The global financial cataclysm of 2008 hit at a confluence of political and geopolitical transformation; a new American president was elected less than two months after the crisis hit and ten days later, the G20 leaders met for the first time in Washington to address the catastrophe. Ten years later, there are few economic thinkers as qualified as former Privy Council clerk, former deputy minister of Finance and current BMO Vice-Chair Kevin Lynch to report on where the global economy stands.

 

Kevin Lynch 

As anniversaries go, it is hardly one to cherish—a decade ago, September 15, 2008 to be precise, Lehman Brothers filed for bankruptcy. In so doing, it triggered the worst financial crisis of our lifetimes.

Much has been written about how a bunch of lousy U.S. mortgages—collateralized, packaged and leveraged beyond comprehension—brought the global economy to the brink of another great depression. There were lots of villains and blame to go around, with regulatory failures in the United States, Great Britain and the E.U. clearly recognized as enablers of the crisis. And, while it started as a crisis in financial markets, it ended up causing incredible destruction to economies, societies, and individuals, not to mention trust in the capitalist system itself. American estimates of the costs are staggering: an unimaginable $13-$22 trillion of lost output, lost incomes, lost jobs, lost wealth, lost homes and government debt.

So, we are now 10 years on. The global economy is experiencing synchronized and strong growth for the first time since the financial crisis. After extraordinary conventional and unconventional policy easing by the Organisation for Economic Cooperation and Development (OECD) area central banks, monetary normalization has begun, slowly, in the U.S. and Canada, with the U.K., E.U. and Japan yet to take this step. Governments, central banks, international institutions and regulators have expended enormous efforts to reform financial systems, to rebuild systemic trust and to reboot economies devastated by the crisis and the ensuing global recession. So, is it “mission accomplished”, to appropriate a favourite phrase of American presidents? It all depends on how you define the mission.

Decrying the dangers of policy complacency at Davos this year, International Monetary Fund Managing Director Christine Lagarde used a metaphor attributed to President Kennedy: “The time to repair the roof is when the sun is shining.” The IMF chief warned that we are enjoying a cyclical economic burst, not a new higher-growth normal, and we still face a longish list of structural growth inhibitors, economic and social vulnerabilities and geopolitical risks. These include: poor productivity; excessive inequalities; rising protectionism; declining international coordination; growing trust deficits between the governing and the governed and financial fragilities. The broader repair job, then, is certainly not complete, and financial sector stability does not exist in isolation.

So, notwithstanding the challenges in the broader economic context, are we done yet with the financial sector repair job? Again, it depends. 

We learned a lot from the post-mortems of what happened, both within and across national financial systems. We understand much better which regulations were ineffective and why, and what were the crisis amplifiers and shock absorbers. To a certain extent, it was relearning the basic principles of finance: adequate buffers for solvency, sufficient firm and system liquidity, the need for transparency to properly evaluate risks, the dangers of excessive leverage, and clear accountability for balance sheets and risks within financial institutions and by regulators. Perhaps most importantly, we learned the hard way how incredibly interconnected and globalized the financial system had become while regulation and oversight remained predominantly national. 

By 2007, many financial systems—particularly in the U.S., the U.K. and the Eurozone—had badly lost sight of these basics and their regulatory systems were not imposing suitable anchors. Canada and its financial system largely avoided the worst of these excesses, but still felt the punch of the global recession.

The size and complexity of the repair job necessitated the creation of new and revitalized remedial mechanisms. In 2009, the G20 at the leaders’ level proved its worth at its second post-crisis gathering in London. The Financial Stability Board came into being, the IMF found new purpose, new national regulatory agencies were established, the Basel Committee was given a new mandate and central bankers became the new guardians of the universe. Together, they have re-established and modernized the core finance principles but through a hugely complex set of prescriptive regulations, with growing differences across countries in their specifics as time goes on. 

The regulatory policy challenge for governments is to learn from the past while not attempting to navigate the future using the rearview mirror. The business challenge for financial institutions is to adapt efficiently to the new regulatory regime while not taking on too many new risks to raise returns. 

What was lost in the great global financial crisis was the public trust in the financial system in many Western countries and the perception of the supremacy of the western market capitalism model in the eyes of many Asian countries. The former may be more possible to regain than the latter.

One lesson, shaped by my experiences as deputy minister of Finance in the run-up to the global financial crisis and as clerk of the Privy Council in its aftermath, is the value of regulatory principles over excessive reliance on prescription, particularly in any period of substantial change, and accountability for holding true to those principles.

In the design of regulatory systems, simplicity usually wins out over complexity if the objective is to clearly convey the desired ex ante behaviours to a dispersed and heterogenous group of market participants. Beyond this, the value of skilled regulators and supervisors, who are open to regular interaction between the regulators and the regulated and inclined to coordinate across borders, is too often under-estimated relative to the addition of more rules. Finally, it is important to build resiliency into systems from a forward-looking perspective not one of hindsight. This, in turn, highlights the value of sophisticated technology and market foresight mechanisms for financial sector policy makers in a world of profound change moving at a frantic pace.

What would such a foresight lens capture today that might reshape regulatory policy thinking? The structure of our economies is very different than it was at the time of the financial crisis, transformed by technological change on steroids and the demographics of aging societies. Inconceivable even a decade ago, we are in the midst of a geopolitical tsunami with the rise of protectionism, populism, and nationalism, combined with a sharp decline in trust in institutions. Pervasive globalization and sustained rapid growth in Asia mean that we are now in a multi-polar world where China, the second largest economy, is asserting its place to be a global regulatory rule-maker. 

Within the direct ambit of financial services, fintech is disintermediating financial functions, E-commerce is doing the same for retail and logistics, and distributed ledgers and cryptocurrencies are challenging clearing systems. Massive data vaults combined with data analytics enhanced by artificial intelligence will likely blur the line among financial institutions, fintechs and infotechs, while the recent controversies involving Facebook serve to highlight the potential risks inherent in the infotech business model of data intermediation. Data privacy, data security (cyberattacks), data rights and data usage are rapidly emerging issues that may require new regulatory measures, new models of financial sector cooperation and possibly new public-private partnerships on security. The World Economic Forum’s Balancing Financial Sector Stability, Innovation and Growth Initiative is exploring new approaches by the financial services sector to respond to cybersecurity and data usage risks and concerns.

At the macroeconomic level, while solid and synchronized global growth has finally been achieved, it has been propelled by massive fiscal (most recently U.S. tax reform) and monetary stimulus. With declining potential growth in many Western countries, including Canada and the U.S. (estimates suggest Canadian potential growth post-2020 around 1.75 per cent, and U.S. potential growth below 2 per cent), much of this stimulus will translate into higher inflation and exacerbate latent financial fragilities. These financial fragilities include global debt levels at over 230 per cent of global GDP—well above pre-crisis levels—and rising debt interest costs for firms, households and governments as monetary normalization picks up pace.  

Indeed, there is some risk of “irrational exuberance” in looking at today’s conjuncture. Ian Bremmer certainly thinks so. At Davos this year, the CEO of the Eurasia Group characterized today’s context as: “Let’s be honest: 2018 doesn’t feel very good. Yes, markets are soaring and the economy isn’t bad, but citizens are divided, governments aren’t doing much governing, and the global order is unravelling.”

Further, as Larry Summers has stressed, we have an aging expansion but a threadbare policy toolkit—average monetary easing in past U.S. recessions was 500 basis points whereas U.S. interest rates today are less than half of that, and U.S. government debt ratios are heading above 100 per cent of GDP despite an economy at full employment. Simply put, it will take sustained monetary normalization and fiscal consolidation to restock the toolkit as well as structural policy reforms to de-age the expansion.

The underlying problem for governments is the declining stock of public “trust capital” and the increasing pace of economic and societal dislocations. Governments still operate in a Gov 2.0 context in a world being reshaped by Tech 4.0 and public confidence can be a casualty of that gap. How do policy and regulation keep pace with the speed and scale of change? 

Global financial order requires establishing and enforcing clear and effective rules of the game for how the financial system will work in a highly interconnected, multipolar world that is in the midst of a technological revolution. 

The Washington Consensus, which provided that framework for many years in a very different global context, is no more. The initial G20 meetings of leaders in late 2008 and early 2009 provided a road map out of a crisis that has largely taken us to this point but its hallmarks of cooperation and coordination are fraying. If a new consensus is to be found, will it be driven by reinvigorated Western leadership (a G6 consensus?) by the new worldview of China (a Beijing consensus?) or from elsewhere?  

Contributing writer Kevin Lynch is Vice Chair, BMO Financial Group and former Clerk of the Privy Council and Head of the Public Service during the financial crisis of 2008-09.