Aspen Member Daniel Daianu on the effects of high finance on economy and democracy

Ziarul Financiar. Daniel Daianu (30 June, 2011)

When high finance cripples economy and corrodes democracy

On May 22, 2008, the French daily Le Monde published an open letter signed by three former presidents of the European Commission, nine former prime ministers and five former finance/economy ministers (including myself) from EU member countries . The text "Financial markets must not govern us" sketched the contours of a devastating financial crisis, which would weaken western societies tremendously. At the time this letter was made public top officials of the Commission and the ECB used to boast about the "robustness" of European economies and claimed that banks in the EU were not involved in the origination and distribution of toxic products; they conveyed also the message that the financial crisis would likely not cross the Ocean. We have seen all what happened after Lehman Brothers' collapse. That is the moment when the financial turmoil has engulfed Europe too. Soon afterwards the euro zone crisis has come.

Two thoughts have been working my mind during this terrible financial crisis. And I would not have put them in writing now unless I had watched a banker's remark made on a public TV channel a short while ago. With much nonchalance he told his audience that the main mission of a bank is to take care of its depositors' money, it is to be trustworthy. I was stunned by his remark for it was publicly known that the bank he represents was bailed out with public money during this crisis, and that it was involved in the origination and distribution of highly questionable financial products. The stark reality is that not a few in the financial industry do not acknowledge, even now, the role it has played in bringing about a crisis that is matched by the Great Depression only, in living memory. The gross abuse of securitization, the promotion of a wide range of exotic (this is a euphemism) financial products that were hardly tradable and frequently of lousy value, the reckless short-termism in maximizing profits and a blatant neglect of risks, have turned major components of high finance into an in-built destabilizer . I would mention here the role played by a paradigm which extols the virtues of self-equilibrating financial markets (the efficient markets hypothesis) and which was embraced by major central banks. This paradigm has proved to be quite wrong. The way financial intermediation has evolved during the past two decades has increased systemic risks enormously. As the research director at the Bank of England, Andrew Haldane, pointed out, the very robustness of economies has suffered dramatically. And it pays to remind a brilliant analysis of Alexander Lamfalussy, who is an eminence grise in the world of finance. Years ago he noted that the proliferation of securitization and the growth of the shadow banking sector, which escapes regulation and supervision, make economies increasingly fragile, vulnerable (Financial crises in emerging economies, 2000)). This financial crisis has compelled governments and central banks to rediscover financial stability as a basic, if not an overriding, policy concern, but at a terrible economic and social cost.

It is not my aim to focus again on flaws of financial intermediation as it has evolved in recent decades. Since the crisis has erupted I did it both in writing and as a member of the European Parliament, where I co-authored a report demanding a radical overhaul of the regulation and supervision of financial markets. On various occasions I decried the wave of deregulations that took place in the US, including the rescinding of the Glass-Steagall legislation in 1999 and the passing of the Commodity Futures Modernization Act of 2000. But there are two processes under way that deeply worry me since both seem to be accentuated by this financial crisis. One process regards what is happening in the financial industry itself. The fear of a financial meltdown forced governments to intervene and, consequently, "too big to fail" financial groups were rescued. It is true that this large scale operation was followed by efforts to reform the regulation and supervision of financial markets. Limits on leverage, rises in capital and liquidity adequacy, regulations concerning derivatives and changes in remuneration schemes, constraints on proprietary trading, were put into place, more or less, around the world. It is an irony that Adair Turner (the head of the Financial Services Authority) and Mervyn King (the governor of the Bank of England) are bolder than European counterparts in this regard. An explanation is, probably, the over-expansion of the City during the past decades, which has made the British economy quite lopsided and highly vulnerable during this crisis (Ireland and Iceland are two other examples of reckless expansion of the financial industry).

The bottom line, however, is that this crisis is entailing market consolidation and the formation of even bigger financial groups. The size of these groups makes it such that systemic risks persist and may even grow further. The increase of own capital and liquidity requirements, as well as a stricter oversight from the European Systemic Risk Board, are necessary. But can these measures cope with risky (trading) operations which are undertaken by giant groups? There are pieces of analyses which say that Basel III should make tier 1 capital go up to 14%. But even such a doubling may not be sufficient. The "too big to fail" syndrome, unless is properly tackled, would maintain a captivity status toward these financial groups, on the part of governments. What is extremely bad is that the very logic of market economy is seriously perverted. Because it is totally unacceptable that losses of the financial industry be recurrently socialized, at the expense of tax-payers,  while gains of employees and capital providers of the financial industry be protected because of "systemic risks". This state of affairs is screwed up morally and shows that something is rotten in the way our economies function.

The bail out operations of financial groups has reinforced moral hazard. And the measures adopted so far do not seem to address this issue adequately, for the mentioned "captivity" relationship has not been broken. I wonder why anti-trust legislation is not resorted to in this respect, as it was used in the case of other industries (oil, telecommunications, etc) during the past century. In the UK, a special commission has proposed a sort of ring-fencing retail banking from risky  (trading) investment operations. But would it be sufficient? What should give us food for thought is that bad practices are going on (bad practices refer to operations that involve big ). The volume of derivatives is rising again at a formidable pace. Thus, more than 60% of the net income of the six biggest US banks is due to trading, as was the case prior to the current crisis. This means that there has hardly been  a diminution of the speculative (casino type) nature of banking. When Angela Merkel, David Cameron, Nicolas Sarkozy prodded high finance to accept its responsibility for this crisis its captains complained of unfair bashing. How upside down the whole situation is can be judged by examining the unfolding of the Greek tragedy, of the European financial drama. Since contagion risk is so high (since deep financial integration and panics can bring about another freeze of markets as a result of a disorderly default) the bailing in of the private sector in a sovereign debt restructuring is vehemently opposed by the ECB. But among the bond-holders of Greek paper are major market-makers, which benefited on bail out operations. It is like a tragicomedy; fundamental rules of market economy are put aside since those who take risks do not bear them. One can use systemic risks as an argument for tolerating a temporary chain of events. But market consolidation and the formation of bigger financial groups (banks), the perpetuation of bad practices, would rather indicate that   seeds of future episodes of crisis are planted. It looks like crises are going to be made permanent. Another worrying sign is that the financial industry is fighting back and it appears to have some success. Neither the Commission in the EU, nor the American administration and governments in general seem to have the power to withstand pressure. Across the Ocean and following a Republican political comeback the Dodd-Franck legislation is under actual menace of being diluted. Likewise may happen in Europe too.

The second worrying process relates economy to its social context for it can not be divorced  from it. This platitude is worthwhile remembering. The financial and economic crisis is reinforcing a worrying tendency in Europe and the US: the erosion of middle class. This erosion can be linked with technological change (that has favored highly skilled labor in advanced economies), Asia's phenomenal economic growth (that has dented western countries' market shares), public policies that have underestimated the role of industrial policies and, not least, an overexpansion of financial industry in several economies, at the expense of other sectors. The excessive growth of finance has entailed a marked change in profit distribution in the corporate world  and in income distribution in society at large. In the US, for instance, the share of financial industry's profit in total corporate profits almost trebled over the past three decades. People's capitalism cannot obscure the significant rise in income inequality in recent decades. OECD data make up a  grim picture in this regard; between the mid 1980s and the late 2000s income inequality rose in 17 out of 22 industrialized countries. In the US the pretax income of the top 1% individuals went up from 8% of the total in 1974 to 18% in 2008.  When the "social pie" is rising income inequality may not cause alarm. But when the social pie stagnates, or even shrinks, its increasingly unequal distribution produces tension and can become dangerous. Even in Germany, which epitomizes the success of the "social market economy" and has a highly productive economy, employees' average real income went down by cca 6% during the past decade. Though, this  was probably the price to pay for dealing with lingering pains of reunification and for containing adverse shocks from the external environment. Anyhow, an uncontrolled rising income inequality harms the "equal opportunities" policy, which was a huge achievement of a civilized, fair society.

Let me dwell more on the erosion of middle class. The rescue operations in favor of the financial industry  has  raised public debts  considerably and dynamics shows that this tendency will continue for a while. This means that painful fiscal corrections are in the offing at some points in time, which will very likely involve expenditure reduction and rises in taxes for most citizens. The undue rent the financial industry extracts from the rest of economy adds further burden to such an inevitable adjustment . There is also the threat of higher inflation as a tax (unless it is accommodated by wage rises, but that can entail vicious economic dynamics). Partly, this higher inflation is due to a historical rise in the relative price of basic commodities which is due to climate change, the availability of exhaustible resources, and rising consumption in Asia.. There is also the effect of quantitative easing (money printing) which has been done by the Fed and other central banks and which fuels inflation worldwide.  A rise in social tension and possible political stalemate (because of distributional struggles), in the years to come ,could bring about "programmed" bouts of inflation as a means to make the pains of servicing public debts more palatable. What, decades ago, was portrayed as a feature of social dynamics in developing economies (in Latin America, in particular) could visit the industrialized world in a surprising fashion. Let us remember that the US, itself, witnessed a period of double digit inflation several decades ago. That inflation was stopped when Paul Volcker came at the helm of the Fed and interest rates of over 10% were used in order to bring it down. But a consequence of that dramatic policy change was a sovereign debt crisis in Latin America.

Years before the eruption of the current financial crisis, Robert Reich and Larry Summers (from Harvard University and former top officials in the Clinton Administration) warned about the dangers ensuing from an erosion of the middle class in the US; their analysis can be extrapolated to other countries. In Europe, Anthony Giddens paid attention to this issue and his "Third way" vision was, arguably, driven by  concerns in this respect too. But what these academics, some of them turned policy-makers, had  principally in mind, were effects of globalization and technological change in conjunction with Asia's economic rise, demographic dynamics and institutional sclerosis that impedes policy reforms. By the way, in an analysis in 1996 (in the Journal of Economic Perspectives), which confounded supporters of mainstream trade theory, Paul Samuelson talked about zero-sum games in the world economy. The current financial/economic crisis speeds up the erosion of middle class in numerous western countries. In a very insightful article in the International Herald Tribune  Christa Freeland cites corporate executives who say that the fortunes of their countries increasingly diverge from the fortunes of their companies ( June 10th, p.2). If the impact of the ecological crisis is factored in things get more complicated. Let us remember what Nicolas Stern mentioned while being the chief economist of the World Bank: that the most egregious case of market failure in human history is the inability to take action against climate change.

 The power exerted by high finance over the rest of economy and the erosion of middle class are bad for the functioning of checks and balances, for securing the social glue and the social capital (in Robert Putnam's understanding) which are underpinning a democratic order. When vested interests are excessively powerful they can easily capture public policy and turn it to their advantage. This is what has happened with the wave of deregulation in the financial industry in recent decades, apart from the influence of a cosmology that upheld the validity of efficient markets and neglected systemic risks. When society gets increasingly polarized prerequisites are created that enhance social fragmentation, compress the public space (as a medium for social dialogue and achieving compromises) and foster political extremism. This can be seen in Europe and the US nowadays against the backdrop of the current financial and economic crisis. The rise in intolerance (xenophobia and chauvinism), high political polarization are quite telling in this regard  and are harbingers of worse things to come unless policies are formulated to counteract them.

There is also a huge ethical problem, which is exposed by this crisis as well and is related to the two worrying processes I mention. Big companies are fond of speaking of corporate social responsibility. But where is it when investment banks sell to investors financial products which they short at the same time? The penalties major banks paid  to the Securities and Exchange Commission for such practices tell quite a story. Where is corporate social responsibility when companies that make billions of dollars (or euros) worth of net income pay almost nothing to national fiscal authorities? I wonder whether president Barack Obama appointed the CEO of GE to head a special task force because of such a "performance". In the wake of corporate scandals (Enron, Worldcom, Parmalat, etc) of about a decade ago the then chief of the French main business association, Claude Bebear, wrote a book entitled "Ils vont tuer le capitalisme" (They are going to kill capitalism). Paraphrasing him one can think of democracy.

Moreover, when rare events (Black Swans, as Nicolas Taleb calls them) multiply and overwhelm the capacity of governments to respond effectively, fairness, a fair burden-sharing, are essential in preserving social cohesion. Adam Smith wrote "The  Theory of Moral Sentiments" before the much better known "The Wealth of Nations". Later, Max Weber, and nearer to our age, Kenneth Arrow and Amartya  Sen underlined the role moral values play in a sound functioning of economy, of society. When cynicism, recklessness, disregard for others, selfishness, spread around social cohesion can be badly impaired. When economic conditions deteriorate and social despair is rising, while moral values are trampled upon, democracy gets under threat.

The claim made by some that big government is the cause of the current financial crisis is, in my view,  false. This crisis originates, essentially, in financial practices that have gone astray in recent decades. High finance has developed its raison d'etre , which is increasingly divorced from the needs of the rest of economy. What is equally serious is that high finance, in major economies, seems to have has captured public policy for its own purpose. It is true that the financial crisis blends with the crisis of the welfare state. But the latter precedes the former and has been caused by a hypertrophy of the public sector (most notorious being the case of Greece), populism and political cronyism, demographics, etc. The financial crisis deepens the crisis of the welfare state. But to claim that the way out of the financial and economic crisis is a demolition of the welfare state is misplaced. The welfare state has to be reformed and, in this context, citizens need to think more of what they can do, individually and as groups, for their society before asking the latter what it can do for them  --to use J.F.Kennedy ‘s famous sentence. But the financial system needs also to be radically overhauled. Taming financial markets is a must so that future deep crises be avoided, or better dealt with. The way financial markets have functioned in recent decades is not God given. Public policy can and should change it, as it did after the Great Depression and after the second World War. The reform of the financial industry is badly needed in order to bring back a sense of fairness in society, which is critical for the functioning of democracy, especially during times of duress. Together with policies which should enhance knowledge based competitiveness taming financial markets would help combat the erosion of middle class and protect democracy.   

PS. Apart from the impact of the financial crisis, the euro zone crisis is one of deep integration when proper institutional and policy arrangements are missing. Fiscal rectitude is not sufficient for rescuing this area. There is need of elements of fiscal integration (the issue of EMU bonds eventually), of tools for dealing with asymmetric shocks (such as insurance for unemployed people via the EU budget), and of stronger means for fostering economic convergence.