Taming financial markets is a must!

The financial crisis has made glaring the European Monetary Union’s inappropriate policy and institutional underpinnings and insufficient economic convergence between its members. These shortcomings have been open secrets among the informed. Fixing Europe’s economy needs, among other things, a push for greater competitiveness among the Mediterranean countries, which hinges on internal reforms and, nota bene, the reform of EMU economic governance as well as credible emergency anti-crisis measures. Among the latter, a substantial rise in the resources available to the EFSF and speedier procedures are urgent. However it is vital that a further, major cause of instability – the financial markets – is also addressed. These markets need to be tamed.

The recent era of cheap money and cheap imports made EMU look more solid than it was in reality and obscured the  “mezzogiornification of the South”[1]. Europe’s economic weaknesses and threatening cleavages need urgent attention, both on the national and EU level. For instance, in a reinvigorated Europe 2020 project that moves towards a knowledge-based economy, and the type of Europe-wide policies that fostered success stories like Airbus and can support widespread economic growth.  

Real steps towards fiscal integration are also needed, such as the issuing of common bonds, tools for dealing with asymmetric shocks and stronger means of fostering economic convergence. Nonetheless, convergence mechanisms need to be organically embedded in the reform of EU economic governance. Unless convergence in the EMU (EU) is stimulated and a sense of common purpose is restored, forces of fragmentation and destruction will continue their work. What we are witnessing, increasingly, is the primacy of national politics undermining the cohesion of the Union[2].

The financial industry also needs attention, not least because many in that industry still refuse to acknowledge the role that it played in bringing about the crisis. The gross abuse of securitisation, the promotion of a wide range of exotic - this is a euphemism - financial products that were hardly tradable and frequently of lousy value, the reckless short-termism in maximising profits, and a blatant neglect of risks have turned major components of high finance into an in-built destabiliser for economies as a whole. The paradigm which extols the virtues of self-regulating financial markets and which was embraced by major central banks has proved to be quite wrong. This financial crisis has compelled governments and central banks to rediscover financial stability as a basic, if not an overriding, policy concern, but at a terrible economic and social cost.

Two processes, accentuated by this financial crisis, should worry us deeply. The first concerns the financial industry itself. The fear of a financial meltdown forced governments to intervene and institutions "too big to fail" were rescued. This was followed by efforts to reform the regulation and supervision of financial markets, introducing limits on leverage, increases in capital and liquidity requirements, derivative regulation, changes in remuneration schemes, and constraints on proprietary trading. This crisis, however, has led to the formation of even larger financial groups, and consequently the persistence of systemic risk. The increase of banks' own capital and liquidity requirements, surcharges on systemically important financial institutions as well as stricter oversight from the European Systemic Risk Board, are necessary. But can these measures cope with the risky (trading) operations which are undertaken by giant groups? The "too big to fail" syndrome perverts the very logic of the market economy. It is morally unacceptable that losses of the financial industry be repeatedly socialised, at taxpayers’ expense, while the incomes of financial industry employees and capital providers are protected because of ‘systemic risks’. Something is clearly rotten in the way our economies function. 

The Greek tragedy at the centre of the European financial drama demonstrates how the whole system has been inverted. Since the risk of contagion is so high the inclusion or "bailing in" of the private sector in a sovereign debt restructuring has been vehemently opposed by the ECB and Commission officials. But among the bondholders of Greek paper are major market makers, all of which have benefited from bail out operations, directly or indirectly. It is a tragicomedy: the fundamental rules of market economics are put aside since those who take risks do not risk the consequences. A temporary set of measures can be justified, but market consolidation and the continuation of bad practices suggests that the seeds of future crises are being planted. Michel Barnier has an important job on his hands resisting any fightback by the financial services industry and the European Parliament should back him firmly.

A second worrying process is that which connects economy to society. This crisis is reinforcing a dangerous trend in Europe and the US: the erosion of the middle class. This erosion can be linked to technological changes favouring highly skilled labour in advanced economies; Asia's phenomenal economic growth (reducing Western countries' market share); the underestimation of industrial policies; and, not least, over-expansion of the financial industry. The excessive growth of finance has entailed a marked change in profit distribution in the corporate world and wider income inequality. According to the OECD, between the mid-1980s and the late-2000s, income inequality rose in 17 out of 22 industrialised countries. In the US, the pre-tax income of the top one percent went up from eight percent of the total in 1974 to 18 percent in 2008. Inequality is less alarming when the ‘social pie’ is growing, or cheap lending affords an illusion of broader affluence. With stagnation, decline and growing indebtedness it produces tension and can be dangerous.

Further problems have been embedded in the system through the bailouts for the financial industry (raising public debt), and the dangers of inflation from both extra global demand for resources and the quantitative  easing that was used to assuage the original crisis.

The power exerted by high finance and the erosion of the middle class are bad for the functioning of checks and balances, and for securing the social glue and social capital which underpin democratic order. Powerful vested interests are then able to capture public policy, as with the financial industry deregulation of recent decades. When society becomes increasingly polarised, the public space is compressed as a medium for social dialogue and compromise, resulting in both political extremism and a rejection of established politics (as with los indignados in Spain). This protest may widen if the public expects sustained austerity over longer periods.

There is also the related problem of declining trust in political leaders. In the EU the “democratic deficit” is an established problem, but the falling prestige of national politicians further undermines decision making and a sense of common purpose. Although claims that dealing with the crisis requires the demolition of the modern welfare state are misplaced, leaders need to convince their people that the welfare state must be reformed and even downsized. At the same time, reforms in the EU’s peripheral economies and elsewhere imply unswerving action against corruption, cronyism and ubiquitous rent-seeking. To paraphrase John F. Kennedy's famous remark, citizens need to think more of what they can do for their societies, individually and as groups, before asking the latter what it can do for them.

But the financial system also needs to be radically overhauled. Taming financial markets is a must if deep crises are to be avoided or better dealt with in the future. Banking needs to turn back to its roots and rationale. Restoring the intial logic of the Bretton Woods arrangements, which focused on supporting economic growth and promoting trade by restraining volatile financial flows, is a worthy aim. The late reconversion of the IMF to a paradigm that does not underestimate the follies of financial markets is, therefore, to be welcomed.If one admits that the EU single market is a downsized version of the global market a legitimate question arises: what are appropriate policies at the EU level (including ECB operations) that can take care of potentially highly destabilising (speculative) financial flows in member states?

Europe needs to rediscover a sense of fairness during this time of extreme strain. This means the restoration of an ethical compass in the corporate and financial world, and the striving of political elites to redeem themselves in the eyes of their voters. Together with policies that enhance knowledge-based competitiveness and make public sectors more efficient, taming financial markets would help combat the erosion of the middle class and protect democracy.

Daniel Daianu is Professor of Economics at the Romanian National School of Political and Administrative Studies and a former Finance Minister of Romania