“If not now, when?” Hillel (2000 years ago)

1. International Conference on “Recovery or the Bubble? The Global Economy Today” 29-30 January, 2010, New Delhi, IndiaFinance and the real economyThe Unraveling of Financialization:A Macroeconomic PerspectiveSaúl N. KeifmanUniversity of Buenos Aires

2. “If not now, when?”Hillel (2000 years ago) • The crisis as opportunity to redefine the real economy -finance relationships • Discuss financial, esp., macro-prudential regulation in a broader perspective. • The financial crisis symptomatic of much deeper problems beyond inadequate financial regulations (Commission of Experts, 2009). • The new emerging consensus on destabilizing nature of the self-regulation paradigm in global finance before the crisis, a sea change. • Task of stabilizing financial markets, let alone the overall economy, will take much more than new financial regulations.

3. Macro-prudential regulation and excessive credit supply • The Turner Review, remarkable paper of what went wrong with global finance • Strong critique of the efficient market hypothesis & simplistic models used (VaR) • Broad array of views: Keynes, Minsky, Kindleberger, Shiller • Market failures and irrational behavior blamed for market bubbles • The report nails the IMF for its eulogy of securitization • Financial liberalization pointed out as one of the causes of higher macro instability

4. BaselII regulations, pro-cyclical. Mark-to-market valuation combined with fixed capital adequacy, exacerbated pro-cyclicality of credit supply. • At the micro-prudential level, an asset-based leverage ratio, proposed to address shortcomings of a risk-based solvency regime. • Special emphasis on taking into account systemic risk, introducing counter-cyclical or macro-prudential regulations. • Counter-cyclical capital reserves/buffers, based on automatic formula, on of the ideas advanced • The virtue of automatic stabilizers is resurrected

5. But, need of discretionary macro-prudential policy, also underscored • Adoption of a core funding ratio to help ensure that banks asset growth is supported by stable funding sources, such as retail deposits and long-term borrowing, recommended • Banco de Espana ‘dynamic provisioning’ formula, offered as example of counter-cyclical automatic buffers. But no comments on Spain’s real estate bubble, one of the worst in Europe • Beyondthe formula, and whethertheemphasis of macro-prudentialregulationisonautomaticordiscretionarymeasures, itsparamountgoalistoinhibit“excessivecreditsupply”. • Thisisrathercurious. Afterrecognizingtheimportance of marketfailures, irrationalbehavior, financialliberalization and securitization in determiningassetpricebubbles, youwouldexpect a callforstructuralregulation. Instead, themainrecommendationistofindwaystopreventormitigateexcessivecreditsupply

6. The Turner Report criticized the prevailing view before the crisis, that price stability, understood as low goods inflation, was a necessary and sufficient condition for financial and macroeconomic stability • This seemed to be a departure from economic orthodoxy but the emphasis on avoiding excessive credit supply, reveals a diagnosis which interprets bubbles as asset price inflation. Then, the key to macroeconomic stability would lie on fighting not only goods inflation but also asset price inflation. This is clearly stated on the report: “Characteristics of the new global financial system, combining with macroeconomic imbalances, helped create an unsustainable credit boom and asset price inflation.”

7. “The adoption of a core funding ratio” recommended to put “a brake on excessive credit supply.”, p. 9. “… a core funding ratio would act as a powerful inhibitor of excessive credit supply”, p. 114. (FSA, 2009b). • Excessive credit might fuel or exacerbate bubbles, but it won’t create them. Inflation is a rise in the general prices level. Asset price inflation is a general rise in the asset prices, but under manias or bubbles speculation is concentrated on some specific objects, like the real estate bubble. • A monetary or credit theory of bubbles must assume (like the monetary theory of inflation) that money/credit is exogenous or under the control of authorities, which is controversial. The hypothesis of endogenous money/credit has a respectable pedigree in the history of economic thought, especially, in the Keynesian and Post-Keynesian tradition.

8. On the other hand, since the market determination of interest rates is not questioned in the report, the proposed brakes on credit supply would raise interest rates. Finally, it all comes down to preventing low interest rates • But, were low interest rates and a lax monetary policy the root cause of bubbles? Shiller(on the real estate bubble) and Stiglitz (on the dot-com bubble) say NO. • The FSA view is not only a credit theory of bubbles but also a credit theory of the business cycle. Keynes rebutted this view in chapter 22 of the General Theory, “Notes on the Trade Cycle” in which he discusses: “… the view that over-investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, ..., the boom can be avoided by a high rate of interest.”

9. Keynes rejects the empirical relevance of overinvestment. Instead, he thinks that the: “... illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output, is ..., a waste or resources; ... It leads, ..., to misdirected investment.” • But this is precisely a bubble! • The credit theory of bubbles is very similar to the business cycle- overinvestment hypothesis rejected by Keynes.

10. A developing country view • Financial crises in developing countries enabled by market liberalization were forerunners, mutatis mutandi, of the current global one, but the implicit warnings were ignored. Instead, the victims were blamed • However, from a developing country perspective the issues regarding financial regulation reform are different from the ones highlighted in the Northern agenda • Financial “deepening” has been much lower in our countries, which probably mitigated contagion. The issue of portfolio diversification gains (illusory or second order in the First World) were never very important.

11. Our main challenge is how to design financial and non financial institutions and regulations which prevent capital flight, reduce drastically capital flows volatility (a main source of macro instability), and mobilize and allocate domestic savings to productive investment • We have given up long ago the illusion of tapping substantive financial flows in international markets to finance development. We cannot count much on the under-funded international multilateral banks. • We try to protect ourselves against “sudden stops” by accumulating huge international reserves to smooth the cycle and avoid IMF conditionality. But this has a sizable welfare cost and collectively imposes a global deflationary pressure. • Capital controls could help to reduce the amount of international reserves needed for self-protection, and will also allow more policy space to pursue monetary and exchange rate policies more conducive to developmental goals, moving away from the corners of Mundell’striangle

12. However, WTO GATS commitments, bilateral preferential trade agreements clauses on financial services, and bilateral investment guarantees might be a serious obstacle in this regard. It is perhaps high time we reviewed the sensibility of these and other commitments • So we live in a world in which the poor lend money to the rich, a terrible anomaly which requires a profound reform of the international monetary and financial system but American or European governments won’t give away their international seignioragepowers. They won’t commit substantial resources to multilateral banks either given the fiscal overhang of the financial crisis • But, South-South swaps and other monetary clearing arrangements to save international reserves, and truly regional banks and/or monetary funds to help out during country-specific crises, have better chances to do the job

13. To prevent capital flight, close down of tax and regulatory havens, end bank secrecy and implement global taxation • Remarkably, several analysts are reconsidering the nature of banking and the positive contributions that state-owned banks can make. State-owned development banks have played an important role across the world • Privatization or downsizing of these institutions was the dominant mantra in the last two decades. Now we have a growing recognition not only of the public utility nature of banking but of the advantages of departing from the private corporate model of banking. For instance, Buiter (2009) concludes that: “Given the failure of the efficient market hypothesis, … Partnerships, mutual ownership, cooperative ownership, and various forms of public and mixed public-private ownership may be more appropriate for systematically important financial institutions.”

14. Towards a broader perspective of bubbles, cycles and policies • It is essential to revert the pro-cyclicality embedded in the Basel agreements regulations. But limiting crisis prevention to new financial regulations is a dangerous and self-defeating illusion. • Bubbles were not only fed by deregulation of finance but also by the deregulation of the overall economy • For instance, Stiglitz (2003) explains how deregulation of telecoms and electrical power interacted with financial deregulation, lax accounting standards and corporate governance problems, to inflate the late nineties stock bubbles that led to the Enron and Worldcomscandals. • Fiscal policyalsofueledthebubbles in thelastdecade and a halfviathe Clinton and W. Bush Administrationstemporaryreductions of the capital gainstaxrates (Stiglitz, 2003, chapter 7).

15. During the Golden Age, high levels of government expenditures, progressive taxation and social protection systems acted as powerful buffers & automatic stabilizers • But in the last decades these three fiscal pillars of macroeconomic stability and a more fair distribution of income were weakened or removed in many countries • Given the recent rediscovery of the importance of counter-cyclical policies, in general, and of the virtues of automatic stabilizers, in particular, it would be wrong to focus just on financial tools to pursue the complex task of macroeconomic stability

16. The increased frequency of financial crises, macro instability and higher inequality in the last three decades is the result of the triumph of the neo-liberal program which resulted in finance-led capitalism or financialization. • Financialization is the result of a political construction that took three decades to dismantle the institutions of what John Ruggie called “embedded liberalism” and replace it with a new institutional architecture which included the inception of WTO • Which brings us to the political economy issue of the need to seize the moment to pursue serious reform and foster the unraveling of financialization. Buiter (2009) asserts that “Financial regulation is a now-or-never proposition as the sector’s lobbying power is greatly diminished” and favors “robust regulation, risking over-regulation.”

17. Philippon (2009) in turn, highlights the power dimension of effective financial regulation: “The critical issue in my view does not lay in the construction of an appropriate cyclical index, but rather in making sure the regulator is powerful enough to enforce tighter prudential regulations based in part in subjective and debatable interpretations of economic data. The financial industry will not like it, and it has a strong track record of capturing regulators, so this will not be easy.”

18. Conclusion • Financialization is in deep trouble. Crises are opportunities for radical change. The unraveling of the current regime demands much more than well-meaning but limited financial sector reform • In particular, we need to overhaul many of our institutions, not only the financial ones, in order to reestablish the balance between the market and the state, and to turn finance into the servant of the real economy and social progress • We need to employ more active fiscal, monetary, and exchange rate policies and strengthen social protection institutions. Institutions conducive to social justice not only serve well this goal but are also a means to achieve macroeconomic stability and sustained growth. In this regard, we should also consider the strengthening (Bolivia, Argentina) and the access to and redistribution of land (Bolivia & Paraguay).If not now, when?