By Zdenek Kudrna
The G20 meeting this weekend was more important for the fact that major emerging economies were invited than for the substantive decisions. It all makes sense to get India and China at the same table with G8, but it does not make it easier for the US to swallow any kind of supranational financial regulation. I guess we need to wait for the new brand of Obama multilateralism to see any progress on this front.
The G20 statement is thick on good intentions, but thin on specific proposals: Increased transparency of financial sector, regulation of rating agencies, avoiding pro-cyclical regulation, increased information sharing between national authorities, expanding the FSF to include emerging economies and ensuring that IMF and other multilateral institutions to have sufficient resources to support emerging economies capital needs. It practically shifts the ball to the Financial Stability Forum that should develop substantive proposals for the next meeting of G20 in April 2009.
I doubt that FSF would be able to cut through the complexity of the global financial markets and formulate the future vision of the global financial architecture that could deal with all aspects listed by G20. Actually, I believe the EU 27 should be the leader in terms of substance of the new financial regulations. If EU cannot make progress towards supranational regulatory regime, than chances for global progress are slim.
Today EU is composed of both developed (EU15 + 2) and emerging economies (EU10) and its financial sectors cover the full spectrum from cutting edge of finance in the City of London, to rather sleepy backwaters in Prague or Bratislava (Today the 'advantage of backwardness' is worth billions of dollars as it means little exposure to 'innovative' financial products that proved 'toxic'. So Czech and Slovaks may still hope to get through the financial crisis without involvement of state finance). At the same time, EU financial markets are highly integrated, but the regulation is still based on home-country supervisors and its supranational dimension did not progress beyond vague memoranda of understanding and more or less informal consultation process.
EU is well aware of the discrepancy between the financial integration and fragmented regulation. A few years ago it even devised the so-called Lamfalussy procedure to be able to catch up on the regulatory side. However, even before the financial crises the regulatory integration hit the wall. Even the idea of regulatory colleges for major internationally active banks that now seems a nobrainer proved too politically contested to be passed.
As is often the case, lack of compromise boils down to interest-group politics. The political cleavages among vested interests in different countries proved too numerous. Brits, like Americans on the global scale, are suspicious of the supranational regulators. French push for centralized heavy-handed approach. Germans worry about their parastatal landes banks. The EU10 countries are not quite sure whether they should try somehow to adjust their regulatory regimes to the fact that all their banks are controlled from abroad (so they just hope for the best now). Moreover, the non-euro countries are not keen on letting ECB (which usurped the bank supervision responsibilities) to supervise their banks. Moreover, the retail banks are not keen on reducing regulatory barriers to competition, whereas wholesale banks support it. Moreover, parties on each side of these plentiful cleavages are shifting all the time. No wonder EU did not make much progress.
the other hand, times of crisis force some clarity of thinking and make clearer the relative costs and benefits of various arrangements. Some refined objections to supranational regime lose their persuasiveness as bad news keeps coming. Some political compromises (such as principles for agreements on burden-sharing of fiscal cost of bailout of banks active in many EU countries) that would be unthinkable in the normal times may be possible in extraordinary times. Economists call this benefit of crisis. If EU could seize on it, the rest of the globe would be more likely to follow.
Nov 17, 2008
G20 on banking regulation and leadership responsibility of EU
Hungarian promises to IMF and future trends in EU10 banking regulation
By Zdenek Kudrna
Hungary had signed a Stand-by agreement with IMF on November 4, 2008. Apart the standard clauses on the fiscal and monetary policy, it includes a section on the financial sector policies. Although, these commitments are made under pressure to fence off the impact of the global financial crisis, they may foreshadow future changes of the EU10 banking regulatory regimes.
The reason why Hungary is threatened by the financial crisis more than her Visegrad neighbors is fiscal profligacy of her government. High debts and high deficits of public finance over the last few years induced the independent central banks to restrictive monetary policy. In turn, high interest rates (and rather stable exchange rate of forint) motivated households to borrow in euro, Swiss francs or even yen. This resulted in the much higher vulnerability of household balance sheets as they essentially bear unhedged exchange rate risk. Both of these risks were exacerbated by the financial crisis that triggered liquidity trap and capital outflows from emerging markets.
In this context, the Stand-by agreement reviews what by today counts as standard firefighting measures including:
To address the foreign lending problem of households, the agreement envisages that banks and indebted families would
The crisis also induced the Hungarian government to submit laws to the parliament that would allow Hungarian Financial Service Authority and financial infrastructure to catch up with what most of their EU10 neighbors have done a few years ago.
Judging what all this means for the future of banking regulation in EU10 is fraught with uncertainties. However, unless we see major moves on the EU level and providing that existing regulatory regime will only be patched not scrapped, we could observe the following:
All of this has always been on the table. However, the unpleasant experience of Hungary and also Baltic states, Romania, and Bulgaria, may help to turn proposals into action in other EU states and on the EU level.
Nov 5, 2008
The Current Financial Crisis: Causes, Consequences and Lessons for Theory and Policy
POLITICAL ECONOMY RESEARCH GROUP organized a round table discussion on:
THE CURRENT FINANCIAL CRISIS: CAUSES, CONSEQUENCES AND LESSONS FOR THEORY AND POLICY
Pictures and complete audio recording (also for download as mp3), and full written summary, from the event available bellow .
Event took place on Tuesday, November 4th at 5.30 p.m. at Central European University Budapest, Nador ut. 9 (MB 201)
Discussion was chaired by Julius Horvath (IRES/ECON), with following participants: Laszlo Csaba (IRES), Bob Hancke (POLSCI/IRES and LSE), Don Kalb (SOC.AN), Ugo Pagano (ECON), Gyorgy Szapary (ECON)
Audio Recordings provided by Gergo Medve-Balint:
1. Gyorgy Szapary Download mp3
2. Bob Hancke Download mp3
4. Ugo Pagano Download mp3
5. Don Kalb download mp3
6. Laszlo Csaba download mp3 A download mp3 B
Discussion:
Part 1: download mp3
Part 2: download mp3
Part 3: download mp3
Part 4: download mp3
 |
| Financial Crisis Panel - PERG - CEU, 4 November 2008 |
Summary: By Vera Asenova
The Current Financial Crisis: Causes, Consequences and Lessons for Theory and Policy
The good news for academics these days is that in time of financial crisis explanations for what the hell happened, are in high demand. The supply of analysis of the situation is not scarce either. Suddenly, all schools of thought celebrate the ultimate prove of their point, the crisis finally demonstrating empirically what the theory has been developing for so many years. Yet none of them is admitting defeat, and none will really disappear.
In an attempt to generate an inclusive debate across disciplines, theories and viewpoints PERG organized a public round table discussion under the title: The current financial crisis – causes, consequences and lessons for theory and policy. Our guest speakers were CEU faculty members from different departments: Laszlo Csaba (IRES), Bob Hancke (POLSCI/IRES and LSE), Don Kalb (SOC.AN), Ugo Pagano (ECON), Gyorgy Szapary (ECON), the discussion was chaired by Julius Horvath (IRES/ECON).
Prof. Szapary, who is also a vice-governor of the National Bank of Hungary, started with outlining the main reasons for the subprime crisis - excess liquidity, and low interest rates, which were kept for too long of a period in the USA, while inflation was also low; on the housing market the high loan to value ratio generated a big amount of toxic assets in the banking system, which is the second main reason for the crisis. He presented the bubble as a rise of real estate prices much higher than the rise of production costs for homes and the population growth. This bubble soon triggered panic: “social intoxication,” and confidence crisis, with banks having stopped lending to each other. The lack of regulation on investment banks and hedge funds had put them in a position of being “too big to fail”, which was not recognized by the national authorities on time. What followed were bankruptcies unseen before in the USA, UK, and Europe, which called for decisive government action. They had “nothing right on the left and nothing left on the right” to use Szapary’s words. Still, two kinds of policy actions followed – central bank injection of liquidity into the financial system, and government bailouts of banks through recapitalization of banks, purchases of toxic assets and deposit guarantees. 3000 billion USD is the total US government commitment so far. Growing fiscal deficit and government debt, followed by increase of taxes, unemployment, inflation and huge losses of wealth are the main consequences of the crisis. One of the lessons to learn is that measures for international burden sharing are needed in a globalized financial world. The countries with the majority of foreign owned banks face a problem of mother banks terminating lending to their subsidiaries abroad, thus forcing the national central banks to bail them out, or inject liquidity beyond its capacity. At the same time, an obvious conflict of interests arises for the central banks in the countries of the origin of the mother banks, who feel reluctant to export capital to foreign financial systems. Who should be the lender of last resort in a globalized financial system?
Bob Hancke spoke of the political roots of the crisis, which in his view lies in the independence of central banks. Lack of regulation, the political roots of the crisis lie in the decision taken in the nineties to deregulate the financial sector. Central Banks have failed as apolitical regulatory agencies, and many of them have in fact been captured by investment banks – serving their particular interests by keeping the interest rates too low. The rule based monetary policy worked for a short while, but soon governments had to come back into the driving seat, although formerly they were considered incapable. Today’s crisis proves this is not true; governments are the viable alternative to failing markets. What they are doing today is not so different from what they did in the thirties. After ”trying out” communism and fascism as alternatives to laissez-faire, social democracy emerged as an understanding that markets are fundamentally good, but you need to regulate them well. It is the kind of viable system where governments play a large role in the economy through central banks and fiscal policy. Hancke opened the debate on central banks and what they are really for. Currently their mandate is diffuse, focused on price stability without achieving it, while the stability of the financial system is taken out of the mandate. Thus the current crisis has shown that central banks are losing their legitimacy, as well as their independence.
Ugo Pagano’s talk entitled “The End of Anglo-American capitalism?“
Both models of capitalism are susceptible to systemic crisis – the one based on flexible financial and labor markets, and the one based on arms length relations between creditors and debtors. The weakness of the Anglo-American flexibility model have now become very clear, and they come down to diluting of agency relations, and destruction of social capital; lower total monitoring; and arising of new rigidities. This new rigidity plays itself out as an impossibility to renegotiate the debt when the price of the collateral went down – when everybody is a creditor the bargaining and renegotiating of debt becomes very difficult.
Secondly, Pagano also shares the view that bubbles are characteristic of the economy – high expectations drive prices up, this was the case of the internet bubble, oil bubble etc. each bubble has a grain of truth – a reason to believe that prices will go up (internet is a great thing; emerging industries, China and India will increase global oil demand etc.) but this grain of truth gets hugely inflated. The more financial instruments created on the basis of this inflated expectation the bigger the bubble gets.
A third phenomenon is the moral hazard problem – some actors are too big, and too interconnected to fail. The danger would have been less severe if these institutions were never allowed to become so big, or to have kept the financial sector under control.
What will happen now? America and Europe follow two different roads. America is an earlier democracy, which believed that wealth should not be concentrated in the hands of a few big families but dispersed. Still the financial sector performed a hidden redistribution function, and is currently in crisis.
Europe’s trajectory starts with first having the big families ruling through concentration of capital. On the other hand, the power of workers is concentrated in trade unions that react, and trigger change.
England started as a strong families, and strong unions capitalism, and moved to a dispersed ownership American model, and is now in crisis due to its huge financial sector and huge state intervention. But this is not the end of the Anglo-American model of capitalism.
Don Kalb – the VoC [Variety of Capitalism] schools is happy about this crisis as it puts the question of what kind of regulation are we going to have. But we need to discuss societies, because societies drive politics, which drive institutions. One thing we learn from this crisis is that institutions don’t work if they are left alone. Even if you introduce more regulation, you need societies to do politics. To analyze the real social forms beyond the Polanyian and VoC framework. Kalb proposed a society-based explanation of the crisis. The neoliberal policies dominant in the last thirty years had two crucial characteristics, which are deeply contradictory and colliding:
- Increased ‘financialization’ of social life – social relations, markets, states;
- Increased social inequality and polarization.
These coinciding developments can explain why the subprime private sector is the domain of the crisis. Regulatory interventions try to prevent, or react to the problem, but cannot succeed. The neoliberal era is an era not of deregulation but of private regulation of risk; the crisis starts form large private indebtedness in the core, which built up in the nineties, and burst out recently. Income stagnation was combined with injections of cheap liquidity (provided by China, Japan and Germany) prevented the contradiction from colliding. Growing private indebtedness, declining prices and inflexible relations have been the causes of the crisis. The possibilities of reversing this adverse combination of social polarization and ‘financialization’ of society lies in the future political decisions taken in the USA. Hopefully Obama, who gets elected today, will listen better than his predecessors.
Laszlo Csaba “The Hungarian reaction. A reaction to what?” Csaba focused on the situation in Hungary which is not facing a deep capitalist crisis like the USA but a panic on the financial market. Due to the underdevelopment of its financial system, Hungary can never commit the mistakes of the USA – the benefits of backwardness. Before discussing the Hungarian government reaction, one needs first to define a reaction what is being sought. Unlike the great depression 1929-35 an overall contraction of GDP in the American economy is not present om the real economy which is not in recession yet. Situations of panic are typical of the financial market. This market has been the source of immense wealth creation – the system which is unregulated, unjust etc. has contributed to eighty percent of the wealth in the last hundred years.
The name of the game is psychology, and the main issue here is the trust. In Hungary the government has very low credibility both because of its members, and because of its economic policy. People do not care about the government because it is politically compromised, and also because it keeps making welfare promises it does not deliver. Low level of credibility is an especially big problem in times of crisis.
Now the reaction of the government was not to listen to the warnings. The national bank, research institutions, and other organizations have been warning the government that tax and spending policy does not work in a small open economy, which has high degree of vulnerability. In this case sustaining a national currency is a luxury and it also enhances the vulnerability of the economy. Joining the currency union as soon as possible should be a priority also of the government, as well as of the median voter. When the crisis hit, the government did not believe it, and kept saying that this was an American problem, which does not affect Hungary. In addition to the liquidity crisis, there was a recent attack on the Hungarian Forint, which lead to almost 20% devaluation of the exchange rate, and from this moment the panic spread. The forecasts was a slum of - 1.5%. An emergency plan was provided by an IMF standby loan of 25 billion dollars together with the European Union, and the World Bank. The attack has now been partially reversed, and the stock exchange is recovering.
Csaba was skeptical regarding the benefits of crisis often discussed by economists – the idea that hard times provide a window of opportunity to sell the wonderful ideas of the economic science to politicians, and bring reform. The primacy of politics will close the window of opportunity and instead of long term economic growth, short term measures, and muddling through will take place for as long as possible.
What followed was an exciting discussion, which can be found on our blog. A commitment to organize another discussion on the topic later, and a few rounds of drinks at a nearby bar.
Read more on The Current Financial Crisis: Causes, Consequences and Lessons for Theory and Policy
May 21, 2008
Review of Soros' book
Financial Times published a review of the latest book by George Soros that I have mentioned here.
A successful prophet of the markets
By John Authers
Published: May 19 2008 03:00 | Last updated: May 19 2008 03:00
This was a book that George Soros badly wanted to write. It is probably not what many of its readers expect to read. But it shows that in his deeper thinking about the way markets operate, Soros was several decades ahead of his time.
The New Paradigm for Financial Markets includes Soros' verdict on the credit crisis. He thinks, as has been widely reported, that it is the most severe since the 1930s, and that it marks the end of a 25-year "era of credit expansion based on the dollar as the international reserve currency".
He also offers some solutions, which centre on new regulation for markets, and how to avoid forced sales for US homeowners. A highly entertaining diary recounts his investment moves in the first three months of this year, culminating with the confusion surrounding the fire sale of Bear Stearns.
His insights are clear and concisely expressed. They are worth reading for anyone interested in the topic. But what is most interesting, and obviously engages Soros at an emotional level, is the idiosyncratic philosophy he has developed to explain the metaphysics of how markets work. Even before the emergence of the efficient markets hypothesis, which has dominated academic thinking on markets for at least three decades, Soros had devised his own theory to prove markets were not efficient. He acted on this philosophy as an investor with spectacularly successful results.
That philosophy derived from his undergraduate studies at the London School of Economics under Karl Popper. The "relationship between thinking and reality", Soros calls "reflexivity." It fills the book's centre in chapters which he admits many will find "heavy going". In markets, Soros says, participants' thinking plays a dual function: they try to understand the situation (the "cognitive function"), and to change it (the "manipulative function"). The two functions can interfere with each other; when they doso the market displays "reflexivity".
So an investor's misperception of reality can help to change that reality, begetting further misperceptions. When market actors' decisions affect outcomes, patterns emerge. If a lot of people are bullish about internet stockstheir price goes up. Soros used the theory to predict, and profit from, a series of "initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles". Each bubble "consists of a trend and a misconception that interact in a reflexive manner".
A key implication of this is that markets do not tend towards "equilibrium", as predicted by modern portfolio theory. And they will not move in the "random walk" promulgated by efficient markets theory, which holds that prices always incorporate all known information and so move randomly in response to new information.
This is important, as the architecture of modern capital markets depends on these theories.And it begins to look as though the credit crisis was the tipping point at which academics and practitioners decided a new paradigm was needed to replace the efficient markets hypothesis. Alternative theories borrow from experimental psychology, advanced mathematics and evolutionary biology and have been built in response to experience in the markets.
The theory of "adaptive markets" - that markets follow trends until they become overblown and then start building up other trends - seems to be gaining ground as an alternative paradigm. Soros' title is a bid for his own theory of reflexivity to become the new paradigm. What is fascinating is how much modern thinking is in line with the theory he developed decades ago.
How does it help explain the credit crisis? Soros believes that a "super bubble" has been formed as the result of a "long-term reflexive process" over the last 25 years. Its hallmarks include credit expansion (boosted by the belief that inflation has been vanquished), and a prevailing misconception, which Soros unsurprisingly blames on Ronald Reagan and Margaret Thatcher, that markets should be given free rein.
There have been numerous financial crises in this period. According to Soros, these "served as successful tests which reinforced the prevailing trend and the prevailing misconception". Thus the current crisis grows in severity because it marks "the turning point when both the trend and the misconception have become unsustainable".
Many will dislike Soros' politics. Others will find the book self-indulgent. He calls himself a "failed philosopher" and badly wants his theory to reach a broader public. It is hard to imagine it would have been published were he not so famous and successful. But his restless intellectual curiosity commands respect. So does his ability to foresee the debate in theoretical finance. He may have been a failed philosopher, but he was a successful prophet.
The writer is the FT's investment editor
Copyright The Financial Times Limited 2008
May 19, 2008
How to pay for ECB failure?
Buiter likes to provoke and think the unthinkable. He does do that exactly in his CEPR piece that ask the question whether ECB can be in need of bail out after taking dubious assets as collateral to its liquidity-enhancing loans. He argues that EU27 governments should come up with the fiscal formula splitting the burden of ECB bailout.
He has a point. However, what seems to be much more likely than ECB going under is one of the medium sized banking groups that control banks in EU10 going belly up. Many of them are big enough in quite a few EU countries to be counted as too-big to fail. So now, you have a bank operation, say in 10, of the EU27 countries in need of bail out. Who is going to pay for it? The home-country government? A syndicate of home- and host-country government? How would they share the bill?
Time is a precious commodity, when a bank is sinking. There might be a window of a few days to agree on the cost-sharing formula, but it is unlikely that governments could strike reasonable agreement under such time pressure. Without pre-agreed formula, the ad-hoc agreement would be a sure recipe for endless disputes, litigations and arbitrations, that would leave noone but bunch of well paid lawyers happy. The political fallout of such disputes on the European integration project would be ugly (Euroskeptics might be the only ones to rejoice).
An alternative would be to let the ECB to step in. Instead of bunch of squabbling governments, the ECB could lead the rescue efforts in multiple EU countries. Given the nature of the financial integration within the EU, shifting the task to ECB would increase chances of a successful solution. However, the ECB would need to pass the costs to governments. At the end, this might be the more important reason to start thinking about the formula for splitting the costs of bail out.
May 15, 2008
George Soros on the current financial crisis and his new book
George Soros, who is inter alia a founder of CEU, has a new book called "The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means". The title pretty much summarizes the topic, although readers might be surprised by his venture into philosophy (of science) in the first part of the book.
Geoge Soros talks about the current financial crisis in the US. Although he does not say anything new that an informed reader would not know, he provides accessible summary of some key issues.
Soros is trying to get across his point that financial models are build on the assumption that markets tend to equilibrium around which prices oscillate randomly are built on the false paradigm. Instead he proposes an alternative paradigm of 'reflexivity' that has a post-modern constructivist flavor (there are no hard facts in social sciences, because people manipulate these facts while trying to comprehend them and act upon such knowledge).
In the interview, he is having hard to explain what is the difference in his line of thinking and the common sense perception of markets (perhaps it is just financial economists who got themselves disconnected from common sense:). At the end he pronounces Basel II failed idea (because it presumes that banks know what they are doing) and calls for the regulation of leverage.
His new book just arrive to the library; I am reading it know an plan to do some review.
Strongly worded argument for varieties of capitalism in banking
Global financial markets have become “a monster” that “must be put back in its place”, the German president has said, comparing bankers with alchemists who were responsible for “massive destruction of assets”.
.... in banking. Finnacial Times report on the comments of the Horst Kohler, current German president and former head of IMF:
Global financial markets have become “a monster” that “must be put back in its place”, the German president has said, comparing bankers with alchemists who were responsible for “massive destruction of assets”.
In some of the toughest comments by a leading European politician since the start of the subprime crisis , Horst Köhler... called for tougher regulations and the reconstruction of a “continental European banking culture”.
Mr Köhler singled out excessive executive pay, the focus of much public resentment against top managers, as a factor in the subprime crisis and accused bankers of acting irresponsibly.
“The complexity of financial products and the possibility to carry out huge leveraged trades with little [of their] own capital have allowed the monster to grow…also responsible [is] the grotesquely high compensation of individual finance managers.
I do not remember the times when he was at IMF, but from comments at other blogs I gather that he is saying something else in Berlin than he was in Washington.
May 9, 2008
Wecome to Banking and Finance Section
Finance is important for economic development. Economists of all stripes and colors consistently find support for this thesis, although they argue loudly on what makes finance work and prevents them form collapsing in a spectacular crises. The EU10 experience in last 20 years actually support this view; finance were key to successful transformations in new Europe, but it has also seen its share of systemic meltdowns almost in every single country.
In EU10 finance means banks. Although financial markets keep developing, they are dominated by banks themselves and this is unlikely to change. The EU10 banking sectors developed towards the universal banking model that will keep banks in the center of economic affairs.
EU10 banking sectors are rather unique. Between 60 and 90 percent of banking sector assets are controlled by a few foreign strategic owners. Although other emerging markets are catching up, nowhere else is the role of transnational banks so profound. This brings a host of questions worth exploring. Does it matter that banks are foreign controlled? Probably not, but the first crisis will test this proposition. Do banks contribute towards economic development? They do, but less than traditional national banks used to; they increasingly finance mortgages and consumer loans, whereas investments are FDI financed (or come as cross-border intra-firm finance).
Is the contagion form the current financial crisis going to get EU10 banks into troubles? Probably not. Can local (host-country) regulators ensure prudential behavior of transnational banks? Probably not; although they remain responsible for safety and integrity of banks in their jurisdiction, they have little leverage over large banks and their home-country supervisors in other EU countries. Then, should the banking regulatory regime switch to supra-national EU level? Probably yes.
These are just some question in the development - finance - regulation&governance nexus, that I explore in my research and thus would explore in this blog. Looking forward to your comments.
Zdenek Kudrna
