Adair Turner's Speech At Mansion House On Financial Crisis And What to Do About Deflatoinary Risks

This speech by Adair Turner, who is chairman of Britain's FSA, provides an excellent summary of how the financial crisis developed, and what is being done in Britain to prevent the next crisis.  More importantly, however, he describes the deflationary headwinds that are in the way of a full recovery from the Great Recession. 

The FSA has been in existence for 12 years.  During the first eight years it was sailing in an ocean that made for good sailing.  During that period, the grounds were being laid for the production of an iceberg that was lying beneath the surface we eventually hit.  The last four years have been devoted to overcoming that disaster.  His description of causes are similar to those made by Financial Crisis Committee funded by the US Senate.  Rules were developed that enabled to financial sector to employ excessive leverage in order to achieve short term gains at the expense of longer term stability. This led to systemic risks which were not detected early enough and it produced a banking culture which took advantage on an opportunity to enrich itself, even at the expense of its customers, and eventually at the expense of the taxpayers.  He argued that banks are not like other businesses that we can afford to let fail.  They put the entire economy at risk when we allow the balance between risk and return to be distorted.

He described many of the reforms underway in the FSA and in the Bank Of England to deal with the use of excessive leverage and liquidity risks in the banking system.  He also spoke about Basal lll and the recommendations of the Vicker's Commission on the separation of retail banking from investment banking, as well as the plan to regulate compensation practices and the banking culture that developed from those practices.

He then turned to the problems of the deflationary risks which were described in the recent IMF forecast of global economic growth.  Excessive leverage by households and the private sector have led to a process of private sector deleveraging which has led to a decline in aggregate demand.  That, in turn, has shifted the use of leverage from the private sector to the public sector.  Public sector debt has increased to the point that fiscal policy is contributing to the decline in demand as austerity programs have been implemented to address the public debt burden.

Orthodox responses to deflationary risk have also become less effective since short-term interest rates are at the zero bound.  Quantitative easing has been used by replacing purchasing long term bonds from banks and replacing them with cash reserves.  Ordinarily, lower interest rates would stimulate demand, but this is difficult when banks are deleveraging and attempting to rebuild capital reserves. The private sector is also deleveraging and less interested in taking advantage of low interest rates to increase investment and consumption.

This has led the Bank of England and the FSA to develop policies that will enable banks to use liquidity buffers when needed as well as capital buffers in order to encourage credit expansion.  Britain is putting capital measures in place, to insure future stability in the financial sector, but needs to insure that they are not the stability of the graveyard in the face of deflationary headwinds to economic growth.

The deflationary headwinds that we face are the result of global deleveraging in the developed world.  Europe correctly blames the US and the UK for their contribution to the deflationary threats that we all face.
On the other hand, the UK and the rest of the world are at risk due to the economic problems in the eurozone.  Our second intellectual problem was not to foresee these problems.  They were not the result of government profligacy in Spain, Italy and Ireland.  The increase in sovereign debt in these countries was due to the overuse of leverage by the private sector.  This led to fears of insolvency in the banking sector that are related to the fear of state insolvency, since states may need to bailout their banking sector.

The eurozone needs to develop a banking union and greater fiscal integration.  If this is not politically possible it needs to find a path to dissolution that does not lead to chaos.  Banks need to be able to provide credit in order to support economic growth and austerity measures taken to reduce sovereign debt burdens have to be developed which do not impede the necessary growth in necessary to restore balance.