Central banks’ long-evolving codependent relationship with the financial sector is creating a dangerous situation that has echoes of 2008.
After the 2008 global financial crisis, governments and central banks in advanced economies vowed that they would never again let the banking system hold policy hostage, let alone threaten economic and social well-being. Thirteen years later, they have only partly fulfilled this pledge. Another part of finance now risks spoiling what could be – in fact, must be – a durable, inclusive, and sustainable recovery from the horrid COVID-19 shock.
The story of the 2008 crisis has been told many times. Dazzled by how financial innovations, including securitisation, enabled the slicing and dicing of risk, the public sector stepped back to give finance more room to work its magic. Some countries went even further than adopting a “light-touch” approach to bank regulation and supervision, and competed hard to become bigger global banking centres, irrespective of the size of their real economies.
Unnoticed in all this was that finance was in the grip of a dangerous overshoot dynamic previously evident with other major innovations such as the steam engine and fibre optics. In each case, easy and cheap access to activities that previously had been largely off-limits fuelled an exuberant first round of overproduction and overconsumption.
Sure enough, Wall Street’s credit and leverage factories went into overdrive, flooding the housing market and other sectors with new financial products that had few safeguards. To ensure quick uptake, lenders first relaxed their standards – including by offering so-called NINJA (no income, no job, no assets) mortgages that required no documentation of creditworthiness from the borrower – and then engaged in outsize trading among themselves.
Policymakers should act now to moderate the financial sector’s excessive risk-taking.
By the time governments and central banks realised what was going on, it was too late. To use the American economist Herbert Stein’s phrase, “what was unsustainable proved unsustainable”. The financial implosion that followed risked causing a global depression and forced policymakers to rescue those whose reckless behaviour had created the problem.
To be sure, policymakers also introduced measures to “de-risk” banks. They increased capital buffers, enhanced on-site supervision, and banned certain activities. But although governments and central banks succeeded in reducing the systemic risks emanating from the banking system, they failed to understand and monitor closely enough what then happened to this risk.
In the event, the resulting vacuum was soon filled by the still lightly supervised and regulated non-banking sector. The financial sector thus continued to grow markedly, both in absolute terms and relative to national economies. Central banks stumbled into an unhealthy codependency with markets, losing policy flexibility and risking the longer-term credibility that is critical to their effectiveness. In the process, assets under management and margin debt rose to record levels, as did indebtedness and the US Federal Reserve’s balance sheet.