Back to the Future? The Shape of Reforms to Come…

Authors: Nouriel Roubini & Arnab Das  ·  May 31st, 2010  ·  258977http%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2010%2F05%2F31%2Fback-to-the-future-the-shape-of-reforms-to-come%2FBack+to+the+Future%3F+The+Shape+of+Reforms+to+Come%E2%80%A62010-05-31+16%3A57%3A13Nouriel+Roubinihttp%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2010%2F05%2F31%2Fback-to-the-future-the-shape-of-reforms-to-come%2F › Share This Print

Editor’s Note: A smaller version of this piece was published today by the Financial Times. 

The largest financial crisis in history is morphing from private entities (the banking sector and the household sector) to sovereign entities. At best, fiscal cuts will hit the European recovery; the collapsing euro will subtract from growth in key trading partners – the U.S., UK, Japan and China. At worst, the financial system may come unhinged if the euro disintegrates or sovereign(s) default disorderly, precipitating a double-dip recession. Without an objective, 360-degree diagnosis and a resolute response, we may sink deeper or face larger crises that we clearly cannot afford.

First, a holistic historical analysis: Financial liberalization and innovation eased credit constraints on public and private sectors starting in the mid-1970s. Income and wealth challenged households in advanced economies – where real income growth was anemic – could use debt to spend beyond their means. Ever laxer regulation and supervision sustained leverage, fed by increasingly frequent and expensive government and IMF bailouts, which kept coming to the rescue in increasingly frequent and expensive crises since the 1980s, boosted by easy monetary policy since the 1990s. Political endorsement for this democratization of credit and wider homeownership compounded the trend after 2000, accelerated by the savings glut of demographically-challenged countries.

The debt-fueled global growth process was justified by paradigm shifts: from Cold War to Washington Consensus; re-integration of emerging markets into the global economy; the Goldilocks high-growth/low-inflation economy; a much-ballyhooed convergence ahead of EMU across Old and New Europe; and the widely-touted benefits of financial innovation.

The result: A consumption binge in deficit countries; an export surge in surplus countries; vendor financing courtesy of the latter; creditors and debtors on different sides of the same coin. Global output/growth, corporate profits, household income/wealth, public revenue/spending temporarily shot well above equilibrium.

Wishful thinking enabled asset prices to scale to absurd heights and pushed risk premia to incredible lows thanks to ever-widening access to credit. The private financial sector intermediated and compounded rising national indebtedness with its own borrowing. When the asset and credit bubbles burst, it became clear that the world is less wealthy, more indebted and faces a lower speed limit on growth than we had banked on.

Now, governments everywhere are re-leveraging to socialize private losses and to slow private-sector deleveraging. But public debt is ultimately a private burden: Governments subsist by taxing private income and wealth, or the ultimate capital levy of inflation or outright default. Thus public debt cannot substitute fully or indefinitely for excessive private leverage. Eventually governments must deleverage too, or else public debt will explode, precipitating further, deeper public and private sector crises.

This is already happening in the current frontline of the crisis, eurozone sovereign debt. Greece is first over the edge thanks to manifold sovereign risks: illiquid (fiscal deficit and maturities); insolvent (public debt); uncompetitive (trade deficits); and vulnerable (external debt). Ireland, Portugal and Spain trail close behind.  Italy, while not yet illiquid, may face solvency risks. Even France and Germany have rising deficits. UK budget cuts are starting. Eventually Japan must cut, too. The elephant in the room is the United States…

Next, crisis management: The G20 coalesced after the global crash of 2008-09; we all were in the same boat together, sinking fast. Governments acted in unison to restore market confidence and economic activity with financial-sector backstops and reflationary policies.

But in 2010, national imperatives reasserted themselves, obstructing coordination. Few ponder solutions to rebalancing global growth; many prefer a return to business as usual. Coordination is lacking: Germany is banning naked shorts unilaterally and the U.S. pursuing its own financial sector reform. Surplus countries are unwilling to stimulate consumption. Deficit countries are building unsustainable public debt to paper over cracks in household or financial sectors.

Thus, the eurozone in 2010 offers the opposite object lesson of the G20 in 2008 – what not to do in a crisis of confidence, illiquidity, and insolvency that threatens contagion and systemic risk. Member states started off by going it alone just as they did when they carved up pan-EU banks along national lines in 2008. Ireland recognized the problem early and cut its budget; the eurozone signaled solidarity. But Greece signaled the opposite – it wanted just to be able to borrow at the same rate as everyone else, even though its debt and deficits were far larger than those of the rest, and larger than originally stated. Germany initially objected to a bailout, and all objected to the IMF. And everyone pointed out stark differences between Greece and the rest of the eurozone. The authorities insisted there need be no bailout, nor any risk of default. The ECB said there would be no change in its repo collateral rules, and certainly no change for the benefit of a single country.

After much dithering and denial, the eurozone pulled itself together for an overwhelming show of force – a trillion dollar bailout. It bolstered confidence for only a day. But in the months leading up to the day-long relief rally and the decades leading up to the crisis, the rules and treaties that underpin the eurozone and by extension, European integration, were progressively undermined. There was no fiscal or political union underpinning the eurozone, even though it is clear from history and theory that monetary unions do not survive without a few critical elements:

1. A lender of last resort, to absorb transitory liquidity shocks to the financial system.

2. Labor mobility and flexibility, to ensure a flexible real exchange rate, given a fixed nominal exchange rate.

3. Fiscal and political union to ensure that “asymmetric shocks” can be managed through transfers to the regions or sectors harder hit by these shocks.

Everyone understood that these were critical, Economics-100 type design flaws in the eurozone, so political compromises were hammered out to deal with the economic realities. However, the design flaws remained in an underlying sense.

• The ECB’s lender of last resort capabilities were limited to the financial system and did not extend to sovereign member states by design, and banks faced limits on how much collateral they could post for refinancing via repos with the ECB.

• Barriers to trade, investment and migration were all torn down, so there was labor mobility on paper, but not much in practice.

• Committees, qualified majority voting and treaties substituted for political union, and fiscal rules for fiscal union. Member states were subject to Maastricht treaty limits to harmonize fiscal policy via limits on public debt and deficits at 60% and 3% of GDP respectively. Violations were to be punished under the Growth and Stability Pact excessive deficit procedure with fines – but no member state wanted to fine another for what it might do later itself.  The ultimate sanction was the no-bailout clause, enshrined in the Lisbon Treaty, as well as Germany’s national constitution. And here we are, staring a bailout in the teeth…

Now, all the rules, commitments and bravado have gone out the window, after repeated about-faces on what the eurozone would and would not do. The ECB did an about-face on the IMF, given Germany’s insistence, and eased its repo collateral rating rules. Sovereign bailouts are being legitimized under Article 122.2, a clause inte
nded to help deal with acts of God like earthquakes, not man-made excessive public debt and deficits. The ECB has begun monetizing government debt by secondary market purchases only days after insisting that it would not. It will sterilize its interventions in the government bond markets, but this might still amount to fiscal federalism by stealth. After all, much of the credit risk will be transferred from banks holding claims on eurozone sovereigns, to the ECB itself through these secondary market purchases. If the bailouts and fiscal adjustments fail, the ECB will bear the capital losses and will need to be recapitalized either by fiscal transfers from solvent creditor countries (Germany in particular), or via inflationary seigniorage (which is anathema to Germany). Perhaps this is part of the agenda – it may be politically easier to bail out Greece and the periphery, or recapitalize the ECB, than to further recapitalize the banks. But stealth is no basis for sustaining credibility.

Even now, too little structural reform is being promoted to contain the deflationary downside of the urgent fiscal adjustment, and to ensure that economic vitality will be restored beyond the socio-political pressures that lie ahead. Plus, the signs of tensions within the Franco-German axis that lies at the core of Europe and underpins the euro, are palpable.

We propose a comprehensive solution to reverse this incipient balkanization of national responses to a global problem of leverage run amok, a shortage of aggregate demand, fiscal and financial incontinence, and gradual erosion of the policy credibility of the institutions of state and those who manage them. We must be honest about the following political, regulatory and market failures and grasp the nettle of urgent solutions:

• The eurozone must get its act together. Starting right away expansion should be put on ice – after all, you don’t add floors or extensions to your house if the foundations are cracking. Whatever breathing room is conferred by the bailout should be used to deregulate and liberalize in the South and to stoke domestic demand in the North. The institutional design flaws in the eurozone need to be corrected, in particular by establishing Sovereign Debt Restructuring Mechanisms to limit the moral hazard created by the current bailout. There needs to be greater harmonization of structural and macro policies across the eurozone. And above all, there needs to be a significant structural reform effort to restore the economic dynamism and competitiveness of the eurozone.

• Debt must be forgiven and balance sheets cleaned up to restore any hope of growth anytime soon. There is too much debt concentrated in several countries. This is more than a liquidity problem, it is a solvency problem, and it requires a work-out on a grand scale. Greece is the tip of the iceberg in Europe; Spanish and other banks are knee deep in bad debt. Equity dilution and effective credit enhancement via debt socialization will very likely prove inadequate – either because there is just too much debt to do this comprehensively or because it will create expectations of future creditor bailouts that are simply unaffordable.

• Macro policies must be rebalanced. The current fiscal trajectory is unsustainable in most high-income countries. Sovereign risk is rising across the developed world. But timing is everything. Some countries, particularly in Europe, are having to tighten fiscal policy prematurely given their position in the economic cycle; this needs to be clearly offset with easier monetary policy – most importantly by the ECB. Most major high-income countries need to maintain large budget deficits and expansionary monetary policy now. So, they should credibly commit to substantial fiscal adjustments with a defined timetable. More important and effective than fiscal rules like Germany’s balanced budget law, the UK Golden Rule, the Maastricht debt/deficit limits – which are mostly observed in the breach anyway – would be a timetable and a set of alternative scenarios to deal with each component of the fiscal challenge:

o   Crisis-related fiscal costs – automatic stabilizers, stimulus programs, and bailouts. (In the United States, Fannie and Freddie must be dealt with, as they may represent a potentially massive increase in federal debt.)

o   Debt dynamics parameters like growth, interest rates and revenues.

o   Age-related and other typically unfunded contingent liabilities.

o   Contingencies for unexpected future increases in the stock of debt and flows of deficits.

• The Western financial system needs radical reform. The majority of proposals on the table are inadequate or irrelevant. Banning naked short selling and cracking down on hedge funds may play well politically and help shine light on the shadow banking system, but it ignores the larger reality. The formal banking system blew up because it was too big and too interconnected to fail, as did parts of the insurance industry, hedge funds within banks, and money market mutual funds. Not only does the old saw hold that if it’s too big to fail, it’s too big; the truth is that if it’s too anything to fail, it will fail. The costs will be spread across society as a whole, once the economic rents and business profits have been concentrated in the hands of a few. The Volcker rule is a step in the right direction, and the U.S. House and Senate bills have much to recommend them. But ultimately, different functions of the banking system need to be unbundled. It is clear that large complex financial institutions are not only too big and interconnected to fail, they are also too big and complex to manage. In this respect, they are no different than the vertically-integrated or horizontally-diversified corporate conglomerates built up during the 1960s-70s, particularly in the United States, and unbundled in the 1980s-90s. If shareholders want or need exposure, for example, to oil/gas, films, hospitality sectors, they can get that exposure in the equity and credit markets; there’s no reason to become a stakeholder in a Gulf & Western. Similarly, investors can find all the traditional banking, investment banking, hedge fund, mutual fund and insurance exposure they could possibly want in a purer form directly in the equity and credit market.

• The global economy requires rebalancing through a far-reaching and gradual structural reform. The deficit countries must rebalance toward savings and investment; the surplus countries must move to stimulate domestic demand. The quid-pro-quo for fiscal adjustment and financial sector reform in the deficit countries must be deregulation of product and service markets, labor market flexibilization, and wholesale corporate reform to improve the labor share of income in the surplus countries.

Without a comprehensive solution along these lines, we will condemn ourselves to lower growth, greater macro volatility, and a heavier burden on future generations than is necessary. We may well still be able to avoid financial Armageddon, but we will still perform well below potential globally and face the risk of further serious crises.