The Global Financial Crisis: The View From German Ordnungspolitik ( 秩序政策 )

The Global Financial Crisis:The View From German Ordnungspolitik (秩序政策) Prof. Dr. Carsten Herrmann-Pillath / 何梦笔 Fall 2008

Agenda The Significance of the Crisis 1 The Failure of Economics 2 The Global Context 3 4 The Role of Corporate Governance and Regulation 5 The Political Economy of the Crisis 6 Cultural Change and the Ethics of Economics 7 The Way Ahead

The Significance of the Crisis • After two decades of transition, we now face a transition of capitalism: • From Washington consensus to Beijing consensus? • Reinstating the diversity of capitalisms (French, German etc.) • Current situation: Difficult for forecasting • Fact: We enter a global recession • Unknown: Whether we face a global depression • Unknown: How far the financial system is really affected: • Reason: The status of the financial system is endogenous to the economy • Examples of unknown variables: hedge funds, credit card companies (see American Express), banks of car companies (leasing), corporate finance in general

The Significance of the Crisis • But the biggest unknown: The Lucas problem in forecasting! • We observe far-reaching institutional changes, hence structural changes of the largest economies of the world • Specific example: downsizing and restructuring of financial asset supply • And certainly: A new role of government in the economy • Hence, our attention should focus on these: This is the perspective of Ordnungstheorie und –politik / Institutional, evolutionary and constitutional economics • What is the institutional framework for finance in the future? • Institutions of financial markets • Embeddedness of financial markets (Interdependenz der Ordnungen)

The Significance of the Crisis • Conclusion: • The crisis changes fundamental premises of global institutional change and policies in the past two decades. We failed to forecast the extent of the crisis, and we will fail to forecast its consequences. Thus, adapting our institutions to our ignorance is the crucial challenge.

Agenda 1 The Significance of the Crisis 2 The Failure of Economics The Global Context 3 4 The Role of Corporate Governance and Regulation The Political Economy of the Crisis 5 6 Cultural Change and the Ethics of Economics 7 The Way Ahead

The Failure of Economics • Economic theory is endogenous to capital market evolution • Modern theory of finance major driving force in the production of new types of financial assets (options, securitization etc.) • Neglect of the institutional dimension of capital markets • No substantial role in theorizing about the role of continuous innovation in financial markets • Innovation continuously recreates patterns of asymmetric information (increasing complexity of assets does not manage risk, but increases information asymmetries, which exploded in the total loss of trust) • Tension between behavioral economics and mathematical modeling in risk analysis and risk management • Mainstream finance modelling assumes efficient markets and rationality: Perfect arbitrage and the market portfolio • The issue of probability distributions: Levy distributions and others, «rare events», instead of normal distributions • Neglect of the lemons problem in market dynamics, which interacts with behavioral determinants («irrationality»)

The Failure of Economics • A systematic neglect of asset prices and wealth effects in simple applied macroeconomics • Asset price inflation versus CPI inflation: An unresolved issue in central banking (which adopted inflation targeting) • Stiglitz on Asia 1997: No role for bankruptcy in modeling crises • The failure is endemic: • In the crisis, we observe a sudden revival of vulgar-Keynesian ideas about fiscal policies • Central banks continue to be entangled in the flow-perspective on macroeconomics: interest rate is the lever • The real issue - choosing the right models: • Hayekian model of credit cycles with very low real interest rates? • Stiglitz‘ revival of loanable funds theory? • General: Eschewing the pure macro-approach in favour of an Austrian/evolutionary approach

The Failure of Economics • Conclusion: • Economics played a major role in the genesis of the crisis. It guided regulation and institutionalization by wrong models of the market and monetary policy. We need to rethink economics as well.

Agenda 1 The Significance of the Crisis The Failure of Economics 2 3 The Global Context 4 The Role of Corporate Governance and Regulation The Failure of Economics 5 6 Cultural Change and the Ethics of Economics 7 The Way Ahead

The Global Context • Bretton Woods II:The US as global lead economy and issuer of the global reserve currency could maintain a very low savings rate by capital inflows from China, in particular: • China swaps safe interest returns from treasury bonds etc. for FDI inflows which transfer technology under risk • FDI profits from stable exchange rates and from the resulting Chinese competitiveness • China funds the American deficit and sustains the market for her exports • Chinese reserves serve different objectives (non-macro): • a cushion for domestic banking system reforms and external shocks • channeled into a Sovereign Wealth Fund, they help to reduce transaction costs in Chinese FDI • they are a pawn for Western FDI in China, and they are a commitment device for Chinese cooperation in international policy coordination (because of dollar denomination)

The Global Context • One of the main causes of the crisis: • Expansion of US money supply creates reserve accumulation / inflationary pressures worldwide • Financial innovation major incentive for capital inflows to the US, simultanously providing the stuff for asset price inflation • However, asset price inflation and CPI inflation have been decoupled because of deflationary pressures from China • Will Bretton Woods II survive? • If Chinese price competitiveness remains strong, a global recession will not translate into a low demand for Chinese exports, rather the other way round (e.g. automobile industry) • Global investors will continue to be interested in investing in China, given the dearth of alternative investments

The Global Context • Conclusion: • A reinterpretation of the macroeconomic imbalances of the past decade follows an Austrian line of thinking: Macroeconomics serves the optimal allocation of real capital in terms of growth potentials, overcoming institutional barriers and reducing uncertainty for entrepreneurs. The major fault line was the Fed‘s monetary policy.

Agenda 1 The Significance of the Crisis The Failure of Economics 2 3 The Global Context 4 The Role of Corporate Governance and Regulation The Political Economy of the Crisis 5 6 Cultural Change and the Ethics of Economics 7 The Way Ahead

The Role of Corporate Governance and Regulation • Both the Anglo-saxon and the Continental system failed because of a lack of personal liability: • In Germany, the Landesbanken were the main protagonists in the crisis (public sector management) • In the US, the supervisory system and the rating agencies failed to curb overexpansion by ambitious managers • In both cases, managers‘ incentives are distorted • Leveraging and shareholder value: The false assumption that shareholders will control excessive risk-taking by management • As leveraging implies a high profit rate on equity, shareholders will always support high leverage ratios, especially because they know that they can sell the shares at any point of time • Competition in financial markets is status competition, not „efficient markets“, because status is a central signaling mechanism (Podolny), hence no reason to curb managers‘ gains

The Role of Corporate Governance and Regulation • Procyclical regulation supports risk-taking • Rating agencies will improve ratings in boom times, and vice versa • Regulation may also cause moral hazard (the higher the level of regulation, the more responsibility can be shifted to the government) • Regulation can never keep up with financial sector innovation • There will be always scope for regulatory arbitrage, such that profits will be made precisely because of regulation (securitization and risk transformation), and by avoiding regulation (hedge funds) • Regulation of single banks and regulation of the system differ – another case of the fallacy of composition • The government can only follow industry benchmarks and has no external beacon to determine structure and level of regulation (example: risk control under Basel II) • On the systemic level, government is captured easily by the finance industry (example: Bush‘s support of soft mortgaging schemes)

The Role of Corporate Governance and Regulation • Conclusion: • The most important single determinant of the crisis was the lack of personal liability in the financial system. Government regulation cannot make up for this fault, unless it usurps financial management, hence establishes state ownership in the financial industry.

Agenda 1 The Significance of the Crisis The Failure of Economics 2 The Global Context 2 4 The Role of Corporate Governance and Regulation 5 The Political Economy of the Crisis 6 Cultural Change and the Ethics of Economics 7 The Way Ahead

The Political Economy of the Crisis • «Too Big to Fail»: Regulation and supervision cannot overcome the power-law dynamics of markets: Finance is a network business, neither monopolistic nor perfect competition

The Political Economy of the Crisis • How can governments solve the problem of information asymmetry between them and the financial institutions? • The Lehman Brothers case: Trying to be tough, but weakness afterwards, see AIG • The deeper the crisis, the larger the asymmetries: Demand for government support grows indiscriminately • Special case US: The two goals of the Fed • In-built tendency to over-expand the money supply and to adopt activist monetary policy • Politicians like to expand their influence • Standard case of bureaucratic growth • Politicians have to show off crisis management capability (see Gordon Brown) • Strong public resentment against increasing inequality of income

The Political Economy of the Crisis • Conclusion: • The nature of financial markets leads to complex patterns of collusion, co-optation and capture between government and finance industry. Facing elections, governments are also prone to short-termism and to claim competences which are in fact limited.

Cultural changeand the ethics of economics • Are Bankers greedy? It‘s the system, as Karl Marx already recognized • Status competition plus short-termism of unfettered financial markets • Lack of personal liability • The past three decades saw a cultural competition between different models • The Anglo-Saxon system of capital-market based finance • The relational / credit-based banking model of Germany and Japan, in particular • The transitional banking systems of emergent economies (e.g. Russia, China) • Emergence of explicitly culture-based finance: Islamic finance • Culture: Different mental models of risk and entrepreneurship, historical roots of government-business relations etc.

Cultural changeand the ethics of economics • The relative advantages of the models are at least partly context-dependent: • Finance is not independent from the structure of other markets, especially labor (Aoki) • Structural characteristics of markets determine the structure of uncertainty (e.g. the relative role of generic / singular knowledge as compared to semi-structured / meso – knowledge) • Theoretical paradigm : complementarities and super-modularity, both on the level of the real economy and the institutions • Result: Finance is global, but banking is national! • Is there a need for enhanced consumer protection? • Again, the question of modeling arises: Hyperbolic time preferences and commitment devices for savings • What is the profession of bankers? A custodian, not a businessman?

Cultural changeand the ethics of economics • Conclusion: • The competition among financial systems is also a battle among different economic cultures. The crisis will trigger cultural change supporting the institutional diversity of the global economy. Global regulation cannot substitute for national regulation of national banking systems.

The Way Ahead • Government bail-outs may help in the short run, but the long run consequences can be desastrous: • Increased government debt • Together with low interest rates, the possibility of a resurgence of stagflation, unless a Japanese scenario occurs • Tighter bank supervision withgovernment equity injections cannot necessarily help • Increasing moral hazard in the system • Triggering further direct interventions of government into banking

The Way Ahead • Solution: Less emphasis on business models of banks, but on safeguarding product quality • Stiglitz: Financial product safety commission • Containing the role of rating agencies • The root of the problem: How can the possible negative externalities of finance business be contained? • There are only two choices: • Either curbing status competition, i.e. turning CEOs into quasi-officials (following Bruno Frey) • Or increasing personal liability, hence strengthening private banks • Major challenge: Defining long-term success indicators for banks which internalize externalities • Caveat: There are also positive externalities of risk taking in finance, supporting innovation in business!

The Way Ahead • There is no way to avoid crises in capitalism • Failure is the king‘s way of learning: creative destruction • But we can try to minimize externalities and collateral damages • Central concern: The social security system must be entirely independent from the financial markets, especially the pension system • Second concern: Maintaining the capacity of the financial system to lend credit to companies, especially SME, thus maintaining the real economy • Third concern: Nurturing a diversified structure of the economy, including finance, by means of competition policy

The Way Ahead • Conclusions: • Central assumptions of Ordnungspolitik are vindicated, again: • Personal liability • Containing big business, nurturing diversity • Primacy of monetary order and monetary policies • Strong, but autonomous government, against «crisis management»

The Global Financial Crisis: The View From German Ordnungspolitik ( 秩序政策 )