naked capitalism

By Swedish Lex, an expert and advisor on EU regulatory and political affairs:

If you belong to those who believe that the debate on how to fix finance is mightily underwhelming when compared to the latter’s monumental failure, then I suggest reading Martin Wolf’s latest column in the Financial Times.

Wolf essentially trashes the financial system and the remedial actions taken thus far, Michael Moore-style:

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.

In Wolf’s view, the separation of utility banking from casino activities would be insufficient as there still would be a risk of the temptations of shadow banking leading to new bubbles and collapses. It seems that Wolf has taken the points made by Carmen Reinhart and Kenneth Rogoff in their recent book “This Time Is Different: Eight Centuries of Financial Folly” to heart. Wolf’s review of the book was published in the FT a couple of days ago. A few notable quotes from Wolf:

Cycles of confidence and panic are inevitable in our world of debt, be that debt public or private, domestic or foreign. Credit is extended freely and then withdrawn brutally.

Financial systems are accidents waiting to happen.

The final lesson is that financial liberalisation and financial crises go together like a horse and carriage. It is no surprise, therefore, that the last 30 years have seen waves of financial crises, of which the latest one is merely the biggest.

Importantly, Wolf concludes that regulation thus far has not been the answer but rather part of the problem. He seems to be recommending that large parts of financial activity may have to be outlawed altogether and that status quo is not an option:

The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go. At present, the official sector believes tighter regulation, particularly higher capital requirements, can contain these risks. But this is likely to fail. If it does, we will need to be radical. Yet narrow banking would still not be enough. We would need to rule out quasi-banking. Otherwise, we would soon return to the world of fragility and bail-outs. Funds that replace banks would have to pass the risks directly on to the outside investors. The authorities will not entertain such radical ideas right now. But the financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant.

So, to conclude, Wolf proposes changes to society that would be truly revolutionary, not as a means to achieve lofty and utopian ideals, but rather as a strategy for economic survival. Interestingly, the IMF yesterday published its new Global Financial Stability Report which contains an analysis of the inadequate policy responses by governments thus far and recommendations for future action. The parallels with Wolf’s thinking are striking, although the IMF obviously uses a different language:

A clear vision of future financial system regulation is needed to provide clarity and boost confidence.

In addition to a well-defined strategy for unwinding unconventional policies, confidence in the financial system will be bolstered by clarity over future regulatory reforms needed to address systemic risks. The recent easing of tail risks should not prompt authorities to relax their efforts to map out the path to a more robust financial system. A holistic, understandable approach needs to be formulated so that the private sector can plan appropriately. The priority should be to reform the regulatory environment so that the probability of a recurrence of a systemic crisis is significantly reduced. This includes not only defining the extent to which capital, provisions, and liquidity buffers are to rise, but also how market discipline is to be reestablished following extensive public sector support of systemic institutions in many countries.

There are already proposals that will go some way toward removing procyclicality in the financial system and increasing buffers against losses and liquidity dislocations. But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.

So, if we accept that the existing system is deeply flawed and that the necessary and desirable reforms are seriously lagging, the next question is; who is going to do the lifting? Wolf is entirely mute on this point but one has to assume that since the theme of his column is finance as such, unilateral UK action is not what he has on his mind. If Wolf’s thinking is limited to the UK alone then the City as we know it would be transformed into a museum. In order for Wolf’s vision for a new financial order to be effective, action would have to cover as many jurisdictions as possible. In fact the IMF Report discusses what it views as a need for globally coordinated policymaking and warns against regional solutions:

A macroprudential approach to global policymaking is needed to restore market discipline and ensure that the benefits of financial integration are preserved.
The further challenge is to place these reforms in the context of an integrated macroprudential policy framework in which both domestic and cross-border institutions can operate securely. There is now recognition that a combination of microprudential and macroeconomic policies operated procyclically and led to a buildup of leverage and systemic risk. Policymakers will need to address ways in which their own actions exacerbate systemic risks, regardless of whether they oversee monetary, fiscal, or financial policy. Cooperation and consistency in the policy field must extend across borders. Cross-border relationships between institutions and markets have made it impossible for policymakers to act unilaterally without consequences for others. Following the crisis, however, there is a danger that some countries will want to ring-fence their institutions and withdraw from global markets to protect their domestic economies from external shocks. What is needed instead is a way to benefit from increasing financial integration, while ensuring that potential negative spillovers are contained and clarity exists about the roles of home and host authorities. As policymakers move forward on this difficult task, the IMF can play a catalytic role through its surveillance activities and work on global macrofinancial linkages.

While I would agree with the IMF on the principle, I think it is wholly unrealistic to think that the Fund would be in a position to develop and broker the type of fundamental change that Wolf and, as it seems, the IMF, at least to some degree, are advocating. I furthermore have no expectations at all that the U.S. would be in a position to introduce the kind of reforms Wolf are suggesting, even if it, miraculously, wanted to.

This leaves us with the EU. The EU’s response to the crisis thus far clearly falls short of what Wolf is suggesting although a thorough analysis and reform program of EU policy for the financial sector is under way. The EU however possess the legal competence, the scope and the clout to undertake the kind of reforms that Wolf is suggesting although such a program would be as comprehensive and far-reaching as the introduction of the Euro and would entail a clear break with existing policies. Impetus for a grand projet to re-design the EU’s approach to finance would have to come from the highest political level with the full support of Germany and France. With Merkel re-elected on a platform of financial reform, Sarkozy unthreatened on the domestic political scene and with support from the European Parliament and Commission, such a development could not be ruled out entirely. Since the IMF now estimates that we still have a 1,5 trillion in writedowns ahead of us, at least, politicians might soon have to consider all options, including Wolf’s revolutionary ideas.

It would be interesting to hear what Wolf has to say on how his ideas for radical reform should be implemented and by whom. Perhaps for his next FT column?