The connection between the real economy and financial markets is often elusive—not least during times of financial crisis. There is, on the one hand, the production of goods and services—real things that Bill Robson, president and CEO of the C.D. Howe Institute, summarized as “food, clothing and shelter”—and, on the other, the claims on those goods and services represented by financial assets.
Robson was speaking on a panel called “Are We Poorer Than We Think?”, which examined the role governments and policymakers play in financial markets and how that role has evolved over the last 20 years. Robson likened the relationship between real wealth and financial claims to two skaters playing crack-the-whip. Sometimes the real skater is ahead—as was true immediately after World War II—sometimes the financial skater is ahead.
“Small changes in the pace set by the real skater,” he said, “can really whip the financial skater backwards and forwards. This has happened spectacularly over the past decade.”
This distinction is important, Robson argued, because people have a tendency to reify financial wealth—like King Midas. Just as Midas could not eat gold, however, wealth is only as a good as the goods and services it can purchase. Homeowners tend to see their house as a retirement asset, forgetting that they still need shelter.
He singled out pension promises as potentially problematic examples of illusory wealth. “Will the participants in those plans ultimately get the food, the clothing, the shelter, the medical care, everything they want?” he asked. “Well, obviously in Detroit, they won’t.”
This is an instance where the financial skater has raced ahead of the real skater.
To avoid a crisis—a wipeout of the financial skater—there are two options for bringing the financial skater and the real skater better in line. One is to deflate the financial tally through orderly writedowns. Better, Robson suggested, is policy that helps the real skater catch up, above all, by boosting productivity.
The role of pensions
Pensions have a role to play—indeed, they have a vested interest, said panelist John Murray, former deputy governor of the Bank of Canada.
“Pension funds have a longer investment horizon, the ability to look through short-term volatility—and, therefore, can act as a stabilizing influence,” he noted. “They bring the advantage of locked-in contributions so we don’t have the risk of deposit flight or runs. And, thirdly, they have limited leverage…for the main, these are real money investors.”
But, there is some evidence from the Bank of England that pension plans contributed to the financial crisis, ironically, by de-risking, which put pressure on bond prices. The strongest were the ones that had the greatest impact, not the weaker ones, which were forced to remain in equities.
Still, governments recognize the stabilizing role of pension funds; so much so that they have a lighter regulatory touch. What’s key is for pension plans to act as thought leaders.
Murray sees a “double coincidence of wants: the markets needing pension funds and pension funds needing stable effective markets.” Pension funds can be “effective lobbyists looking to their own self-interest in an enlightened way to ensure that this connection between the real and the financial side is as close and unexaggerated as we like.”