January 22, 2012 6:39 pm

Seven ways to fix the system’s flaws

Capitalism in crisis

Three years ago, when the worst financial and economic crisis since the 1930s gripped the global economy, the Financial Times published a series on “the future of capitalism”. Now, after a feeble recovery in the high-income countries, it has run a series on “capitalism in crisis”. Things seem to be worse. How is this to be explained?

In 2009, the world was in a state of shock. Now, despite successful efforts at stabilising economies, people are closer to despair.

Something seems to be wrong with the system. But what, and what needs to be done?

Capitalism has always changed. That is its genius. Today’s shocks make the case for reform urgent.

Let us consider seven challenges. Some relate to capitalism itself, others to the context in which it operates.

Managing macro instability

One of the biggest debates in economics is whether a modern capitalist economy is inherently stable. Before the crisis, the orthodox view was that it would be if one had a competitive economy and a central bank that anchored inflation expectations. Events have disproved this view.

The late Hyman Minsky, in his masterpiece, Stabilizing an Unstable Economy, provided incomparably the best account of why this theory is wrong. Periods of stability and prosperity sow the seeds of their downfall. The leveraging of returns, principally by borrowing, is then viewed as a certain route to wealth. Those engaged in the financial system create – and profit greatly from – such leverage. When people underestimate perils, as they do in good times, leverage explodes.

Finance then progresses from what Minsky calledhedge”, in which interest and principal is repaid out of expected cash flow, to “speculative”, in which interest is paid out of cash flow but debt needs to be rolled over, and finally to “Ponzi”, in which both interest and principal is to be paid out of capital gains. Does this sound familiar? It certainly should.

What is the answer? We can see three elements if one puts to one side the notion that we should return to the 19th-century gold standard or eliminate banking.

The first is to recognise that, as critics have long noted, crises are inherent in free-market capitalism. This is partly because of the way capitalism itself behaves. It is also because all participants, including regulators and even economists, act and think pro-cyclically.

Second, so-called “macroprudential policyoversight over the financial system as a wholematters. Regulators need to watch the build-up of leverage. They also need to ensure adequate levels of loss-absorbing capital in financial institutions and among the ultimate borrowers.

Finally, the government and its agencies, including the central bank, have a big role. They acted as stabilising forces during the crisis. But they also acted as destabilising forces before the crisis: central banks responded too aggressively to incipient recessions in previous decades and governments were too willing to encourage excessive leverage in the household sector. These serious mistakes must not be repeated.

Fixing finance

The financial system is an essential part of any market economy. But it is based on a complex and fragile network of trust. The lesson of the crisis is that such networks are prone to abuse and then to collapse.

Again, what is the answer? It is to protect finance from the economy and the economy from finance. This requires bigger shock absorbers. If that change is made, the normal disciplines of the market can operate, as they should: no moretoo big and connected to fail”. Yet mistakes will still be made. People are always influenced by the fads and fashions of the moment. But if the financial system is more robust, it will be in a better position to survive such errors.

What are the elements of the shock absorbers? The most important is far more capital. The core financial institutions should not in the long run have leverage of more than 10 to one. An additional requirement is a resolution regime that lets the authorities act promptly once institutions are on the brink of losing funding.

Moreover, as the UK’s Independent Commission on Banking (of which the writer was a member) has also recommended, managing the payments system and providing credit to households and small and medium-sized businesses should be separated from investment banking, to strip away implicit subsidies.

Finally, too often, consumers cannot understand what they are buying. The principle of “caveat emptor” – let the buyer bewaredoes not work. People need protection from the predatory practices seen so egregiously in US subprime lending before 2008.


Addressing inequality and jobs

As the Organisation for Economic Co-operation and Development, the Paris-based think-tank, showed in a recent report, high-income countries have seen large rises in inequality over the past three decades. This is captured in the slogan of the Occupy Wall Street protest movement: “We are the 99 per cent”. The rise in inequality is the result of complex forces: globalisation, technological change, “winner-take-all markets, the birth of new and dynamic industries, changes in social norms over pay, the rise of finance, and shifts in taxation.

Many of these changes were irresistible and are irreversible. But the level and increase in inequality does vary across countries, which suggests that economic structure and policies do alter outcomes. The US and UK, for example, have seen far faster rises in the real incomes of the top decile than of the bottom decile of household income distribution since the 1980s. In France, this went the opposite way.

Many would argue that inequality is unimportant. To this, there are two powerful responses. The first is that it is important if it is politically salient. It is. The second is that inequality of outcome has a strong bearing on equality of opportunity, about which many more do care. It is harder for children who grow up in deprivation to obtain a decent start in life than those brought up in happier conditions. The effort becomes harder still if parents cannot find remunerative jobs and young people cannot hope to do so when entering the job market.

What are the answers? Among them must be explicit fiscal redistribution from the winners to the losers and particularly to the children of the losers; subsidisation or direct provision of jobs; big efforts to improve the quality of education and childcare for all, including public financing of access to higher education; and a determination to sustain demand more effectively in severe downturns.

Changing corporate governance

The core institution of contemporary capitalism is the limited liability corporation. It is a brilliant social invention. But it has inherent failings, the most important of which are that companies are not effectively owned. That makes them vulnerable to looting. Incentives allegedly provided to align the interests of top employees with those of shareholders, such as share options, create incentives to manipulate corporate earnings, at the expense of the long-term health of the company. Shareholder control is too often an illusion and shareholder value maximisation a snare, or worse.

What is the answer? Unfortunately, no simple remedy exists. The corporation is the best institution we know of for running large, complex and dynamic businesses. It is surely important to ensure that taxation and regulation do not obstruct other forms of ownership, including partnerships and mutuals.

It is vital to encourage the creation of genuinely independent, diverse and well-informed boards. It is sensible to ensure that pay packages are transparent and any incentives for destructive forms of remuneration are removed. But except in banks, where the public interest demands intervention in the incentives of management, governments should not intervene directly.

Tinkering with taxation

The general thrust of political discussion, outstandingly so in the US, is against any and all taxation. Yet taxes play a decisive role in determining how the market economy operates, for good and ill. They determine the resources available for the supply of essential public goods and services. Finally, they can make a big difference to the outcome on inequality.

What are the answers? Among the most important tasks is to remove the incentives for leverage embedded in personal and corporate taxation. On the latter, treating equity and debt equally might significantly reduce fragility. Another sensible idea is to shift the tax burden from incomes on to consumption and wealth. Yet another objective is to ensure richer people pay tax. At present a host of loopholes protect them, including the ability to turn income into capital gains. Some of this demands global co-operation, which is horribly difficult to obtain.

Curbs to purchasing politics

Among the biggest concerns must be the relationship between wealth and democratic politics. Politics and markets each have their proper spheres. The market is based on the roles of people as producers and consumers. Politics is based on their roles as citizens. In the absence of protection for politics, the outcome is plutocracy. Plutocrats like closed political and economic systems

But if they succeed, they undermine the open access on which democratic politics and a competitive market economy depend. Protecting democratic politics from plutocracy is among the biggest challenge to the health of democracies.

What is to be done? The protection of politics from the market comes by regulating the use of money in elections and by the supply of public resources to those engaged in them. At least partial public financing of parties and elections is inescapable.

Globalising public goods

Last but not least, today’s capitalism is global. This creates a host of both challenges and constraints.

One issue is how to regulate businesses that operate on a vast global scale. This has turned out to be particularly difficult in finance. There is a choice: align support in times of trouble with regulation at the national level and so break up the integrated global financial system, or align support with regulation at higher levels and move towards a more integrated European or global politics.

More broadly, the disjunction between the level at which politics operates and the levels at which business and the economy function is a concern. Among the issues it raises is how to provide a host of global public goods by agreement among a range of very different states. Those include open markets, monetary and financial stability, security and, above all, protection of the environment.

What are the answers? The long-term one is likely to be more global governance. Will that be feasible? Not in the near future, in many areas.

. . .

A crisis, it has been said, “is a terrible thing to waste”. Capitalism has always changed. It needs to change right now if it is to survive and thrive. We need to find specific practical reforms within capitalism and to review the framework within which it operates.

But capitalism must still be capitalism. It is highly imperfect. Yet so are we. It is still a uniquely flexible, responsive and innovative economic system. It may bein crisisright now. But it is still among humanity’s most brilliant inventions. It is the basis for the prosperity that so many now enjoy and far more aspire to. It is transforming the lives of billions of people. Let us strive to make it better.

Change born of experience and a revolution in economic thinking

Capitalism has an extraordinary survival instinct. This is partly because crises trigger reforms that make it more robust, effective and politically legitimate. The bigger the crisis, the bigger the reforms. Since the Great Depression of the 1930s was the biggest economic crisis in history, it delivered commensurately hefty reforms. The second world war assisted this effort, by underlining the dire consequences of crises, by bringing the allies together and by making society more cohesive.

The resulting reforms were born of the experience itself and the revolution in economic thinkingKeynesianism – it triggered. Many governments, including that of the US, enacted the objective of full employment and accepted the primary role of fiscal policy. The goal of full (or “maximum”) employment is still, along with price stability, one of the twin mandates of the Federal Reserve.

Keynesian economics also shaped the thinking about the new global monetary regime, enshrined in the International Monetary Fund. The objective of currency convertibility was as a result limited to current account transactions, since free capital flows were seen as destabilising.
The experience of the 1930s brought forth three further reforms.

The first was financial regulation and controls on capital flows. In the US, the Glass-Steagall act split investment from commercial banking. Tight controls on finance were introduced everywhere.

The second area of reform was the birth or at least rapid development of the welfare state in many countries. In the US, this was the product of Franklin Delano Roosevelt’s New Deal. In the UK, the Beveridge report paved the way for today’s welfare state. Similar ideas about state provision of a safety net spread across the west.

Finally, after the second world war, a carefully managed reversal of the protectionism of the 1930s began. This was enshrined in the General Agreement on Tariffs and Trade and, ultimately, the World Trade Organisation; and also in the forerunners of the OECD and the European Union.

Today’s crisis is smaller than that of the 1930sso far. Yet it is a big event, particularly in conjunction with a shift in economic power to the east. Whether this brings forth big reforms remains unclear. But it is possible.

The writer is the FT’s chief economics commentator

Copyright The Financial Times Limited 2012

01/23/2012 05:48 PM

Merkel's Increasing Isolation

Germany at Odds with Partners over Euro Crisis Berlin has been unflinching it its efforts to both increase fiscal discipline in the euro zone and to avoid throwing more money at the European debt crisis. Increasingly, though, Germany's EU partners are unwilling to play along. Chancellor Merkel now finds herself confronted with powerful opponents. By SPIEGEL Staff

Boyko Borisov cuts an imposing figure. The Bulgarian prime minister has the build of a piano mover, and he used to coach his country's national karate team. He towered over German Chancellor Angela Merkel while walking with her through the Chancellery in Berlin.

Indeed, he almost seemed like a Merkel bodyguard during his visit to the German capital last Wednesday, particularly when the subject of the euro crisis came up. For days, Italian Prime Minister Mario Monti has been insisting that Germany needed to do more to save the common currency. But Borisov, in contrast, told his audience that he would like to "thank Germany on behalf of many countries in the European Union." He said that what was important now was budget consolidation, to only spend as much as is brought in and to save, save, save.

"Everyone has to work as much as the Germans," he added.

Merkel nodded with satisfaction. Finally someone was showing some understanding for once. Then she took her earphones off and addressed Monti's repeated demands. "I'm still searching for what else exactly we are supposed to do," she said. And when she figures that out, she added, she'll actively pursue it.

Monti has been crystal clear about what he thinks is missing in this process. He wants more money from the Germans -- a lot more. And he's not alone in Europe.

'Isolated Measures Here or There'

A large alliance of the finance ministers, heads of government and central bankers from almost all of the 17 euro-zone member states has been calling for the European Stability Mechanism (ESM) to be enlarged -- significantly. The permanent euro backstop fund, which will go into effect this year and will ultimately replace the temporary European Financial Stability Facility (EFSF), needs to encompass fully €1 trillion ($1.3 billion) instead of the planned €500 billion, Italian government officials have told their German counterparts.

At the same time, widespread resistance in Brussels to German plans for a new system of financial regulation within the EU is becoming more assertive. Merkel's proposal for all EU member states to pass balanced budget initiatives -- known in Germany as a "debt brake" -- has been torpedoed as has the idea to allow the European Commission to bring countries that stubbornly violate deficit rules before the European Court of Justice.

Belgium Prime Minister Elio di Rupo says that politicians are currently trying to "solve the problems of each country and of Europe with slogans." But, he adds, "one can't solve the euro zone's most important problems with isolated measures here or there."

Just a week before the next EU summit will be held in Brussels, Merkel is facing yet another test of her power. She has pledged to Germans that she won't invest another euro in efforts to rescue the currency. But, in the rest of Europe, the grumbling of those who claim that Germany is trying to dictate economic and financial policies to the rest of the EU is growing louder.

"The split is dramatic," Danish Prime Minister Helle Thorning-Schmidt complained last week before a small group in Strasbourg. "That is being massively underestimated in Berlin."

Expert Support for Monti

Indeed, the balance of power in Europe has shifted. As long as Italy was ruled by a clown like Silvio Berlusconi, it hardly had any voice in efforts to save the euro. But ever since Monti, a respected financial expert, took over, the front of Merkel opponents is stronger than ever, all the more so because quite a few experts endorse Monti's position.

Monti, too, would like to see additional money be used to bolster the euro bailout fund, to send a calming signal to the capital markets. A professor of economics, Monti insists that Italy has no intention of asking for help. But bolstering the bailout fund would create confidence, he believes, which in turn would lower the risk premiums on his country's sovereign bonds. Yields on the bonds of other cash-strapped countries would also fall, he says.

The governments of Spain and Portugal agree. In confidential crisis meetings, they have long argued that financially healthy euro-zone countries should make larger contributions. It was a point they pushed at the most recent European Council meeting on Dec. 9 in Brussels, and nothing has changed since.

Southern European countries have yet another advocate, one who is generally considered to be an ally of Merkel's. French President Nicolas Sarkozy has repeatedly urged Merkel to be more generous. Germany must leverage its economic and financial power to assist the common currency, Sarkozy insists. If Merkel refuses, he warns, then Germany will be held responsible should the euro collapse.

Sarkozy is now getting the support of prominent economists from around the world. Christine Lagarde, the head of the International Monetary Fund (IWF) is calling for more money for the euro backstop fund as is Mario Draghi, the president of the European Central Bank (ECB), who has been in regular contact with his compatriot Monti. In a Monday appearance in Berlin, Lagarde said "we need a bigger firewall."

The Challenges Facing the Most Indebted Countries

Draghi is backing a proposal that could very well lead to a compromise. The plan envisions not carrying over the €250 billion in unused EFSF funds to help make up the €500 billion in total funding being allocated to the permanent ESM fund. Instead, the unused funds would be added on top of that planned for the ESM, bringing the total available funding to roughly €750 billion.

Despite the growing pressure, Merkel and her finance minister, Wolfgang Schäuble, haven't budged. They point to an agreement made at the last EU summit stipulating that there would be no scrutiny of whether the ESM had sufficient funding until March.

They argue that there is absolutely no reason to deviate from this timeline. After all, they note, the situation on the bond markets has finally relaxed, and yields on Italian and Spanish government bonds have dropped despite the fact that rating agency Standard & Poor's recently downgraded the credit rating of both countries. In effect, they argue, this means that the governments of Southern Europe can already borrow for less.

But Monti doesn't want to trust that things will stay this way. When he visited Merkel in Berlin two weeks ago, he said that the reform process in Italy was encountering difficulties. Not only were economic developments threatening the future, he explained, but there were also increasing political risks.
Although he didn't elaborate on what he meant, everybody already knows: Berlusconi, his political predecessor in office who is responsible for years of economic stagnation in Italy, is preparing his comeback.

Since nobody in Europe wants to see Berlusconi back in power, Monti senses he has more political support. He argues that, since Germany benefits from the euro "more than others," it is "in Germany's interest" to help Italy and the other heavily indebted countries by making it cheaper to refinance their mountains of debt.

Teaming Up Against Germany

Monti's statements have been met with growing displeasure in the Chancellery. But Monti believes he has a very good chance of softening up Merkel -- especially if he teams up with France. Merkel has been able to repeatedly stonewall French calls for a change of course. But now, as the Italian daily La Repubblica quoted a Monti adviser as saying after his visit to Paris in early January, "La Merkel has to understand that we are now two."

The Germans discovered just how well the French-Italian duo could work together during last week's talks about the proposed fiscal pact. Indeed, without their support, Berlin failed to push through any of its key demands.

The main demand to fail in the face of opposition from the other countries was that calling for debt brakes to be written into the national constitutions of all euro-zone countries. In previous negotiation rounds, German officials had insisted that debt brakes be adopted. But, last Thursday, they were forced to concede defeat.

Irish government officials had warned that writing this provision into the constitution would require them to hold a referendum -- and everyone participating in the talks understood this warning for what it ultimately was: a threat. A referendum on the island has already stopped a European treaty in its tracks once previously.

The most recent draft of the fiscal pact is correspondingly weak. The document proposes that member states be obliged to adopt a "binding and permanent" debt brake into their national legal systems, but then it qualifies this by saying these provisions should be "preferably constitutional" or merely "otherwise guaranteed to be respected through the national budgetary process."

Berlin also had to give up its call for allowing the European Commission to bring individual deficit offenders before the European Court of Justice. This would have contradicted EU law, which stipulates that a simple pact between individual states cannot define the role of an EU institution. As one EU diplomat assigned to the talks says, in actuality, the pact will bring about absolutely no change in budgetary policies.

Anger, Disappointment, Confusion

There is growing disappointment in Germany, as well. "The cornerstone for a genuine fiscal union has yet to be laid," complained Jens Weidmann, the president of Germany's central bank, the Bundesbank, last Wednesday in Berlin. "For now," he told his audience of politicians from Merkel's center-right Christian Democratic Union (CDU) and its Bavarian sister party, the Christian Social Union (CSU), "there will be no genuine rights to intervene in national legislation, even in cases of continued fiscal misconduct."

Likewise, there is much anger about the way the Germans have led the negotiations, not only in Berlin, but particularly among EU politicians in Brussels. All of them understand that the Germans want to hold on to their money. But hardly anyone can fathom why Merkel would insist on having provisions in the pact that are of questionable legality or meaningless when it comes to financial policy.

Indeed, many are puzzled as to why the Germans are even opposed to the kinds of proposals that would promote economic recovery without costing them anything at all. For example, when Monti recently suggested loosening the rigid service-sector labor market throughout Europe, the Germans brusquely rejected the proposal.

Yet no one disputes how important economic growth is for resolving the debt crisis. A team of researchers led by Henning Klodt at the Kiel Institute for the World Economy have corroborated this view. The economists believe the euro crisis has not been permanently resolved. On the contrary, were the economy to significantly soften, it would make the crisis even worse.

For each of the euro-zone's 17 member countries, the team of economists has also calculated how much government revenues must surpass expenditures in order to allow their finance ministers to keep making interest payments on their debts both now and in the years to come. Klodt's team gives the all-clear to most countries -- even France, despite Standard & Poor's recent downgrade.

"The markets' appraisals are much worse than the actual budgetary situations," Klodt says, adding that the same holds true for Spain. "If the yields don't keep going up and there is a return of growth, it will soon get its debts under control."

A Possible Silver Lining for Italy

But Klodt's calculations also show just how futile reform efforts are in some of the most heavily indebted countries. Should growth in Italy not significantly increase, for example, the country will have major problems paying off its debts on the long term.

Klodt believes that Rome will have to either raise taxes or slash expenditures -- and to a virtually unprecedented extent. According to his calculations, the country would have to devote almost 6 percent of its annual economic performance to its rescue efforts. "Even with the best will in the world," Klodt says, "that's still utopian."

Klodt also believes that Portugal's situation is downright bleak. If the economy doesn't pick up there, he says it will also be essential for debt to be slashed as in Greece. His calculations indicate that those who have invested in Portuguese debt would be forced to waive more than half of their claims, or over €170 billion, just to give the country a shot at getting its finances under control.

And in Greece, Klodt's team believes it is no longer possible. That private creditors have signaled their willingness to waive a major part of their claims doesn't help, he says. If interest rates on the markets remain at their current level, the country will need to have more than 80 percent of its debts forgiven. Were that to happen, the ECB and other euro-zone countries would lose a lot of money, as well.

For Italian Prime Minister Monti, the economist who once studied under Nobel Prize laureate James Tobin, there is only one way out. "There will be a European growth initiative," he says, and refers to the one country in Europe in better economic condition than all the rest: Germany.

"The bigger you are," he says, "the more responsibility you have."


Translated from the German by Josh Ward