Guest Commentary: The Financial Crisis - Five Years On

This week marks the fifth anniversary of the first tremors of the financial crisis. In fact, the warning signs had been emerging before that. The MPC minutes for the meeting of 1st/2nd August 2007 read as follows:

“The main news this month in financial markets had been the sharp deterioration in credit markets and the associated falls in equity prices and changes in market interest rates. A trigger for this turbulence appeared to be renewed concerns about the US sub-prime mortgage market, the losses of some prominent hedge funds, and the revisions to the ratings of some mortgage-backed securities; this had led to a reduction in demand for products such as sub-prime mortgage-backed securities and collateralised debt obligations…. It was not clear how far the downturn in financial markets would go, nor how long it would persist.”

More than just a financial crisis

We now know that the downturn in financial markets was very serious indeed and its consequences are still with us today. But it is not just the scale of the financial shocks which hit major economies from 2007 until early 2009 which is making economic life so challenging at present. There are three other factors which are contributing to the current environment of disappointing growth and volatility which has become the “new normal” for the major western economies.

First, we are in the middle of a big geopolitical transition, as the Asia-Pacific region becomes the dominant force in the world economy – led by the emerging economic superpowers of China and India. The Asia-Pacific region – including Japan, Australia and New Zealand – now accounts for over 30% of global GDP, compared with 22% for the US and 24% for the European Union. No longer are the mature western economies the dominant force in the world economy.

This creates a disconnect between growth in the West and across the global economy more broadly. The world economy is still growing reasonably strongly – powered by Asia and other emerging economies - even though growth in the US and Europe is disappointing. The IMF’s forecasts still show global growth in the years 2011 to 2013 in the 3.5-4% range, above the 3.3% long-term average. One consequence has been a climate of much higher and more volatile energy and commodity prices – as successive price surges since the mid-2000s have eroded the low import costs which supported western consumer growth in the 1990s and first half of the 2000s. This erosion of cheap imports is being compounded by the impact of domestic inflation in emerging market and developing economies – expected to average 6% from 2011 to 2013.

The second factor aggravating the impact of the financial crisis is the need for many western economies to make structural adjustments to find new sources of growth after a long period of economic expansion. The UK and many other western economies enjoyed a long expansion which started in the early 1980s and was only briefly interrupted by the early 1990s recession. UK economic growth averaged 3% in the twenty-five years 1982 to 2007, very similar to the growth rate of the previous long expansion which included the 1950s and 1960s.

A key driver of this period of growth from the early 1980s through to 2007, was a process of supply side reform, liberalisation and regulatory change which allowed resources to shift from the manufacturing industries which had powered the 50s and 60s long expansion into the services sector. A key component of this liberalisation agenda was the deregulation of financial services, which broadened the access of consumers and businesses to sources of finance.

The financial crisis has undermined confidence in the ability of banks and financial institutions to operate safely and responsibly in such a deregulated climate. A process of financial re-regulation and reassertion of state control is underway. And in other areas of economic life – employment law, environmental protection, infrastructure development and planning – there has been a tide of re-regulation and increasing government intervention for some time. This creates potential barriers to the adjustment of the economy to the changed economic circumstances since the financial crisis.

The third ingredient contributing to a “new normal” world of disappointing growth and volatility in the major western economies is the difficulties which policy-makers are experiencing in adjusting to new realities. Prior to the financial crisis, an economic policy consensus had developed in the major western economies. As long as economies grew at a reasonable rate, public sector finances could be kept on an even keel and central banks appeared able to steer economies on a steady growth, low inflation course. In 2008/9, governments and central banks adopted extreme and emergency measures to stabilise their economies – very low interest rates, direct injections of liquidity and monetary stimulus, and various forms of fiscal stimulus. Five years on from the onset of the crisis, we are struggling to move away from these emergency policy settings. And there is a danger that persisting with these emergency stimulus policies over the medium term will add to distortions in the economy rather than facilitating the process of structural adjustment.

In the private sector, the fact that policy-makers are struggling to set a clear and credible medium-term direction for policy adds to the general feeling of nervousness and lack of confidence. It makes financial markets jittery and volatile. Businesses are reluctant to invest and hire new workers. And so we are stuck in a negative feedback loop of uncertain policy responses, financial market nervousness and weak private sector confidence. Breaking out of this loop is a key pre-condition of establishing a new and sustained growth momentum.

To read the rest of this post, please visit Andrew Sentence’s blog, The Hawk Talks.

Written by Dr. Andrew Sentence, former Bank of England Monetary Policy Committee member

Further commentaries are available from http://www.sentance.com/ or @ASentance on Twitter.

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