Lehmann Lesson or "Was the Financial Crisis Wasted"?

Though it has now been a decade since the collapse of Lehman Brothers, lingering questions about the global financial crisis remain. Chief among them is whether it can happen again.

In this Big Picture, Howard Davies laments that despite the global nature of the crash, financial regulations have yet to be harmonized internationally. And Jeffrey Frankel warns that the US is now pursuing the same kind of pro-cyclical fiscal agenda that had tied its hands in 2008.

Meanwhile, Richard Kozul-Wright argues that the post-crisis response has done nothing either to change the culture of the financial sector or to prevent a massive build-up of global debt. And, as Carmen Reinhart pointed out last year, the loose monetary conditions that have made legacy debts from the crisis more manageable are now coming to an end.

For his part, Jim O'Neill worries that while the global imbalances that gave rise to the crisis have been addressed, a dangerous short-term outlook still drives business. And Harold James adds that the problem is not just business practices, but also the broader cultural impact of rapid technological change and disruption. While financial regulation has been materially strengthened since the 2008 crisis, its implementation remains in the hands of a patchwork quilt of national agencies. The resulting structural diversity of post-crisis reforms does not help ensure consistency in the implementation of global standards. As the tenth anniversary of the start of the global financial crisis approaches, a wave of retrospective reviews is bearing down on us. Many of them will try to answer the Big Question: Has the financial system been fundamentally reformed, so that we can be confident of preventing a repeat of the dismal and destructive events of 2008-2009, or has the crisis been allowed to go to waste? There will be no consensus answer to that question. Some will argue that the post-crisis reforms, especially those concerning banks' capital requirements, have gone too far, and that the costs in terms of output have been too high. Others will argue that far more must be done, that banks need far higher capital, and possibly, as the proponents of a recent Swiss referendum argued, that banks should lose their ability to create money. But any reasonable observer must acknowledge that there has been a very significant change. Most large banks now have 3-4 times as much capital, and of far higher quality, than they had in 2007. Additional buffers are now required in systemic institutions. Risk management has been greatly strengthened. And regulatory intervention powers are far more robust. Political support for tough regulation remains strong, at least everywhere except the United States, and even there the Trump administration's measures have mainly benefited community banks, not Wall Street. There is one area, however, where far less has been achieved. As former US Federal Reserve board chair Paul Volcker has observed, "virtually every post-mortem of the financial crisis cites the convoluted regulatory system [in the US] as a contributory factor in the financial meltdown." Yet the 2010 Dodd-Frank legislation, which sought to address the shortcomings exposed by the financial crisis, made very few changes. It abolished only one small agency, the unlamented Office of Thrift Supervision, and added another, the Consumer Financial Protection Bureau, a body so little loved by the current administration that one wonders about its longevity. The convolution highlighted by Volcker was not addressed. His verdict today is that "the system for regulating financial institutions in the US is highly fragmented, outdated, and ineffective." Aside from that, all is well! The US is undoubtedly an outlier. What of the rest of the world? There have been a few changes, perhaps most notably in the United Kingdom, where we enjoy rearranging institutional deck chairs. The functions of the fully integrated Financial Services Authority (of which I was the first chair) have been returned to the Bank of England or reallocated to the Financial Conduct Authority. A recent study by the Financial Stability Institute, established by the Bank for International Settlements and the Basel Committee on Banking Supervision, concludes that 11 of the 79 countries assessed have made some changes. Interestingly, despite the UK reform, the weak international trend remains toward integrated regulation, and away from the traditional model whereby different agencies regulate insurance and securities, while the central bank oversees the banking system.

But there remains a remarkable diversity of practice worldwide. Of the 79 countries, 39 still operate a three-way sectoral breakdown, and 23 have integrated agencies (nine of which double up as the monetary authority). Nine others have two agencies divided along sectoral lines, and eight have chosen a so-called Twin Peaks system, with one agency handling capital-market regulation and the other overseeing business conduct. One might have expected that some degree of agreement would have emerged from an analysis of what did, and did not, work in the crisis. But there is little sign of it. The conclusions of what analysis there has been are somewhat ambiguous. It is hard to say that one structure worked better than another in every place. But there are some suggestive assessments. An International Monetary Fund study of pre-crisis regulation concluded that "countries with integrated supervisory agencies [at that time generally outside the central bank] enjoy greater consistency in quality of supervision." In other words, their compliance with Basel-set standards was more rigorous. Yet, where changes have been made since the crisis, central banks have typically been given greater powers. This structural diversity of post-crisis reforms does not help ensure consistency in the implementation of global standards. It is particularly problematic in the European Union. There is now a banking union in the eurozone, but supervisors in around half of the member states are in the central bank, while they are outside it in the other half. Is there not a job here for the Financial Stability Board? Could the FSB not review practices and point to a preferred structure, or at least some non-preferred ones? There is, unfortunately, no appetite there for picking up that thistle. National supervisors have no interest in criticizing their own systems. The Financial Stability Institute's review showed a bit more courage. Reading between the lines, the authors think little of the sectoral model, but their anticlimactic conclusion is only that "it looks worthwhile to regularly conduct assessments of the functioning of the supervisory architecture in each jurisdiction in the light of prevailing objectives." Who could disagree with that? The authors were clearly mindful that every academic paper worth its salt ends with a plea for more  research. So we seem set to limp along with a highly diverse system. Even the 2008 financial crisis did not dislodge the vested interests in many countries. So while financial regulation has been materially strengthened, which is clearly the most important thing, its implementation remains in the hands of a patchwork quilt of national agencies.

'Dr.Doom' Sees The Makings Of A 2020 Recession & Financial Crisis

Although the global economy has been undergoing a sustained period of synchronized growth, it will inevitably lose steam as unsustainable fiscal policies in the US start to phase out. Come 2020, the stage will be set for another downturn – and, unlike in 2008, governments will lack the policy tools to manage it.

As we mark the decennial of the collapse of Lehman Brothers, there are still ongoing debates about the causes and consequences of the financial crisis, and whether the lessons needed to prepare for the next one have been absorbed. But looking ahead, the more relevant question is what actually will trigger the next global recession and crisis, and when.

The current global expansion will likely continue into next year, given that the US is running large fiscal deficits, China is pursuing loose fiscal and credit policies, and Europe remains on a recovery path. But by 2020, the conditions will be ripe for a financial crisis, followed by a global recession.

There are 10 reasons for this.

First, the fiscal-stimulus policies that are currently pushing the annual US growth rate above its 2% potential are unsustainable. By 2020, the stimulus will run out, and a modest fiscal drag will pull growth from 3% to slightly below 2%.

Second, because the stimulus was poorly timed, the US economy is now overheating, and inflation is rising above target. The US Federal Reserve will thus continue to raise the federal funds rate from its current 2% to at least 3.5% by 2020, and that will likely push up short- and long-term interest rates as well as the US dollar.

Meanwhile, inflation is also increasing in other key economies, and rising oil prices are contributing additional inflationary pressures. That means the other major central banks will follow the Fed toward monetary-policy normalization, which will reduce global liquidity and put upward pressure on interest rates.

Third, the Trump administration's trade disputes with China, Europe, Mexico, Canada, and others will almost certainly escalate, leading to slower growth and higher inflation.

Fourth, other US policies will continue to add stagflationary pressure, prompting the Fed to raise interest rates higher still. The administration is restricting inward/outward investment and technology transfers, which will disrupt supply chains. It is restricting the immigrants who are needed to maintain growth as the US population ages. It is discouraging investments in the green economy. And it has no infrastructure policy to address supply-side bottlenecks.

Fifth, growth in the rest of the world will likely slow down – more so as other countries will see fit to retaliate against US protectionism. China must slow its growth to deal with overcapacity and excessive leverage; otherwise a hard landing will be triggered. And already-fragile emerging markets will continue to feel the pinch from protectionism and tightening monetary conditions in the US.

Sixth, Europe, too, will experience slower growth, owing to monetary-policy tightening and trade frictions. Moreover, populist policies in countries such as Italy may lead to an unsustainable debt dynamic within the eurozone. The still-unresolved "doom loop" between governments and banks holding public debt will amplify the existential problems of an incomplete monetary union with inadequate risk-sharing. Under these conditions, another global downturn could prompt Italy and other countries to exit the eurozone altogether.

Seventh, US and global equity markets are frothy. Price-to-earnings ratios in the US are 50% above the historic average, private-equity valuations have become excessive, and government bonds are too expensive, given their low yields and negative term premia. And high-yield credit is also becoming increasingly expensive now that the US corporate-leverage rate has reached historic highs.

Moreover, the leverage in many emerging markets and some advanced economies is clearly excessive. Commercial and residential real estate is far too expensive in many parts of the world. The emerging-market correction in equities, commodities, and fixed-income holdings will continue as global storm clouds gather. And as forward-looking investors start anticipating a growth slowdown in 2020, markets will reprice risky assets by 2019.

Eighth, once a correction occurs, the risk of illiquidity and fire sales/undershooting will become more severe. There are reduced market-making and warehousing activities by broker-dealers. Excessive high-frequency/algorithmic trading will raise the likelihood of "flash crashes." And fixed-income instruments have become more concentrated in open-ended exchange-traded and dedicated credit funds.

In the case of a risk-off, emerging markets and advanced-economy financial sectors with massive dollar-denominated liabilities will no longer have access to the Fed as a lender of last resort. With inflation rising and policy normalization underway, the backstop that central banks provided during the post-crisis years can no longer be counted on.

Ninth, Trump was already attacking the Fed when the growth rate was recently 4%. Just think about how he will behave in the 2020 election year, when growth likely will have fallen below 1% and job losses emerge. The temptation for Trump to "wag the dog" by manufacturing a foreign-policy crisis will be high, especially if the Democrats retake the House of Representatives this year.

Since Trump has already started a trade war with China and wouldn't dare attack nuclear-armed North Korea, his last best target would be Iran. By provoking a military confrontation with that country, he would trigger a stagflationary geopolitical shock not unlike the oil-price spikes of 1973, 1979, and 1990. Needless to say, that would make the oncoming global recession even more severe.

Finally, once the perfect storm outlined above occurs, the policy tools for addressing it will be sorely lacking. The space for fiscal stimulus is already limited by massive public debt. The possibility for more unconventional monetary policies will be limited by bloated balance sheets and the lack of headroom to cut policy rates. And financial-sector bailouts will be intolerable in countries with resurgent populist movements and near-insolvent governments.

In the US specifically, lawmakers have constrained the ability of the Fed to provide liquidity to non-bank and foreign financial institutions with dollar-denominated liabilities. And in Europe, the rise of populist parties is making it harder to pursue EU-level reforms and create the institutions necessary to combat the next financial crisis and downturn.

Unlike in 2008, when governments had the policy tools needed to prevent a free fall, the policymakers who must confront the next downturn will have their hands tied while overall debt levels are higher than during the previous crisis. When it comes, the next crisis and recession could be even more severe and prolonged than the last.