Taming financial markets is a must!

Daniel Daianu, 2 August, 2011 in European Council on Foreign Relations

The current financial crisis has made structural weaknesses of the European Monetary Union (EMU) more than salient. It was an open secret among informed people that the fiscal underpinnings of the single currency area were quite inappropriate, apart from its widely acknowledged sub-optimality. Insufficient economic convergence has created enormous strain in the EMU once the global financial storm hit. This dynamic, too, should not have been a surprise since astute observers, years before the introduction of the euro, anticipated a "mezzogiornification of the South", be it in relative terms, if comparative advantages were left to their own drivers (Paul Krugman, Geography and Trade, MIT Press, 1993, p.80). But cheap money and cheap imports from Asia, which epitomize the "Great Moderation" period (or the Great Misperception, as some put it), misled both policy-makers and citizens for quite a while and postponed a confrontation with a stark reality. The current bail out packages for Greece, Ireland, Portugal can not obscure the huge challenge of how to foster convergence in the EMU via EU policy and institutional arrangements. For, were the public debts of these countries reduced (restructured) drastically, unless their economies grow steadily (turn competitive) problems would resurge. Fiscal rectitude alone, as some and not only in Berlin think, will not rescue the EMU, in the end. It urgently needs elements of fiscal integration -- the eventual issue of common bonds, tools for dealing with asymmetric shocks (such as insurance for unemployed people through the EU budget, as Sebastian Duillien and others suggested) and stronger means of fostering economic convergence. In this context, radical internal reforms that should eliminate endemic inefficiencies have a key role to play.

The recent summit of EMU leaders made a big advance on what the EFSF can and should do. But its size is too small in view of potentially devastating contagion effects in the EMU and its operations are likely to be hindered by cumbersome procedures. European funds, that should be used in an interventionist manner, as Jean Pisani Ferry and Bruegel colleagues put forward, can make a difference (Financial Times, 28 July 2011). However, a state of distress does not relate to Greece only; at stake is an evolving  highly deleterious fracture between the North and the South of the EMU. Moreover, convergence tools and mechanism need to be organically embedded in the reform of the EU economic governance. The Pact euro plus is still lacking in this respect. Unless convergence in the EMU (EU) is stimulated and a sense of common purpose is restored, forces of fragmentation and destruction will continue their work. Ulrike Guerot and Mark Leonard say that the primacy of politics has to get the upperhand, again, in the decision-making process in the EU. I guess they refer to the primacy of European politics, in the service of the European dream. For what we are witnessing, increasingly, is the primacy of national politics which is undermining the cohesion of the Union; as Jose Ignacio Torreblanca put it in his May essay, "European leaders are governing on the basis of opinion polls and electoral processes" at home, even if that may undo the European Project.

The thoughts below go beyond the crisis of the euro zone as an expression, simply, of its initial design weaknesses and recurrent policy indecisiveness; they take a look at a broader context of the current crisis, at the relationship between finance and economies/society in industrialized countries. "Reinventing Europe (the EU)" has, in my view, to look at the social contract in our democratic societies, in conjunction with an ensuing ethical question; it should also examine the relationship between state and markets in providing citizens with public and private goods. This relationship is increasingly complicated in a Union that does not have a significant budget of its own, and in which national governments have to react to proliferating extreme events. Just reinforcing the logic of the Single Market is, arguably, not a sufficient response in this regard. Mario Monti makes a strong case on strengthening the Single Market ( in his report to the President of the Commission, April, 2010), but it can not be a Deus Ex Machina. The Union needs stronger and wider ranging policies at the EU level, that should consider where markets do not perform adequately, on one hand, and the need of EU level industrial policy measures on another hand. Because, without such measures, Airbus, for instance, would not have existed. Europe 2020, which resurrects the partly failed Lisbon Agenda, needs more vigorous EU level policies. Likewise, overhauled national welfare arrangements and competitiveness-oriented reforms are also badly needed, in most EU member countries, in view of demographic dynamics, the ecological menace and the need to cope with mounting fiscal pressures. Such reforms are not easy to undertake during an era of growing uncertainties and of diminishing opportunities, but they are not impossible to implement if there is vision and political determination. What Germany and several Nordic countries have achieved during the past two decades (and in the mirror, the policy failures of several EMU member states) shows that national policies matter  in the EU. I would turn now to the relationship between finance and society.

1. Financial markets as an in-built destabiliser
Many in the financial industry still do not acknowledge the role it has played in bringing about a crisis that is matched in living memory only by the Great Depression of the late-1920s and 1930s. 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 destabiliser for economies as a whole.  The paradigm which extols the virtues of self-regulating financial markets and which was embraced by major central banks has proved to be quite wrong. The way financial intermediation has evolved during the past two decades has increased systemic risks enormously. As Andrew Haldane, research director at the Bank of England, pointed out eloquently the very robustness of economies has suffered dramatically. Years ago, Alexander Lamfalussy 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, Yale University Press, 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.
Two processes , which seem to be accentuated by this financial crisis, should worry us deeply.. The first concerns the financial industry itself. The fear of a financial meltdown forced governments to intervene and, consequently, financial groups "too big to fail" 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, increases in capital and liquidity requirements, regulations concerning derivatives, changes in remuneration schemes, and constraints on proprietary trading were put into place, more or less, around the world. It is an irony that Adair Turner, head of the UK Financial Services Authority, and Mervyn King, governor of the Bank of England, seem to be bolder than their European counterparts in this regard. This is probably as a result of the over-expansion of the City during the past decades, which 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, which brought their economies to their knees.

The bottom line, however, is that this crisis is entailing the formation of even bigger financial groups. The size of these groups means that systemic risks persist and may even continue to grow. The increase of banks' own capital and liquidity requirements, surcharges on systemically important financial institutions (28 of the world's biggest and most interconnected banks) as well as stricter oversight from the European Systemic Risk Board, are necessary. But can these measures cope with the risky (trading) operations which are undertaken by giant groups? There are analyses which say that Basel III should increase tier 1 capital to 14 per cent. But even such a doubling may not be sufficient. The "too big to fail" syndrome, unless properly tackled, would keep governments hostage to these financial groups. The very logic of the market economy is seriously perverted. It is unacceptable that losses of the financial industry be repeatedly socialized, at the expense of taxpayers, while the incomes of employees and capital providers of the financial industry are protected because of "systemic risks". This state of affairs is morally unacceptable and shows that something is seriously rotten in the way our economies function.  The bail out operations of financial groups has reinforced moral hazard. The measures adopted so far do not seem to address the "too big to fail" issue adequately, since the hostage or "captive" relationship has not been broken. Why have we not resorted to anti-trust legislation for financial groups as we did with other industries -- oil, telecommunications, etc -- in the past century. In the UK,commission has proposed ring-fencing retail banking from risky (trading) investment operations. But would that be sufficient?

What should give us food for thought is that bad practices -- operations that involve high risk -- are continuing. The volume of derivatives is rising again at a formidable pace. And cca. 2/3 of the net income of the biggest US banks is from trading, as was the case prior to the crisis. Close numbers can be seen in Europe too. This means that there has been hardly any reduction in the speculative (casino type) nature of banking. When Angela Merkel, David Cameron and Nicolas Sarkozy prodded high finance to accept responsibility, its captains cried foul. How inverted the whole situation is can be judged by examining the unfolding of the Greek tragedy at the centre of the European financial drama. Since contagion risk is so high -- deep financial integration and panics can bring about another freeze of markets as a result of a disorderly default -- the inclusion, or "bailing in", of the private sector in a sovereign debt restructuring has been vehemently opposed by the ECB and Commission officials. But among the bondholders of Greek paper are major market makers, all of which have benefited from bail out operations, directly or indirectly. It is a tragicomedy: fundamental rules of market economy are put aside since those who take risks do not bear the consequences. One can use systemic risks, contamination, as an argument for tolerating a temporary set of measures. But market consolidation and the formation of bigger financial groups (banks), the perpetuation of bad practices, rather indicates that the seeds of future crises are being planted. It looks as though crises will be made permanent. Another worrying sign is that the financial industry is fighting back and it appears to have had some success. Let us hope that commissioner Michel Barnier will be able to maintain a strong stance and resist pressures. And let us hope that the European Parliament will support Barnier's endeavours firmly. And that in the US,  the Dodd-Franck legislation will not be diluted beyond recognition. 

2. The financial crisis and the erosion of the middle class
A second worrying process is that which connects economy to its social context The financial and economic crisis is reinforcing a dangerous tendency in Europe and the US: the erosion of the middle class. This erosion can be linked to the technological change that has favoured highly skilled labour in advanced economies, Asia's phenomenal economic growth that has dented western countries' market share, public policies that have underestimated the role of industrial policies and, not least, over-expansion of the 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. "People's capitalism" cannot obscure the significant rise in income inequality in recent decades. OECD data make up a grim picture in this respect: between the mid-1980s and the late-2000s, income inequality rose in 17 out of 22 industrialized countries. In the US, the pre-tax income of the top 1 per cent of individuals went up from 8 per cent of the total in 1974 to 18 per cent in 2008.

When the "social pie" is rising, or cheap lending bolsters the illusion of steadily rising affluence in society as a whole, income inequality may not cause alarm. But when "the social pie" stagnates, or even shrinks, and growing indebtedness starts to bite, an increasingly unequal income distribution produces tension and can become dangerous. Even in Germany, which  the success of the "social market economy" and has a highly productive economy, employees' average real income went down by around 6 per cent during the past decade. This was probably the price of dealing with the lingering pains of reunification and the containment of adverse shocks from the external environment. Even so, uncontrolled rising income inequality harms the "equal opportunities" policy, which was a huge achievement of a civilized, fair society.

Rescue operations in favour of the financial industry have raised public debt considerably and the present dynamics show that this tendency will continue for some time. This means that at some point, painful fiscal corrections are inevitable and that these will very likely involve expenditure reduction and rises in taxes for most citizens. The undue rent the financial industry extracts from the rest of the economy adds further burdens to such an inevitable adjustment. Unless it can be accommodated by wage rises, which can themselves entail vicious economic dynamics, there is also the threat of higher inflation as a form of taxation. This higher inflation is partly due to an historical rise in the relative price of basic commodities as a result of available exhaustible resources, climate change and rising consumption in Asia. But there is also the effect of quantitative easing (money printing), which has been done by the Fed and other central banks during this crisis and which fuels inflation worldwide. A rise in social tension and possible political stalemate as a result of distributional struggles could bring about "programmed" bouts of inflation as a means of making the pains of servicing public debts more palatable in the years to come. 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 arrived at the helm of the Fed and interest rates of over 10 per cent were used 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, both 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. In Europe, Anthony Giddens' Third Way vision was driven by similar concerns. The current financial/economic crisis deepens the erosion of the middle class in numerous western countries.If the impact of the ecological crisis is factored in, things get more complicated still.

3. Finance and democracy
The power exerted by high finance and the erosion of the middle class are bad for the functioning of checks and balances, for securing the social glue and the social capital -- in Robert Putnam's words -- which underpin a democratic order. When vested interests are excessively powerful they can easily capture public policy and turn it to their advantage. This is the cause of waves 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 becomes increasingly polarized, prerequisites are created that increase social fragmentation, compress the public space as a medium for social dialogue and achieving compromise, and foster political extremism. This can be seen in Europe and the US today against the backdrop of the current financial and economic crisis. There is spreading political paralysis in numerous western countries and there are social movements that reject current political configurations. "Los indignados", as they are called in Spain, embody a frustration, a malaise, that goes across frontiers. At a recent Bertelsmann organised conference in Brussels, Sony Kapoor (the head of Re-define, a think tank) echoed the view that this frustration may turn into wider social protests in view of expected longer periods of austerity measures. The rise in intolerance demonstrated in xenophobia and chauvinism, and extreme political polarization are harbingers of worse to come unless policies are formulated to counteract them. The recent atrocity in Norway has not come from nowhere. It is worthy to notice that the rise of extreme right wing formations and their accession into national parliaments is more sizeable in better-off European societies. Imagine what could happen in countries that may become mired into lasting stagnation because of policies that trap them into vicious circles.

The current crisis also underlines a huge ethical problem. Big companies are fond of speaking of corporate social responsibility. But where is it when investment banks sell investors financial products that they are short-selling at the same time? Where is corporate social responsibility when companies that make billions of dollars or euros in net income pay almost nothing to national fiscal authorities? In the wake of the corporate scandals of a decade ago, the then chief of the main French business association, Claude Bebear, wrote a book entitled Ils vont tuer le capitalisme (They are going to kill capitalism). Paraphrasing him, one might say the same of democracy. Moreover, when rare events - "Black Swans" as Nicolas Taleb calls them -- multiply and overwhelm the capacity of governments to respond effectively, then fair burden-sharing is essential in preserving social cohesion. Adam Smith wrote The Theory of Moral Sentiments before his better-known The Wealth of Nations. Later, Max Weber, and more recently, Kenneth Arrow and Amartya Sen underlined the role moral values play in the sound functioning of the economy and of society. When cynicism, recklessness, and disregard for others rule, when sentiments of shame and guilt for wrong-doing hardly operate, social cohesion can be badly impaired. When economic conditions deteriorate and social despair rises while moral values are trampled on, democracy is threatened.

There is also the problem of declining trust in political leaders; this is what polls indicate persistently. Probably, as a result of the deep financial and economic crisis, but not only due to this. In the EU the "democratic deficit" is not of recent vintage and creates a handicap for a reform of economic governance that, inescapably, would further erode national prerogatives. But what may pose an additional challenge to an effective decision-making process is the very low esteem not a few national politicians enjoy among citizens. This combination -insufficient credibility of EU institutions and low trust in national politicians- should give pause for thought. For it does not help in creating a sense of common purpose and unity in bearing the burdens and pains that are imposed on society by this crisis, at an individual and at a community level.

High finance has developed a raison d'etre that is increasingly divorced from the needs of the rest of the economy. Equally seriously, high finance seems to have captured public policy for its own purposes (just remember the rescinding of the Glass Steagal legislation in 1999 and the introduction of the Commodity Futures Modernization Act in 2000, in the US). While the financial crisis deepens the crisis of the welfare state, the latter precedes the former having been caused by a hypertrophy of the public sector and demographics, in the main; the crisis of the welfare state has also been accentuated by non-zero sum games in the global economy against the background of Asia's economic rise. To claim that the way out of the financial and economic crisis is the demolition of the modern, welfare state is misplaced. The welfare state must be reformed and, in not a few places, downsized, including a range and volume of entitlements that are no longer affordable. At the same time, reforms in the EU's peripheral economies and elsewhere implies firm action against corruption, cronyism and ubiquitous rent-seeking. To paraphrase John F. Kennedy's famous remark, 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.

But the financial system also needs to be radically overhauled. Taming financial markets is a must if deep crises are to be avoided or better dealt with in the future. Banking needs to turn back to its roots and rationale. Larry Summers, in suggesting what to do about the Greek sovereign crisis, stresses that any rescue program needs to consider "the confidence of markets" (How to save the eurozone, Financial Times, 18 July, 2011). But what about the trust of people in their political elites, in the programs that are asked to heed financial markets' concerns? Who takes care of citizens' fears and concerns? The way financial markets have functioned in recent decades is not God-given. Public policy can and should alter it, as it did after the Great Depression and World War II. The initial logic of the Bretton Woods arrangements tried to solve the impossible trilemma (autonomous monetary policy, stability of exchange rates, and free capital flows) by imposing restrictions on capital movements. This logic was undermined once financial liberalization became an aim of the core of the western world several decades ago and the IFIs embarked upon promoting it worldwide. Episodes of crises later on, in Asia in particular, were clearly due to a premature opening of financial markets. Ironically, unmanaged financial liberalization turned now against this core. The late reconversion of the IMF to a paradigm that does not underestimate the follies of financial markets is, consequently, to be welcomed. If one admits that the EU single market is a downsized version of the global market a legitimate question arises: what are appropriate policies at the EU level (including ECB operations) that can take care of potentially highly destabilizing (speculative) financial flows in member states? By the way, as waivers operate on labour markets, which restrict labour movement from several NMSs to certain older EU member states, why should n't  this modus operandi apply to destabilizing capital flows? The amendment added to the Lisbon Treaty on the possibility of undertaking bail-out operations in the EMU shows that the Accession Treaties can be modified accordingly. The boom and bust cycles in peripheral economies of the euro zone and in several NMSs demand more effective policies --that can, among other objectives, off-set the downside of a "one size fits all monetary policy" and avert "low equilibria".
An ever more uncertain environment and complexity on the rise ask for a more simple, resilient financial intermediation system, for the sake of its own stability. If this does not happen and big imbalances in the EU and globally persist, more fragmentation is to be expected, with societies turning, probably, more inward looking. This will have profound implications for the EU, for the global system.
Reform of the financial industry and restoring an ethical compass in the corporate world are also badly needed in order to bring back a sense of fairness in society. Fairness is critical for the functioning of democracy, especially during times of duress and upon entering an age in which the profligacy of the past decades is no longer an option for society as a whole. Political elites, too, need to redeem themselves in the eyes of citizens and regain trust. Together with policies that enhance knowledge-based competitiveness and make public sectors more efficient, taming financial markets would help combat the erosion of the middle class and protect democracy.

Ps. Excerpts from this article appeared in Dilemma Veche (Bucharest), Eurozine, and Aspen Institute Romania. 

Daniel Daianu is Professor of Economics at the Romanian National School of Political and Administrative Studies, a former Finance Minister of Romania and Member of the Aspen Institute Romania