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What could sustainable exit from covid-19 ‘debt trap’ look like?

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The pandemic has struck developed nations at a time when they are already faced with a swath of problems; rising debt, climate change, low interest rates and increasing inequality, to name just a few.

Lockdowns are seeing even more mountains of debt piled onto already struggling nations, and economic growth figures have been plummeting.

But what if many of these problems could be fixed with one type of solution? What if we realised that the answer to many problems lies in a systemic solution; which could, at its core, be the redefinition of the purpose of economic growth and also the financial system towards sustainability and inclusiveness?

In order to tackle the enormous and increasing challenges at the roots, should nations seek to drive deeper strategic and systemic change?

Expert Investor has talked to two economists who believe that a system change is needed: William White, senior fellow at the policy research think tank C.D. Howe Institute and former chairman of the Economic and Development Review Committee at the OECD, and Nick Silver, a director of Callund Consulting and actuary among other roles.

They explain their views on the current state of the financial system, why it needs a fundamental overhaul and ways to advance a sustainable reform.

The debt trap and financial stability risks

Citing OECD figures, White says that the debt level of the OECD countries is estimated to increase by $17trn (€15trn) in 2020 due to the pandemic.

He warns that financial stability risks are just one of several unintended consequences of the repeated use of monetary easing, along with its declining effectiveness.

In his view, the 2008 global financial crisis was, among different factors, caused by too influential academic theories that markets would be “efficient” and that economies self-stabilise, which have proven to be wrong.

Liberalised markets are not always efficient and achieve the highest overall gain in output and welfare, the OECD noted in a paper from 2019 titled Beyond Growth.

Market failures, such as environmental degradation from unpriced environmental damage, can be significant.

White believes that monetary easing by central banks has led to a “debt trap”, a state where central banks can neither raise low interest rates nor keep them.

“You have these low interest rates which contribute to an increase in debt. But the point is, you’ve now accumulated so much debt that, if you raise interest rates, you bankrupt everybody.

“That’s where we were and, honestly, that’s where we are in spades going forward,” he says, warning that at a certain point, “markets will lose patience”, especially in terms of government debt.

But the negative effects of monetary easing go beyond this and work against free markets, White believes. By rescuing corporates, it supports their zombification and halts economic development.

“You need new entries and you need exits. And, so, again, orderly insolvencies and bankruptcies […] is a very important part of it. That process of constant change, evolution, is gotta be encouraged,” he says.

Bailing out companies that ought to be going under goes not only beyond economics, but would be fundamentally unfair and dangerous, he adds.

Investments without ‘real world’ impact

Adding to this difficult macroeconomic condition of the financial system, as White describes it, Silver sees the financial markets having morphed into some state of purposelessness.

He argues in his book titled Finance, Society and Sustainability, published in 2017, that, while one objective of governments is to get people to save for their retirement via the financial system, intermediaries intercept these savings and manage them to maximise their own revenue.

Investments neither succeed in providing people with a sufficient pension, nor do they finance the ‘real economy’ and its sustainable growth.

Instead, Silver points to the ‘financialisation’ of the economy, which can be defined as the increasing dominance of the finance industry in the total sum of economic activity, as the culprit.

Silver explains that “lots of financial activity is not really related to the real-world economy”.

Generally speaking, pension money does not get invested in, for example, assets like renewable energy, but stays within the financial system.

“The whole of the stock market takes money out of the corporate sector,” he says, which is due to an incentive structure supporting this system.

Banks, for example, are incentivised to allocate their resources into real estate assets, driving up their value rather than building new houses.

Asset managers and chief executives of companies, on the other hand, are incentivised to increase short-term profit, as their performance and pay are based on quarterly targets, for example, Silver explains.

As a result, investments into the long-term and sustainable growth of companies get foregone.

Intermediaries can also harm the real economy, as they take out a large portion of return as fees, Silver says.

As one example, he points to how private equity firms often load up the companies they purchase with high levels of debt, increasing their value and then selling them on at a profit.

The company is then more vulnerable to future shocks, as it can be seen during the covid crisis.

So, for example, many restaurant chains in the UK are facing bankruptcy – nearly all of them highly indebted following private equity buy-outs, Silver explains.

Given such financialisation of the economy, he is sceptical about the effectiveness of environmental, social and governance (ESG) investing, despite its enormous growth.

“The industry doesn’t shift,” he notes.

The need for system change

White says that a paradigm shift is needed, arguing that at the heart of it is the recognition that economies are complex and adaptive systems which are inextricably linked with the environment.

“The fundamental problem is that economic policies to date have been based on silo rather than systemic thinking,” he says.

This silo thinking has to date led to “false beliefs” by agents such as policy makers and central bankers.

Among these beliefs, he says, are well-intentioned but mistaken macroeconomic policies and mistaken assumptions about the nature of the global economy.

The path beyond growth to sustainability

White promotes bankruptcy and restructuring procedures to solve environmental problems, and when debt levels are already high.

“In this regard, the sooner the problem of ‘stranded’ energy (high carbon) resources is recognised the better. The greatest danger is the suggestion that all these real problems can be papered over with continued monetary expansion,” he says.

In its paper, the OECD calls on policymakers to go “beyond growth”.

It writes that “we can no longer rely on economic growth on its own to make our societies better off” given the significant harm and systemic risks that it brings.

A wider set of objectives and measures of economic and social progress needs to be achieved alongside rising GDP economic policy, the OECD argues.

These policy objectives are: environmental sustainability, rising wellbeing, falling inequality and system resilience.

“It is now widely argued that a more active fiscal policy is both necessary and desirable in present conditions when interest rates are very low and monetary policy has largely run out of options.

“Contrary to neoclassical orthodoxy, it has been shown how high levels of public borrowing and debt can be sustained so long as the growth rate of the economy exceeds the rate of interest paid,” the paper notes.

Steps towards sustainable reform

To create a financial system that supports sustainable growth of the real economy, Silver emphasises, among numerous ways, impact investing, infrastructure investments, lowering the capital requirements for green investing and the creation of a digital currency.

A group of central banks is currently considering the latter, including the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank.

Silver believes that a digital currency would reduce the banks’ monopoly on allocating resources, adding that it would be more egalitarian.

“Now that banks have become risk averse after the financial crisis, they are not lending enough, and when they are lending it is to the wrong sectors,” he writes in his book.

While Silver sees some problems with Bitcoin, he still believes that digital money could solve this issue, as money supply can expand in line with the needs of the economy and not be misused.

White suggests to policymakers to embrace the complexity of the financial system and its adaptive behaviour, for example by accepting that multiple objectives make trade-offs inevitable.

A decisive step forward would be if policymakers correct their assumptions about macroeconomic policies, he writes in a 2020 article.

However, this is also the biggest challenge, as it would require admitting past errors, which is problematic for both policymakers and central bankers, White adds.

Elena Johansson

Senior Reporter

Part of the Bonhill Group.