Leaders of the G20 nations will convene in Pittsburgh on September 24-25, about a year since the world’s financial system teetered on the brink of collapse.
The global economy went into deep freeze and, at a G8 meeting in mid-October, leaders issued a communiqué in which they said that they were “united in our commitment to fulfil our shared responsibility to resolve the current crisis, strengthen our financial institutions, restore confidence in the financial system and provide a sound economic footing for our citizens and businesses”. One year on, how have they done?
They certainly succeeded in bringing the financial system back from the brink. Money markets have normalised, capital markets have opened for business again, banks have boosted their capital and earnings, equity markets have risen strongly and now merger and acquisition activity is beginning to pick up.
However, this does not mean that the task of repairing the financial system is done. Consider three principal arguments.
First, the financial system is dysfunctional, dependent and deleveraging. It is dysfunctional to the extent that it is not able or willing yet to intermediate credit freely and independently.
It is dependent on vast liquidity and asset purchase and guarantee programmes. Deleveraging is a slow process, sometimes complicated by accounting practices that prevent full disclosure and recognition of loan losses. While bank balance sheets are being repaired, credit is likely to remain in hibernation. Moreover, apart from the bad loans already sitting on balance sheets, new defaults and losses could intensify if economic growth momentum stalls in 2010.
Second, the agenda for regulatory reform, without which systemic risk will remain, is still being crafted, despite previous assertions about the need for action and speed.
In fact, in the months leading up to the G20 finance ministers’ meeting in London on September 5, it looked as though governments had dropped the ball altogether, whether out of inertia or a failure of political courage.
However, a statement released after the meeting by the Basel Committee on Banking Supervision confirmed that it was working towards several important goals.
These include the introduction of higher and counter-cyclical capital requirements, a change in capital structure that would emphasise common equity and retained earnings, the establishment of a leverage ratio (assets as multiple of capital), minimum standards for funding liquidity (the lack of which is, ultimately, what causes banks to fail) and ways of lowering systemic risk in cross-border banks.
Equally important, the statement said that concrete proposals would be ready by the end of this year. We shall see how progress evolves.
Third, no one seems to be willing to take on the elephant in the room, to which Lord Turner of Ecchinswell recently alluded, namely the consequences of “swollen” size. He referred to the banking sector, but the size of institutions matters more. We have created even bigger banking behemoths as a necessary response to the crisis, but the concentration of risk in a few too-big-to-fail institutions is hazardous and needs to be unwound.
Moreover, it perpetuates practices, including on compensation, that need to change. It would be far more effective if G20 leaders were to seek, as a matter of priority, to break up the biggest banks and promote greater competition in banking along with improved regulation, than for European leaders to play to the political gallery with meaningless platitudes about bankers’ bonuses. Sadly, there is no sign of such intent yet.
With financial stabilisation, the global economy has recovered from excessively depressed levels. Asia is leading the charge, but the recession in richer nations ended this summer. Changes in several key indicators have been impressive, tracing out an unexpected V-shape.
In the second half of 2009, prepare to be surprised again. The bounce from depressed levels, the temporary effect of inventory rebuilding and the continuing effects of fiscal and financial stimulus could drive economic growth a little faster than people expect.
The real issue, though, is not about this sort of recovery but about whether it can develop into a sustainable expansion. Here the prospects are rather gloomier.
Economic performance will be restrained by the eventual withdrawal of policy stimulus, aka exit strategies. Some financial programmes in the United States are already being phased out.
The tightness of fiscal policy will be the centrepiece of Britain’s election campaign in 2010, for example, and the money markets already think that the Bank of England and other central banks will be raising interest rates from June next year.
The loss of leverage and borrowing as growth drivers will continue while bank and household balance sheets are being repaired. Note that in July, for the first time, British households paid off more mortgage debt than they acquired new loans.
American households paid off consumer debt for the sixth consecutive month in the largest and longest pay-down since records began in the late 1940s.
The baby boomers, the driving force of the expansion of the past 25 years, are now heading off into retirement. Because of weak fertility, the boomers aren’t going to be replaced fully, or at all, and so we are losing an additional key growth driver.
These constraints mean that economic growth is likely to be anaemic and, for a while, at least, it may resemble Japan’s experience from 1989 to 2008 of a succession of U-shaped cycles, in which underlying growth amounted to 1.1 per cent per year.
So while the G20 leaders are in Pittsburgh, they should look around the “Steel City’ and understand how this fallen industrial star is surviving the recession better than many American cities and is reinventing itself and its labour force in medical science, education services and the green and high-technology sectors.
If they really want to “provide a sound economic footing for our citizens and businesses”, the policies of financial repair and healing need to be more assertive and augmented by employment-generative economic programmes, and strategies to harness new technologies to drive the next expansion.
• George Magnus is senior economic adviser, UBS Investment Bank, and author of The Age of Aging (2008)
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