle? Simple, says Cœuré. The euro area needs to regain its role as a global supplier of safe assets. Something which could be achieved by a) ensuring that Eurozone countries have become fiscally sound and b) diverting excess liquidity from other zones back into “programme countries” by way of the IMF.
As Cœuré explains:
One obvious way to do this would be via the IMF. The IMF could borrow global excess reserves and use them to support programme countries that are suffering from liquidity shortages, under strict conditionality. Restoring confidence in these economies would in turn stabilise regional debt markets and contribute to the global supply of safe assets.
Whilst it might appear a highly controversial move, Cœuré points out that this sort of liquidity diversion would hardly be a large departure from what has already been inacted by central banks via coordinated actions focused on FX swap lines.
Accordingly, it might even be the obvious next step.
Either way the lesson is clear.
Fundamental factors like lax supervision of the banking system and a lack of fiscal discipline clearly played a role in generating the current crisis, but the role played by global liquidity surpluses and deficits was arguably as big if not greater. At the very least it acted as the catalyst which pushed the system’s fault lines to their limits.
And on that note, it’s worth pointing out that the BIS is still trying to figure out what “global liquidity” actually is.