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.