Today we are fortunate to present a guest contribution written by Alessandro Rebucci, Associate Professor, and Jiatao Liu, at the Carey School of Business at Johns Hopkins University.
This month marked the beginning of the 10th year since the collapse of Lehman Brothers, which triggered the most acute phase of the U.S. subprime financial crisis. The United States is still coping with the consequences of the ensuing great recession, and its policymakers have spent the past decades reining-in an overgrown financial system. Over the past 10 years, in contrast, China’s policy makers have worked toward getting the domestic financial system off the ground and connecting it with global capital markets. This is an opportune time to take stock of what lessons can be drawn for China from the American experience.
- Mind the regulatory “perimeter.” In the U.S., a too-narrowly defined regulatory perimeter around traditional banks gave pervasive incentives to shift activity and risks outside it in the so-called shadow banking system. Until recently, regulation of the banking system in China was repressive and it continues to be much stricter than in the United States. As a result, over the past 10 years, shadow banking has exploded in China to circumvent strict credit and interest rates controls. An innovative, efficient financial system has now developed. But risks and vulnerabilities have grown dramatically alongside with it. The latest of these is a huge bubble in crypto currencies to avoid restrictions on capital outflows.
- Watch for “excesses” in the real estate sector. Real estate is the largest asset class in households’ portfolios, an important market segment for financial businesses, and a key source of revenue for local administrations in the United States, as in China. Once imbalances build, they unwind very slowly, affecting the economy for a very long time. Real estate crises affect banks and take much longer to resolve than a crisis in the stock or FX market, like the ones experienced by China in 2015. In China, real estate boomed during the past 10 years, fueled by an extremely fast urbanization and rapid income growth, but also by abundant credit, lack of diversification opportunities, and restrictions in the budgeting process of provinces and cities.
Figure 1. Leverage shock. Note: 1 Percent increase in the leverage. Real exchange rate, an increase is a depreciation.
- Keep the financial system simple. Complexity is difficult to evaluate and distorts financial decisions. While the regulator may have a good sense of the total quantity of systemic risk, monitoring its distribution and concentration is nearly impossible. Complexity also impedes efficient intermediation and liquidity provision. For instance, while there are potentially enormous benefits from the emergence of a thriving fin-tech industry, fin-tech increases add to complexity by posing operational and technology risks of different orders of magnitude.
- Financial crises are costly, and these costs are not spread evenly. Crises disproportionally harm the young and the old. Younger workers are the first to be laid off and, because of their lack of experience, find it hard to regain employment. An entire cohort of high school, college, and MBA graduates saw a sharp deterioration in their lifetime earnings over the past several years in the U.S.. Older workers in those same households saw not only their lifetime savings but also their prospects of reemployment vanishing with the crisis. Financial crises increase income inequality and hurt the poor disproportionately because they have worse access to social protection, medical insurance, and access to credit. Ultimately, financial crises cost the jobs of the politicians at the helm of society. The new waves of protectionism and populism in the U.S. and Europe owe much more to the global financial crisis than to the merits of those economic and political ideas.
- A government-run financial system is not immune from trouble. Using public financial enterprises to cushion the blow, such as the U.S.-sponsored enterprises Fannie Mae and Freddie Mac, shield the national budget from the credit rating agencies but it is short-sighted. Using GSEs to keep the financial system afloat, like regulatory forbearance, saved costly capital and scarce liquidity resources during the crisis, but undermined their long-term financial independence and hence their support role for the efficient allocation of credit risk in the US system. One bequest of the U.S. crisis has been the politically intractable issue of GSE reform: once scaled up to resolve the crisis, scaling down this type of government intervention does not take years, but decades, and is a politically charged enterprise.
- Macro-prudential policy is not a silver bullet. In the presence of financial excesses, monetary policy might have to be tighter than what it would be, based only on business cycle conditions. In theory, macro-prudential policy could target financial excess, and monetary policy the business cycle, but it is hard to find effective tools and even harder to know how to adjust them over the cycle. In the United States, regulatory tools to moderate the financial cycle in the run-up to the crisis were available, but were perceived to be ineffective. The short-term interest rate was the only instrument that could have gotten get into all cracks of the financial system and provide incentives to internalize risks and externalities. In the run-up to the crisis, some feared introducing distortions in the broader economic system by using monetary policy to address the problems of a specific sector. It is now well understood that monetary policy has to trade off economic and financial stabilization gains in the presence of distortions in financial intermediation.
Figure 2. US Mortgage and Treasury Rates.
- Read carefully your brokerage statement, your mortgage contract and your lease. Financial literacy and consumer protection are as important as financial innovation and development for efficient and safe intermediation. At the core of the U.S. crisis were also outright fraud and the financial illiteracy on which fraud thrives. A domestic financial system that is dynamic and innovative supports and facilitate consumers’ risk sharing and firms’ investments. But efficiency also requires information and the ability to process it. Promoting financial literacy and protecting consumers from fraud and predatory lending is all the more important in a fast- growing system such as China’s.
- When the intermediaries are big, they are too big to fail. We don’t know what the optimal size of banks and financial intermediaries is. Financial intermediation needs economies of scale to reduce costs and operate efficiently. But excessively large financial institutions are hard to liquidate in the case of insolvency, like Lehman Brothers, AIG, and other entities that had be resolved during the U.S. crisis. They also create pervasive moral hazard problems in the system. This challenge is compounded by concern for monopolistic behavior in China’s mushrooming fin-tech industry. While still a relatively small-scale industries in the U.S., crowd sourcing, P2P lending, mobile payment systems, and crypto currencies have already grown into big businesses in China with high concentration and astonishing penetrations shares among households and firms.
- If a crisis struck, it would need to be resolved as quickly as possible. The speed, size, and momentum of the policy intervention matters for the final outcome. Crisis resolution interventions must be fast, larger than strictly necessary to resolve the problem, and sustained past the immediate urgency. While the U.S. monetary policy response to the subprime crisis was very different from the Federal Reserve’s response to the Great Depression of the 1930s, the fiscal policy response got stuck in the legislative process. The result has been an anemic recovery and lingering fears of relapse, which lasted well after the recession was officially over. In contrast, China’s intervention in the equity and foreign exchange market in 2015, while heterodox and hence problematic in a nascent financial system, was massive and decisive, which explains why it succeeded despite its shortcomings.
- No crisis is alike. The next financial crisis in the United States will be different from the previous one. Policy makers sometime sow the seeds for the next financial crisis by how they respond to the previous one. In the United States, aggressive financial deregulation aimed at creating a level playing field for banks combined with low inflation and very successful monetary policy ultimately led to the subprime excess and collapse after the Saving & Loan crisis. The next financial crisis in China will be different from the one in the United States. Nonetheless, financial crises have a centuries-old history and will continue to happen. A financial system that is crisis-proof would be an excessively stiff and cannot support growth and innovation. Fortunately, China has the privilege to be able to design its own with the benefit of the lessons learnt from other countries and eras, including the 10-year old crisis in the United States.
This post written by Alessandro Rebucci and Jiatao Liu.