It is only a few short years ago that the world economy was shaken to its core by the global financial crisis. That we again face the threat of profound and traumatic disruption so soon after these events is a measure of the urgency that governments must employ to correct the structural imbalances necessary to get the global economy back on song for the long term.
After World War Two, the world’s superpowers tried to maintain a system of semi (or quasi) gold standard in which major currencies were fixed to the US dollar, which was in turn fixed to gold at $35 an ounce. This global monetary system was basically a fixed-rate regime, which imposed an external discipline to restrain monetary expansion globally.
The Bretton Woods system became unsustainable as the US began to allow money supply to grow well beyond the gold reserves held by the US government. When the system collapsed in 1972, the world’s monetary system was converted to a fiat money regime in which major international currencies freely floated against each other. The post-Bretton Woods era represented a new era in which governments would be given more or less a free hand to pursue their national interests and domestic policy agenda without the rigid constraints imposed by a gold exchange standard. Unfortunately, the initial experience under the new regime was far from satisfactory.
A three-D view
In my view, financial and macroeconomic stability cannot exist without an effective monetary anchor. For many centuries, the link to the precious metals had provided an external monetary anchor. Of course, the gold standard or silver standard had many shortcomings but it nevertheless provided an externally imposed discipline against monetary expansion.
However, under the fiat money and floating rate regime, financial and macroeconomic stability can only be achieved if we have 'the three Ds'. The first D stands for 'monetary discipline', the second 'fiscal discipline' and the third 'market discipline'. Conceptually, the removal of the external monetary anchor in the form of backing by precious metals must be replaced by these three types of discipline. If any of these three disciplines breaks down, then serious consequences or even a financial crisis may occur.
Unlike a fixed-rate regime in which a national government can only issue currency if it can provide the backing (such as gold reserves), a floating rate regime allows national authorities to issue currency freely to suit their domestic needs. As we know, national central banks play a crucial role in controlling or influencing the supply of money. By changing interest rates or the price of money, central banks indirectly influence the expansion of credit and thus money supply. Good monetary discipline is clearly needed to ensure that money or credit expansion does not become out of control.
The initial experience in the US with the fiat money regime was not at all successful or pleasant. There was runaway inflation, rising from 5.8% in 1970 to 11.2% in 1979, and, as a result, Paul Volcker, chairman of the Federal Reserve, had to introduce drastic measures to combat inflation by pushing interest rates to as high as 19%. It is now widely accepted that the breakdown of monetary discipline will lead to financial chaos with huge shocks to macroeconomic and financial stability.
When economies break down
After the recent global financial crisis, we have come to realise how important it is to maintain the appropriate monetary discipline. It has been argued by many economists that one of the contributing factors leading to the crisis was that the US policy interest rate was set too low for a prolonged period, which further fuelled credit growth and the housing bubble in the US. Of course, financial innovation and the creation of highly opaque and leveraged financial derivative products, such as collateralised debt obligations, also helped amplify the severity of the problem and transmit the shockwaves across the global financial system. The result: the global financial system nearly collapsed.
More often than not, monetary discipline breaks down because of the lack of fiscal discipline. One major reason why the US had to abandon the Bretton Woods system was the huge fiscal burden of financing the war in Vietnam, which also led to a sharp deterioration of the current account position of the US. There have been many examples of governments spending beyond their means resulting in the piling up of government or public debt.
Traditionally, we all believe that market forces would be the last guard when national authorities failed to exercise monetary or fiscal discipline, or both. In theory, the market should respond to a breakdown in monetary or fiscal discipline by demanding a higher risk premium for the sovereign debt issued by those countries that are not behaving in a prudent manner. However, market discipline also seems to have broken down in many instances. For example, right after Greece joined the eurozone, the market was somehow attracted by the so-called convergence play and for eight years from 2001 to 2008 it ignored the fundamentals of Greece and its A rating and traded Greek sovereign debts as an AAA credit, with a spread of as low as eight basis points above German bunds in February 2005.
Looking back, the rationale for this kind of convergence play defies common sense and any analysis of fundamentals. However, the breakdown of the market discipline had played a key role in encouraging and facilitating continued erosion of fiscal discipline of the national authorities by conveying the wrong signals about the market tolerance, and the appetite for their sovereign debts. As an illustration, the sharp fall of interest cost (10-year government bond yield) from more than 10% in the mid-1990s to a low of 3% in the mid-2000s had also helped lower the cost of Greek government borrowings and created the illusion of the affordability and sustainability of the rising pile of government debts.
A wake-up call
While we have seen many instances where market discipline has broken down, it is hard to believe that market discipline will break down permanently. As Europe has recently found out, the market can suddenly awaken and begin to doubt the fiscal sustainability of some members of the eurozone. This belated awakening has so far created considerable dislocation to the banking system and capital markets. Once the market discipline begins to kick in, the national and pan-European authorities have little choice but to push forward a series of drastic, painful but necessary austerity measures to quickly achieve fiscal consolidation and to restore market confidence.
Another important issue we are facing is to what extent monetary policy could be effective in supporting and stimulating economic growth. In other words, it is by no means clear that excessive accommodative monetary policy would be effective in boosting demand and creating jobs in the US and elsewhere and whether such policy, if deployed for a long period of time, would have undesirable consequences, both overseas and domestically, that would outweigh the likely benefits it could potentially generate.
I would argue that we central bankers must be able to recognise the pitfalls of trying to achieve goals that are beyond our reach. And I would agree with US Federal Reserve chairman Ben Bernanke when he said in his speech at the Jackson Hole conference in August 2011 that “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank”. While monetary discipline, fiscal discipline and market discipline are absolutely necessary conditions for economic stability and prosperity, they are clearly not sufficient conditions. For the global economy to recover and to return to its long-term growth trend, important structural imbalances in the major advanced economies have to be corrected. We must recognise that economic growth and prosperity built on excessive debts by households, corporates and the governments are clearly not sustainable. We must awaken to the cruel reality that somehow the debt overhang accumulated over the years has to be reduced and redressed before consumers and investors can regain confidence in a brighter future.
In conclusion, the breakdown of monetary, fiscal and market disciplines has contributed to the deepness and severity of the latest crisis in the advanced economies. In my view, there is unfortunately no easy way out or clever solution that could avoid the need and thus the pain of structural adjustments that would redress the imbalances built up in the past decade or two. Going forward, we must realise that we have to restore the 'three disciplines', without which the conditions for sustainable economic recovery would not exist. Are we now in an era of awakening? I am not totally sure but I think, or at least I hope, we are. If not, then market forces would eventually push all of us into that position, except that the later the awakening occurs, the heavier the price we will have to pay.
Norman T L Chan is the chief executive of the Hong Kong Monetary Authority.
