00:00:03
so the research I'm going to talk about
00:00:04
is is part of a long agenda it it's to
00:00:08
do with the way that central banks and
00:00:11
governments intervene in the economy so
00:00:14
for the last 20 or 30 years central
00:00:18
banks have by and large focused on
00:00:20
fighting inflation after we had the big
00:00:23
shocks in the
00:00:25
1970s that was the major problem and
00:00:28
that's what they've spent their main
00:00:30
efforts doing some other some of the
00:00:34
central banks like the Federal Reserve
00:00:36
have a dual mandate so in addition to
00:00:38
worrying about inflation they also have
00:00:40
to worry about
00:00:42
unemployment now the way that this has
00:00:45
been implemented in most countries
00:00:47
either explicitly or implicitly is that
00:00:50
the central bank has focused on
00:00:53
inflation and it's usually granted
00:00:57
formal independence from the government
00:01:00
and the idea there is to stop it
00:01:03
lowering interest rates just before an
00:01:05
election and making the economy boom but
00:01:08
then inflation going up and so on so
00:01:11
that was an idea that has been widely
00:01:14
accepted for some
00:01:16
time now Financial stability was in the
00:01:19
mix but it was usually regarded as
00:01:22
something that was secondary so that was
00:01:25
dealt with either by the central bank or
00:01:28
in many countries such as the UK or
00:01:31
Japan by a separate Financial Services
00:01:34
Authority or
00:01:36
FSA and they would deal with problems to
00:01:40
make sure that there were
00:01:43
no difficulties in transmitting monetary
00:01:47
policy because Banks were having
00:01:49
problems so the way they did that was to
00:01:52
stop uh Banks taking risks one by one so
00:01:56
they would look at each bank and make
00:01:58
sure that they weren't doing doing risky
00:02:00
things and the idea was that that would
00:02:03
stop any problems in the financial
00:02:06
system fiscal policy was done
00:02:09
separately by the treasury or the
00:02:12
finance ministry depending on the
00:02:14
country so we could break up all these
00:02:17
different parts of the way the
00:02:19
government and central banks intervened
00:02:22
and they could all do their job
00:02:24
separately now the problem is that what
00:02:27
the crisis has shown is that that system
00:02:29
didn't work properly and what we need to
00:02:33
do I argue in this research is to think
00:02:37
carefully about how we should proceed
00:02:40
going forward and I think it may well be
00:02:43
that we need to change the architecture
00:02:46
of the structure of policymaking and
00:02:49
have a much more holistic view because
00:02:52
all of these things I think are
00:02:54
intertwined Financial stability isn't
00:02:57
secondary it's a primary target in the
00:03:00
same way that inflation fighting is we
00:03:03
also have to worry about the fiscal side
00:03:07
because that also is a important part of
00:03:10
the
00:03:14
mix so I think the most important is
00:03:18
that central banks need to worry about
00:03:21
the effects of their policies on asset
00:03:24
prices we used to think of asset prices
00:03:28
as being independent of of what they do
00:03:31
to a large degree but I think what the
00:03:33
housing bubble Illustrated was that they
00:03:37
can have a big effect and if things go
00:03:40
wrong in the sense that they rise
00:03:42
quickly and get out of line and then
00:03:44
collapse that can trigger a whole set of
00:03:48
very
00:03:49
unfortunate events and that's what we
00:03:51
saw during the
00:03:53
crisis now when they lower interest
00:03:57
rates it has an effect on house price
00:03:59
but it potentially has many other
00:04:02
effects and one of the problems that
00:04:05
they now face is that interest rates are
00:04:08
going to go up at some point and when
00:04:09
they go up it's important that they go
00:04:12
up slowly enough that we don't have a
00:04:15
big fall in prices of long-term bonds
00:04:19
mortgages and so on which will get us
00:04:22
back into a crisis in just the same way
00:04:24
that house prices led to a fall in the
00:04:27
price of securitized mortgages and so on
00:04:30
so that's the second big takeaway they
00:04:32
need to worry about that the third I
00:04:35
think is that as I say they have to
00:04:37
start thinking holistically because when
00:04:41
they run up debt in large amounts and
00:04:44
interest rates go up again there may
00:04:47
also be a fiscal problem and that can
00:04:50
also be
00:04:56
significant so I think the country that
00:04:58
is a is a very good illustration of some
00:05:01
of these issues is Japan Japan had a
00:05:04
massive property and stock bubble back
00:05:06
in the late 80s and early '90s and then
00:05:10
since then they've had 25 years of low
00:05:14
interest rates and very slow growth now
00:05:18
they're trying to get out of that by
00:05:21
having these three arrows of
00:05:24
abenomics the first arrow is monetary
00:05:28
policy and what they're trying to do is
00:05:31
to create
00:05:33
inflation and the way they're doing that
00:05:36
is by having large amounts of quantitive
00:05:40
easing now their target is to get
00:05:43
inflation up to 2% now it's currently
00:05:47
around zero or negative or before the
00:05:50
they implemented it started implementing
00:05:52
it a year ago it was around that now
00:05:57
most of our theories suggest that if
00:05:58
inflation goes go up by 2% nominal
00:06:01
interest rates should go up by about
00:06:05
2%
00:06:07
now that creates a number of problems
00:06:10
the first is that there's a potential
00:06:13
Financial stability problem because the
00:06:15
banks hold many long-term assets like
00:06:19
mortgages government bonds loans and so
00:06:23
forth and if interest rates go up their
00:06:27
value Falls so last April the bank of
00:06:32
Japan in its Financial stability review
00:06:35
looked at the effect of 100 Point
00:06:38
basis sorry 100 basis point rise in
00:06:41
interest rates on the assets held by
00:06:44
Banks the large banks are fine they
00:06:48
don't hold too much and and they're
00:06:50
reasonably well hedged the regional
00:06:52
Banks and the small banks have a bigger
00:06:57
problem 100 basis point rise has the
00:07:00
potential to knock their asset values by
00:07:04
an amount that would wipe out 30 to 40%
00:07:08
on average of their tier one
00:07:11
Capital 200 basis point rise would do
00:07:15
twice that so 60 to
00:07:17
80% now that's clearly a
00:07:20
problem their solution to that
00:07:25
was we're going to extend the current
00:07:29
regulations which allow them to not mark
00:07:32
their assets to Market of course that
00:07:35
was one of the big problems in the
00:07:37
subprime crisis people didn't know where
00:07:39
the subprime securitized mortgages were
00:07:43
and so everybody came under suspicion
00:07:46
and I think that this is potentially a
00:07:48
problem in Japan so that's the first
00:07:53
issue the second issue is that if
00:07:56
interest rates do go up by 2%
00:08:00
then they're going to have a fiscal
00:08:02
problem because they have over 200% of
00:08:06
GDP in Gross debt and about 135 140% in
00:08:14
net debt now in recent years people have
00:08:17
focused more on the net debt but an
00:08:20
important issue in this case is what's
00:08:23
the maturity of the gross debt versus
00:08:27
the Net debt and particular the assets
00:08:30
that offset the gross debt now much of
00:08:34
that is the money held by the Central
00:08:39
Bank the the foreign exchange reserves
00:08:42
and that's invested by and large short
00:08:44
term I don't think we have a good idea
00:08:48
of precisely what the maturities of all
00:08:50
these debts are but one of the things
00:08:54
that's hen going to happen over the long
00:08:55
term is if interest rates go up 2% then
00:08:59
then on the gross side their funding
00:09:02
costs are going to go up by four or 5%
00:09:04
of GDP uh on the net debt they're going
00:09:08
to go up by uh roughly two and a half to
00:09:12
3% those are both very large num so even
00:09:16
the 3% is is a large amount in terms of
00:09:21
actually raising revenue to pay those
00:09:24
those uh amounts and so that's going to
00:09:27
create a fiscal problem which they
00:09:29
already have and which the tax rise that
00:09:32
came into effect on April 1st is
00:09:34
designed to offset but this is again
00:09:37
similar order of magnitude kind of
00:09:39
problem to their uh deficit problem that
00:09:42
they've been running for many many years
00:09:44
now so that's the second issue now may
00:09:47
be that interest rates don't rise and in
00:09:50
fact there isn't much evidence so far of
00:09:53
that happening so the current yields on
00:09:59
10-year J jgbs Japanese government bonds
00:10:03
is about 60 basis points so they haven't
00:10:06
ticked up last year uh just after the
00:10:10
start of of these policies they did go
00:10:13
up a little bit to 90 to 100 basis
00:10:15
points but they're now backed down now
00:10:18
what that seems to suggest is that the
00:10:20
market is not so sure that these
00:10:23
inflation policies are going to work now
00:10:28
if they don't work there's another
00:10:30
problem which is if
00:10:33
inflation is at uh 2% and long-term
00:10:38
interest rates are at 60 basis points or
00:10:41
or less then there's a negative yield on
00:10:46
these very large quantities of assets
00:10:49
and that raises the issue of will people
00:10:52
take their money out of the country and
00:10:54
put them in higher yielding assets so
00:10:56
they avoid the negative yield and that's
00:11:00
another problem they face so if the
00:11:03
interest rates and inflation rates both
00:11:06
go up by
00:11:07
2% then there is a an effect in the
00:11:11
sense that the the value of the debt
00:11:13
will be eroded in real terms and in that
00:11:16
sense it'll be easier but it's still the
00:11:18
case that the cost of raising the taxes
00:11:23
is is large and at the beginning that's
00:11:25
a large burden so that there's a again a
00:11:28
complex ated tradeoff which needs to be
00:11:31
taken into account in designing these
00:11:34
policies so what I think these things
00:11:36
illustrate is that there's a holistic
00:11:39
problem that you can't just focus on one
00:11:42
particular Target and forget about
00:11:45
everything else the whole set of
00:11:47
policies has to be consistent and the
00:11:50
current architecture of the
00:11:53
policy entities is not well designed to
00:11:56
deal with those kinds of problems
00:12:04
I I think the first key takeaway is
00:12:08
that we need to worry a lot more about
00:12:12
financial stability and worrying about
00:12:15
St Financial stability is very different
00:12:18
from worrying about
00:12:21
inflation the reason is we can't just
00:12:23
separate it out in the way that we've
00:12:25
done in the past we have to have a holis
00:12:29
view of policies by central banks and
00:12:32
governments and treasuries they're all
00:12:34
closely interrelated when it comes
00:12:37
to financial stability and the reason is
00:12:41
that systemic risk is a very complex and
00:12:46
involved phenomenon and it pops its head
00:12:49
up in many different
00:12:54
ways so let me talk a little bit about
00:12:57
systemic risks because I think it's very
00:12:59
important in this whole
00:13:02
issue systemic
00:13:06
risk has at least five components the
00:13:10
first component is panics traditionally
00:13:12
I think that's the way people thought
00:13:14
about financial crisis that there were
00:13:18
good equilibrium bad equilibrium good
00:13:20
equilibrium people keep their money in
00:13:22
the bank everything's fine but if you
00:13:24
think other people can take their money
00:13:25
out of the bank then you better get your
00:13:27
money out too because they only have a
00:13:30
limited amount of liquidity and if there
00:13:32
are going to be problems in the bank you
00:13:34
want to make sure that you get your
00:13:35
money out
00:13:38
first panics are a big problem but as
00:13:41
we've seen in the current crisis they're
00:13:43
not the only problem what we saw here
00:13:46
was Falls in asset prices and in
00:13:49
particular Falls in real estate
00:13:52
prices that lies at the heart of many
00:13:55
Financial crises if you go back
00:13:57
historically and that was the case
00:13:59
particularly here in the US but also in
00:14:02
Spain and in Ireland that was really
00:14:04
what drove them but there are many other
00:14:07
reasons for asset price Falls rises in
00:14:11
interest rates are
00:14:12
one the flash crash is another example
00:14:16
Sovereign default is another example so
00:14:19
many many and what we need to do is to
00:14:23
understand all those different aspects
00:14:25
but that doesn't exhaust the list of
00:14:29
forms of systemic risk contagion is
00:14:32
another one if we have one financial
00:14:35
institution go down then others with
00:14:38
claims on it may also be affected and we
00:14:41
may get a whole domino effect a second
00:14:44
form of contagion is if you see a bank
00:14:46
like Leman default then you may think
00:14:49
that other Banks like Goldman Sachs and
00:14:52
Morgan Stanley which at some level do
00:14:54
similar kinds of things may also be
00:14:57
threatened and then may be a problem for
00:15:00
those Banks and of course that's what we
00:15:01
saw during the crisis if they hadn't
00:15:04
been granted access to the fed's
00:15:06
discount window then many people believe
00:15:09
that they may also have have gone down
00:15:13
the third type of contagion is a very
00:15:17
important one which is that many
00:15:20
countries which weren't that exposed to
00:15:23
subprime crisis had massive Falls in
00:15:27
GDP after Leman defaulted so Japan is
00:15:31
one example they had a 10% fall in GDP
00:15:34
in the subsequent year even though their
00:15:36
Banks weren't involved with subprime and
00:15:40
in fact stayed fairly strong throughout
00:15:42
the whole
00:15:43
episode Another example is Finland which
00:15:46
also had a a GDP drop of about the same
00:15:50
magnitude trade played a part in that
00:15:53
but again it's interesting that these
00:15:56
effects are so large we don't really
00:15:59
understand that very
00:16:01
well Fourth Kind of systemic risk is
00:16:05
problems in the financial architecture
00:16:07
what many people refer to as the
00:16:09
plumbing um so many markets like the
00:16:12
interbank market sto working very well
00:16:15
uh there were repo runs and so on uh and
00:16:19
problems in uh derivatives markets and
00:16:22
things like
00:16:24
that the fifth kind of systemic risk is
00:16:27
problems in the foreign exchange
00:16:30
markets uh or foreign exchange
00:16:32
liabilities that Banks and firms have
00:16:35
that wasn't a problem in in this uh
00:16:39
crisis because the central banks did a
00:16:41
very good job having foreign exchange uh
00:16:45
swaps but it was a big problem for
00:16:47
example in the Asian crisis so we still
00:16:49
have to keep worrying about
00:16:55
it so I
00:16:57
think
00:16:59
the relationship between fighting
00:17:02
systemic
00:17:04
risk
00:17:07
and the kinds of policies that are
00:17:09
needed to do that this inter
00:17:12
relationship is not quite as obvious
00:17:17
particularly when we started on this
00:17:19
research as it is becoming as as we get
00:17:23
more and more into it Central Bank
00:17:25
Independence is at the heart of
00:17:30
the whole way that monetary and fiscal
00:17:32
policy has run at the moment and
00:17:35
although there have been calls that it
00:17:38
maybe too much because much of what
00:17:40
central banks currently do is fiscal in
00:17:43
nature I
00:17:45
think it still isn't quite
00:17:49
appreciated how the whole set of
00:17:51
policies needs to be coordinated in in
00:17:55
the way that I I think will be done
00:17:58
going forward so I think policy makers
00:18:02
as I say they need to coordinate much
00:18:04
more and they can't do things separately
00:18:08
in the way that the architecture is
00:18:11
designed to implement they need to worry
00:18:14
about for example the effects of
00:18:15
interest rates on government deficits
00:18:19
now in many countries we have debt to
00:18:21
GDP over 100% every 1% rise in interest
00:18:26
rates potentially means that there's
00:18:28
going to in the long run at least be a
00:18:30
1% increase in the deficit so that's an
00:18:34
important issue we need to have policy
00:18:38
makers worry about the effects of their
00:18:40
policies on asset prices this is not
00:18:43
something that they currently do that
00:18:45
much but that was at the heart of the
00:18:48
start of the financial crisis because we
00:18:52
had this big run up in prices and then
00:18:54
the collapse which triggered the
00:18:56
subprime mortgage problem s and the
00:18:58
other mortgage problems and then that in
00:19:01
turn triggered a whole set of problems
00:19:03
in the financial
00:19:07
system so one of the major systemic
00:19:11
risks that's there at the moment I would
00:19:13
say is a rise in interest rates and at
00:19:17
the
00:19:18
moment the question is why should that
00:19:21
happen interest rates are low in most
00:19:23
parts of the world and so it seems as
00:19:26
the central banks can control it and
00:19:29
gradually raise them I think that's true
00:19:32
but the thing that's changing is China
00:19:36
in China many entrepreneurs and firms
00:19:41
are willing to pay much higher interest
00:19:43
rates than we see in the US and Europe
00:19:46
or Japan so they're paying 15 20% now
00:19:52
part of that is a risk premium a default
00:19:54
premium but the real interest rate rates
00:19:59
on average so accounting for default
00:20:01
problems and inflation in China are it
00:20:04
seems much higher now at the moment that
00:20:09
is not affecting the rest of the world
00:20:11
because China has very stringent Capital
00:20:14
controls but they're going through a set
00:20:17
of
00:20:17
policies to ease those Capital controls
00:20:22
the start of that is an experimental
00:20:24
phase which is going to be conducted to
00:20:27
a large extent in the Shanghai free
00:20:29
trade zone which has now been going for
00:20:33
a few months what they're doing there is
00:20:36
experimenting with policies to allow
00:20:39
firms to financial firms Banks and other
00:20:44
um financial institutions to go overseas
00:20:48
and start uh having products based on
00:20:52
overseas but also they're going to allow
00:20:55
foreign institutions to come in to make
00:20:58
the Chinese Financial system much more
00:21:01
competitive when they do relax Capital
00:21:04
controls which presumably will be done
00:21:06
quite slowly then there'll be an inflow
00:21:09
of capital into China and an outflow and
00:21:13
one of the big questions is what's that
00:21:15
going to do to the exchange rate and so
00:21:18
forth and one of the interesting things
00:21:20
is that they've been allowing the R&B to
00:21:25
fall which hasn't happened for a long
00:21:27
time and I think this is part of this
00:21:29
preparation for opening up the financial
00:21:33
system now one of the interesting
00:21:36
aspects of China's economy today is that
00:21:39
trade isn't nearly as important as it
00:21:41
used to be people quote the gross figure
00:21:45
which is usually about a third of GDP is
00:21:49
is exports but that includes a lot of
00:21:52
things that were imported and embedded
00:21:55
in the products so for example energy or
00:21:58
raw
00:21:59
materials a few years ago the net trade
00:22:04
was about 10% so still significant now
00:22:07
it's down to about 2% or thereabout so
00:22:11
trade is not that important the
00:22:14
traditional justification for the vast
00:22:16
foreign exchange reserves that they have
00:22:19
in China of 3.8 trillion now was that
00:22:23
this was to make sure their exporters
00:22:27
were competitive
00:22:28
but they don't need that anymore because
00:22:30
it's such a small part of of the economy
00:22:32
because the rest of the economy has
00:22:34
grown so much so what China is doing is
00:22:38
investing lots of money in low yielding
00:22:42
assets while at the same time their
00:22:45
entrepreneurs are paying very high rates
00:22:47
of 15 20% and as we unwind these Capital
00:22:52
controls what we're going to see is that
00:22:56
there's going to be an effect on global
00:22:59
interest rates in my view as China is
00:23:01
now such a large part of the global
00:23:04
economy and this is the part that the
00:23:06
central banks are going to find
00:23:08
difficult to control because as
00:23:11
long-term rates go up globally driven by
00:23:14
the uh real rates in China then this is
00:23:18
potentially a problem so the question as
00:23:22
always in finances how much will people
00:23:24
anticipate these changes if they don't
00:23:28
anticipate these changes very much then
00:23:31
the period where this will be relevant
00:23:33
could be stretched out over years but if
00:23:36
they anticipate that this is going to
00:23:38
happen then it could be shorter than
00:23:41
that and I think that that that's where
00:23:43
one of the risks
00:23:48
lies so one of the interesting issues is
00:23:52
quite the extent to which the central
00:23:55
bank and government have everything
00:23:58
under control
00:24:00
and as we saw in the financial
00:24:03
crisis most governments most central
00:24:05
banks just missed it and one of the big
00:24:08
worries that I think many people have is
00:24:12
whether they'll miss the next one too or
00:24:15
whether now everything is under control
00:24:18
and I think one of the things that our
00:24:20
research is trying
00:24:21
to to do is to get governments and
00:24:26
central banks and policy made because to
00:24:29
think ahead and not just try to react to
00:24:32
what happened last time and just put in
00:24:35
place measures that will control that
00:24:41
particular aspect of the
00:24:43
phenomenon what they need rather to do
00:24:45
is worry about what is the general
00:24:48
nature of the problem in this case
00:24:50
systemic risk and how may it rare its
00:24:53
ugly head going
00:24:56
forward
00:25:00
what we're trying to do here is is to as
00:25:03
I say look at the inter
00:25:05
relationships between various different
00:25:08
policies so between banking regulation
00:25:11
monetary policy fiscal policy the whole
00:25:14
mix of all these policies typically what
00:25:18
we do and there are good reasons for
00:25:20
doing it is look at each one separately
00:25:24
when you do try to do it as a whole it
00:25:27
necessarily becomes
00:25:29
complex we need to understand systemic
00:25:31
risk much better and so a lot of it will
00:25:34
be looking at the individual components
00:25:37
of systemic risk trying to understand
00:25:40
any additional components that are out
00:25:42
there and drilling down into each uh
00:25:47
area separately and then going back and
00:25:51
trying to look at the holistic picture
00:25:56
again
00:26:01
[Music]
