John Llewellyn, the former deputy economist of the Organisation for Economic Cooperation & Development in Paris, now runs a London consultancy. Our thanks to Vivian Lewis, who shares Mr. Llewellyn's commmentary, which was featured this past weekend in her Global Investing newsletter.
“It is not possible to predict exactly when a crisis will eventuate, nor the precise form it will take. But it is possible to identify pre-conditions, and today the macro breeding ground is not only serious, but intensifying
“Policymakers meanwhile cannot agree on what constitutes a bubble and how to regulate financial markets and new products now on offer. It has become a commonplace to say that considerable progress has been made in financial regulation. This may be true in a narrow sense, but much remains to be done.
“Markets run on greed. While greed cannot be eradicated, it can be discouraged. But few financiers have been fined, and almost none have been jailed. Incentives remain unduly skewed towards risk-taking.
“Banks, are now better capitalised, but still not sufficiently sound. Banks in Europe can still hold their own national sovereign debt without reserving any capital against it, sustaining the latent ‘doom loop’ between them and often barely-solvent sovereigns.
“Banks also still have too much latitude to use internal models to set their own risk-asset provisioning. “Meanwhile, systemically-important non-bank intermediaries remain seriously undercapitalised, and likely have increased their share of financial activity as a result of regulatory arbitrage.
“Moreover, recent policy in many countries – most notably the US — is increasingly moving towards easing financial regulations, rather than tightening them further.
“So there are increasing links and interconnections between markets. Even if capital requirements are sufficient at individual-bank level, the regulation of economy-wide leverage is insufficient.
“The US is particularly at risk. Its diffuse regulatory system remains complex and unwieldy: five separate entities oversee banks at the federal level, and many more bodies operate at the state level. No single agency has overall systemic responsibility.
“Most of the attention has been focussed on banks and investment banks. But the 2008 crisis went much wider: extending to the insurance industry, hedge funds, structured investment vehicles, and beyond. The US lacks any counter-cyclical macro-prudential authority. Moreover, Congress has voted to limit the emergency loans that the Fed can make to non-bank financial institutions in extremis.
“At the global level, swap lines from the Federal Reserve were one of the most important cross-border crisis responses, helping to alleviate potentially-devastating dollar funding gaps at non-US banks.
“Today, such cooperation might not be politically possible. Yet the same problems remain without a solution. Post-2008 regulatory reforms can keep the same crisis from happening again. But the capacity to respond to a crisis which is a bit different is lower.
“More worrying is that the next trauma – whether originating in shadow banking, cryptocurrencies, poor auditing, or whatever — will almost certainly be different. And there is scant evidence of policymakers being able to recognise the early symptoms, let alone respond.
"Macroeconomic conditions are dangerous:
▪ Debt is at an all-time high. The total global debt stock now stands at $175 trillion (or 325% of GDP). In the US alone, outstanding car loans – mostly sub-prime – total $1.2 trillion, close to the $1.3 trillion-odd of outstanding prime mortgages in 2007, while outstanding student loans total $1.4 trillion.
▪ Macroeconomic imbalances are intensifying. The US is heading for Reagan-era twin deficits; Germany’s external surplus is a huge 8% of GDP; Emerging Market dollar liabilities have doubled since the 2008 financial crisis.
▪ Financial conditions remain very easy. Long rates and term premiums are still at historical lows.
▪ Irrational exuberance is on display, especially in the US where, following unwarranted pro-cyclical fiscal stimulus, the equity market is near an all-time high. Valuations are stretched.”