A Regulatory Architecture for Cross-Border Banking Groups

by Stefano Micossi © VoxEU.org

Policymakers and commentators have suggested that large banks should be broken up. This column argues that such an idea risks the very existence of a global financial system. It outlines an alternative framework in which deposit insurance should be covered by banks not taxpayers, banks should not be guaranteed a bailout, and regulators should be mandated to step in when the warning signs begin.

Following the demise of Lehman Brothers, the debate on regulatory reform has led to the conclusion that large banking institutions must be broken up and their risk-taking activities limited by law along the lines of the ‘Volcker rule’ (Gros 2010). Not only are such actions unnecessary, they may be hard to implement and could reduce the availability of credit to the economy (if for example they reduce the ability of banks to hedge their credit positions). The main consequence of such a plan would be the disintegration of global financial markets as they break down into segregated national markets.

In recent research, my colleagues and I set out an alternative solution that can achieve a more stable and resilient financial system without renouncing the benefits of global and multi-purpose financial institutions and innovative finance (Carmassi et al 2010). These are predicated on effectively curtailing moral hazard and strengthening market discipline on banks’ shareholders and managers by raising the cost of the banking charter to fully reflect its benefits for the banks, and restoring the possibility that all – or at least most – large banks can fail without unmanageable systemic repercussions.

Back to basics

The crisis was generated by cross-border banks levering their deposit base and acting, through the wholesale interbank market, as the residual suppliers of liquidity for all the other players in financial markets. This multiplied funds for speculation and helped to sustain a gigantic inverted pyramid of securities made up of other securities and yet again other securities. Without the money-multiplying capacity of the banks, the asset price bubble and the explosion of financial intermediation and aggregate leverage would not have been possible. Extreme investment strategies by bankers obviously reflect moral hazard created by the expectation that governments would step in to bail them out in case of large losses.

The first thing that needs to be done in order to restore corrective incentives for bank managers and shareholders is to eliminate the most obvious pitfall in banking regulation, that is, reliance on capital requirements based on risk-weighted assets. This approach is flawed since asset risk cannot be assessed and measured independently of market conditions and market sentiment. As a result, the need for capital will always be underestimated under favourable market conditions, leading to balance-sheet fragility and precipitous asset sales when market sentiment turns sour. Banks need a capital buffer to overcome the massive asymmetries of information between bank managers on one side, and investors and regulators on the other. This asymmetry currently makes it easy for bankers to accumulate excessive risks in the quest for higher returns, before markets become aware. The way to do this is to set capital requirements in straight proportion to total assets or liabilities of banking groups.

Fixing flaws in prudential capital rules does not remove moral hazard from the banking system, whose specific sources must be tackled separately. These are:

• the deposit-institution franchise,
• the implicit or explicit promise of bailout in case of threatened failure, and
• regulatory forbearance.

The problem associated with the deposit franchise is well known. If depositors have doubts on the bank’s solvency, they will run for the exit, forcing rapid liquidation of banks’ assets, possibly with large losses and contagion spreading instability to other banking institutions.

First pillar for tackling moral hazard

Deposit insurance can reassure depositors, and thus is the first pillar for tackling moral hazard, but it also mutes their incentive to monitor the management of their bank, since they no longer risk losing their money.

More importantly, deposit insurance has evolved in most countries into a system effectively protecting the bank, or the entire banking group, rather than depositors. When a bank risks becoming insolvent, supervisors step in to cover its losses and replenish its capital so as to avoid any adverse repercussions on market confidence. Moreover, most deposit insurance systems are inadequately funded by insured institutions, entailing an implicit promise that taxpayers’ money will make up the difference in case of failure of large banks.

Thus, in order to re-establish a proper price for the banking charter, banks should carry, ex ante, the full cost of deposit protection, making sure that in most circumstances the guarantee fund would be adequate to reimburse depositors when individual banks fail. Of course, no fund could ever be sufficient to meet a general banking crisis, but a fund of an appropriate size would offer adequate protection in normal circumstances, with only a predictable share of banks going bankrupt.

Deposit insurance fees are the right instrument to make banks pay for risk generated by banks. They should be determined on the basis of a careful probabilistic assessment of the likelihood of failure within the overall pool of deposits and risks of the banking system (within appropriately defined market jurisdictions). This is where the risk profile of banks’ asset and loan portfolios can be taken fully into consideration, together with, more broadly, the quality of bank management and risk control, thus creating effective penalties for riskier behaviour. Size itself could be appropriately penalised by higher fees that would incorporate a probabilistic price for the potential threat for systemic stability.

Second pillar: Not “too big to fail”

The second pillar required in order to greatly limit moral hazard in the financial system is credibly removing the promise that large banks cannot fail. To this end, all main jurisdictions should establish special resolution procedures – as already exist in the US and the UK – managed by an administrative authority, with powers to require early recapitalisation, manage required reorganisations and, once all this has failed, liquidating the bank with only limited systemic repercussions. Crisis prevention, reorganisation and liquidation would all be part of a unified consolidated resolution procedure managed for each bank, by one administrative authority.

In order to make resolution feasible, all banks and banking groups would be required to prepare and provide to their supervisors a document detailing the full consolidated structure of legal entities that depend on the parent company for their survival, the claims on the bank and their order of priority, and a clear description of operational – as distinct from legal – responsibilities and decision-making, notably regarding functions centralised with the parent company. This "living wills" document may also comprise "segregation" arrangements to preserve certain functions of systemic relevance even during resolution: for clearing and settlement of certain transactions, netting out of certain counterparties, suspension of covenants on certain operations.

Third pillar: No regulatory forbearance

Finally, the third pillar of an effectively reformed financial system is a set of procedural arrangements that will prevent supervisory forbearance. Supervisory discretion to postpone corrective action would be strictly constrained, so that bankers, stakeholders and the public would know that mistakes would always meet early retribution. To this end it is necessary to establish a system of early mandated action by bank supervisors ensuring that, as capital falls below certain thresholds, the bank or banking group will be promptly and adequately recapitalised. Should capital continue to fall, then supervisors should be required to step in and impose all necessary reorganisation, including disposing of assets, selling or closing lines of business, changing management, ceding the entire bank to a stronger entity.

Should this not work, then liquidation would commence. A bridge bank would take over deposits and other “sound” banking activities, thus ensuring their continuity. All other assets and liabilities, together with the price received for the transfer of assets to the bridge bank, would remain in the “residual” bank, which would be stripped of its banking licence. An administrator for the liquidation of the residual bank would be appointed to determine its value and satisfy creditors according to the legal order of priorities (based on the law of the parent company and other jurisdictions involved).

The attractive feature of mandated corrective action is that asset disposals and change of management will normally take place well before capital falls to zero, so that losses for the insurance fund and ultimately taxpayers are more likely to be much smaller.

References

Carmassi, E L, and Stefano M (2010), "Overcoming too big to fail - A Regulatory Framework to Limit Moral Hazard and Free Riding in the Financial Sector," CEPS-Assonime Report.

Gros, D (2010), "Too interconnected to fail = too big to fail: What is in a leverage ratio?", VoxEU.org, 26 January.

Republished with permission of VoxEU.org

Controlling vs Collateralizing Risk

Regulatory reforms that focus on improving risk controls rather than increasing capital reserves are the better path for the future of banking, according to Katsunori Nagayasu, president of the Bank of Tokyo-Mitsubishi UFJ and chairman of the Japanese Bankers Association (“How Japan Restored Its Financial System,” WSJ, Aug 6, 2009).

Regulatory authorities around the world are currently discussing ways to prevent another financial crisis. One idea is to mandate higher levels of capital reserves. Japan’s banking reform shows that a comprehensive solution would work better.

Requiring banks to increase capital reserves is itself, “risky.” For one thing, banks may not be able to raise sufficient capital in the equity markets to meet the revised capital requirements. Moreover, raising capital requirements tends to disadvantage banks that focus on traditional borrowing and lending transactions, and advantage banks that trade and take risks with their own accounts.

A new regulatory framework must also distinguish between banks whose main business is deposit taking and lending—the vast majority of banks worldwide—and banks that trade for their own account. The recent financial crisis demonstrated that balance sheet structure matters. Trusted banks with a large retail deposit base continued to provide funds to customers even in the depths of the crisis, whereas many banks that relied heavily on market funding or largely trading for their own account effectively failed. Investment banks with higher risk businesses by nature should be charged a higher level of capital requirement—otherwise, sound banking will not be rewarded.

That the government has undertaken to save only the largest banks under the “too big to fail” presumption is of concern to the public for a variety of reasons, not the least of which is that such an approach may actually reward the banks that are taking the biggest risks, while closing those that have played by the rules. Additionally, requiring banks to maintain excessive capital reserves may sound good, but high reserves brings reduced capital efficiency, particularly at a time when money is scarce.

Regulators would be wise to consider the capital efficiency of the reforms they intend to invoke, or the current recession could extend well into the future. The US should take a lesson from the Japanese banking experience and focus on new ways to control risk, rather than simply collateralizing it.

Eleven Lessons from Iceland

by Thorvaldur Gylfason © VoxEU.org

How to stop a repeat of Iceland’s crisis – both in the country and elsewhere? This column provides eleven lessons covering asymmetric information, moral hazard, better warning systems and improved regulation, preventing banks becoming “too big to fail” and restricting asset bubbles, holding creators of externalities to account, and providing safeguards on political interference.

Iceland’s economic crisis has destroyed wealth equivalent to about seven times its GDP. The damage inflicted on foreign creditors, investors, and depositors amounts to about five times its GDP, while the asset losses thrust upon Icelandic residents account for the rest. These figures do not include the cost of Iceland’s increased indebtedness. Iceland’s gross public debt, domestic and foreign, is estimated to increase by more than 100% of GDP as a result of the collapse of the banks, or from 29% of GDP at the end of 2007 to 136% by the end of 2010. In 2009, the government spent almost as much on interest payments as on healthcare and social insurance, the single largest public expenditure item. The damage due to Iceland’s tarnished reputation is harder to assess.

A number of economists have discussed the consequences of Iceland’s troubles and suggested solutions (Buiter & Sibert, 2008; Danielsson, 2010), but a key question remains: How could this happen?

To make a long story short (for the longer story, see Gylfason et al., 2010), the absence of checks and balances that had led to an unbalanced division of power between the strong executive branch and the much weaker legislative and judicial branches came to haunt the country when unscrupulous politicians put the new banks in the hands of reckless owners who then found themselves in a position to expand their balance sheets as if there were no tomorrow – and no supervision. Politicians who privatise banks by delivering them on a silver plate to their friends are not very likely to subject the banks to stringent supervision or other such inconveniences.

Collective guilt and responsibility

Iceland’s predicament raises old questions about collective guilt and responsibility. Many wonder how taxpayers can be held responsible for the failures of private bankers. But taxpayers are also voters – many of them voted for the politicians who sided with the bankers, having abstained or voted for the opposition is clearly not a valid excuse. Guilty or not, many feel responsible as taxpayers, but not all.

Opinion polls suggest that a majority of the electorate did not want parliament to approve the IceSave deal between Iceland, the UK, and the Netherlands by which Iceland agrees to repay the British and the Dutch about a half of the amount that the latter unilaterally decided to pay out in compensation to depositors in the IceSave accounts of Landsbanki.*

The stakes are high because Iceland’s agreement with the IMF appears to hinge on the parliament’s approval of the deal with the British and the Dutch. As it turned out, even this is not enough, because the President of Iceland chose to intervene by referring the IceSave law to a national referendum. It is a matter of record that the stipulation concerning the deal on the IceSave accounts is part of the IMF-supported programme at the behest of the Nordic countries, or at least some of them (Gylfason 2009). Without their support, the programme – with less financing available – would require stricter adjustment of public expenditures and taxes. In other words, without a settlement of the IceSave dispute, Iceland’s short-run crisis would deepen – an almost certain outcome of a “no” vote in the referendum scheduled for 6 March.

Parting company

In 2009, while the unemployment rate shot up to 9% of the labour force, a very high rate by Icelandic – if not by European – standards, GDP fell by 7%, and is not expected to be restored to its 2008 level until 2014 in local currency at constant prices. In dollars or euros, however, per capita GDP will take longer to recover enough to regain parity with the Nordic countries because the króna is not expected to rise in value for a number of years to come. As a result of the collapse of Iceland’s banks and of the króna, Iceland’s GNI per person sank in 2008 to a level one-third below that of Denmark, Finland, and Sweden (see Figure 1; Norway’s oil puts it in a class of its own). Due to emigration, Iceland’s population fell slightly in 2009 for the first time since 1889. Significant emigration over the next few years would weaken the tax base and depress the living standards of those who stay.

Figure 1. Nordic countries: Gross National Income per capita 1980-2008 (at purchasing power parity, current international $)

Source: World Bank (2009), World Development Indicators.

And the lessons?

What can be done to reduce the likelihood of a repeat performance – in Iceland and elsewhere? Here are eleven main lessons from the Iceland story, lessons that are likely to be relevant in other less extreme cases as well.

Lesson 1. We need effective legal protection against predatory lending just as we have long had laws against quack doctors. The problem is asymmetric information. Doctors and bankers typically know more about complicated medical procedures and complex financial instruments than their patients and clients. The asymmetry creates a need for legal protection through judicious licensing and other means against financial (as well as medical) malpractice to protect the weak against the strong.

Lesson 2. We should not allow rating agencies to be paid by the banks they have been set up to assess. The present arrangement creates an obvious and fundamental conflict of interest, and needs to be revised. Likewise, banks should not be allowed to hire employees of regulatory agencies, thereby signalling that by looking the other way, remaining regulators may also expect to receive lucrative job offers from banks.

Lesson 3. We need more effective regulation of banks and other financial institutions; presently, this is work in progress in Europe and the US (see Volcker, 2010).

Lesson 4. We need to read the warning signals. We need to know how to count the cranes to appreciate the danger of a construction and real estate bubble (Aliber’s rule). We need to make sure that we do not allow gross foreign reserves held by the Central Bank to fall below the short-term foreign liabilities of the banking system (the Giudotti-Greenspan rule). We need to be on guard against the scourge of persistent overvaluation sustained by capital inflows because, sooner or later, an overvalued currency will fall. Also, income distribution matters. A rapid increase in inequality – as in Iceland 1993-2007 and in the US in the 1920s as well as more recently – should alert financial regulators to danger ahead.

Lesson 5. We should not allow commercial banks to outgrow the government and Central Bank’s ability to stand behind them as lender – or borrower – of last resort. In principle, this can be done through judicious regulation, including capital and reserve requirements, taxes and fees, stress tests, and restrictions on cross-ownership and other forms of collusion.

Lesson 6. Central banks should not accept rapid credit growth subject to keeping inflation low – as did the Federal Reserve under Alan Greenspan and the Central Bank of Iceland. They must take a range of actions to restrain other manifestations of latent inflation, especially asset bubbles and large deficits in the current account of the balance of payments. Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth.

Lesson 7. Commercial banks should not be authorised to operate branches abroad rather than subsidiaries if this entails the exposure of domestic deposit insurance schemes to foreign obligations. This is what happened in Iceland. Without warning, Iceland’s taxpayers suddenly found themselves held responsible for the moneys kept in the IceSave accounts of Landsbanki by 400,000 British and Dutch depositors. Had these accounts been hosted by subsidiaries of Landsbanki rather than by branches, they would have been covered by local deposit insurance in Britain and the Netherlands.

Lesson 8. We need strong firewalls separating politics from banking because politics and banking are not a good mix. The experience of Iceland’s dysfunctional state banks before the privatisation bears witness. This is why their belated privatisation was necessary. Corrupt privatisation does not condemn privatisation, it condemns corruption.

Lesson 9. When things go wrong, there is a need to hold those responsible accountable by law, or at least try to uncover the truth and thus foster reconciliation and rebuild trust. There is a case for viewing finance the same way as civil aviation: there needs to be a credible mechanism in place to secure full disclosure after every crash. If history is not correctly recorded without prevarication, it is likely to repeat itself.

Lesson 10. When banks collapse and assets are wiped out, the government has a responsibility to protect jobs and incomes, sometimes by a massive monetary or fiscal stimulus. This may require policymakers to think outside the box and put conventional ideas about monetary restraint and fiscal prudence temporarily on ice. A financial crisis typically wipes out only a small fraction of national wealth. Physical capital (typically three or four times GDP) and human capital (typically five or six times physical capital) dwarf financial capital (typically less than GDP). So, the financial capital wiped out in a crisis typically constitutes only one fifteenth or one twenty-fifth of total national wealth, or less. The economic system can withstand the removal of the top layer unless the financial ruin seriously weakens the fundamentals.

Lesson 11. Let us not throw out the baby with the bathwater. Since the collapse of communism, a mixed market economy has been the only game in town. To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks – and even General Motors – having to be propped up temporarily by governments, even nationalised. Even so, it remains true that banking and politics are not a good mix. But private banks clearly need proper regulation because of their ability to inflict severe damage on innocent bystanders.

Footnotes

* According to the IceSave agreement, Iceland must during 2016-23 pay the UK 2.350 million pounds and the Netherlands about 1.330 million euros. The sum of the two figures is equivalent to about a half of Iceland’s GDP in 2009, and seems, with reasonable asset recovery, likely to overstate the ultimate cost involved. The interest rate on the loans is 5.5% per year.

References

Buiter, W, and Sibert, A (2008), “The Icelandic Banking Crisis and What To Do About It,” CEPR Policy Insight, 26.

Danielsson, J (2010), “The Saga of Icesave,” CEPR Policy Insight, 44.

Gylfason, T (2009), “Governance, Iceland, and the IMF,” VoxEU.org, 26 September.

Gylfason, T , Holmström, B, Korkman, S, Söderström H T, and Vihriala, V (2010), “Nordics in Global Crisis,” Helsinki: ETLA.

Volcker, P (2010), “How to Reform Our Financial System,” New York Times, 31 January.

Republished with permission of VoxEU.org

Risk, Reward and Responsibility: The Financial Sector and Society

by Jonathan Portes © VoxEU.org

A strong financial sector is essential to a modern economy, but private actions can impose enormous costs on taxpayers; a balance must be struck. This column explains why the UK Government believes that there is a case for increasing the costs of risk-taking to banks and their shareholders while reducing those borne by taxpayers.

A strong and competitive financial sector is essential to a productive modern economy. But when banks fail the costs are high. Following the failure of Lehman Brothers in September 2008, governments around the world acted decisively to protect retail depositors, maintain financial stability, and enable banks to continue lending. Without such action the consequences of the financial crisis would have been far worse – but the result was a significant burden on taxpayers.

To reduce the probability of a repetition of these events, G20 finance ministers and leaders have committed to implementing higher regulatory and supervisory standards to guard against excessive risks. The objective of these reforms is to ensure that the costs of failure of institutions are borne by shareholders and other creditors in an orderly way without triggering a systemic crisis. This should limit the circumstances in which any future government intervention is necessary. But in practice there may always be a risk that the potential costs to the wider economy of a systemic crisis will be sufficiently great that government intervention is appropriate. After all, systemic financial crises have been an intermittent but pervasive feature of financial systems throughout recorded economic history.

A key question is therefore how to ensure that any costs of government intervention are distributed more fairly across those in the financial sector who benefit, reflecting the risks and rewards associated with financial intermediation. This should mean ensuring that the costs of bank failure fall primarily to banks and bank investors, rather than taxpayers. A paper published by the UK government last week (HM Treasury 2009) considers in detail options for ensuring banks meet the immediate costs of interventions to prevent systemic failure. The provision of emergency liquidity facilities and of deposit insurance is already well established, so this article concentrates on the potential new proposals in the paper: contingent capital and systemic risk levies. It also discusses the case for additional taxation of the financial sector to ensure that the sector makes a fair contribution to society and broader social objectives.

Contingent capital and capital insurance

The Basel Committee is considering how to reform global capital standards and banks are likely to have to significantly strengthen the quantity and quality of capital that they hold. In the recent crisis existing subordinated debt and hybrid capital largely failed in its original objective of bearing losses, so the focus of regulatory capital requirements should be on capital that can absorb losses on a going concern basis, typically common equity. More equity will enhance the resilience of banks to shocks. However, if equity is insufficient to absorb losses, banks may have to try to raise more. And in a systemic crisis the cost of raising new capital could be prohibitively high, so that banks may find it difficult to raise new capital when they need it most.

Contingent capital or capital insurance held by the private sector could help address this potential issue and supplement common equity in times of crisis. There are a variety of proposals (e.g. Raviv 2004, Flannery 2009) under which banks would issue fixed income debt that would convert into capital according to a predetermined mechanism, either bank-specific (related to levels of regulatory capital) or a more general measure of crisis. Alternatively, under capital insurance, an insurer would receive a premium for agreeing to provide an amount of capital to the bank in case of systemic crisis.

From an economic perspective, the attraction of contingent capital or insurance is clear; creating such instruments, especially if they were traded, would improve both market discipline and market information. Unfortunately, however, as we have seen, it is precisely in a crisis that markets for such instruments – which will essentially be put options sold by investors to banks – can fail. Such instruments may ultimately not be appropriate for many fixed-income investors such as insurance funds which have in the past invested in subordinated debt and hybrid capital instruments; and the systemic stability consequences would need to be explored.

Alternatively, the Government could offer a capital insurance scheme. For example, Caballero and Kurlat (2009) propose that the central bank should issue tradable insurance credits, which would allow holders to attach a central bank guarantee to their assets during a systemic crisis; or the government could set out an explicit arrangement to deliver capital and liquidity to banks in times of a systemic crisis in return for an up-front fee, as proposed by Perotti and Suarez (2009). Trigger events, fees and the equity conversion price would all be set in advance.

Such a scheme would provide greater certainty for market participants about the circumstances and limits of government intervention, while also ensuring government receives an up-front fee for implicit support. However, there would be potential for moral hazard resulting from reduced loss-sharing across subordinated debt and hybrid capital, unless such capital converted to equity ahead of any government injection. In general government-provided capital insurance would seem to be less useful and less flexible than a wider systemic levy or resolution fund, an option outlined below, although capital insurance could be an element of any wider solution.

Systemic risk levies and resolution funds

Since it is impossible to eliminate entirely the risk that some of the costs of intervention will have to provided by government, there is a case for ensuring that in future the financial sector itself meets these residual costs through a systemic risk levy or resolution fund. A “systemic risk scheme” would have a wider scope than existing deposit-guarantee schemes in that contributions would be sought from all systemically important firms rather than just retail deposit-takers; and wider coverage in that it would fund the costs of restoring financial stability more broadly rather than just the costs of compensating retail depositors. Funds could be used towards the recapitalisation of failing or failed banks, to cover the cost of other guarantees to creditors, or potentially other costs from resolution.

Such a levy might be charged on either a pre- or post-funded basis. It could be weighted towards financial firms which, because of their size or the nature of their business, were a potential source of significant risk to the stability of the financial system. The levy would not fund insurance for any individual firm but rather would support intervention, if needed, to stabilise the system as a whole, hence avoiding some of the moral hazard problems typical of insurance schemes. Given that financial crises requiring direct government intervention are relatively rare in developed economies, any fund would have to be built up over an extended period. When financial crises do occur, however, they can be exceptionally costly to the public finances, and therefore the fund may ultimately need to be quite large.

A key consideration in designing any systemic levy or general resolution fund would be how to assess systemic significance and/or a firm’s contribution to systemic risk, and how to reflect that in any levy. In principle, a well-designed levy could achieve two objectives. It would both raise funds to cover the costs of restoring financial stability and, to the extent that the levy accurately reflected both systemic risk and institution-specific risk and charged for individual institutions’ contribution to those risks, it would embed incentives that would reduce the probability that such costs would ever materialise. For these reasons, a prefunded, rather than a “survivor pays” approach appears more attractive in principle.

Ensuring the financial sector makes a fair contribution

Going beyond the measures described above to deal with systemic risk, there might be other reasons why the financial sector should make a greater fiscal contribution:

• to defray the wider fiscal, economic and social costs of the recent crisis;
• to help correct what might be considered excessively risky or destabilising activities that may have negative externalities;
• if elements of the financial services industry were shown to be generating supernormal returns to executives or shareholders – economic rents – because of the existence of market failures, then there may be a case for increasing taxation on these returns;
• the global nature of the financial services industry and the mobility of its activities might suggest that a more internationally coordinated approach would help ensure the sector makes a fair contribution through tax, irrespective of where firms are located or where the activity takes place.

A financial transaction tax has been suggested as a potential method of ensuring that the global financial services sector makes a fair contribution. It has been argued that some financial transactions have little or even negative social value (see e.g. Krugman (2009), Turner (2009)); that even if such a tax reduces liquidity in some markets, there are likely to be diminishing marginal returns to liquidity, and so any negative impact would be minimal; and that the potential revenues could be large. Full analysis of the potential economic implications of introducing a transaction tax will help determine the desirability of such a tax, the level at which it should be set if it were introduced and the likely consequences.

As well as considering the economic impact of a financial transaction tax, there are some significant issues to explore regarding its design and implementation. Key points include:

• identifying the tax base: to protect against avoidance a financial transactions tax would ideally have as broad a base as possible, including over-the counter transactions;
• establishing a means of tracking transactions in order to implement the tax, given financial transactions are currently recorded through a range of exchanges and other systems;
• setting a rate, or rates, to ensure the introduction of a financial transaction tax does not have a negative economic impact, given the different margins on particular types of transactions;
• determining a means for allocating revenue raised, given the international nature of many financial transactions; and
• defining a method for monitoring and ensuring compliance, and determining action that should be taken in the event of avoidance or evasion.

Common principles and next steps

The IMF will report in April to the G20 on these issues. Any proposals should respect the following principles:

• Global – some options could realistically only be implemented at a global level, while others would require international agreement and coordination on key principles to be effective;
• Non-distortionary – avoiding measures that would damage liquidity, drive inefficient allocation of capital or lead to widespread avoidance;
• Stability enhancing – actions must support and not undermine the regulatory action already being taken. This is likely to mean any option would take several years to implement; and
• Fair and measured – financial services must be able to continue to contribute to economic growth and any additional costs should be distributed fairly across the sector. A thorough impact assessment must be conducted prior to implementation.

References

Caballero, Ricardo J and Pablo Kurlat (2009), "The 'Surprising' Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal," Federal Reserve Symposium at Jackson Hole, August.

Flannery, Mark (2009), "Contingent Tools Can Fill Capital Gaps," American Banker, 174(117).

HM Treasury (2009), "Risk, Reward and Responsibility: The Financial Sector and Society," December.

Krugman, Paul (2009), "Taxing the Speculators," New York Times, 27 November.

Perotti, Enrico and Javier Suarez (2009), "Liquidity Insurance for Systemic Crises," VoxEU.org, 11 February.

Raviv, Alon (2004), "Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes," Unpublished working paper.

Turner, Adair (2009), "Responding to the Financial Crisis: Challenging Assumptions," Speech to the British Embassy, Paris, 30 November.

Republished with permission of VoxEU.org

Beware of Zombie Banks

According to Yalman Onaran (2011) in Zombie Banks: How Broken Banks and Debtor Nations Are Crippling the Global Economy:

Zombie banks refers to an insolvent financial institution whose equity capital has been wiped out so that the value of its obligations is greater than its assets. The level of capital is crucial for banks, more so than for non-financial companies, because the event of bankruptcy, a bank's assets lose value faster and to a bigger extent. Thus, when a bank's equity declines significantly due to losses, its creditors panic and head for the door (deposits are insured in most Western economies, so depositors don't run away as easily).

Read More

Banking stakeholders will find the contents of this book disturbing...

Source: Onaran, Y (2011), Zombie Banks: How Broken Banks and Debtor Nations Are Crippling the Global Economy, Bloomberg Press.

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The Empire Strikes Back

by Avinash Persaud © VoxEU.org

The role of financial institutions in the global crisis has led to a consensus that financial regulation must change. This column argues that the banking lobby, far from depleted, has struck back with a vengeance. It has managed to postpone the much needed regulation for a time when the need for it will be forgotten.

There are two remarkable aspects of the consensus around international financial regulation emerging in the run up to the November G20 meeting in Seoul. The first is that there is a consensus. International regulators are agreed that banks must set aside much more capital for risky assets; be less dependent on the whims of money markets; constrain the maturity mismatches between their assets and liabilities and set aside capital for holding complex derivatives where there may be settlement and clearing risks. They also agree that capital adequacy should move counter to the economic cycle and that banks should not be “too big to fail”. Getting an international consensus around action that is sensible – save for the emphasis on “too big to fail”- is no mean achievement.

The second is that despite appearing to be down and out, the banking lobby has struck back, successfully making the case that all of these initiatives should be postponed or phased-in between 2015 and 2019. By then the pressure for regulatory reform could be a distant memory. Financial regulation veterans will be experiencing déjà vu. In each of the last seven international financial crises, plans for a radical shake up of international regulatory or monetary arrangements made surprising progress, only to be tidied away and stuffed in the bottom drawer once the economy recovered. Many of the new initiatives being proposed today have been pulled out of that same drawer, dusted down and updated.

The argument that the banking system is too broken and the world economy too fragile, to support more onerous regulations, is seductive for politicians desperately trying to boost consumer demand. But it is suspect. It highlights that attempts to make banking regulation more counter-cyclical have not gone far enough. The point of counter-cyclicality is to loosen the constraints to lending in times of recession like today and to tighten them when growth and optimism have returned and the worse credit mistakes are being made. Counter-cyclicality needs to be at the heart of the new regulatory regime and not an optional extra. As Professor Charles Goodhart of the LSE and I have said before, crashes will not be avoided if we continue to feed the booms. The methodology of counter-cyclicality is complex and given that economic cycles are more national or regional than global, it makes for greater host country regulation and national ring-fencing of bankers’ operations. International banks do not like that. To counter they appeal to the “right”-sounding notion of level playing fields.

The other problem of kicking regulatory initiatives into the long grass is that as long as the prospect of new profit-squeezing regulation is out there, uncertainty will limit the one thing everyone is agreed the banking system needs more of – capital from investors. It is one of those delicious fallacies of composition that what banks want individually is often not in their collective interests. I recall writing in October 2002, what the FT headline writers presciently captured as “Banks put themselves at risk in Basel.”

Competitive finance is critical to the development of a robust and dynamic economy – locally and globally. But the lesson currently being repeated is that regulatory capture – subtle, sophisticated, and seductive – has the power to stop us from developing a financial industry that serves the economy rather than the other way around.

Tackling regulatory capture head on is the better argument for limiting bank size. The notion that smaller institutions will make the financial system safer ignores history. The UK Secondary Banking Crisis of 1973-75, for example, had a bigger impact on property prices and the stock market than the current one. The principal avenue of financial contagion is the panic-stricken search for institutions that look similar to the one that has just failed. Moreover, a large number of small institutions doing the same dangerous thing is just as toxic, if not more so, than a small number of large institutions engaged in the same activity. But smaller institutions invest less in political lobbying. A politically less powerful financial system has a better chance of being reassuringly boring.

The way to make the financial system safer is to break up institutions not by the porous boundaries of “narrow” and “wholesale” banking, but by the more fundamental boundaries of risk capacity. To create systemic resilience we need a systemic approach to capital adequacy requirements across the entire financial system, one that pushes different financial risks to wherever across the entire financial there is greater capacity for those different risks.

This is simpler than it sounds. There are three major types of risk: credit risk, market risk, and liquidity risk. Their differences can be found by the different ways in which these risks can be hedged or absorbed. The capacity to absorb liquidity risk comes from having time to sell an asset because liabilities, like promises to pay a pension in twenty years, are long-term. The capacity to absorb credit risk comes from having access to a wide range of uncorrelated credit risks to pool together, like a loan to an international oil company and another to a local wind farm. A financial system in which liquidity risks were held by young pension funds because of the capital required to set aside maturity mismatches, and credit risks by large consumer banks, because of the capital required to set aside for concentrated credit risks, would be far safer than one with twice the amount of capital but where the banks fund illiquid private equity investments and pension funds hold credit derivatives because regulators and accountants treated risk as if all that mattered was price volatility not risk capacity. Limiting risk taking to risk capacity would limit the size of banking institutions. It would create opportunities for new players with different risk capacities.

But the odds of a systemic approach to systemic risk appear slim. It’s politics, stupid!

Republished with permission of VoxEU.org

Iceland: People Ahead of Markets

According to Omar R Valdimarsson of Bloomberg:

Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger.

Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association....

The island’s households were helped by an agreement between the government and the banks, which are still partly controlled by the state, to forgive debt exceeding 110 percent of home values....

Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed....

Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn....

Iceland’s special prosecutor has said it may indict as many as 90 people, while more than 200, including the former chief executives at the three biggest banks, face criminal charges.

Read More

Flag of Iceland

Perhaps America and Europe could learn something from Iceland's handling of the financial crisis since 2008.

Source: Valdimarsson, O R (2012, February 19), Icelandic Anger Brings Debt Forgiveness in Best Recovery Story, Bloomberg.

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Central Banks Make Historic Turn

Writes Anatole Kaletsky in Reuters (2012, September 19):

When the economic history of the 21st century is written, September 2012 is likely to be recorded as a defining moment, almost as important as September 2008. This month’s historic events – Ben Bernanke’s promise to buy bonds without limit until the US returns to something approaching full employment, Angela Merkel’s support for the European Central Bank bond purchase plans and the Bank of Japan’s decision to accelerate greatly its easing program – may not seem earth-shattering in the same way as the near-collapse of every major bank in the US and Europe. Yet the upheavals now happening in central banking represent a tectonic shift that could transform the economic landscape as dramatically as the financial earthquake four years ago.

Read More

I tend to believe that global austerity measures have yet to run their full course, especially in public sectors. Nevertheless, all indications are that central banks are seeking ways to inject liquidity into the global economy in ways that will foster consumption. Quantitative easing to date in the US has been about capitalizing producers and bankers. In contrast, QE3 appears to be solidly focused on creating demand, which is a major change...

Source: Kaletsky, A (2012, September 19), Central Banks Make an Historic Turn, Reuters.

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Elevating the Roles of Risk Analysts and Managers

The ongoing economic crisis has brought with it a heightened interest in risk analysis and management. Yet, something seems awry at the risk management desks of our nation’s largest banks and financial institutions. Goldman Sachs CEO, Lloyd C Blankfein was recently quoted as saying, “too many financial institutions and investors simply outsourced their risk management -- rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them.” Mr Blankfein contended that banks and financial institutions must elevate the status of risk analysis in order to alleviate the “systemic lack of skepticism” that he alleged was precursor to the ongoing economic crisis. Mr Blankfein suggested that banks and financial institutions redefine the roles of risk managers, including giving them equal stature “with their counterparts in revenue producing divisions.” This redefinition of roles includes delegating greater responsibilities and authority onto risk managers, whereby “if there is a question about a mark or a disagreement about a risk limit, the risk manager's view should prevail” (WSJ, April 7, 2009). My personal interpretation of Mr Blankfein’s statements is that those trained and charged with risk analysis and management were apparently left standing outside the boardroom as our nation’s banking and financial “executives” undertook investment policy-making in isolation. Let us hope that the regulatory changes to come might at least mandate that risk managers and analysts get a seat at the table.

Well Said...

"What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, and have banks do something that's not going to risk the taxpayer dollars, that's not going to be too big to fail."

~ Sandy Weill

Sanford I "Sandy" Weill (1933- )

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Public Trust in Banking Declines Dramatically

According to a Gallup poll cited by The Atlantic (2012, April 20), public trust in banks, the US Congress, and the presidency, declined dramatically over the past decade. Between 2002 and 2011, public trust in banks declined by 24%, while trust in support of Congress and the presidency declined by 17% and 23%, respectively.

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Given these shifts, I have to wonder why the US Congress and presidency are always so eager to affiliate with banks. Let's face it, banking is somehow at the center of something bad happening in America today...

Source: Fournier, R & Quintin, S (2012, April 20), How Americans Lost Trust in Our Greatest Institutions, The Atlantic.

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How to Save the Euro? Lessons from the US

by Jacques Melitz © VoxEU.org

Earlier this year, the fiscal situation in Greece caused turmoil across Europe. This column examines why the financial difficulties of several state governments in the US are not having similar impacts on its economy.

The problems of the Eurozone this year brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than we might have expected. Questions have even arisen about the survival of the system (see Baldwin 2010 and Blejer and Levy-Yeyati 2010 for discussions). Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP raised questions about ‘saving the euro’ and the survival of the Eurozone?

The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the Eurozone centre on strengthening the Pact, increasing joint political control over fiscal policy, and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place this year has resulted from financial markets’ conviction, based on this doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the Eurozone?

Lessons from the US

That is precisely what the US example would suggest and what I will defend. With this idea governing beliefs, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.

In the US, default on state and municipal contractual obligations is very much a possibility whenever lower-level governments are in financial trouble; bailout cannot be taken for granted. New York City defaulted in 1975, the biggest default of all by a lower-level government unit since World War II took place in 1983 when the Washington Public Power Supply System went into bankruptcy, and Orange County defaulted in 1995. Various municipal governments have been on the verge of default at times in the last few decades, including Philadelphia and Cleveland. There is also no Stability and Growth Pact in the US. Yet financial discipline is considerably higher in the US at the state government level than in the Eurozone at the national level. All states except Vermont have balanced-budget rules; but these rules are self-imposed. It is easy to argue that this difference in fiscal discipline on the two sides of the Atlantic is related to the fact that when push comes to shove in the US and a lower-level government unit cannot or will not meet its debt obligations, the lenders can expect to take a big part of the hit.

Some rudimentary analysis is relevant. Consider any government unit unable to print money and without any prospect of a bailout. Theory tells us that credit rationing is very much a possibility. As the interest rate that such a government offers on its debt goes up, extra lending dries up completely at some point as the expected rate of return on the government debt falls. This must happen because higher nominal interest rates impair the government’s solvability and bring default nearer. Risk aversion simply lowers the interest rate at which credit rationing begins.

Suppose we compare the situation in the US and the Eurozone since the 2007-2009 financial crisis in this light. The crisis brought about dire financing problems for many lower-level government units in the US and some national governments in the Eurozone. According to the spreads on credit default swaps, California and Illinois now have a higher probability of non-performance on public debt than Portugal and Spain. This has been true for months. Consider next the difference in response in the States and Europe. Recently Illinois simply stopped paying $5 billion of bills. In June of last year California issued vouchers for wage payments. In addition, savage cuts in public services have begun and are now threatened in various states in difficulty, not only these two. Nevada has made startling reductions in spending on higher education and welfare. In the case of Portugal and Spain, nothing so drastic has happened thus far. There have been occasional spikes in interest rate spreads over German bunds of 100 to 200 percentage-points above usual levels. Both Spanish and Portuguese governments have also been forced to plan greater austerity and reduced government deficit spending. Meanwhile, they have been able and willing to keep borrowing.

Why the difference between the Eurozone and the US?

Part of the explanation may be that Portugal and Spain are more able to raise tax revenues than US states. But another part is the higher probability of a bailout in Europe. The example of Greece is to the point. Greece has been able to continue borrowing this year at interest rates typically around 200 percentage-points above Portugal and Spain on 10-year government bonds (and since May more than 500 percentage-points higher than German bunds). If you do the math, it is clear that this could never have happened without a high probability of a bailout. In fact, you do not need to do the math: there have been occasions in February/March and particularly May when some Greek issues would clearly have failed without the assurance of public lending and ECB support. If Greece can borrow on the probability of a bailout, so could Portugal and Spain.

Based on this evidence, the current Eurozone strategy of treating government default as anathema permits member governments to sink into deeper waters, weakens the forces that would otherwise exist toward self-imposed budget restraints, and thereby raises the probability of a bailout. But an actual bailout is perhaps the most likely setting for the breakdown of the Eurozone. If taxes ever need to rise all over the Eurozone in order to bail out a member government, one can easily imagine a pullout by Germany, followed by the Netherlands and Austria (if no others), in order to form a separate monetary union.[1]

What are the dangers of the opposite strategy of mimicking the US instead and moving toward heavier reliance on markets to discipline member governments and to price sovereign risk? The answer lies in the external effects of government default on the payment system and the banks, and this problem would be aggravated by contagion. But those dangers exist in the US as well. If the US federal government were to allow Illinois or California to default on state government debt in today’s circumstances of widespread financial difficulties across the states, there is a serious threat that interest premia would go up on the debt of most state governments and a wave of state defaults would follow. For this reason, the federal government might well step in. But if we look at the institutional manner in which the US deals with the problem, we find the answer to lie in country-wide prudential rules for banks and central bank powers of lender of last resort. There is no general announcement that state government default is incompatible with the dollar. Instead there is a strict separation of the issue of joint support of the financial system and joint support of financing by the sub-government units in the country. Would Europe not be wise to adopt the same strategy and to cease to conflate the two issues?

Tweaking the Pact

What this would mean, of course, is adopting Eurozone-wide prudential rules on banks, providing the ECB full powers of lender of last resort, and, very significantly, dismissing the idea that the Stability and Growth Pact is the pillar on which the whole Eurozone project stands. This idea is highly perilous.[2] Markets believe it, and at times of financial precariousness, what markets believe is extremely important. According to my proposal, the Pact could still be upheld as a code of good behaviour which improves public finances in Europe and facilitates the task of the ECB. But the basic philosophy would be that if any individual member government in the Eurozone engages in irresponsible fiscal conduct, contrary to the Pact, the creditors and its taxpayers would bear the brunt of the consequences. Everything would be done to assure the stability of the financial sector in the Eurozone and the lack of repercussions on the risk premiums that the more financially responsible member governments need to pay. Banks might be bailed out but not governments. Any aid to member governments, if it came, would not concern the euro system but the IMF or if any aid did come from the EU it would be part of a programme that could as well have existed had the euro never appeared and would be clearly sealed off.

VoxEU Editors' note: This article will appear as a roundtable discussion in Miroslav Beblavy, David Cobham and Ludovit Odor, eds., The euro area and the financial crisis, Cambridge University Press, forthcoming.

References:

Baldwin, R (2010), A re-cap of Vox columns on the Eurozone crisis” VoxEU.org, 13 May.

Blejer, M and Levy-Yeyati, E (2010), Leaving the euro: What’s in the box, VoxEU.org, 21 July.

Economist (2010), Can pay, won’t pay, June 19.

Poterba, J (1996), Do budget rules work? NBER Working Paper 5550, April.

Public Bonds (2010), Municipal bonds and defaults, downloaded 23 August.

Reinhart, C M and Rogoff, K (2009), This time is different: eight centuries of financial folly, Princeton: Princeton University Press.

Sinn, H-W (2010), Rescuing Europe, CESifo Forum, special issue, August.

Notes:

[1] Many would say that Greece has already been bailed out. But so far no holder of Greek debt has yet suffered a credit event. Further, no one outside of Greece has yet paid any taxes to fulfil a claim on Greek debt. Thus, according to my usage, no bailout has happened. However, none of the argument hinges on this choice of words.

[2] If we really think that a government default would bring the euro under, we must conclude that the euro has no long-run future ahead – that it is doomed. A reading of Reinhart and Rogoff (2009) should convince anyone.

Republished with permission of VoxEU.org

Fed Prefers Wall Street to Main Street with $1.2 Trillion in "Secret Loans"

According to Derek Thompson of The Atlantic:

Bloomberg reporters Bradley Keoun and Phil Kuntz catalog the Fed's $1.2 trillion in "secret loans" to banks, including Bank of America, JPMorgan, and Goldman Sachs.... The Fed's secret bailout comes out to the same amount US homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The progressive take on this story will be that the Fed has preferenced Wall Street over Main Street by using its exceptional authority to extend trillions in loans to banks without offering similar guarantees to underwater home owners.

Let's face it, bankers watch out for other bankers...

Source: Thompson, D (2011, August 22), The Fed's 'Secret' $1.2 Trillion Bailout of Wall Street, The Atlantic.

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The Nordics in the Global Crisis

by Thorvaldur Gylfason, Bengt Holmstrom, Sixten Korkman, Hans Tson Söderström, and Vesa Vihriälä © VoxEU.org

Is the Nordic model an asset or a liability? The global crisis has seen GDP in the region decline by between 4.5% and 7%. This column argues that the Nordic model, with its welfare state and high rate of investment in human capital, can, properly implemented, be part of the solution.

The Nordic countries – Denmark, Finland, Iceland, Norway and Sweden – are champions of free trade and open markets. And for a good reason; they see international specialisation within a global framework as a means of raising productivity and income. Much of the Nordic socio-economic model can be interpreted as aiming at collective risk sharing with a view to fostering acceptance of open markets, new technologies and the need for change.

In a broad sense the model includes a set of labour market organisations, with an important role for negotiations, a comprehensive safety net and a high rate of publicly supported investment in human capital. Embracing globalisation and sharing risk are mutually reinforcing planks of the Nordic Model, as discussed in Andersen et al. (2007).

Is the Nordic model an asset or a liability?

The current crisis is not only a financial and economic crisis but also a crisis of the much heralded globalisation process itself. It therefore raises many key questions for small open economies, not least the Nordics. What are the lessons of the crisis for economic policies? Is the future of the global economy more unstable than the past, and does that perspective call for a fundamental review of the economic policy strategy? Is the Nordic model an asset or a liability in the light of the crisis?

As we discuss in our new report (Gylfason et al. 2010), the crisis is best seen as the outcome of a lopsided globalisation process that overwhelmed the global financial system. The global savings glut was largely absorbed by the US shadow banking system, because of its capacity to create innovative products. It seemed to offer safe investment outlets at attractive rates of return, while at the same time encouraging excessive leverage. Once the bubble burst and the world economy went down, the Nordics, with their high dependence on exports of investment goods and consumer durables, were particularly hard hit (with the exception of oil-rich Norway). Their GDP in 2009 declined at rates between 4.5% and 7%.

While the sharpness of the global downturn was a surprise, so was the early stabilisation, which started around the middle of 2009. At this point the recession has been declared over in many countries and a recovery – though weak and hesitant – seems to be underway. There is little doubt of the explanation; policies matter. Authorities have demonstrated an unprecedented activism in monetary and fiscal policy as well as inventiveness in financial crisis management. While the world escaped a repetition of the Great Depression, the crisis has nevertheless left a legacy of difficult issues and challenges.

The Nordics are vulnerable but also resilient. While Iceland is a case of its own, we believe that the Nordics have the capacity to recover and to continue combining economic efficiency with high social ambitions. Sweden and Finland experienced a severe banking crisis in the early 1990s, thereby learning a lot about the need for better financial regulation and supervision.

Lessons were learnt about the need for a solid crisis management framework, the pros and cons of a blanket government guarantee for financial institutions, the need for precautionary and other capital injections, the problems of transferring assets into “bad banks”, and the case for not shying away from the government taking over institutions in certain circumstances. Many of these lessons were useful in avoiding mistakes in this crisis and they have attracted interest in other countries. This is also why companies and banks in the region have had balance sheets strong enough to weather the crisis pretty well (we obviously leave out Iceland again).

The effect of the euro

The Nordics have all had different monetary regimes since the euro. Given their similarity in other respects, a comparison of Finland and Sweden is especially interesting. It is almost a laboratory experiment. Sweden has a floating exchange rate and an independent central bank geared to price stability, while Finland is part of the Eurozone. Who has made the better choice?

The krona was mostly stable and developments in Finland and Sweden were strikingly similar during the first decade of the euro. Once the crisis erupted, however, the krona fell significantly relative to the euro, thereby strengthening the price competitiveness of Sweden relative to Finland and the euro area. One might expect this to help Sweden come through the crisis at less cost than Finland, arguably benefitting at the expense of its neighbour by capturing market shares.

The decline in exports and output in 2009 was indeed smaller in Sweden than in Finland, and GDP growth is forecast to be somewhat faster. However, the differences do not seem large. Also, manufacturing output shows little response to the change in competitiveness, and unemployment is rising in parallel with developments in Finland.

Either the effects of the improved competitiveness are relatively modest or the lags are long, or a depreciation of a floating currency has less effect on export and output volumes than a devaluation of a pegged currency used to have. What is clear is that the floating exchange rate does not insulate an economy from external shocks, and the economic differences between the two exchange rate regimes seem smaller than often claimed in the heated debate about the Eurozone.

An effective fiscal stimulus?

For small and open economies, in particular, one may question the power of fiscal expansion as an instrument of demand management. Nevertheless, we still find that an expansionary fiscal policy is helpful in a crisis. It is a useful complement to monetary policy when the interest rate hits its lower bound or when the credit system becomes dysfunctional. Also, fiscal action may alleviate particular problems such as long-term or youth unemployment. Furthermore, automatic fiscal stabilisers allow the government to avoid hasty and unduly harmful measures. The social contract is very valuable in a crisis as it tempers the panic and gives the government more time to plan and undertake measures to reignite growth in an orderly manner.

Of course, sustainable public finances need to be restored, and it is useful to consider the merits of alternative means of fiscal consolidation. Public expenditure may be cut or its composition twisted in a growth-friendly direction, and efficiency in the provision of public services improved. The tax base may be broadened by measures to raise the employment rate, particularly by prolonging the length of working careers. There is some scope for changing the structure of taxation with a view to encouraging economic growth, notably by reducing the share of taxes that fall directly on corporate profits and wage income.

The Nordics were in a position to pursue fiscal expansion in the crisis because these countries were – in contrast to the US and almost all other EU countries –running sizeable budget surpluses in the preceding decade. The government debt level of the Nordics is only half of what it is in the OECD on average and they continue to borrow at very favourable terms. Given their track record, there is reason to believe that the Nordics will continue to be countries with relatively sound public finances, retaining the scope for fiscal policy to be used when needed.

Safety in numbers

Most importantly, the Nordic model itself contributes to resilience. The comprehensive safety net, one of the attributes of the Nordic model, has proved to be robust also in times of crisis. The entitlements are not tied to the fate of individual companies or particular markets, and risks are widely shared in the society. While forest plants are shutting down in Finland and car manufacturing is sharply contracting in Sweden, the governments are firmly rejecting requests for support of ailing industries. Still, there are no crowds protesting in the streets, largely because flexible work arrangements, based both on general and company-specific agreements between businesses and labour, alleviate a rise in unemployment. Structural change is enhanced by the employment protection legislation, which is more liberal than in most other EU countries. A well-educated labour force, another of the attributes of the Nordic model, facilitates adjustment by making it easier to upgrade skills through additional training.

Provided that governments continue to be able to take the decisions needed to safeguard competitiveness and the sustainability of public finances, the Nordic model can be both robust and resilient. The Nordic model with its welfare state, labour market institutions and high rate of investment in human capital, is not the source of the current problems. On the contrary, the Nordic model, properly implemented, can be part of the solution.

References

Andersen, T, Holmström, B, Honkapohja, S, Korkman, S, Söderström, H T, and Vartiainen, J (2007), ”The Nordic Model – Embracing Globalisation and Sharing Risks,” The Economic Research Institute of the Finnish Economy, Helsinki: ETLA.

Gylfason, T, Holmström, B, Korkman, S, Söderström, H T, and Vihriälä, V (2010), "Nordics in Global Crisis – Vulnerability and Resilience,” Helsinki: ETLA.

Republished with permission of VoxEU.org

What Derailed the Recovery?

An interesting question was posed in the Wall Street Journal (2011) this morning under the title, What Derailed the Economic Recovery? Three Possible Explanations. I provided my own short explantion as a posted comment in response:

The economic recovery was "derailed" by the myopic response of the Federal Reserve and Congress -- when the crisis began, the US embarked on efforts to save Federalism as the first priority, which meant bailing out or protecting "too big to fail" banks, automobile manufacturing, the defense industry, and government salaries -- unfortunately, those efforts ignored the problems on Main Street, including comsumption -- reality to date is that consumption has not been restored, probably because consumers have no money -- any money that was dispersed went to Federal and state workers, defense, and the automobile industry -- but nothing whatsoever has been done to put money directly into the hands of consumers -- at this point, Federalism is consuming all the nation's resources and then some -- anything left is being consumed by state workers and programs -- nothing is left for the consumer-at-large in America -- the US has become a safe-haven for the largest "too big to fail banks," government workers, unionized manufacturing, and the defense establishment -- public employees are a protected class, while small businesses and consumers have been "written off" in a misguided effort to save Federalism from itself...

Source: What Derailed the Economic Recovery? Three Possible Explanations (2011, July 21), Wall Street Journal.

National Currency Notes

As a resident of the city of State College here in Central Pennsylvania, I was surprised to learn that years ago this city was home for a US National Bank that issued money. The photograph below depicts a US $20 National Currency note issued by the First National Bank of State College in 1929.

US $20 National Note issued by the First National Bank of State College in 1929 [click to expand]

National Notes were issued by banks who received a charter from the US government authorizing such banks to issue money. The Government Printing Office printed these notes with the same design as other US currencies with the exception of including the name of the issuing bank, signatures of the bank officers, and the charter number. National Currency notes were printed in the US between 1863 to 1929.

I have to wonder if this currency innovation might be repeated in the US sometime in the future.

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Greece Through the Rear-View Mirror

by Domingo Cavallo and Miranda Xafa © VoxEU.org

Thursday's EU summit in Brussels announced new plans for tackling the Eurozone crisis. This column says that restructuring of Greece's debt will reduce Greece's access to external financing without reducing its debt burden to sustainable levels. It suggests additional financial support contingent on larger haircuts.

European officials have struggled for weeks to reconcile the competing priorities of Germany and other surplus countries with those of Greece. Until Thursday's summit, the EU treated the debt crisis as a liquidity problem rather than a solvency problem. This contributed to the market turbulence and allowed the crisis to spread to Italy. This undermined confidence and threatened the stability of the euro itself.

Recognising that “re-profiling” of the debt by pushing maturities into the future is no longer sufficient, EU leaders reached an agreement that tries to address medium-term debt sustainability concerns while keeping the resulting losses for banks manageable.

The Deal is Probably Not Enough

The deal implies a 21% reduction in the net present value of debt owed to bondholders, which constitutes about 70% of Greece’s total public debt. This implies a reduction of 15% in total public debt, which would bring it down from 156% to 132% of GDP. With most analysts estimating the needed debt reduction closer to 50%, this deal is unlikely to ensure debt sustainability even if Greece fully implements the medium-term fiscal plan it has just voted into law.

Since it is impossible to have a fully voluntary scheme that shifts part of the financing burden to bondholders while keeping Greece’s funding costs at sustainable levels, Greece will almost certainly get a “selective default” rating. Such a rating would complicate Greece’s access to ECB financing without ensuring that Greece will emerge from default with a sustainable debt burden.

Analogies with Argentina

The situation confronting Greece today is similar to Argentina’s situation in the summer of 2001. The economy was in recession and credit spreads had widened as market participants realised that fiscal tightening was becoming less palatable economically and politically.

At the request of the Argentine government, which still wanted to avoid what would have been considered a selective default by the rating agencies, the IMF proceeded with a substantial augmentation of the financial support already committed under the existing three-year stand-by agreement. Argentina thus missed the opportunity to restructure its debt while it still had ample reserves and bank deposits remained near peak levels.

With the benefit of hindsight, the financial resources of the international community used to bail out private creditors should instead have been used to deal with the consequences of an orderly debt restructuring, including the provision of ample liquidity and capital to the banking system.

Greek Choices

Greece is facing the same choices now. With Greece’s dim prospects for market re-access in 2012-13, the EU/IMF-supported programme has been augmented with new EU resources, with more to come from the IMF, to make up for the shortfall in private financing.

But this additional financial support is likely to be wasted on what is a lost cause. The sustainability of public finances remains in doubt, as evidenced by the still-wide credit spreads (wider than in Argentina a month before it defaulted) and the large withdrawals of bank deposits, which continue even after the approval of the medium-term fiscal plan by parliament in early July. In view of the above, IMF participation in the financing of a new programme for Greece should be conditioned on a debt restructuring involving a significant haircut.

A Lasting Solution: Debt Buyback at Market Prices

A lasting solution to the Eurozone’s debt crisis would call for the European Financial Stability Facility (EFSF) to issue AAA-rated bonds in exchange for the outstanding bonds of the countries that need to restructure their debt, taking as collateral their assets under privatisation. Greece, Ireland, and Portugal could capture the discount on the debt that the markets have already reflected. The mechanism would be a massive repurchase of the old bonds at the current market price. The cost for European taxpayers will be much lower than that associated with continuation of the ongoing bailout. The most costly scenario is that of a disorderly Greek default that would have spillover effects on other countries, very similar to the contagion generated by the collapse of Lehman Brothers in the US.

The EU and the IMF should help Greece ensure that the debt restructuring will not destabilise the banking system and will not force conversion of financial assets and obligations into a new Greek currency. Otherwise a run on the banks with large holdings of Greek debt will force “de-euroisation” in Greece in the same traumatic way that it forced “de-dollarisation” in Argentina in 2002.

The latest IMF staff report on Greece shows that public and external debt sustainability “hinges critically on full and timely implementation of fiscal, privatisation, and structural reforms... and the restoration of market access at reasonable terms in the post-programme period.” In cases where restoration of market access within the programme period is judged to be unrealistic, IMF rules encourage “comprehensive debt restructuring, to provide for an adequately financed programme and a viable medium-term payments profile.” It’s an idea whose time has come.

Republished with Permission of VoxEU.org

The Most Significant Developments of 2011 with Trends in 2012

From Jesse's Café Américain Copyright © 2011 Droit d'Auteur

As always the four great variables in human history are war, weather, disease, and religion.

Weather includes a wider range of natural phenomenon, and similarly religion includes secular movements such as fascism and communism that are essentially godless religions that involve the ordering of the relationship of the individual with a higher power that is not supernatural.

I do not address stocks, including the miners, specifically as I see that investment sector as extraordinarily risky. Tell me what the Fed and ECB will do and I will tell you how stocks will perform. That is the nature of this market.

As I am comfortable with stagflation, stocks most likely will not perform well in real terms. However, they could be targeted by the Fed as they implement nominal GDP growth and it puts more weight on selective inflation within the stagnant real economy.

Stocks tend to play the role of a variable hedge in my forecast and my own portfolio. The bigger investments are bonds, including cash which is a bond of zero duration, and alternative currencies like gold and silver, oil and income producing physical assets.

1. Wall Street dropped some of its pretense to fairness and softer forms of fraud and resorted to overt theft as MF Global stole significant sums of money, bonds, and bullion assets directly from customer accounts, under the eyes of the regulators, and transferred the money to its global bankers who refused to give it back.

Trend: Theft by the financiers will continue and intensify. The victims will be vilified to blunt public reaction.

2. The Eurozone came under unremitting assault by the ratings agencies and their associated banks and hedge funds. The Euro is an inherently 'difficult' currency to manage and has always been more susceptible to broad swings in value. This is because it is an economic union without a comprehensive political and financial union. It more closely resembles the original thirteen states of the US under the Articles of Confederation than it does a comprehensive Republic.

Trend: The Eurozone will continue to struggle to find a balance between political and financial factors, and will evolve into a stronger union of fewer members. Germany and France will continue to emerge as the great Western European power. The UK will be preoccupied by its own set of severe internal problems and regional unrest as austerity bites deeply. The UK will begin to act as more of an Anglo-American agent in the Eurozone. It may take on more of the character of an Orwellian state.

3. The Federal Reserve is expanding its power as a monetary authority and regulator of the financial system in an extra-Constitutional manner. The Fed is determined to fight the deflationary forces of global trade and credit contraction by expanding its balance sheet. They have little fear of inflation. Hyperinflation is highly unlikely in the absence of an exogenous shock. Stagflation is the new normal disguised somewhat by government statistics.

Trend: The Fed will start a new program of 'nominal GDP targeting' without stated limits in size of activity, as it will be defined by the scope of its objectives. The bond bubble will continue particularly in the long end of the curve. It will falter and breakdown at some point, but this is not likely in the near term unless some external standard is imposed or exogenous force intervenes.

4. A currency war is well underway in the aftermath of the closing of the gold window and the erosion of the Bretton Woods agreement, into an uneasy floating exchange rate system known informally as 'Bretton Woods II.' This currency war manifests in currency devaluations and pegs in support of mercantilism, particularly in the developing countries. It is a form of neo-colonialism supported by the great multinational corporations.

Trend: Global trade will begin to come under greater political assault as the exchange rate mechanism fails to impose a reasonable balance on the flows of goods and capital. The SDR is the most likely replacement for the US dollar as the world migrates towards a dual currency regime with one currency for domestic only use and an international unit for the settlement of world trade. The composition of the SDR will be a major point of contention between the BRICs and the Anglo-Americans.

5. The US political process is dominated by Big Money, a system in which a small number of people choose the candidates which will be allowed on the final ballot despite great pretense of a selection process and primaries. Despite the usual emotional heat expressed by a minority on each side in any competitive process, the end result is that no candidates can be chosen without being vetted and approved by the monied interests. This tends to continue to promote and support a status quo.

Trend: There may be a third party candidate, and perhaps one other fourth party of any real significance, but the end choice will be between Obama and Romney who are the corporate candidates. Strong voter dissatisfaction will cause minority parties to secede from the two major political parties, including at least one crypto-fascist movement and one progress movement. Watch for a rising current of racism, and attempts to make prejudice socially acceptable, and a growing class hatred. There will be major riots and demonstrations each summer from now until 2020 or a return to representative government.

6. As the global monetary regime continues its change, the US dollar continues to be stretched thinly. Despite all the odds and strong opposition from Western central banks and monetary authorities, gold has sustained an eleven year bull market.

Trend: Gold is in a bull market that will last until around 2020, or until the global monetary system reaches a sustainable equilibrium with a replacement for the US dollar as the reserve currency that is acceptable to the new economic powers. Silver and gold will continue to move with significant volatility as their prices increase. Bonds are the current asset bubble. At some point this may break as the housing market has done, and this will have a negative impact for gold if interest rates on the short end turn positive. This may not happen if inflation increases faster than interest rates rise.

7. China and Russia have replaced their command and control communist economies with command and control oligarchies. The power of China is the exploitation of labor, and of Russia, natural resources. Despite their calm outward appearance, there is significant turmoil beneath the surface, often regional in nature.

Trend: The governments of the world will continue to be shaken by the restructuring of the world economy. Change and calls for reform will most often be met by repression, often harsh. The world will continue to develop into three or four spheres of influence, with the greatest unrest and contained wars on the fringes of those spheres. The greatest region of conflict will remain where Europe meets Asia, and Asia meets the subcontinent.

I hesitate to put forward such a gloomy outlook, but this is in keeping with the forecast I put out in 2005 and it seems that most of the trends have occurred and even intensified. This is a period of great change, and this presents both risks and rewards.

And as always, against the backdrop of great events, while nations rise and fall, the life of the ordinary family goes on. 'There are these three things that endure: faith, hope and love, and the greatest of these is Love,' for it is the highest likeness to God in this world.

Republished with permission of Jesse's Café Américain

Source: The Most Significant Developments of 2011 with Trends in 2012 (2011, December 31), Jesse's Café Américain.