Having recovered their composure after a tumultuous start to 2016, investors are now looking for a new catalyst, but what will it be and where next for markets?
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Q: What were your key areas of interest before you joined Schroders?
A: At London Business School I worked on what was then the macro model of the UK economy. I was part of a 12-strong team working on the model and also got involved in one or two papers that we wrote including one on UK exports. It was a great introduction to macroeconomics and econometric modelling.
Q: Do you think that the models you were working on then would have been able to spot the warning signs of an impending financial crisis such as we have experienced?
A: Clearly, with recent events in mind, there were areas that the models didn’t pick up. You have to look into the way economists treat the banking system as very often in these models it is treated as very passive. It was assumed that all you had to do was work out the demand for credit from households and businesses and the banking sector would provide it. Now that we’ve had the financial crisis that is something that can’t be taken as a given because the banks are not providing credit in the way they used to. Yet even before the crisis there was an issue that the banking sector was taking on a lot more risk than we had been aware of. It was therefore driving a lot of economic activity rather than simply acting as a passive source of credit. That was also something that the models simply didn’t detect. That’s the sort of area that economists are trying to focus on at the moment. Of course rather than having the problem of banks driving things forward, they are now pushing things backward as they try to deleverage and repair their balance sheets.
Q: Have the policy responses to the crisis been insufficient due to a misunderstanding of the impact of a deleveraging banking system?
A: People have got a much better grasp on the deleveraging and what it’s doing, albeit five years into the crisis. One of the problems with the models was that we hadn’t had a financial crisis on this scale in living memory. There are a lot of economists who are now drawing on the work of Reinhart and Rogoff as a sort of template to look back at previous financial crises. Just looking at the way economies behaved after previous financial crises has actually provided some good insights into what we are currently going through. The main question for policymakers is how best to navigate this period of deleveraging to get us back to a thriving banking system. The difficulty is that the banks themselves are having to do this very slowly and the politics surrounding it is very complicated. I do have some sympathy with what Mervyn King was saying at a recent Treasury Select Committee hearing about breaking up RBS to try and get the lending system working again more efficiently.
Q: Does a banking system trying to pay down debt complicate the ability of monetary policy to impact the real economy?
A: Absolutely. I would actually take that one step further and say that in such an environment you have to use fiscal policy much more actively because clearly monetary policy is struggling to gain traction. What’s happening now is that the main tool available to monetary policy appears to be the exchange rate. So by saying you’re going to print more money than anybody else you can drive down the exchange rate but that, of course, is a zero sum game on a global level. The transmission mechanism from monetary policy looks to be weaker now but it is also coming through different channels such as asset prices. The process of boosting wealth in the economy through stronger asset prices, hopefully leading to higher consumption, and increasing the incentives to invest by driving down the cost of credit takes a long time. Before the crisis much of the work being produced suggested that you use monetary policy to steer the economy and fiscal policy should only be concerned with the medium term. However, I think that is this environment there is a case for trying to stimulate growth fiscally because the worrying thing is that if you have a long period of very weak growth you get a hysteresis effects whereby persistent high unemployment can lead to people becoming deskilled. So there is a case to be made for targeted, temporary measures to increase spending on particular projects that afford younger people the opportunity to get work experience. It will come to an end after a few years but if you’ve provided that stimulus then maybe the economy will have gained some momentum and the deleveraging process will be further along.
Q: Is there a concern that politicians are starting to rely too heavily on central bankers?
A: That is a concern but the bigger worry of the markets is the risk of inflation in the longer run. As a result of this we have already seen an increase in inflation expectations by the market and the Bank of England is already moving quite a lot in this direction. QE is helping to keep yields on government debt down so there’s not been a signal from the gilt market apart from this increase in the breakeven rate. Yet it’s beginning to ring an alarm bell
Q: In Europe the European Central Bank has been criticised for not providing sufficiently supportive monetary policy. Do you think that criticism is fair?
A: First of all, [Mario] Draghi has said that he will do “whatever is necessary” to protect the euro so it was at least a statement of intent. The bigger problem, which we have alluded to in a number of recent research pieces, is that this helped to drive down yields meaning that struggling countries breathed a sigh of relief. We then see an election in Italy that has threatened the reintroduction of the old guard who are quite frankly anti-reform. So Draghi’s done a great job of driving down yields and thereby putting finances onto a more sustainable path without having to spend any money but the cost of that may have been a certain amount of complacency in Europe. The risk now is that countries start backtracking on structural reforms and austerity. The Outright Monetary Transactions programme is only available to nations that are implementing these reforms so if they start to backtrack on them what will the ECB do?
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Visiting Professor of International Economic Policy, Princeton University14 articles | View profile
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