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Are Reforms of the Financial Sector Enough?

by Alexander Hageluken
This article focuses on seven errors and seven remedies of the financial crisis. The financial crisis was also a crisis of easy money. For years and again today, speculators exploited the situation that money was and is very easy to borrow in states like the US and Japan. Financial bubbles arise. The American Federal Reserve has a tradition of stimulating the economy with cheap money and low key interest rates. They contributed to the last financial bubble.
ARE REFORMS OF THE FINANCIAL SECTOR ENOUGH?


By Alexander Hageluken


[This 2009 article focusing on seven errors and seven remedies of the financial crisis is translated from the German on the Internet.]


...The risky transactions of banks and investors have plunged the world into the worst financial crisis since the 1930s. The problems of the banks lie on national economies like an ice storm. This week we learned that the German economy shriveled five percent in 2008. The last time there was something like this was in another age that seems far away: 1932, in the Great Depression, in the year before Hitler's seizure of power.


Industrial states and their inhabitants are coming to terms with the consequences of this economic catastrophe. Unemployment in Germany will rise this year even though the economy is growing again. Millions of jobs are lost all over the earth. Most governments accumulated gigantic debts to bail out the banks and support the economy. The EU commission estimated what the measures to bailout Europe's banks could cost the states. It could be 1.8 trillion euros in the worst case. That would be 3500 euro for every EU citizen, infant and senior or what the German government spends annually for educational policy – for a time period of 180 years. The question is obviously how such a catastrophe can be prevented from happening again. For more than two years, there has been much talk about reforms of the financial sector. The politicians of the leading 20 industrial nations have already met three times to agree about the consequences. But is that enough? The feeling steals over people that many things are unchanged and that bankers secretly or openly are returning to the behavior that triggered the financial crisis. I believe we are poorly prepared today for the next financial crisis. Therefore I want to be a little provocative.


In the final part of the address, I will examine what measures are implemented against the next financial crisis and whether they are sufficient. Before that, I'd like to draw a critical conclusion on the past two-and-a-half years in which reforms of the financial markets were discussed. I consciously exaggerate this stocktaking. The seven errors of the financial crisis could also be called the seven lies of the financial crisis. Error Number 1 is:


THE BANKERS HAVE LEARNED


The error is that many bankers have not learned. The American mega-bank Goldman Sachs has eleven billion dollars ready this year to reward its best employees with bonuses. This sum is approximately what the German government spends annually for education. Other banks act similarly. They promise their top managers extreme bonuses so they make extreme profits. Such profits only occur when the business partners of the banks are extremely uninformed or extremely dumb because otherwise they would force lower prices. Profits arise when very high risks are taken. The bankers did this and triggered the financial crisis. Now and then America's banks realized nearly half of the profits of all businesses in the United States although they only amount to a tenth of the economy in the size of their workforce. Such extreme profits cannot be maintained in the long run. Still the banks in America and partly in Europe try to return to this wrong track that ignited the financial crisis. This attempt increases the likelihood that we will plunge into the next crisis.


We come to Error Number 2 of the financial crisis:


INVESTORS HAVE LEARNED


Banks do not finance all the risky transactions on their own account. They carry out many transactions for investors. Among these investors, the idea was prominent before the crisis that very high profits could be realized. However such high profits can only be realized with superior or well-marketed products like Apple or Microsoft. In the financial realm, a bank can get high fees for a stock transaction. 20 or 30 percent is only conceivable when the risk of a failure is correspondingly high.


So-called private equity firms promise profits from 20 to 30 percent. They achieve this by buying firms with debts, charging firms with debts, smashing firms and selling parts of them. This is neither sensible nor sustainable for national economies. Another example is the housing credit to bad American debtors – high profits with a risk that is passed on worldwide through dispersal of the risk. What are the next businesses that will dreadfully go under? We don't know. But one thing is clear: profits of 20 or 30 percent are impossible in the long run. These profits are only made with high risk, high indebtedness and dangers of massive breakdowns. However many investors refuse to bid farewell to the expectation of very high profits. This means increased likelihood of the next crisis.


Error Number 3 is:


POLITICIANS HAVE LEARNED


On first view, it seems politicians have learned from the financial crisis. There are many declarations of intent and first laws. But after looking more closely, many things are uncertain. What risks may the banks take in the future? How much of their own capital must banks have in the future so they don't collapse so quickly in a crisis? How greatly can they become indebted? How much can they pay their bankers? Many things are intimated internationally but not resolved. Decisions about capital holdings and indebtedness will first be made at the end of 2009. At the same time financial managers try to prevent strict rules. The more temporally removed the outbreak of the crisis, the more self-confident bankers appear. More than a year has passed in Germany since the government approved billions for Hypo Real Estate and Commerzbank. Time passes, the pressure of suffering declines and politicians turn to other projects in our promoter-democracy in which something is always demanded of them again. They should create jobs, prevent running amok, improve the school system, counter terrorist attacks and so on. SPD financial decision-maker Joachim Poss said this week he had the feeling the “time window is closing” when reforms can be carried out. Have politicians learned from the financial crisis? There are hardly any signs of that.


Error Number 4:


REGIONAL POLITICIANS HAVE LEARNED FROM THE FINANCIAL CRISIS


In Germany, regional banks like Bavaria LB, Saxony LB and HSH were among the money houses that posted the greatest losses. Regional banks once had a function in which they assumed tasks for regional savings accounts. For the most part, they don't have that function any longer. They operate like enormous train stations where there are no trains any more. These stations have not become smaller in the last years but much larger. The Bavaria LB purchased a degenerate Kartner bank named Hypo Alpe Adria with branches in Mailand, New York and Asia. It had 19,000 co-workers, as many as Europe's largest sugar manufacturer or Europe's largest producer of printing presses. But unlike these businesses, the Bavarian LB doesn't have a functioning business model any longer. They fell head over heals in risky businesses to earn vast amounts of money and make regional politicians happy. They made dreadfully bad deals with political backing and the money of taxpayers. Therefore they should be abandoned.


The regional politicians in Munich, Stuttgart and Hamburg have not learned from this. They fear a loss of power if they don't have a firm grip on a regional bank any more, give needy credits to a business in a crisis or pursue economic policy in other ways. Instead of making one bank or no bank out of 7 regional banks, they hold fast to these institutes. It will not take long until the next regional bank is made the next loss-maker.


Error Number 5:


THE CENTRAL BANKS HAVE LEARNED


The financial crisis was also a crisis of easy money. For decades, central banks tried to keep the money circulation going so the economy would run. But they couldn't keep up mentally with the increasing linkage of the financial markets. For years and again today, speculators exploited the situation that money was and is very easy to borrow in some states like the US and Japan. They stuck this money in all possible projects around the globe. When money can be borrowed cheaply, the investment doesn't need to yield so much to repay the credit. Maybe one doesn't need to scrutinize an investment so carefully as to its risk. The credit is cheap. Thus financial bubbles arise. Investors invest like crazy. Some time or other the stock exchanges collapse. Europe's central bankers have traditionally been cautious. However the American central bank (Federal Reserve) has a tradition of stimulating the economy with cheap money and low key interest rates. This contributed to the last financial bubble.


After the outbreak of the crisis, all central banks felt compelled to give banks money quickly so they could make ends meet. They also try to promote the recovery of the economy through low interests. A dilemma arises here. If money remains cheap for too long, the bubble grows. If central banks raise interests too quickly, they strangle the upswing. Finding the right speed is hard. In China, the prices of shares and real estate are already rising so a bubble is noticeable. The price increases on the stock markets in the US and Germany in 2008 were very intense. Central bankers owe us the proof that they see the bubbles – and thus have learned from the crisis.


Error Number 6:


CITIZENS HAVE LEARNED


O yes, it is easy to make evil bankers, rotten politicians or someone else responsible. But the truth is: little happens without the pressure of citizens and taxpayers. Has anyone seen mass demonstrations where a reform of the financial sector was demanded? Did anyone think these reforms would play a greater role in the election campaign before the German Bundestag election? Citizens grumble but don't demand – in any case not so that politicians feel pressure. But nothing happens without the citizens – and without all of you sitting here.


Error Number 7:


JOURNALISTS HAVE LEARNED FROM THE FINANCIAL CRISIS


Reforms of the financial sector are an arduous theme: complicated, full of details and hard to communicate to people. The media could do more to take up the complex theme, summarize the reform steps and compare the announcements and actions of the actors. It seems as though a certain fatigue has set in. This is bad for public attention on the theme.


Taking all this together, these are seven errors about seven different groups reacting sufficiently to the financial crisis. That is the global feeling. It makes us fear the barriers are not high enough to prevent the next catastrophe.


What do the details look like? Who decides which reforms are attempted? The thicket and confusion of institutions is considerable – G20, EU commission, Basel Committee for Bank Oversight and the Financial Stability Forum. Several of the different reform steps could be analyzed. There are countless reform ideas. I focus on seven as in the errors of the financial crisis, seven touchstones whether something will come out of the reform of the financial markets.


Number 1 – A year ago German chancellor Angela Merkel and other top politicians emphasized one principle again and again: every financial institution on earth must be controlled to prevent the next crisis. That is an ambitious project when one considers how easily money can be transferred from one place to another. Several thousand hedge funds are registered on the tiny Cayman Islands. What will come out of this ambitious project? Much is uncertain.


Number 2 – The problem with the bad American housing credits was not only that they were bad. They were also separated, dispersed, packaged and so on until the final recipients of these credit packages didn't know or didn't want to know what risks were bound with what allegedly miraculous products – where high losses accumulated. The banks that unscrupulously passed on these products have responsibility for this process. Therefore there has long been the demand that banks with such sales should keep a part of the transactions on their books so they can examine what they sold – instead of unloading toxic waste on customers. The EU commission proposed a law. Meanwhile there was the demand banks must keep 20 percent of the sum total on their books. Now it is only five percent. The question is whether that is enough as a security buffer to prevent b ad products spreading over the whole globe like a virus.


Number 3 – Money was cheap in the years before the financial crisis. That brought many financial houses to maximize the expended capital. In speculating, they accepted massive credits. For every dollar of their own capital, some banks pumped an additional 25 or 30 dollars. As long as the prices went up and businesses stayed solvent, fantastic profits per dollar of their own capital resulted with low credit interests. But the problems multiplied as soon as the markets stuttered. Losses and the obligation to service the credits forced some to their knees. Setting limits to indebtedness for banks was demanded. The financial houses refuse with the argument that the amount of debts in relation to capital says nothing about the actual risks. However a limit on indebtedness would at least prevent a bank becoming saturated with debts and then dying as soon as a storm rises on the financial markets. What is the standing of this project? The heads of government of the 20 largest industrial states urged such an indebtedness limit. The Basel Committee for Bank Oversight, an international group of central bankers, will present detailed proposals by the end of 2010. The industrial states must convert these into national law. Then we will see whether the indebtedness of the banks will be limited.


Number 4 – More of their own capital is necessary. This proposal aims in a similar direction. Banks should back their transactions with more of their own capital. In good times, they should amass capital to cover provisions for bad times. The G20 states also resolved that in Pittsburgh. But what counts as capital? Capital is different in the individual countries. Therefore experts should grapple and decide this question. How much capital holding will be established. The Financial Stability Board on which guards and central bankers sit should work out definitions. At the end of the year, the incisiveness of the resolutions will be clear.


Touchstone Number 5: Last will and testament of the banks. International money houses are linked closely with one another along with a large number of insurances, investors and state institutions. If such a bank falls in a downward spiral, it threatens to drag along other actors. Thus so-called system-relevant banks are bailed out. They can count on being bailed out – and take massive risks with this free insurance at their backs. A normal industrial business could not afford that – it would go bankrupt without simply being bailed out by the state. Therefore the dissolution of banks must be possible – to spare taxpayers of unnecessarily high costs and make bankers feel the danger of going bust with a risking business model. In the future, banks should write detailed last wills and testaments to give guards an adequate overview of their businesses and make possible a dissolution without great damage for the national economy when a bank falls in a dislocation. The G20 governments resolved such testaments in Pittsburgh. No one knows what this will look like exactly. There is only a bill for this in Great Britain.


Number 6 – Who pays when banks fall in a downward spiral? Most economists agree allowing big banks to simply go bankrupt is dangerous because the money system comes to a standstill, businesses lack credit and customers storm the counters which could trigger a panic. But why should the taxpayer take responsibility to bailout banks? According to an estimate of the EU commission, it cost the governments of EU states 800 billion euros to support Europe's banks. The money houses and their shareholders come off much too well with this kind of bailout, many observers believe. Therefore the demand that banks pay for their bailout has been urged for a long time. Suppressing the risk aversion of the banks is careless. Some economists urge an insurance that banks take out in advance to pay for a later rescue. This would have the advantage that the money would be there when needed. A degenerate bank will hardly pay for its own bailout. The debate about participation of banks in the costs of the crisis now gains energy through the advance of US president Barack Obama to impose a penalty tax. The resistance oi the financial branch and its lobbyists is massive. We will see what comes out of this sensible idea.


A related idea is for banks to share in other ways in the costs of the financial crisis – through an international tax on speculative stock market transactions. This idea has had an amazing career. Firstly, it was raised in a vague form by the American economist James Tobin who was not a leftist. Then it was the core foundation of the globalization-critical movement Attac. Before the world financial summit, the heads of government of Germany and France suddenly adopted the idea in a related form. The United States preferred no speculation tax. Such an instrument would work best when internationally negotiated and involving financial transactions without exchanges. Otherwise the money houses will try to evade the tax. No one can say a moderate tax would paralyze the worldwide financial markets. Nevertheless it isn't really in sight – and threatens to become a fading hope.


Touchstone Number 7 – For many years, there was no debate over how much bankers could earn. The market determines that, bank executives said. No one can tackle that. Politicians were silent. Today we know bonuses in the millions influence the stability of the financial system. Financial managers received incentives for realizing short-term profits – without paying attention whether these short-term profits are changed later into shocking losses on account of the risk of the business – even for the customers. When their bank fell into serious difficulties, the managers could usually change to another money house. Thus they received wrong incentives to take risks. Therefore the payment of bankers jointly triggered the crisis. Has this changed at all? According to estimates, bonuses on Wall Street could again reach the record level of 2007 – the year in which the financial crisis erupted.


The bonuses are the most visible sign and the easiest to understand sign that the financial branch will continue as before in many things. Previously public indignation concentrated on that. Nevertheless politicians react rather cautiously. In Germany, a law has been in effect for a short whole according to which bonuses must be distributed over a few years and need not only be paid for short-term success. At the world finance summit in Pittsburgh, the G20 states resolved that bonuses must be coupled to the long-term success of the bank. They may not be guaranteed in advance, that is made independent of business success. A substantial part must be given as stocks or stock options so that the bonuses are coupled to the success of the bank. What will come out of these salary regulations is unclear. With its special tax for bonuses, the British government is by far the most daring.


These are the seven touchstones for financial reform. Many things could still be explored, rating agencies, central banks and global imbalances. But this may be enough for a first sketch. After the earthquake of the financial crisis, politicians have urged some reforms. But how the reforms will turn out remains unclear – two-and-a-half years after the eruption of the financial crisis. At the same time the suffering pressure of politicians and citizens dwindles. The theme falls to the background. Ever more strongly, bankers try to block reforms. Misguided regulation damages and makes it difficult for banks to fulfill necessary tasks for the economy. But a new financial crisis will come without genuine reforms. Whoever doesn't want that should monitor the process very closely. Otherwise the next crisis threatens after this financial crisis. Thanks for your attention.
Thomas Palley is a Senior Economic Policy Adviser, AFL-CIO.

to read the 36-pp Macroeconomic Policy Institute Working Paper published in March 2013, click on

http://www.boeckler.de/pdf/p_imk_wp_111_2013.pdf

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