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so the research I'm going to talk about is is part of a long agenda it it's to
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do with the way that central banks and governments intervene in the economy so for the last 20 or 30 years central
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banks have by and large focused on fighting inflation after we had the big shocks in the
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1970s that was the major problem and that's what they've spent their main
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efforts doing some other some of the central banks like the Federal Reserve have a dual mandate so in addition to
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worrying about inflation they also have to worry about unemployment now the way that this has
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been implemented in most countries either explicitly or implicitly is that the central bank has focused on
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inflation and it's usually granted formal independence from the government and the idea there is to stop it
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lowering interest rates just before an election and making the economy boom but then inflation going up and so on so
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that was an idea that has been widely accepted for some time now Financial stability was in the
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mix but it was usually regarded as something that was secondary so that was dealt with either by the central bank or
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in many countries such as the UK or Japan by a separate Financial Services Authority or
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FSA and they would deal with problems to make sure that there were no difficulties in transmitting monetary
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policy because Banks were having problems so the way they did that was to stop uh Banks taking risks one by one so
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they would look at each bank and make sure that they weren't doing doing risky
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things and the idea was that that would stop any problems in the financial system fiscal policy was done
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separately by the treasury or the finance ministry depending on the country so we could break up all these
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different parts of the way the government and central banks intervened and they could all do their job
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separately now the problem is that what the crisis has shown is that that system
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didn't work properly and what we need to do I argue in this research is to think
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carefully about how we should proceed going forward and I think it may well be that we need to change the architecture
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of the structure of policymaking and have a much more holistic view because all of these things I think are
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intertwined Financial stability isn't secondary it's a primary target in the
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same way that inflation fighting is we also have to worry about the fiscal side because that also is a important part of
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the mix so I think the most important is that central banks need to worry about the effects of their policies on asset
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prices we used to think of asset prices as being independent of of what they do to a large degree but I think what the
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housing bubble Illustrated was that they can have a big effect and if things go wrong in the sense that they rise
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quickly and get out of line and then collapse that can trigger a whole set of very
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unfortunate events and that's what we saw during the crisis now when they lower interest
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rates it has an effect on house price but it potentially has many other effects and one of the problems that
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they now face is that interest rates are going to go up at some point and when they go up it's important that they go
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up slowly enough that we don't have a big fall in prices of long-term bonds mortgages and so on which will get us
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back into a crisis in just the same way that house prices led to a fall in the price of securitized mortgages and so on
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so that's the second big takeaway they need to worry about that the third I think is that as I say they have to
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start thinking holistically because when they run up debt in large amounts and interest rates go up again there may
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also be a fiscal problem and that can also be significant so I think the country that
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is a is a very good illustration of some of these issues is Japan Japan had a massive property and stock bubble back
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in the late 80s and early '90s and then since then they've had 25 years of low
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interest rates and very slow growth now they're trying to get out of that by
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having these three arrows of abenomics the first arrow is monetary policy and what they're trying to do is
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to create inflation and the way they're doing that is by having large amounts of quantitive
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easing now their target is to get inflation up to 2% now it's currently around zero or negative or before the
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they implemented it started implementing it a year ago it was around that now most of our theories suggest that if
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inflation goes go up by 2% nominal interest rates should go up by about 2% now that creates a number of problems
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the first is that there's a potential Financial stability problem because the
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banks hold many long-term assets like mortgages government bonds loans and so forth and if interest rates go up their
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value Falls so last April the bank of Japan in its Financial stability review looked at the effect of 100 Point
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basis sorry 100 basis point rise in interest rates on the assets held by Banks the large banks are fine they
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don't hold too much and and they're reasonably well hedged the regional Banks and the small banks have a bigger
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problem 100 basis point rise has the potential to knock their asset values by an amount that would wipe out 30 to 40%
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on average of their tier one Capital 200 basis point rise would do twice that so 60 to
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80% now that's clearly a problem their solution to that was we're going to extend the current
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regulations which allow them to not mark their assets to Market of course that was one of the big problems in the
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subprime crisis people didn't know where the subprime securitized mortgages were
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and so everybody came under suspicion and I think that this is potentially a problem in Japan so that's the first
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issue the second issue is that if interest rates do go up by 2% then they're going to have a fiscal
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problem because they have over 200% of GDP in Gross debt and about 135 140% in net debt now in recent years people have
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focused more on the net debt but an important issue in this case is what's the maturity of the gross debt versus
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the Net debt and particular the assets that offset the gross debt now much of that is the money held by the Central
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Bank the the foreign exchange reserves and that's invested by and large short
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term I don't think we have a good idea of precisely what the maturities of all
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these debts are but one of the things that's hen going to happen over the long
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term is if interest rates go up 2% then then on the gross side their funding costs are going to go up by four or 5%
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of GDP uh on the net debt they're going to go up by uh roughly two and a half to
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3% those are both very large num so even the 3% is is a large amount in terms of
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actually raising revenue to pay those those uh amounts and so that's going to
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create a fiscal problem which they already have and which the tax rise that came into effect on April 1st is
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designed to offset but this is again similar order of magnitude kind of problem to their uh deficit problem that
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they've been running for many many years now so that's the second issue now may
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be that interest rates don't rise and in fact there isn't much evidence so far of
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that happening so the current yields on 10-year J jgbs Japanese government bonds
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is about 60 basis points so they haven't ticked up last year uh just after the
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start of of these policies they did go up a little bit to 90 to 100 basis points but they're now backed down now
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what that seems to suggest is that the market is not so sure that these inflation policies are going to work now
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if they don't work there's another problem which is if inflation is at uh 2% and long-term
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interest rates are at 60 basis points or or less then there's a negative yield on
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these very large quantities of assets and that raises the issue of will people take their money out of the country and
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put them in higher yielding assets so they avoid the negative yield and that's
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another problem they face so if the interest rates and inflation rates both go up by
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2% then there is a an effect in the sense that the the value of the debt will be eroded in real terms and in that
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sense it'll be easier but it's still the case that the cost of raising the taxes
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is is large and at the beginning that's a large burden so that there's a again a
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complex ated tradeoff which needs to be taken into account in designing these policies so what I think these things
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illustrate is that there's a holistic problem that you can't just focus on one
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particular Target and forget about everything else the whole set of policies has to be consistent and the
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current architecture of the policy entities is not well designed to deal with those kinds of problems
00:12:04
I I think the first key takeaway is that we need to worry a lot more about financial stability and worrying about
00:12:15
St Financial stability is very different from worrying about inflation the reason is we can't just
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separate it out in the way that we've done in the past we have to have a holis
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view of policies by central banks and governments and treasuries they're all
00:12:34
closely interrelated when it comes to financial stability and the reason is that systemic risk is a very complex and
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involved phenomenon and it pops its head up in many different ways so let me talk a little bit about
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systemic risks because I think it's very important in this whole issue systemic
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risk has at least five components the first component is panics traditionally I think that's the way people thought
00:13:14
about financial crisis that there were good equilibrium bad equilibrium good equilibrium people keep their money in
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the bank everything's fine but if you think other people can take their money
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out of the bank then you better get your money out too because they only have a limited amount of liquidity and if there
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are going to be problems in the bank you want to make sure that you get your money out
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first panics are a big problem but as we've seen in the current crisis they're
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not the only problem what we saw here was Falls in asset prices and in particular Falls in real estate
00:13:52
prices that lies at the heart of many Financial crises if you go back historically and that was the case
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particularly here in the US but also in Spain and in Ireland that was really what drove them but there are many other
00:14:07
reasons for asset price Falls rises in interest rates are one the flash crash is another example
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Sovereign default is another example so many many and what we need to do is to understand all those different aspects
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but that doesn't exhaust the list of forms of systemic risk contagion is another one if we have one financial
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institution go down then others with claims on it may also be affected and we may get a whole domino effect a second
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form of contagion is if you see a bank like Leman default then you may think that other Banks like Goldman Sachs and
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Morgan Stanley which at some level do similar kinds of things may also be threatened and then may be a problem for
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those Banks and of course that's what we saw during the crisis if they hadn't
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been granted access to the fed's discount window then many people believe that they may also have have gone down
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the third type of contagion is a very important one which is that many countries which weren't that exposed to
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subprime crisis had massive Falls in GDP after Leman defaulted so Japan is one example they had a 10% fall in GDP
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in the subsequent year even though their Banks weren't involved with subprime and
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in fact stayed fairly strong throughout the whole episode Another example is Finland which
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also had a a GDP drop of about the same magnitude trade played a part in that but again it's interesting that these
00:15:56
effects are so large we don't really understand that very well Fourth Kind of systemic risk is
00:16:05
problems in the financial architecture what many people refer to as the plumbing um so many markets like the
00:16:12
interbank market sto working very well uh there were repo runs and so on uh and problems in uh derivatives markets and
00:16:22
things like that the fifth kind of systemic risk is problems in the foreign exchange
00:16:30
markets uh or foreign exchange liabilities that Banks and firms have that wasn't a problem in in this uh
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crisis because the central banks did a very good job having foreign exchange uh swaps but it was a big problem for
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example in the Asian crisis so we still have to keep worrying about it so I think
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the relationship between fighting systemic risk and the kinds of policies that are
00:17:09
needed to do that this inter relationship is not quite as obvious particularly when we started on this
00:17:19
research as it is becoming as as we get more and more into it Central Bank Independence is at the heart of
00:17:30
the whole way that monetary and fiscal policy has run at the moment and although there have been calls that it
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maybe too much because much of what central banks currently do is fiscal in nature I
00:17:45
think it still isn't quite appreciated how the whole set of policies needs to be coordinated in in
00:17:55
the way that I I think will be done going forward so I think policy makers as I say they need to coordinate much
00:18:04
more and they can't do things separately in the way that the architecture is
00:18:11
designed to implement they need to worry about for example the effects of interest rates on government deficits
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now in many countries we have debt to GDP over 100% every 1% rise in interest rates potentially means that there's
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going to in the long run at least be a 1% increase in the deficit so that's an
00:18:34
important issue we need to have policy makers worry about the effects of their policies on asset prices this is not
00:18:43
something that they currently do that much but that was at the heart of the start of the financial crisis because we
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had this big run up in prices and then the collapse which triggered the subprime mortgage problem s and the
00:18:58
other mortgage problems and then that in turn triggered a whole set of problems in the financial
00:19:07
system so one of the major systemic risks that's there at the moment I would
00:19:13
say is a rise in interest rates and at the moment the question is why should that
00:19:21
happen interest rates are low in most parts of the world and so it seems as the central banks can control it and
00:19:29
gradually raise them I think that's true but the thing that's changing is China
00:19:36
in China many entrepreneurs and firms are willing to pay much higher interest rates than we see in the US and Europe
00:19:46
or Japan so they're paying 15 20% now part of that is a risk premium a default
00:19:54
premium but the real interest rate rates on average so accounting for default problems and inflation in China are it
00:20:04
seems much higher now at the moment that is not affecting the rest of the world because China has very stringent Capital
00:20:14
controls but they're going through a set of policies to ease those Capital controls
00:20:22
the start of that is an experimental phase which is going to be conducted to a large extent in the Shanghai free
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trade zone which has now been going for a few months what they're doing there is
00:20:36
experimenting with policies to allow firms to financial firms Banks and other um financial institutions to go overseas
00:20:48
and start uh having products based on overseas but also they're going to allow
00:20:55
foreign institutions to come in to make the Chinese Financial system much more competitive when they do relax Capital
00:21:04
controls which presumably will be done quite slowly then there'll be an inflow
00:21:09
of capital into China and an outflow and one of the big questions is what's that
00:21:15
going to do to the exchange rate and so forth and one of the interesting things is that they've been allowing the R&B to
00:21:25
fall which hasn't happened for a long time and I think this is part of this preparation for opening up the financial
00:21:33
system now one of the interesting aspects of China's economy today is that trade isn't nearly as important as it
00:21:41
used to be people quote the gross figure which is usually about a third of GDP is
00:21:49
is exports but that includes a lot of things that were imported and embedded in the products so for example energy or
00:21:58
raw materials a few years ago the net trade was about 10% so still significant now
00:22:07
it's down to about 2% or thereabout so trade is not that important the traditional justification for the vast
00:22:16
foreign exchange reserves that they have in China of 3.8 trillion now was that this was to make sure their exporters
00:22:27
were competitive but they don't need that anymore because it's such a small part of of the economy
00:22:32
because the rest of the economy has grown so much so what China is doing is investing lots of money in low yielding
00:22:42
assets while at the same time their entrepreneurs are paying very high rates of 15 20% and as we unwind these Capital
00:22:52
controls what we're going to see is that there's going to be an effect on global
00:22:59
interest rates in my view as China is now such a large part of the global economy and this is the part that the
00:23:06
central banks are going to find difficult to control because as long-term rates go up globally driven by
00:23:14
the uh real rates in China then this is potentially a problem so the question as
00:23:22
always in finances how much will people anticipate these changes if they don't
00:23:28
anticipate these changes very much then the period where this will be relevant could be stretched out over years but if
00:23:36
they anticipate that this is going to happen then it could be shorter than that and I think that that that's where
00:23:43
one of the risks lies so one of the interesting issues is quite the extent to which the central
00:23:55
bank and government have everything under control and as we saw in the financial
00:24:03
crisis most governments most central banks just missed it and one of the big worries that I think many people have is
00:24:12
whether they'll miss the next one too or whether now everything is under control
00:24:18
and I think one of the things that our research is trying to to do is to get governments and
00:24:26
central banks and policy made because to think ahead and not just try to react to
00:24:32
what happened last time and just put in place measures that will control that particular aspect of the
00:24:43
phenomenon what they need rather to do is worry about what is the general nature of the problem in this case
00:24:50
systemic risk and how may it rare its ugly head going forward what we're trying to do here is is to as
00:25:03
I say look at the inter relationships between various different policies so between banking regulation
00:25:11
monetary policy fiscal policy the whole mix of all these policies typically what
00:25:18
we do and there are good reasons for doing it is look at each one separately when you do try to do it as a whole it
00:25:27
necessarily becomes complex we need to understand systemic risk much better and so a lot of it will
00:25:34
be looking at the individual components of systemic risk trying to understand any additional components that are out
00:25:42
there and drilling down into each uh area separately and then going back and trying to look at the holistic picture
00:25:56
again [Music]