Mervyn King - 'We are not out of the woods yet'

Lord King says the major rebalancing needed for the global economy to become sustainable is likely to be resisted to the last. Photo / AP

Former Bank of England governor takes gloomy view of future unless investment becomes more profitable.

The global financial crisis is far from over and the underlying problems that gave rise to it remain unsolved, says Lord King.

While policymakers had taken action to deal with the immediate consequences of the crisis, after five years the understandable and widespread anger at the magnitude and distribution of the costs was growing, not diminishing, said King, who was governor of the Bank of England from 2003 to 2013, at a public lecture in Wellington on Monday evening.

People were questioning whether capitalism still worked and whether it inevitably led to greater inequality.

On King's analysis, focus on the rise and fall of housing markets and the huge expansion of household and government debt mistakes symptoms for causes.

He identified two underlying factors whose toxic interaction gave rise to the crisis of 2008.

One was a global imbalance between saving and investment and the other the hubris of a Western bank system unable to put that capital to sensible use, leading instead to an unsustainable build-up of debt.

Over the past 25 years the global economy has had to absorb billions of additional workers when China, India and countries of the former Soviet Union joined the international trading system.

As countries followed what had been the proven strategy of an undervalued exchange rate to permit export-led growth, the consequences were ballooning current account surpluses and in the words of King's former US counterpart Ben Bernanke, a savings glut.

Even though many Western economies (New Zealand among them) were saving less than they required to fund their investment needs it was not enough to absorb that excess of savings.

So real interest rates fell, to levels "difficult to reconcile with the efficient operation of a market economy", and asset prices climbed.

"Although the flow of borrowing seemed sustainable, the rising stock of debt was not, or to put it another way, part of the domestic spending in deficit countries was unsustainable and based on a false and overly optimistic view of future incomes and consumption," King said.

While King and his fellow policymakers recognised the large current account imbalances were unsustainable, they expected the adjustment when it came it would probably take the form of a collapse of the US dollar.

Instead it was the banking system that collapsed under the weight of sometimes absurd levels of leverage, as a desperate search for yield in a time of low interest rates tempted financial institutions, and the investors to whom they sold products, to take on more and more risk without adequate compensation, he said.

The result has been millions of jobs lost and public bailout of a financial sector which had been home to the most fervent advocates of the disciplines of the market - for others.

The vast global monetary stimulus since the crisis had brought forward so much spending from the future that it was unsurprising we were struggling to maintain demand and see a recovery, he said.

"Monetary policy is only ever a temporary solution to a problem, a temporary stimulant. It can't provide a motive for investment when so much future spending has been mortgaged to the present.

"Around the world what we have to do is raise the profitability of investment. That means a programme of reform to boost future output and raise productivity, including infrastructure investment, improvements in education and in the operation of markets.

"Second, there needs to be a rebalancing of the world economy to allow deficit countries to shift from reliance on domestic demand to growth led by exports, with an opposite shift by surplus countries."

The imbalances have appeared to become smaller but only in the context of the downturn in the global economy, King said.

"We are in danger of pursuing policies that recreate the conditions of 2006, before the crisis."

Achieving this rebalancing, King readily acknowledges, will not be easy and will require international quantitative agreement on a path forward.

"It cannot just be [accomplished] by exchange rates. The Americans have got to be willing to talk about longer-term debt sustainability and supply side reforms and the Chinese have got to be willing to spell out how they are going to rely less on exports and more on domestic demand."

While the pressure is on debtor countries it is an arithmetical necessity for the surplus countries to adjust too.

"This is what [Maynard] Keynes talked about 70 years ago. The creditor countries need to understand that willy nilly an adjustment will be forced on them. If they don't co-operate what will happen is that people will default on their debts to them.

"That is what happened in the inter-war period."

But restructuring the relative burdens of debtors and creditors will be resisted to the last by both sides, as in the euro area today, King said.

"Certainly we are not out of the woods yet, by any means."

Mervyn King

* Governor of the Bank of England from 2003 to 2013.

* In July was appointed a life peer in the British House of Lords.

* Took the name Baron King of Lothbury, a reference to one of the streets flanking the Bank of England.

* Born in 1948, Lord King studied at King's College, Cambridge, and Harvard and taught at Cambridge and Birmingham universities.