Bubble trouble: We're sacrificing financial stability for a growth illusion

 
Bob Swarup

THERE is a growing conflict at the heart of economic policymaking – and a rising danger. The risk is that financial stability is being sacrificed on the altar of growth, and that memories of the financial crisis are growing short. Consider these recent disparate examples.

Mario Draghi has boldly gone where no G7 central banker has gone before, introducing negative rates to fight deflation and encourage bank lending. It wasn’t the QE many hoped for, but sovereign yields shrank to multi-century lows. China agreed, easing lending restrictions on commercial banks, despite concerns about the sustainability of growth. The Fed continues to taper (though the current $45bn monthly asset purchases are still more than the last round of QE). But it also signalled it may impose its own capital regime on financial institutions and has approved tougher rules for the largest banks. The resulting shortfall: an estimated $68bn for holding companies and $95bn for subsidiaries. The industry argues this could hurt the economy by reducing the banks’ ability to lend.

Meanwhile, Boston Consulting Group estimates that private wealth advanced 15 per cent globally over 2013 to a staggering $152 trillion. The main driver – the average 21 per cent gain in stock markets and the rise in asset prices. The World Bank, however, has revised down its 2014 global growth forecast.

For policymakers, the narrative goes something like this. Use loose policy to encourage lending and entice back growth. Meanwhile, rely on regulation and macro-prudential policy to manage the risks of future bubbles and maintain financial stability. Keep a watchful eye on banks’ activities, reduce the size of balance sheets, and ensure they hold buffers against future black swans.

It’s a compelling narrative. It is also a wonderful exercise in cognitive dissonance that does not fit the facts. Instead, there is a looming dilemma of where to draw the line between making the financial system safer and maintaining growth.

Financial stability and growth are fundamentally opposed. When financial crises hit, liquidity vanishes and the price of risk rapidly rises. This is directly related to the vulnerability of the financial system. Thus, a more leveraged system or one with easy provision of credit will likely face far greater disruption.

The logical incentive for policymakers is to minimise potential disruption. But to do this means ensuring that credit is far less easily available, leverage is lower and so on. Lowering systemic risk implies a higher cost of capital and tighter financial conditions. This may be a safer financial system, but it is also one with a harder journey to stimulating growth and increasing employment.

Unfortunately, economic policy does not live in a vacuum. It is a prisoner to conflicting socio-economic and political pressures. Its rules are also written, interpreted and executed by people, who can and do change their minds.

Six years on, an anaemic global GDP recovery means the incentives have shifted. Growth is a political imperative. While banks are under pressure to strengthen balance sheets, they are also being asked to lend more to key political sensitivities such as small businesses. These are dissenting priorities that cannot co-exist, particularly given banks’ own pressures from shareholders.

As memories grow short, politicians are increasingly focused on recovery by any means. And stimulus and debt-fuelled growth is far easier to ignite and faster to kickstart than organic growth.

Monetary support eases debt burdens and servicing. At the same time, artificial distortions in interest rates themselves distort market psychology. As markets adjust to a new paradigm, it becomes easy to extrapolate current support into a distant horizon and assume that stimulus will always be as easy and effective in future iterations. Alongside, in a low yield and low growth world, any opportunity for return sparks a stampede among investors.

All of this is positive for asset prices. This should not be confused with growth, however, notwithstanding talk of nebulous wealth effects and growing confidence. Rather, they represent a succession of new asset bubbles and increased systemic risk.

Unfortunately, pricking these bubbles is an unpalatable political risk, particularly given electoral myopia. Burst the housing bubble, and you risk another debt deflation downturn. Kill the equity markets and worry about the effect on confidence. Pursue stability and you may find yourself out of power.

This is a battle that proponents of financial stability are doomed to lose. Human behaviour habitually trumps analysis. As growth returns, memories will grow short. Regulation – asphyxiating in any case under onerous complexity – will be emasculated.

Meanwhile, macroprudential policy remains an untested tool. Questions persist over whether the political courage exists to pull the trigger on hard decisions that might brake markets or growth in the short term.

We will have booming financial markets. We will have growth. But we are still unlikely to have stability.

Dr Bob Swarup is a fellow at the Institute of Economic Affairs, and author of Money Mania: Booms, Panics and Busts from Ancient Rome to the Great Meltdown (Bloomsbury, 2014). swarup@camdorglobal.com.