dialogue
to pay us. They have used that money to make illiquid, long-term loans. So the idea that you can permanently finance long-term, risky investments by using short-term finance, provided by people who believe it to be safe, is clearly impossible to achieve. There is an element of sleight-of-hand and there is risk involved, but it’s a certain kind of risk, which means that most of the time you never see it, but when you do see it, it is pretty catastrophic.
LOOKING AT WHAT LED TO THE 2007-08 FINANCIAL CRISIS, YOU OBSERVE THAT THE USUAL SUSPECTS – THE US HOUSING MARKET, COLLATERALISED DEBT OBLIGATIONS, BANKS BEING TOO BIG TO FAIL – ARE ONLY SYMPTOMS AND NOT THE FUNDAMENTAL CAUSE?
Whether it be sub-prime mortgages or fancy instruments, these are symptoms of a trend over 30 years towards extremely low, long-term interest rates. That’s in large part because countries in the East, but also including Germany, decided to pursue an export-led growth strategy. That led them to save a great deal, and they deposited those savings in the world capital markets. Countries in the West, like the US and the UK, but some other European countries too, found that because they faced a significant trade deficit, they had to boost their domestic spending, and in order to do that, they cut interest rates. Interest rates right across the spectrum – short-term and long-term – were continuously falling. That kept pushing up asset prices and as asset prices rose, such as house prices, people needed to borrow more in order to finance the purchase of those assets. The banking system willingly provided that debt finance by lending to households and companies that wanted to borrow. That put a great strain on the balance sheets of the banking system – they themselves had borrowed a good deal of money – and they didn’t have enough equity finance to withstand even the smallest concerns about their solvency. So when concerns were triggered in 2007, people started to run from the banks, both individuals but particularly financial institutions. It was that concern about the weakness of the banking system that really was the cause of the banking crisis, but, in turn, it reflected macroeconomic developments over quite a long period.
WHY WAS IT NOT POSSIBLE TO SEE THE CRASH OF 2008 COMING?
A lot of people did see that the developments in the world economy were unsustainable, and, indeed, many international meetings talked about the unsustainability of the current situation. Of course, it just kept on going, so that rather blunted the thrust of people who asked “Is this really sustainable?” At the level of central banks and governments, most people thought it would come to an end through a big and violent movement of exchange rates, rather than a collapse of the banking system.
YOU INTRODUCE ANOTHER CRITICALLY IMPORTANT CONCEPT: ‘RADICAL UNCERTAINTY’ – WHAT DOES THAT MEAN? This is absolutely fundamental because it explains why many economists were using so-called models that assumed that all risks could be adequately captured by known probability distributions and so priced in financial markets. In fact, the big risks that come along and create crises are ones that noone anticipates. You simply don’t imagine it happening, and
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INTEREST RATES RIGHT ACROSS THE SPECTRUM – SHORT-TERM AND LONG-TERM – WERE CONTINUOUSLY FALLING” therefore, if you don’t imagine it happening, you can’t price it and trade it in the markets. When banks get into trouble, it’s because they themselves, as well as their customers, experience a shock that they too didn’t see coming. This can cause mayhem both for the financial system but also the economy as a whole. It’s very important to recognise that the uncertainty that matters in causing booms and slumps is radical uncertainty, not uncertainty that can be emasculated in its effects by being represented by known probabilities and so priced in markets and tamed in that way.
THEN CAME THE CRISIS, THE COLLAPSE OF LEHMAN BROTHERS, AND THE SOLUTION THAT WE KNOW AS ‘QUANTITATIVE EASING’. AS YOU LOOK BACK, WAS THAT THE RIGHT ACTION?
In the immediate aftermath of the events of autumn 2008, it was the right thing to do – launching what might be described as a Keynesian stimulus. That stimulus helped to prevent a repeat of the Great Depression and it bought time for governments to deal with the underlying problems. Unfortunately, governments have not dealt with the underlying problems and so central banks have gone on creating more money and cutting interest rates. This maybe buys us a bit more time but it doesn’t actually solve the underlying problem, the disequilibrium, as I call it, in the big economies and in the world economy as a whole. The problem is that we’re actually not dealing with the underlying problems and until we do, central banks are going to find it extraordinarily difficult to do anything other than keep interest rates close to zero.
IS THAT WHY, IN YOUR WORDS, “… WEAK DEMAND HAS BECOME A DEEP-SEATED PROBLEM, AND ONE THAT APPEARS IMMUNE TO FURTHER MONETARY STIMULUS?…ONE THAT THREATENS TO PERSIST INDEFINITELY…”? Yes. Weak demand is a reflection of the fact that what monetary policy can do is to try to persuade people to spend today rather than tomorrow by cutting rates. People do that and, temporarily, you seem to get an improvement in the data on spending and output growth, but then it peters out. The reason is that once time has passed, what was tomorrow becomes today. So, having persuaded people to bring spending forward from what was tomorrow to today, you’ve now dug a hole in today’s spending and you’ve got to cut interest rates yet again to bring spending forward from the new tomorrow to today. That also works for a little while, but then time passes, that peters out, and then you’ve