Martin Khor, Third World Network, 9 October 2008
Geneva, 7 Oct (Martin Khor) — The present global crisis shows that the financial system has become a beast that must be tamed by governments, and excessive financial innovation turned into “financial weapons of mass destruction”, according to an UNCTAD assessment of what it calls “the crisis of a century.”
The UNCTAD policy brief, released Tuesday, says that the United States’ bailout scheme is necessary to prevent a meltdown, but added that protecting banks’ deposit holders and creditors must have higher priority than protecting shareholders. There should also be priority to government equity stakes, not just subsidizing banks.
The UNCTAD brief gave a strong warning that in contrast to the US’ activist stance, other large developed countries are taking reactive or contractionary macroeconomic policies, and this is now “the major global problem.”
It criticized the European Central Bank for its “extremely hawkish monetary stance”, which is the opposite to the monetary stimulus it should be providing, while Europe’s fiscal policy remains “straitjacketed” by the EU’s Stability and Growth Pact.
It also warned that the accelerated de-leveraging process has tremendous negative implications for world growth.Japan and large European countries should counter this by providing policy stimuli to avoid a long global recession or depression. UNCTAD attacked arguments that such actions should not be taken because of inflation fears.
The UNCTAD brief said that as the financial crisis evolves at dizzying speed, the business model underlying a growing share of financial sector activity has been increasingly discredited.
“Public intervention is required to avoid greater damage to the financial system and the real economy. It is also imperative to strengthen regulation and increase the transparency of financial instruments and institutions. Overall, macroeconomic policy should aim at avoiding a global recession or even depression. Ultimately, deflation and not inflation may be the main economic policy challenge.”
UNCTAD said that 13 months since the crisis erupted, things are getting worse, as a full-fledged financial meltdown looms. The almost daily news of collapsing banks, and the fact that a once-trumpeted business model of investment banks has disappeared down the black hole of the crisis, bodes ill for the global economy.
It noted that governments have come back onto centre stage as only they can stabilize markets when confidence has been lost and all other actors are attempting to cut expenditures or clean up their balance sheets at any price, in order to avoid bankruptcy. The market cannot find the bottom without counter-cyclical government intervention.
“Governments and central banks must also recognize that a modern financial market chasing higher and higher returns based on the expectation of ever-rising prices in certain sectors or certain assets is a beast that must be tamed before it causes acute damage and threatens the whole system.
“Governments that have watched the huge bubbles emerging from recent leveraged speculation in the Russian or Chinese stock markets, for example, should know that such bubbles will not burst without risking systemic crisis. For other governments — including some in Eastern Europe — speculation is resulting in currency overvaluation and huge currency mismatches on the balance sheets of domestic households and companies.
“They should be aware of the repercussions on their trade balances and of the possible need to devalue their currency, even if this will increase the domestic currency value of the foreign debt held by households and firms.”
UNCTAD said that financial markets are characterized by frequent herding behaviour, which creates manias and panics. The standard recent view that financial innovation can help diversify risk (because it can allocate it efficiently to agents who are better suited to bear it) is misleading.
This is because at a certain stage, nearly all actors — including the agencies entrusted with rating credit risk — become infected by the euphoria over high returns. Systematically separating risk from information about creditors and their ability to repay has now been revealed as a major flaw of modern financial engineering.
On the US bailout scheme, UNCTAD said that the “socialization of losses” associated with the bailout has been criticized. But given the risks to financial stability and the domestic economy, the government had no choice but to provide insurance for some of the largest endangered institutions. This intervention should also be seen as an attempt to minimize the negative effects on the real economy.
“Of course, protecting the deposit holders and creditors of imperilled banks deserves higher priority than does protecting the shareholders. Similarly, the long-run cost for both government and taxpayer should be kept in check by giving priority to government equity stakes and not just to subsidizing banks.”
UNCTAD added that government insurance and rescue packages should not come for free, neither in their immediate cost to the taxpayer nor over the longer term of market restructuring.
Bailouts must have regulatory consequences. In future, such institutions must be treated like deposit-taking banks and subjected to tighter prudential regulation — or, as has already happened in some cases, forced to change their business model and adapt to more traditional banking arrangements.
The market-fundamentalist argument against stronger regulation based on the idea that market discipline alone can most efficiently monitor banks’ behaviour has clearly been discredited by this crisis, said UNCTAD.
A key lesson is that excessive financial innovation can generate what billionaire investor Warren Buffet has called “financial weapons of mass destruction”.
UNCTAD said that regulatory policies should aim at increasing the transparency of financial products. To this end, there are a few quick regulatory fixes at national and international levels.
The first is to reassess the role of credit rating agencies. They seem to have played the opposite role and made the market even more opaque.
The second is to create incentives for simpler financial instruments. The current regulation system creates a bias in favour of sophisticated financial products which are poorly understood by market participants.
The third is to address maturity mismatches in non-bank financial institutions and limit the involvement of banks with lightly regulated agencies.
The fourth is to limit credit deterioration linked to securitization. Banks that sell their loans off quickly are less interested in monitoring the quality of the borrowers. This problem could be mitigated by forcing banks to keep on their books a part of the loans they make.
UNCTAD noted that the past weeks’ fire fighting focused on limiting the direct impact of the financial crisis on the real economy, but the looming indirect effects must be tackled next.
Since the beginning of 2008, the US government has been acting to mitigate the indirect effects and restore consumer and company confidence. However, the monetary and fiscal stimulus injected at the beginning of 2007 may have faded, with the new downward spin of the financial spiral and the breakdown of major banks.
“The major global problem is that the activist stance of the US authorities in reviving the real economy is swimming against the tide of reactive, or even contractionary, macroeconomic policies in other large developed countries,” said the UNCTAD brief.
“While the European Central Bank is actively providing liquidity to the system and thus avoiding a collapse of the inter-bank market, it is not providing a much-needed monetary stimulus. In fact, the ECB decided to do just the opposite, adopting an extremely hawkish monetary stance at a time when fiscal policy remains straitjacketed by the EU’s Stability and Growth Pact.”
Throughout the world, added UNCTAD, policymakers have failed to grasp the full implications of an acceleration of the de-leveraging process (i. e., the process of depreciating assets without value and reducing debt at all levels) in the United States, the weak US dollar, and the uncertainty of Americans in the aftermath of the crisis.
Such forces can have tremendous negative implications for the world economic outlook. Said UNCTAD: “The undesirable effects of the unwinding of unsustainable debt can be compensated only if the surplus countries — especially Japan and the large countries in the Euro zone, where growth is already anemic or negative — reduce their surplus positions at all levels and quickly provide policy stimuli to avoid a long recession or even a depression of the global economy.”
The UNCTAD brief criticized international responses to the current situation that overplay concerns about inflation as “misguided.” It said the risk of a prolonged downturn or depression is far more important, as the slowdown will further reduce commodity prices. Moreover, there is not much evidence that wage-price spirals similar to the ones that triggered inflation in the 1970s are a real threat at this point.
Only in very few developing and developed countries have nominal wage increases consistently exceeded the growth rates of labour productivity by more than what is tolerable in terms of inflation, said UNCTAD, concluding that deflation, not inflation, is the main policy challenge.