Financial crisis highlights need to focus on asset side of balance sheet
Andrew Sheng says the solution to financialisation is not more debt, but structural reform
The failure of Lehman Brothers on September 15, 2008 marked the beginning of the end of the world's love affair with financialisation, one of three mega trends that has swept the world in the past 30 years - the others being free markets and globalisation.
Financialisation is defined as the growing importance of finance in daily activities, both at national and global levels. The effect has been massive credit creation and financial turnover in terms of scale, speed and geography that has turned finance into a power in its own right.
The dream was that financial innovation was creative, supported economic development and contributed to global market efficiency. The outcome was a massive bubble, inflated by hidden leverage and a collapse requiring massive public sector bailouts, from which the world has yet to totally unwind.
Finance theory taught that risk is best diversified, but geographical diversification through globalisation disguised the fact that everything was interconnected and became more and more co-related. Borderless finance meant that no firm, no country, was an island. The failure of one hub, like Lehman, led to a cascading failure across the board.
Financial supervisors were the convenient scapegoats, for a lack of supervision, or oversight of the shadow banking-banking nexus. No one noticed that massive credit was being generated below the line, moved off the balance sheet to special investment vehicles or totally offshore.
Because it was a systemic crisis, no single banker, regulator or anyone was held personally accountable. The ensuing public anger was assuaged through massive regulations and rules as a substitute for action. The two key responses were to fight financialisation with more financialisation through quantitative easing and fight complexity with more complexity, meaning new rules. After five years of QE, a strong global recovery remains elusive.
If we agree with Nomura's chief economist, Richard Koo, that the global financial crisis is a balance sheet crisis, then financialisation has focused on the wrong side of the balance sheet. As one wise cynic reminded us, it was a crisis where, on the right side of the balance sheet nothing was right, and on the left side, nothing was left. While it is understandable that QE was a "tool of last resort", the printing of more central bank debt to prevent the bubble deflation was to use more debt to cure debt, sustainable only under lower and lower interest rates.
The threat of tapering means that if real interest rates rise, the current asset bubbles and value of sovereign debt will deflate, causing more huge losses and forcing central banks to again print more money. Real interest rates are rising despite the fact that QE is holding the so-called risk-free rate low, because the market perceives that risks and uncertainty are rising.
In other words, if the core of the problem is the asset or real side of the balance sheet, you can only deal with it through structural reform. You need to deal with the quality of assets, not the quantity of liability. You need to deleverage not by inflating the debt, but by increasing the quality of equity.
As Nobel Laureate Joseph Stiglitz shrewdly observed, the heart of the problem of financialisation has been the growing inequality of income and wealth. The negative side of financialisation is that the global financial system is turning over faster and still concentrating, with an increasing maturity mismatch.
First, trading in foreign exchange markets averaged US$5.3 trillion per day in April this year, 60 per cent higher than in April 2007. Most of the trading is between financial institutions.
Second, concentration in the financial sector is still increasing. Financial Stability Board (FSB) data on the top 28 globally systemically significant financial institutions showed that their assets rose to US$45.4 trillion, or 63.3 per cent of 2011 world gross domestic product, compared with 47.7 per cent in 2002.
Third, FSB data from 2011 showed that roughly 80 per cent of the financial system is financed with short-term liabilities, but world demand for long-term mortgages, sovereign debt and infrastructure funding is rising.
Hence, the solution to unsustainable financialisation is not more debt, but more equity, or the net worth of real sectors - households, enterprises and the government sector. That has to be generated through real-sector reforms - the asset side of the balance sheet.
The real lessons from Lehman are therefore about the need for rebalancing: moving away from short-termism towards long-term financing of the real economy; promoting the quality of assets that contribute to GDP growth; addressing social inequality by increasing access to financing; and funding infrastructure development to sustain long-term growth.
Flirting with finance diverts attention from what really matters - the real economy. The focus should be on real people, not more pieces of paper.
Andrew Sheng is president of the Fung Global Institute