Some thoughts on the Franco-German plan and financial regulation

Barry Eichengreen laments about the lack of financial regulation as part of last Friday’s Merkel-Sarkozy proposal, and calls it a mystery. I certainly don't see it as such. The last three years have made it clear that both Europe and the United States have one single powerful coalition in economic policy-making: the financial sector. This must change.

Banks complain that their bashing has gone too far, but if one has followed policy-making around the world, one wonders if any bank-bashing ever even took place. Financial reforms both in the United States and Europe have been ineffective at solving the perverse incentives in banking. The financial sector retains political power in policy-making despite having failed in all of its social responsibilities: in providing liquidity, in allocating capital efficiently, and in managing risk. Providing liquidity, for banks, has meant encouraging over-indebtedness with high transaction costs when times are good, and freezing lending when recessions are nigh. Bankers will offer you an umbrella when, and only when, it’s sunny outside. Capital allocation is also all but efficient. Money has mostly flowed to consumption instead of investments with high returns. I don’t think I even need to mention risk mismanagement.

How is it possible that policy-making has been captured by banks that just caused the greatest recession after the Great Depression? One theory suggests that regulatory oversight by the electorate is a function of the salience and complexity of the issue area. Financial regulation has no doubt been a salient policy issue in the few years, but the complexity of the policy area means that the public is not demanding their elected officials to take any specific measures to regulate the sector. Of course, much of the complexity is just a smoke-screen invented by banks to shed off opposing coalitions to their interests.

The banks’ first preference is to have a global framework for financial regulation because they know that such a framework will produce weak regulation as a result of the least common denominator compromise among countries. However, banks also prefer national regulation over EU wide regulation because they fear that EU-level rules may be too stringent as well as make it hard to affect the outcome through lobbying. Domestic politics is safer because governments take care of their own – that is banks.

If we are to avoid catastrophic crises in the near future similar to the one we just had, as well as complete political capture of our governments by financial elites, we must build coalitions that stand against the financial sector. That simply means demanding more accountability from our elected officials why they have failed to regulate banks effectively. A European Citizens’ Initiative would also be a signal to policy-makers, although EU-wide financial regulation would finally have to be negotiated in the Council. We should not be intimidated by bankers’ threats to pull out their operations to countries with more favorable financial regulation. To the extent that they are managing savings and investments in Western countries, they are forced to follow national legislation, if they wanted to continue operation in those countries. I guarantee you they will. Similarly, money from emerging markets and developing countries should stay in those countries in the first place. After all, if banks claim to allocate capital efficiently, capital should flow to countries where it finds highest marginal productivity. That’s what Adam Smith’s invisible hand would do, if it existed.

More generally, the Franco-German ‘competitiveness pact’ hardly deserves its name. There is nothing in the proposal that will make the Union truly more competitive. Again, Barry Eichengreen is more optimistic than I am. However, I can't see how the productivity differentials can be corrected by abolishing wage-indexation. How does that stop inflation from creeping back to the periphery? It will certainly lower inflation, but in doing so it will drive a wedge between the poor whose income is mainly derived from a monthly salary and the rich who have other income sources.

The duty of journalism

I was excited today as John Sides directed me to a Harvard project, called Journalist's Resource. The title, Knowledge-Based Reporting sounds like much needed training for journalists. However, the code of ethics disappoints me on a few accounts, namely:

• Tell the story of the diversity and magnitude of the human experience boldly, even when it is unpopular to do so.

• Support the open exchange of views, even views they find repugnant.

• Give voice to the voiceless; official and unofficial sources of information can be equally valid.

Journalists have a great responsibility in explaining phenomena to people in narrative form. In the light of news stories such as Climategate, I would really like to see journalists FIRST assess how 'telling the story of the diversity and magnitude of the human experience boldly' affects the narrative, or how 'the open exchange of views' or 'the voice of the voiceless' helps people understand the phenomenon more accurately. You don't just give equal 'air time' to every person who wants to tell his 'side' of the story. That's irresponsible. You focus on explaining the meaning of the phenomenon. Nick Stern emphasised this (responsibility) well in his talk at LSE earlier this year.

Requiem for the Niger Delta

According to Aaron Hay, The Financial Times would not publish this Amnesty ad. The accusation is quite plausibly true. The reality may be a bit too ugly to run on the FT. If there is one group of people who have been utterly screwed over by oil extraction, it is the indigenous people of the Niger Delta (for more info, see here, here, here, and here). The environmental concern is one, and it's only partly connected to the economic one. This Oxfam video says it all:



In all fairness, we need to emphasize the responsibility of the Nigerian government and the political elite, and not just blame it all on Shell. Granted, the former is a much more difficult target for us outside Nigeria.

On the Future of the Euro

I had floated the idea to some friends of Germany temporarily leaving the euro as the least bad of all available options. Edward Hugh seems to share that view:

Having Germany temporarily separate from the Eurozone would, in fact, have a number of evident advantages. The first of these would be that citizens in the South would not need to see their wages slashed, while those in Germany would not be asked to pay for bailouts via their tax bill, or lead to blame Greeks or Spaniards for having their hospitals closed or their pensions reduced: ie it would all be politically much easier to handle at this point.

Evidentally German banks would have to swallow a write-down, as loans paid back in Euros would not be worth the same in (new)marks, but 70% of something (say) is better than zero or 20%, and the big plus would be that as the Euro devalued sharply the peripheral economies could rapidly return to growth, and government finances could be quickly turned round as exports grew, tourists returned, and (in addition) many of those coastal properties that currently stand empty could be sold. At the end of the day, what would be left would be a private sector, and not a public sector, problem, and it was (in part) the private sector who got us all into this mess (wasn’t it?).

Indeed this solution does to some extent coincide with what could be termed the new economic reality, since economic growth in emerging markets mean that these are fast becoming key trading targets for German industry, as consumption in Southern and Eastern Europe looks to be increasingly “maxed out”. In fact, according to the recent March trade report from the German Federal Statistics Office, the rate of interannual growth in exports to ex-EU “third” countries (34.7%, as compared with 15.1% for the euro area) was significant, while the volume of trade (34.2 billion euros as opposed to 35.2 billion euros for the Euro Area) is roughly comparable, and indeed at this rate countries outside the EU will soon replace the Eurozone group as destinations for German exports.

I say I hope this move (if undertaken) would be temporary, since I think in the mid term the German economy is neither so strong, nor the peripheral countries so weak, as many commentators assume. But being out of the zone would give the Germans the opportunity to see this for themselves.

Germany, unlike the PIIGS, could exit the euro without causing "the mother of all banking crises", because the Deutsche Mark would only appreciate as a result. There would be a capital flight out of the euro, but it may only be a minor one, because most assets are presumably European owned, anyways, and there would be uncertainty about the timing of safe repatriation of that capital. The German exit would help correct EU's current account imbalances, and it would allow cost levels to adjust to better match productivity indifferences.

However, this would not solve the core problem. As Hugh points out, but he doesn't deal with it:

one thing seems evident: under the existing set-up the 16 economies are not converging.

One-off devaluation may help in the short-term, but how do you solve the structural differences? We lived under the illusion that a country such as Greece would have its economy restructured as a result of joining the EU and the euro. That never happened. The country still lives out of agriculture and tourism, and there is no reason to believe this will change anytime soon. The euro will keep pushing inflationary pressures to Greece (and Portugal, etc.) through tourism and real-estate, and it's getting increasingly difficult to keep the faith that productivity will radically increase in these countries in the near future. Another major problem is the lack of labor mobility, which is a prerequisite for optimal currency areas. You can't drag a Greek olive farmer to Germany, kicking and screaming, to start a new profession (or vice versa). The language and cultural barriers are too high.

A Fresh Business Idea: A Bank

In theory, the financial sector is supposed to serve a social purpose in supporting the economy: 1) by allocating capital efficiently, 2) by managing risk, and 3) by providing liquidity. However, banks have lately, fulfilled only the last of these three functions, at most. Moreover, and what the bankers refuse to admit publicly; providing liquidity only hurts the economy when capital is allocated inefficiently, and risk management is out of control. Another common fallacy among bankers seems to be that the financial sector is a part of the real economy, and any growth in the financial sector is therefore good for the economy - Not so. We now know that a significant part of banks' profits in the west during the 21st century have been artificial, and tax payers have picked up the tab after the smoke screen has cleared while bankers themselves walked away with astronomical bonuses. Nothing new here. However, while we're waiting for a financial reform - one that will most likely come in the form of some diluted international compromise; one wonders, if there's a real window of opportunity for a 'new' business model: namely a bank.

A bank that served its three core purposes could increase its social value in many additional ways: it could reward its private customers for sustainable choices (e.g. house builders for environmental solutions, car or house appliance buyers for energy efficient purchases, etc.), it could allocate capital to clean energy projects and energy efficiency investments, or it could offer cheaper credit lines for companies with sustainable business models and/or positive social impact. The possibilities are endless, but there's no compromising on the core functions.

So, what's the catch? Why isn't this a popular business model among major banks? Well, it may just turn out that creating complex financial products and trading them is simply more profitable than for banks to actually fulfill their real purpose. To an extent, we can also call today's banking social banking. After all, we've already socialized the losses of the financial sector.