Excerpt
The Only Game in Town
Chapter 1
Setting the Stage
“Like ancient doctors, who tried to explain the causes of diseases while knowing nothing about germs or bacteria, academics sought to describe the functioning of developed economies while ignoring the financial sector and the risks it contained.”
—Ferdinando Giugliano
This is a pivotal moment for the global economy. Our romance with the financial service industry—“finance”—has come crashing down in the midst of loud recriminations. With trust broken and the blame game continuing, it is simply not feasible to restore a close and warm relationship, and any relationship that does survive certainly shouldn’t be as intimate and exclusionary as the one that prevailed in the run-up to the 2008 global financial crisis. Yet breaking up is also not an option. The interconnectedness and interdependencies among real economies and the financial system are too deep for them to ever go their own separate ways—and so their interaction is still critical in determining growth, jobs, and financial stability.
Recognizing the importance for both current and future generations of establishing a better working relationship between global economics and global finance, central banks have been working overtime since the global financial crisis to buy time. They have engaged in a series of unprecedented policy initiatives using experimental measures—and taking enormous risks.
The stakes are extremely high and, as yet, no specific outcome is preordained—if only because, acting on their own, central banks cannot deliver the needed good outcome involving that important and quite elusive combination of high and inclusive growth, plentiful well-paying jobs, low and stable inflation, and genuine well-anchored financial stability. Governments and politicians need to be more constructively engaged in the endeavor with central banks, and we, as individuals, through our preparedness and actions, also have a lot to do with what eventually transpires in the collective effort to overcome the damage left by the failed romance.
Parts of the global economy are healing and regaining their composure, led by the United States. But others, such as countries in Europe and Japan, continue to languish and are still a ways from decisively turning the corner. Still others, such as Greece and Venezuela, face the imminent risk of awful tipping points. Meanwhile, a less than fully rehabilitated financial sector continues to deliver one anomaly after the other. These are not just confined to obscure technical corners. They are visibly relevant for you—whether you are an investor looking for relatively safe returns on your savings, a small company looking for working capital, or a family looking to reclaim your financial destiny and establish a durable sense of long-term stability and security.
There was a time—and it was not so long ago—when governments would pay you interest income in order to convince you to hold the bonds they issued to finance their spending overages. After all, shouldn’t you be compensated for assuming risks for your money? Today a sizable amount of government bonds in Europe is trading at negative nominal yields—that is to say, investors are paying governments for the opportunity to lend them money!
There was a time—and, again, it was not so long ago—that banks would compete for your deposits. From free toasters to cash handouts, they were eager to get their hands on your money. It is no longer the case. A growing number of banks in Europe and, now, in the United States actively pursue approaches to discourage deposits.
There was a time when society trusted the banking system’s role in channeling loanable funds to productive uses, and society trusted the regulatory and supervisory skills of governments and central banks. This went out the window when banks’ irresponsible risk taking, coupled with lax regulation, took the world economy to the edge of a great depression. It will take a long time to restore the trust. In the meantime, alternative platforms, such as Lending Club and Payoff, are springing up and looking to better connect marginalized borrowers and lenders.
And there was a time when the political system celebrated central banks, respecting their technical expertise and trusting them with enormous operational autonomy. This is less so today. On both sides of the Atlantic, there are recurrent political efforts to subject these influential institutions to greater oversight and auditing.
All this speaks to a much deeper and more consequential phenomenon. As stable as it may seem on the surface to some, the current configuration of the global economy and the financial system is getting harder to maintain. Below the façade of the unusual calm of the last few years, interrupted by relatively few bouts of instability since 2008–09, tensions are rising and the effectiveness of central banks is coming under stress, so much so as to raise serious questions about the durability of the current path that the global economy is on.
This is both good and bad news.
It is good news because it provides a window for us to exit a frustratingly prolonged phase of economic mediocrity and artificially priced financial markets—one that has been dominated by a global economy that operates well below its potential, thereby holding back job creation, fueling political dysfunction, contributing to geopolitical tensions, and aggravating inequalities.
Already there is unusual consensus among economists on the components of a durable solution. Its impact would be turbocharged by exciting innovations and the engagement of lots of cash that is currently sitting on the sidelines or being used defensively. All it takes is for our politicians to step up to their national, regional, and global responsibilities—by pursuing more comprehensive national policy agendas, by coordinating better regionally, and by improving global policy cooperation; and for the private sector to respond to a more enabling environment, including deploying more of its accumulated cash into productive activities.
The bad news is that politicians don’t have a great track record of pursuing comprehensive solutions in recent years, and the more the national agendas struggle, the harder it is to coordinate and cooperate across borders. Meanwhile, acting on its own, the private sector as a whole is unable to deliver the decisive breakthroughs needed for economic liftoffs; the pockets of excellence that are delivering transformation benefits are unlikely to have as much impact as they could and should; and some could even be contaminated by the challenging neighborhood.
If we fail to pivot to better outcomes we risk losing generations of economic growth. In addition to alarmingly high pockets of youth unemployment, financial instability, and a real sense of insecurity for many, this would reduce the potential for future growth. Political polarization, dysfunction, and gridlock would grow, as would geopolitical tensions, inequalities, and alienation, all of which will affect millions of young and old around the world.
The central banking community has worked notably hard trying to tip the balance in favor of the successful outcome. Acting both individually and collaboratively, they have bought time for the private sector to heal and for politicians to get their act together, and this after they acted boldly to help the world avoid what would have been an incredibly damaging multi-year depression.
While we should be thankful and praise central banks for their involvement, we must also recognize that their effectiveness is waning, and not surprisingly so, since they could use only the limited instruments available to them. As such, today’s global economy is best viewed as traveling toward what the British call a “T junction.” That is to say, the current road we are on, one engineered and maintained by hyperactive central banks, will likely end within the next three years, if not earlier, to be replaced by one of two roads that fundamentally contrast in their implications and destinations.
One road out of the T junction ahead involves a restoration of high-inclusive growth that creates jobs, reduces the risk of financial instability, and counters excessive inequality. It is a path that also lowers political tensions, eases governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats.
The other road is the one of even lower growth, persistently high unemployment, and still worsening inequality. It is a road that involves renewed global financial instability, fuels political extremism, and erodes social cohesion as well as integrity.
At this stage, there is about equal probability of these two very different outcomes. But both the public and the private sector have the potential to determine which of these two roads will eventually become our course. And it is only by better understanding this most recent, rather unusual, phase of economic and financial history that we can tip probabilities in favor of the better road out of the T.
We can—and must—do everything possible to steer ourselves onto the better road, thereby unleashing the untapped potential of so many people around the world, and, most important, the under- and unemployed youth. Nothing today is more consequential.
Chapter 2
The Only Game in Town
“Sometimes it is the people who no one imagines anything of who do the things that no one can imagine.”
—The Imagination Game (film)
“In recent years monetary policy has been the rich world’s main, and often only, tool to support growth.”
—The Economist
On a rather pleasant November day in Paris, Christian Noyer, the respected governor of France’s central bank, welcomed participants to the Banque de France’s International Symposium “Central Banking: The Way Forward?” A who’s who of the central banking world was gathered to hear him and to participate in the 2014 edition of this prestigious symposium held at the Westin hotel, substituting for the more ornate Banque de France room, which was being renovated.
Sitting in a rather intimate setting were many central bank governors from both advanced and developing countries. Janet Yellen, the chair of the U.S. Federal Reserve, was there along with several of the presidents of the regional Feds. Bank of England governor Mark Carney and Governor Raghuram Rajan of the Indian central bank were also there, as were other governors from Africa, Asia-Pacific, Latin America, and the Middle East.
This impressive gathering of officials was joined by leading academics, thought leaders, and commentators on monetary policy. Private sector participants from major financial firms were also there, as were members of the media (though, due to space constraints, most had been seated in the balconies overlooking the nearly overflowing room).
Presenting his preview of the day’s much-anticipated panels, Governor Noyer verbalized up front what many in the room viewed as both the strength and weakness of modern-day central banking. Acknowledging that “central banks have been considered the only game in town,” he wondered whether “the very high expectations placed on them [might] backfire in the future.”
The participants had no way of knowing that just a few weeks later, the world of central banking would be shaken, and not by the actions of large institutions but rather by the unexpectedly abrupt and surprising behavior of smaller ones whose brands and reputation had been carefully aligned for many years—at least until then—to be synonymous with stability and predictability.
In the span of a few weeks, the Swiss National Bank would suddenly dismantle a key element of its exchange rate system, and do so in what proved to be an incredibly disruptive manner for markets; Singapore would alter its own exchange rate system; and Denmark would declare that it would refrain from issuing any more government bonds.
The next few weeks would also witness a market collapse in government yields, including negative levels all the way out to the nine-year point in the German yield curve and the benchmark ten-year bond there trading at just five basis points (that is, 0.05 percent). They would see investors rush to buy many newly issued bonds directly from some European governments, agreeing to pay (rather than receive) interest income for doing so. And they would witness large banks actively discourage depositors from keeping money with them.
These were just some of the many unthinkables. Switzerland’s negative interest rate structure would surpass that of Germany as the central bank there battled hard to weaken the Swiss franc, long seen as an indisputable currency of strength. Even rates on more “risky” European government securities, such as those issued by Italy and Spain, would reach ultralow record levels, while Greece, another “European peripheral,” would face the risk of economic implosion and threaten to default on loan payments to the International Monetary Fund, one of the world’s very few “preferred creditors.” (Greece did eventually default on those payments for a short period.)
Adding to the unthinkables, the Swedish central bank would join Denmark and Switzerland in opting for negative policy interest rates. Commenting on this, one observer noted that there was “no history book to turn to,” adding that it was “like learning to drive backwards.”
The world of modern central banking and global finance was evolving in previously unthinkable ways. It had now entered a new phase of even more obvious artificiality and distortions. And it was doing so in a manner that both fascinated and deeply troubled me.
Reflecting my economics training and professional experiences in both the private and public sectors, I had grown to greatly admire central banks and cherish the important way they contribute to economic well-being. I had no doubt about their critical importance in any well-functioning ecosystem, and especially in a market-based economy.
Over the years, I had also developed quite a bit of affection for those mysterious and often ill-understood institutions of economic and financial soundness—ones whose skillful management of the price and quantity of money in an economy was key to containing inflation, promoting economic growth, and avoiding financial crises. And I had lots of respect for the very talented technocrats who were devoted to their important jobs there (and often underappreciated for the good they were responsible for).
Because of all this, I had become increasingly anxious about the growing policy burden placed on central banks, including the consequences for their future credibility, impact, and reputation. Their operational prospects were becoming more uncertain by the day. Their continued efforts since the global financial crisis to repress market volatility and promulgate a paradigm of “liquidity-assisted growth”—that is, economic growth derived from financial market booms buoyed by exceptional liquidity infusions (rather than fundamental drivers)—was failing to transition fast enough to “genuine growth” and orderly policy normalization. Meanwhile, a growing number of politicians were looking into ways to rein in the operational autonomy of central banks—an autonomy essential to their effectiveness.
Ever since the 2008 global financial crisis, central banks had ventured, not by choice but by necessity, ever deeper into the unfamiliar and tricky terrain of “unconventional monetary policies.” They floored interest rates, heavily intervened in the functioning of markets, and pursued large-scale programs that outcompeted one another in purchasing securities in the marketplace; to top it all off, they aggressively sought to manipulate investor expectations and portfolio decisions.
Because all this was so far away from the norm, neither central banks nor anyone else, for that matter, had tested playbooks and historical precedents to refer to. It was bold policy experimentation in real time, and for an unusually prolonged period of time.
