The financial crisis of 2008 may have started in the US banking sector but it went on to unleash the deepest global recession since the Great Depression.
The year 2009 became the first on record where global GDP contracted in real terms and the lost growth resulting from the crisis and ensuing recession has been estimated at over $10 trillion (more than one-sixth of global GDP in 2008).
Across the globe, governments and central banks rallied to avert a major crisis: bailing out banks that proved too big to fail; cutting interest rates to near zero; and pumping liquidity into the system with quantitative easing.
That process took most of the decade to implement before there was a reliable return to growth across the US and Europe. The IMF has warned that governments and regulators failed to push through the reforms needed to protect the system from reckless behaviour. Economists say we are approaching conditions ripe for another financial crisis, followed by a global recession.
The big concern is that governments do not have the policy tools they had in 2008 to prevent a financial shock turning into a freefall, and overall debt levels are higher than during the previous crisis.
At the World Economic Forum’s Annual Meeting in January 2019, we spoke to Kenneth Rogoff, Professor of Public Policy and Professor of Economics at Harvard University, and former chief economist of the IMF about these issues. Below is an edited transcript.
How will policymakers react, if there is another financial crisis?
I don't think we'll necessarily have another financial crisis any time soon, although the political turmoil in the United States and the world is such that I don't really feel terribly safe about anything at the moment.
When we have another financial crisis, our tools are limited. One problem is that interest rates are very low and it gives the central banks very limited room to cut interest rates.
Another problem is that there's so much divide across the political spectrum that, unless the situation is incredibly grave, it may be difficult to put together a strong enough government spending fiscal response.
The thing that concerns me the most is the view that only stimulus should be used in response to a financial crisis and that there isn't a need to address the problems within the financial sector; that's very problematic.
In the last crisis many people reached the conclusion that the simple and most elegant intervention would have been to find a way to write-down subprime debts in the United States using the government's balance sheet; and also in the Eurozone, to find ways to write down the debts of the highly indebted periphery countries. That's very difficult to do but countries and regions that are very successful at emerging from financial crises have debt write-downs.
The problem is, if you don't do that, you're left with a weak financial sector for years and years and years – it can't make loans, you don't grow again – and that's not very healthy either.
Do central banks have the independence they need to react effectively?
In the last financial crisis, central banks surprised a lot of policymakers with just how much independence they have. After all, the central bank can issue debt of its own – that's what the Federal Reserve did – very much like the government does. All the central banks issued masses of debt in order to try to increase the money supply. They issued very short-term debt to buy back long-term debt.
I don't think governments totally realized they could do this. Unfortunately, there had been a lot of restrictions put on central banks and their ability to respond creatively, particularly in the United States. Whether those restrictions would be blown through we don't know. But central bank independence remains very strong around the world, despite these restrictions.
They have the independence they need but the tools are lacking. I would like to see central banks have the ability to push interest rates well into negative territory in a deep emergency, not in normal times, as a way to try to stimulate the economy.
It would have been much more effective than quantitative easing, forward guidance, these obscure things that they were doing that had some effect, but most studies show the effect was pretty limited.
Given that wages haven’t quite recovered since the last crisis, what would a downturn mean for normal people?
Unfortunately, when there is a financial crisis, a debt crisis, any kind of crisis, the hardest hit are almost invariably the disenfranchised, the poorest people and, very often, the middle class.
So, a financial crisis would be bad for the wealthy but it would be worse for ordinary people. After all, they don't have a cushion, they don't have things they can live off of.
So, when we think about protecting the economy from a financial crisis, it's not just about protecting the wealthy financiers; it's about protecting ordinary people. That said, there are things the government can do to make sure that the burden is shared more equally. One of the ways would be by having much more aggressive debt write-downs than we had the last time.
Is the global economy always going to be prone to these types of downturns or is there a better way to do things?
Unfortunately, financial crises trace more to human nature than the particulars of the legal system, the financial system. We've been having them for centuries; they go in cycles.
What we can do is make it longer till the next time, to put in stronger measures, to put in more creative measures. To some extent that really has been done after this financial crisis. There's been a lot done to try to heal the banking sector, to make it more safe.
But, at the end of the day, we are very positive people, particularly entrepreneurs, businesses. So, a lot of this money that was causing problems in the conventional financial sector are now radiating out into what's called the shadow banking sector and other places.
How should we measure economic progress?
We have trouble measuring ideas and goods. An example is, I'm here at the World Economic Forum in Davos, Switzerland, I can speak to my children using different kinds of media, it costs almost nothing. People can speak to their relatives around the world; businesses can speak to each other. There are kinds of innovations that we don't measure very well, particularly ones that relate to consumers, but also some that relate to businesses.
The old way of measuring – gross domestic product – was good at measuring cars, how many houses we build, certain other things. But it's getting farther and farther from what we really think of as economic progress.
Of course, there are other issues like equality. Economic welfare depends not just on the total income the society has but how it's distributed. We can't get all this in one measure, but we could have better measures of what we have in society. We certainly should use measures of how equally it's distributed more in determining policy.
What's the biggest thing the world economy gets wrong right now?
There's no question that policymakers are forced to have a very short-term focus and this leaves out future generations: climate change is the big one. I don't know what the world will be in 2100 but there's pretty clearly a risk and it gets understated in policy, and the private sector solutions are not adequate.
Virtually every economist would favor having a carbon tax of some sort, much more than we do today. That's just one example where we look short-term but not long-term, and we depend on our institutions and policymakers to try to try to be longer term. It's very tough because of course voters are here now and politicians have to care about them. So it's a very difficult balance.
How optimistic are you for the future?
My children and their friends are very optimistic about technology for the future. It's interesting the contrast: if you speak to economists, to central banks, to Wall Street, they say we're done inventing anything, we’ve had 250 great years, now it's going to slow down. I think that's wrong; that actually we're likely to see an acceleration in technology.
Does that make me optimistic for society? I'm not sure because society has a very difficult problem handling rapid change, handling innovation. In some ways, it might be easier if we settle down to a slower pace of technological growth.
That's not what's going to happen. Mankind's innate optimism, innate curiosity is going to be producing new ideas. Artificial intelligence is here; it's coming very rapidly. Whether it's 10, 20, 30 years, there's no question that its imprint will be very great.
So, I'm impressed that technology will improve very quickly. My biggest worry is that society and politics will not progress at a similar pace and that disconnect between the fast pace of technology and the slow pace at which societies and politics change could bring many problems.
Is there one particular issue that keeps you up at night?
I certainly worry about the growth in populism worldwide. I strongly agree with trying to have a more egalitarian society. I don't think that simply going to back to 1960s socialism is really the answer to that.
I would like to see more market-oriented policies to try to improve education, improve the distribution of income. I worry that that's not the direction that we're going; that we'll see a much cruder, more Neanderthal approach to trying to solve these problems. We've seen it a little bit in the United States in recent years. I worry that that's something we may see in other countries in the not distant future.