At the fourth annual CFA Institute European Investment Conference, Roger Bootle, managing director of Capital Economics, provided a wide-ranging examination of the macroeconomic and institutional factors that contributed to the credit crisis of 2007-2009 and that underpin the ongoing sovereign debt crisis. He also contended that the financial services sector is simply too big relative to its contribution to society.
Bootle pointed to international trade imbalances as a major source of instability. These imbalances contributed to excess leverage at various levels of the global financial system, he said, and inevitably resulted in a liquidity glut that has constrained the effectiveness of monetary policy options within western economies.
“Like so much else, the financial crisis was made in China,” said Bootle, referring to the country’s massive trade surplus and foreign exchange reserves.
The economist also critiqued the pervasive and now disputable intellectual dogma of efficient markets, which has led to unrestrained and deregulated capital markets. He argued that the advantages of the supposed propensity of free markets to self correct is outweighed by the significant negative externalities that financial institutions impose on society. Bootle made a strong case for shrinking the financial sector, one premised on the observation that finance is today focused on “distributive” versus “creative” activities; that compensation within the industry is excessive; and that finance tends to divert societies’ brightest talents from other career pursuits.
Recent economic crises have highlighted the limits of several types of policy interventions, Bootle said, including inflation-targeted monetary policy and macro-prudential regulatory policy, and have limited central bankers’ maneuvering room given the prevailing liquidity glut.
Bootle suggested that another undesirable feature of the financial sector is the erratic spread of returns over time, and the tendency of players to “pick [up] small dimes for elongated time periods, before being steamrolled,” with society then picking up the tab for huge losses. However, Bootle was less sanguine about the efficacy of some of the mooted prescriptions for reforming the banking sector, such as the Vickers report in the UK, which recommends the split of investment and retail activities within banks. He took the view that such prescriptions could be stymied by the deeply ingrained propensity of avaricious financiers to game regulatory regimes.
Bootle concluded that western economies can reduce systemic risk, reform their banking sectors, and lower excess leverage from households, firms, and sovereign borrowers without jeopardizing their economic growth. However, this belief arises against the challenging backdrop of limited headroom from the traditional levers of monetary or fiscal policy, and poses a severe dilemma for policymakers as they grapple with unwinding excess leverage while simultaneously encouraging banks to lend in order to spur growth.
Still, Bootle did not shy away from laying out some arguably workable policy prescriptions. These include the elimination of preferential tax treatment of the cost of debt relative to dividends; a globally coordinated transaction tax that ensures a level playing field across countries; lower capital gains taxes for assets that are held by investors for the long term; addressing excess pay within the financial sector; and finally, legal changes to enhance the power of institutional shareholders.
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