If you are looking for something utterly terrifying to watch this Halloween season, check out Mervyn King’s speech at the IMF from a couple weeks ago.
The former Bank of England governor used his lecture slot at the IMF’s annual meetings to not only cast doubt on the soundness of the American financial system, but also on the safety and soundness of the global financial system as a whole—shocking those in attendance and questioning whether the safeguards put in place since the Great Recession actually promote a more robust financial system.
“Another economic and financial crisis would be devastating to the legitimacy of a democratic market system” he said. “By sticking to the new orthodoxy of monetary policy and pretending that we have made the banking system safe, we are sleepwalking toward that crisis.”
Now at first glance, such rhetoric seems unnecessarily dramatic—especially from a seasoned veteran like King. But this is a man who has lived “central banking during crisis,” and if anyone knows what it takes to bring a developed economy to its knees, it’s him.
I have disagreed with King on some issues in the past, but he is not wrong about the serious vulnerabilities that currently exist in our financial and regulatory systems. Take, for instance, Dodd-Frank. Dodd-Frank was undoubtedly a landmark piece of legislation that drastically improved how the US supervises large banks, but because the law removed any possibility of future bailouts—even when doing so is in the best interest of the country—regulators only added greater risk to the US financial system. This policy error manifested when Congress assumed that, by ending bank rescue packages, banks would take on less risk, which would in turn reduce the number of bank failures. In reality, however, ending bailouts only reduced the options policymakers have when banks inevitably need rescuing.
But the common drawback with bailouts —especially for politicians — is that, even if taxpayers end up making a profit, voters hate them. When we rescued the banks in 2008, it angered many hard working, middle class people and created divisions within our society that potentially fueled the populist attitudes we see today. More often than not, however, saving the institutions that provide vital funding to our economy is a prudent policy decision. King touched on this during his IMF speech, saying: “It is hardly surprising that such interventions have proved highly unpopular. Yet without them, the financial system and the wider economy would have collapsed.”
I agree with King’s assessment, but it’s not as if regulators can’t do things to make bailouts a less frequent occurrence. For example, by improving how they conduct bank supervision, the agencies responsible for ensuring financial stability here in the US have added impressive safeguards since 2008 — many of which make banks far less vulnerable to market disruptions and much more prepared for low probability events like those witnessed in the fall of 2007. A couple examples are stress tests and living wills, both of which have been regarded as primary lines of defense against future crises.
But King argues these measures have given policymakers a false sense of security, making them lazy and ill prepared for the next downturn. He thinks policymakers should direct more attention to what he believes is a much more pressing and ubiquitous challenge, one that makes reverting recessionary forces even harder: persistent low growth.
Surprised by how little attention policymakers have given to the problem of secular stagnation (low growth over the long term), King is concerned that the usual prescriptions for stimulating growth during times of economic weakness — lowering interest rates, cutting taxes, increasing deficit spending, etc. — are becoming increasingly antiquated, especially since most of the developed world has already incorporated such measures and growth remains relatively low. In addition, he thinks we may be reaching a limit to what can be achieved through monetary stimulus and says a more tailored fiscal approach is necessary for increasing demand, particularly in sectors that have struggled in recent years.
To put it simply: economic growth is becoming harder to attain; twentieth century policy prescriptions won’t provide the returns necessary to stem a global downturn; and a new monetary doctrine is needed.
But rather than being a terrified teenager eagerly waiting for a horror film to end, we should take heed of this warning. If economic growth is going to regain its crown as the ultimate crisis defense, rather than relying solely on monetary measures to return economies to steady growth paths, policymakers should begin incorporating more sectoral approaches when drafting fiscal policies.
Further, we need to come to terms with the fact that financial systems are precarious networks, and the last thing we should do in a crisis is tie our hands by removing the possibility of government intervention.
The next recession will bring many challenges, but as King outlined, there is plenty we can do before then to make navigating those challenges easier. I only hope our leaders are listening.