By Michael Pomerleano

Reforms typically take place when the urgency of now is evident in the midst of a crisis. That is when vested interests are weak, and policy makers and regulators are no longer complacent. Recently there is a sense that the financial crisis is abating,  that business is returning to normal and a false sense of stability in taking hold; but it does not imply that the crisis is almost over. The belief that the world has overcome the crisis is faulty for several reasons.

First, the guarantees have instilled a false sense of stability and well being, and financial risks, such as spreads, are no longer indicative of the condition of the financial system. Second, as far as one can tell, few measures address structural problems. For example, the international policy community has not demonstrated that it create an orderly global monetary and financial system. Third, budget deficits and public debt are increasing and will take a growing toll on education, health, and welfare expenditures, and sap social well being. We have moved from a raging crisis to a silent, but equally pernicious crisis, with a weak economic outlook, financial sector fragilities, and strains on public finances.

Numerous authors have endeavoured to identify the causes of the recent crisis, and proposed measures to reform the monetary and financial system. In this context, it is instructive to assess how much progress we have made in key financial policy priority areas or, for that matter, along any other public financial policy dimension that was discussed at the height of the crisis. In the following section I identify several economic policy challenges in a subjective order of priority, and assess the progress against the prescriptions considered.

Global policy challenge 1: The global Imbalances. As Martin Wolf has pointed out, global imbalances were at the core of the excess liquidity that swept the financial markets. The global imbalances cannot and will not go on forever without causing repeated financial crises. The imbalances have receded temporarily during the crisis, but structurally they are bound to resume when the hoped for recovery arrives. Nothing has been done in the policy arena to prevent global imbalances.

Global policy challenge 2: Financial Stability. The limited and half-hearted efforts under the Westphalian principles (of sovereignty of states and the fundamental right of political self determination; equality between states; and of non-intervention of one state in the internal affairs of another state) of the International Monetary Fund are not suited to meet the challenges of interconnected markets.

As Michael Spence writes (Lessons from the Crisis, Pimco Viewpoints, November 2008), it would be desirable to establish a global commission of top industry professionals and academics to address the challenge of measuring and detecting systemic risks and provide the underpinning of an effective “early warning” system.

Global policy challenge 3: Recapitalisation of banking systems and removal of toxic assets. The TARP in the US and the recapitalisation effort in the UK have achieved limited objectives. In the US, the Public-Private Partnership Investment Program,  introduced by the Treasury on March 26,  was designed to help banks to rid themselves of loans that hurt their operations.

The Federal Deposit Insurance Corporation parallel scheme was the Legacy Loans Program. Recently, the FDIC called off LLP and the PPIP is a fading memory. Incontinental Europe, and in particularly in Germany, there is virtual denial about the severity of the banking problems.

Global policy challenge 4: Recognition and acceptance of financial regulation as a benefit and not as a cost of doing business. The US was expected to lead the world by example to a sounder financial system. This week, the Obama administration released the blueprint for reforming financial regulations in the US. Many of Treasury secretary Tim Geithner’s initiatives never reach implementation after their triumphal unveiling, such as the PPIP. The headlines from the media, such as The Economist point to the obvious disappointment: “Barack Obama’s plan for regulatory reform is not bold enough”. Other  analysts, such as Simon Johnson in The Baseline Scenario (Too Big to Fail, Politically) have joined the criticism.

However, the Obama reforms have some virtues. The reform package belatedly emulates the Australian reform approach from 10 years ago, or more, in two respects: consumer protection and systemic stability. The proposed consumer protection appears to be similar to the Australian Competition and Consumer Commission - responsible for competition; and the powers proposed for the Fed appear similar to those of The Reserve Bank of Australia’s responsibility for overseeing systemic stability through its influence over monetary conditions and through its oversight of the payments system. However, as opposed to the Australian authorities, the Obama plans fails to consolidate the fragmented Byzantine US supervisory apparatus in an entity similar to the Australian Prudential Regulation Authority that is responsible for prudential regulation; Australia as well adopted measures to ensure competition. In Obama’s plan, the US’s fragmented supervisory apparatus, including the benign neglect of insurance and pension supervision, as well as other aspects such as competition policies are not addressed.

It is interesting to benchmark the plan with regard to basic reforms that have been talked about for a while:

• creating a wall between commercial banks and investment banks as suggested by Paul Volcker and the G30;
• introducing better prudential countercyclical measures;
• addressing the derivatives landmines such as instilling a requirement that investors who buy credit default swaps have provable exposure to the underlying security that they are insuring and standardizing derivatives on exchanges with adequate clearance and settlement;
• reforming the short term determinism of compensation structure and settlement.The proposed US reforms are silent on those issues.  Under Obama’s plan, trading in customised derivatives will remain an important part of the financial landscape. The reforms are cosmetic and politically motivated to diffuse public outcry over the excesses.

Global policy challenge 5: Conduct of monetary and fiscal policy. The Fed, under Chairmen Greenspan and Bernanke, has a long standing aversion, founded in analytical research, to “leaning against the wind” in preventing asset bubbles. There has been little if any discussion by the chairman on how the conduct of monetary policy will be reformed in the aftermath of the bubble.

A recent IMF note, Fiscal Implications of the Global Economic and Financial Crisis, discusses the fiscal implications to the crisis. It is instructive reading. The urgent need for solutions is evident but the policy actions are not in sight.

There is a considerable disconnect between the stern principles enunciated by policymakers and their actions. Recently Jacob Frenkel made an astute observation: there are two types of investors: the ones with short memories, and the others with shorter memories. To that we need to add two set of policy makers as well. We are back to business as usual. How disappointing!

Michael Pomerleano is advisor on financial stability to the Bank of Israel, on external service from the World Bank

June 21, 2009 6:00pm in Crisis, Regulation | Comment