Real estate and the great crisis: Lessons for macro-prudential policy

John Duca, 9 October 2017

John Duca, Deputy President of the Dallas Fed, spoke to PEFM in Balliol College on October 9 on macroprudential policy and the financial crisis. In his presentation Duca challenged the Rogov and Reinhart thesis that crises are caused by excessive build-ups of debt, arguing that crises are much more related to real estate booms and busts. These in turn were generated by massive relaxation of regulatory requirements in the period up to the crisis.

Duca argued that price trends in the US commercial and residential real estate markets are usually distinct, but unusually they were both booming in the run up to the crisis. He ascribed this to not only the well-known pervasiveness of low interest rates but, as importantly, the marked reduction in prudential requirements, as enforced through the risk-weighting on capital requirements, and the regulatory environment more generally. There was an underappreciation of the risks, particularly the tail risks, with no recognition of inter-connectedness. There was an illusion that mortgage-backed securities (MBS) were safe.

Until around 2000, the US financial system was regulated through a series of provisions largely enacted after the Great Depression. In 2000 it became possible to protect MBS through credit-default swaps; the market took when, under the Commodities Futures Modernization Act, derivatives contracts were to be honored before regular contracts in bankruptcy. As regards sub-prime mortgages, investors thought they were getting short term investment grade assets, when in fact they were getting junk. In 2004 capital requirements on banks were 8%, but risk-weights on bank holdings of MBS were slashed, so that the effective rate became just 1.6%. Issuances of MBS soared into the stratosphere.

Journal of Financial Regulation and Compliance: Policy responses to the Great Financial Crisis

Journal launch: Journal of Financial Regulation and Compliance: Policy responses to the Great Financial Crisis: edited by Charles Enoch (PEFM, St Antony’s, Oxford), Tom Huertas (Ernst and Young), David Llewellyn (Loughborough) and Maria Nieto (Bank of Spain)

On 29 September, 2017 PEFM hosted a conference to mark the launching of a double-number special edition of the Journal of Financial Regulation and Compliance (JFRC), looking at policy responses to the global financial crisis (GFC)—see programme attached. The event was co-sponsored by Ernst and Young and the JFRC, together with PEFM. Speakers were largely contributors to the special edition.

Tom Huertas, introducing the conference, noted that the volumes were divided into sections on firefighting, macro policy and micro responses. As to the first, the US and UK had provided solvency support. Through the G20 a comprehensive reform agenda was agreed at the Pittsburgh summit, and the Financial Stability Board (FSB) was enhanced as the overall coordinating body. As regards recovering the public costs incurred, in the US over $300 billion of restitution fees have been levied over the past five years.

Bilateral and regional trade agreements: A case for economic reform?

Speaker: Paul Gretton, Australian National University

Chair: David Vines, Balliol College, Oxford

In this PEFM seminar, Paul Gretton tackled one of the thorniest questions plaguing trade policy today –the implications of the shift from a multilateral system to a proliferation of bilateral and regional trade agreements (BTAs and RTAs). As global action through the Doha round has stalled and trade growth has significantly slowed down, countries have sought other instruments to advance trade liberalization. By far the most common approach has been to rely on preferential agreements, either of ‘hub-and-spoke’ nature such as the EU, or on a bilateral basis.

However, such preferential deals that liberalize trade between participants but not externally have created a phenomenon known as a ‘noodle bowl’ of agreements. Their proliferation has led to complexity through associated rafts of regulations necessary to enforce them and has eroded productivity by diverting trade from lowest cost suppliers. Thus, such BTAs and RTAs are increasingly viewed not as a stepping-stone to a global agreement, but as impeding trade liberalization.

Economic and Financial Challenges in South East Europe

Speaker: Gent Sejko, Governor, Bank of Albania
Chair: Othon Anastasakis, St Antony’s College, Oxford

Building on its long association with the Bank of Albania, PEFM was delighted to welcome its Governor, Mr. Gent Sejko, for a discussion on the role of central banks as guardians of price and financial stability. In his talk, he presented Albania’s experience in addressing the global financial crisis and its aftermath and highlighted some of the lessons learned from the perspective of a small South East European economy.

Governor Sejko began by presenting the general regional dynamics. Initially, strong financial integration with the EU benefited South East Europe, particularly through rapid credit growth. However, integration turned into a shock propagator in the aftermath of the global financial crisis. Inflation, previously a significant concern, fell across the Western Balkans. In addition, an increase in NPLs also contributed to lower growth, particularly in Albania and Serbia, while unemployment and emigration remain a challenge for the whole region. Finally, the crisis has had a structural impact on South East European economies, halving growth to 3.5% annually, and leading to declining productivity and investment rates.

An exposé of the Asset Management industry

Speaker: Ron Bird, University of Technology, Sydney

Chair: David Vines, Balliol College, Oxford

How can we explain the existence of a multi-trillion dollar industry that consistently underperforms? This is the provocative question that Prof. Bird addressed in his seminar talk for PEFM. In particular, he focused on asset managers, that is, those that invest other people’s funds. In this arrangement, risk stays with the fund owners who get the investment returns net of all costs, while managers charge an asset-based fee and may charge a performance fee.

The size of the industry is impressive – over 71 trillion USD worth of assets under management, with profits of 102 billion USD. The biggest division within is between active and passive management. Active managers seek to pick stocks that outperform relative to a benchmark index by overweighting better performing stocks. This is opposed to passive management, which is becoming more and more popular in recent years, accounting for up to one-third of US mutual funds.

The Changing Roles of Central Banks

Speaker: Prof. Charles Goodhart, LSE
Chair: David Vines, Balliol College, Oxford

Today there appears to be a cacophony of opinions about the future of central banks. To separate the signal from the noise, PEFM was privileged to host Prof. Goodhart. Taking a long-term view of the past and the future, he argued that the history of central banking has alternated between periods of consensus and uncertainty. Using this framework, he placed in context the many disparate debates taking place today in the world of central banking.

Prof. Goodhart began with the late Victorian consensus (1873-1914) focused on the gold standard and the real bill doctrine (the idea that the proper assets for commercial banks are bills of exchange focused on real activity). However, both of those broke down between 1914 and 1933 as they contributed to deflation and depression. Thus, a new consensus of fiscal dominance was born that lasted from 1934 to 1970. With the rise of Keynesianism and with central banks subject to financial ministries, the understanding emerged that financial instability is a result of excessive competition that squeezed profit margins and pushed banks towards riskier activities. However, between 1971 and 1990 the growth of technology and financial markets, stagflation and disputes about the appropriate anchor for monetary targets induced a period of uncertainty.

Technology and the future of the labour market

Speaker: Daniel Susskind, Balliol College, Oxford
Chair: Adam Bennett, St Antony’s College, Oxford

These days, it is hard to imagine a topic with more significant implications for the future than the impact of technology on the labour market. It is also hard to find people who have combined policy work with research on this topic, such as Daniel Susskind. In this seminar, he presented his insights, particularly regarding the role of ‘advanced’ capital in overturning traditional understandings of the relationship between technology and labour market skills.

Susskind begins by looking at historical data on the labour market. Thus, in the 20th century a ‘skills wage premium’ emerged based on increasing returns to college education. Strikingly, this premium remained even as more and more people were graduating from college due to the skill-biased nature of technological change, which meant demand for skilled labour to operate this new technology outpaced increasing supply. By contrast, in the 19th century, the industrial revolution appeared to have a bias toward increasing the demand for unskilled workers, displacing skilled workers (such as the luddites) with machines that could be operated by unskilled workers. Initial data from the 21st century suggest that today both things are happening at the same time, leading to more employment at the bottom and the very top of the skill distribution, but also to the ‘hollowing out’ the semi-skilled middle classes, which have thereby seen their wages stagnate.