Last week, I posted a section of a speech I delivered in Seoul at a conference organised by the government of the Republic of Korea on “Financial Reform: An Emerging Market Perspective“. This conference was part of the preparation by the South Korean government for the summit of the Group of 20 leading countries, which will take place in Korea in November. This week, I am posting the most important section, on reform. This looks at the twin aspects of the global challenge: macroeconomics and so the global imbalances; and microeconomics and so the regulation of finance.
“What are the priorities for global reform?
“First, the needed rebalancing of the world economy has to be managed, without generating additional crises. That will require a big change in the global monetary system: larger insurance mechanisms for countries hit by crises, via central bank swap lines, and easy access to funds from the International Monetary Fund, including larger allocations of special drawing rights (SDRs).
“Why is this so important? Remember the background to the global imbalances. After the Asian financial crisis, emerging countries moved into current account surplus and recycled the private capital inflow. This was not just the result of private decisions. It was also the result of exchange rate intervention, accumulation of foreign currency reserves and sterilisation of the monetary consequences. Between January 1999 and July 2008, just before the worst of the financial crisis, global foreign currency reserves soared from $1,620bn to $7,150bn. They then fell, modestly, to $6,650bn in March 2009, as they were used to protect their owners from the crisis, before restarting their rise. By June 2010, reserves had reached $8,430bn. Thus, we have had the spectacle of a massive and ongoing capital outflow from relatively poor countries into the liabilities of rich countries and, in particular, of the US government. This turned out to be a disaster: the rich countries were unable to use these resources. They are still unable to use these resources.
“It is also vital to understand what is at stake. If the rebalancing does not occur, there is a very good chance of what I call “macroeconomic protectionism” of a kind recommended by John Maynard Keynes in the depths of the Great Depression. What is macroeconomic protectionism? It is the attempt to shift inadequate aggregate demand onto one’s own output. Deliberate attempts to keep exchange rates down are a form of macroeconomic protectionism. But so would be across-the-board tariffs. If the US economy does not recover, such protectionism seems disturbingly likely.
“Second, what, broadly speaking, needs to be done to reduce the likelihood of a breakdown of the financial system? The broad answer is: control finance better or frighten it more. But, since we have rescued all the systemically significant institutions and so their creditors, we have removed much of the fear. Yes, some of those who worked at – or lent to -the “sacrificial Lehman” lost a great deal of money. But almost everybody else is still alive and very much kicking.
“The big lesson bankers should, alas, learn is to get into trouble with all the other bankers. As Keynes famously said, “”A sound banker is one who, when he is ruined, is ruined in a conventional and orthodox way, so that no one can really blame him.” John Maynard Keynes, “The Consequences to the Banks of the Collapse of Money Values”, 1931. You can then be sure of being saved, particularly if yours is a big and interconnected bank. This, of course, creates a lethal moral hazard. It can only be dealt with by making bankruptcy of such institutions more credible. Efforts are being made in that direction, via “living wills” and “resolution regimes”. Whether they will work in a crisis is an open question. In the end, it is unclear that we will be able to impose normal market disciplines on the financial system.”So can we then at least curb the excesses of the financial system by regulation? This is what we would probably have to do: raise capital requirements dramatically – and I mean dramatically – with a strong bias against large “too big to fail” institutions; ensure institutions are adequately liquid or possess assets that central banks can easily and readily discount; and put much of the trading onto exchanges or at least central clearing houses, to reduce the uncertainty created by the risks of failure of counterparties. I see this as an exercise in trying to make the “nodes” of the financial system and the “network” safer.
“Some propose much more radical solutions. John Kay, for example, a fellow columnist on the FT, has proposed narrow banking, with separation of deposit taking from credit creation. The disadvantage is that the entire credit system would be outside the banking system. It is highly likely that the government would still respond to a collapse, as the US government responded to the collapse of its so-called “shadow banking system”. A still more radical proposal is “Limited Purpose Banking”, in which all financial institutions, except partnerships, become mutual funds, with all risk borne by the suppliers of the funds. This would eliminate the pretence that thinly capitalised institutions can finance risky long-term assets with riskless and often short-term liabilities. Limited Purpose Banking, proposed by Larry Kotlikoff of Boston University, would end it and, with it, the financial system as we know it. This is surely too radical for most people to contemplate.
“At the least we can try to make our economy safer, by discouraging banks from engaging in risky trading, by greatly increasing the capital required against trading positions, and eliminating the fiscal incentives for borrowing throughout the economy. The former suggestion seems simpler than reintroducing a distinction between commercial banking and investment banking that is now extremely hard to draw and was, in any case, unique to the US.
“Yet, in attempting to tighten up regulation of a financial sector drowning in moral hazard – a problem far worse now, after the rescues, than before, when rescue was more uncertain – we must remember the other big lesson: beware the perverse consequences of regulation. Some of the biggest disasters – the creation of huge numbers of off-balance-sheet vehicles, the manufacture of va\st numbers of pseudo-AAA assets via structured finance, and the gatekeeper role of the rating agencies – were all a perverse consequence of regulation. It is not just a question of ensuring that regulation makes things better. It is still more about ensuring it does not make them even worse. We know that the financial sector will do everything it can to evade regulations. Can the regulators hope to be ahead of them? I very much doubt it.
“In short, with what we know to be grossly inadequate market discipline and the perverse consequences of regulation, we still have a huge problem. The financial system is a huge cuckoo in the global economic nest. We have barely survived this crisis – the biggest of all the crises of the past three decades. Can we survive the next?”
Well, can we? What do readers think?
