On 22 May 2008, Le Monde published an open letter signed by three former presidents of the European Commission, nine former prime ministers and five former finance ministers (including myself) from EU member states. The text “Financial markets must not govern us” sketched the contours of a devastating financial crisis, one that would greatly weaken western societies. At the time, top officials of the European Commission and the European Central Bank (ECB) were boasting of the “robustness” of European economies and claiming that banks in the EU were not involved in the origination and distribution of toxic products. They also assured the public that the financial crisis would be unlikely to cross the Atlantic. We have seen what happened after the collapse of Lehman Brothers. That was the moment the financial turmoil engulfed Europe too.
Two thoughts have continued to preoccupy throughout the crisis. I would not have put them in writing now had I not recently watched a banker nonchalantly stating on public TV that the main mission of a bank is to take care of its depositors’ money; that it must be trustworthy. I was stunned by his remark, for it was publicly known that the bank he represents was bailed out with public money during this crisis, and that it was involved in the origination and distribution of highly questionable financial products.
The stark reality is that many in the financial industry still do not acknowledge the role it played in bringing about a crisis that is matched in living memory only by the Great Depression of the late-1920s and 1930s. The gross abuse of securitization, 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 maximizing profits, and a blatant neglect of risks have turned major components of high finance into an in-built destabilizer for economies as a whole.
The paradigm that extols the virtues of self-regulating financial markets “the efficient markets hypothesis” – and that was embraced by major central banks has proved to be quite wrong. The way financial intermediation has evolved during the past two decades has increased systemic risks enormously. As Andrew Haldane, research director at the Bank of England, pointed out, the very robustness of economies has suffered dramatically. It is also worth remembering an analysis of Alexandre Lamfalussy, an eminence grise in the world of finance. Years ago, Lamfalussy noted that the proliferation of securitization and the growth of a “shadow banking sector” that escapes regulation and supervision make economies increasingly vulnerable.
Aexandre Lamfalussy, Financial Crises in Emerging Economies, Yale University Press 2000. The current crisis has compelled governments and central banks to rediscover financial stability as a basic, if not overriding, policy concern – but at an horrendous economic and social cost.
It is not my aim to focus once more on the flaws of financial intermediation as it has evolved in recent decades; since the crisis has erupted I have already done so, both in writing and as a member of the European Parliament, where I co-authored a report demanding a radical overhaul of the regulation and supervision of financial markets. On various occasions I decried the wave of deregulations that took place in the US, including the rescinding of the Glass-Steagall legislation in 1999 and the passing of the Commodity Futures Modernization Act of 2000. But there are two processes underway that deeply worry me, both of which seem to be accentuated by this financial crisis.
“Too big to fail”
The first concerns what is happening in the financial industry itself. The fear of a financial meltdown forced governments to intervene and, consequently, financial groups “too big to fail” were rescued. It is true that this large-scale operation was followed by efforts to reform the regulation and supervision of financial markets. Limits on leverage, increases in capital and liquidity requirements, regulations concerning derivatives, changes in remuneration schemes, and constraints on proprietary trading were put into place, more or less, around the world. It is an irony that Adair Turner, head of the UK Financial Services Authority, and Mervyn King, governor of the Bank of England, are bolder than their European counterparts in this regard. This is probably as a result of the over-expansion of the City during the past decades, which has made the British economy lopsided and highly vulnerable during this crisis. Ireland and Iceland are two other examples of reckless expansion of the financial industry, which brought their economies to their knees.
The bottom line, however, is that this crisis is entailing market consolidation and the formation of even bigger financial groups. The size of these groups means that systemic risks persist and may even continue to grow. The increase of banks’ own capital and liquidity requirements, as well as stricter oversight from the European Systemic Risk Board, are necessary. But can these measures cope with the risky trading operations carried out by giant groups? There are analyses that say that Basel III should increase tier 1 capital to 14 per cent. But even such a doubling may not be sufficient. The “too big to fail” syndrome, unless properly tackled, would keep governments hostage to these financial groups.
The very logic of the market economy is seriously perverted. It is totally unacceptable that losses of the financial industry be repeatedly socialized, at the expense of taxpayers, while the incomes of employees and capital providers of the financial industry are protected because of “systemic risks”. This state of affairs is morally unacceptable and shows that something is rotten in the way our economies function.
The bail out operations of financial groups has reinforced moral hazard. The measures adopted so far do not address the “too big to fail” issue adequately, since the hostage or “captive” relationship has not been broken. Why have we not resorted to anti-trust legislation for financial groups as we have with other industries – oil, telecommunications – in the past century. In the UK, a special commission has proposed ring-fencing retail banking from risky (trading) investment operations. But would that be sufficient?
What should give us food for thought is that bad practices – operations that involve high risk – are continuing. The volume of derivatives is rising again at a formidable pace. And more than 60 per cent of the net income of the six biggest US banks is from trading, as was the case prior to the crisis. This means that there has been hardly any reduction in speculative, casino-type banking. When Angela Merkel, David Cameron and Nicolas Sarkozy prodded high finance to accept responsibility, its captains cried foul.
On can judge how inverted the whole situation is by examining the unfolding of the Greek tragedy at the centre of the European financial drama. Since the risk of contagion is so high – deep financial integration and panics can bring about another freeze of markets as a result of a disorderly default – the inclusion, or “bailing in”, of the private sector in a sovereign debt restructuring is vehemently opposed by the ECB. But among the bondholders of Greek paper are major market makers, all of whom have benefited from bail out operations, directly or indirectly.
It is a tragicomedy: fundamental rules of market economy are put aside, with those taking the risks bearing none of the consequences. One can use systemic risks as an argument for tolerating a temporary chain of events. But market consolidation and the formation of bigger financial groups (banks), the perpetuation of bad practices, indicates that the seeds of future crises are being planted. It looks as though crises will be made permanent.
Another worrying sign is that the financial industry is fighting back and it appears to have had some success. Neither the European Commission nor the US administration or governments in general seem to have the power to withstand pressure. Following a Republican political comeback, the Dodd-Franck legislation is currently threatened with dilution. A similar process may happen in Europe too.
The threat to society
The second worrying process is that which connects the economy to its social context, something it cannot be divorced from. This platitude is worth remembering. The financial and economic crisis is reinforcing a worrying tendency in Europe and the US: the erosion of the middle class. This erosion can be linked to several developments: the technological change that has favoured highly skilled labour in advanced economies; Asia’s phenomenal economic growth that has dented western countries’ market share; public policies that have underestimated the role of industrial policies; and, not least, over-expansion of the financial industry in several economies at the expense of other sectors.
The excessive growth of finance has entailed a marked change in profit distribution in the corporate world and in income distribution in society as a whole. In the US, for instance, the share of the financial industry’s profit in total corporate profits has almost trebled over the past three decades. Talk about “people’s capitalism” cannot obscure the significant rise in income inequality in recent decades. OECD data provide a grim picture in this respect: between the mid-1980s and the late-2000s, income inequality rose in 17 out of 22 industrialized countries. In the US, the pre-tax income of the top 1 per cent of individuals went up from 8 per cent of the total in 1974 to 18 per cent in 2008.
When the “social pie” is growing, or cheap lending bolsters the illusion of steadily rising affluence in society as a whole, income inequality may not cause alarm. But when “the social pie” stagnates, or even shrinks, and growing indebtedness starts to bite, an increasingly unequal income distribution produces tension and can become dangerous. Even in Germany, which epitomizes the success of the “social market economy” and which has a highly productive economy, employees’ average real income went down by around 6 per cent in the past decade. This was probably the price of dealing with the lingering pains of reunification and the containment of adverse shocks from outside. Even so, uncontrolled rising income inequality harms the “equal opportunities” policy, which was a huge achievement of a civilized, fair society.
Let me dwell a little longer on the erosion of the middle class. Rescue operations in favour of the financial industry have raised public debt considerably and the present dynamics show that this tendency will continue for some time. This means that painful fiscal corrections will be inevitable and will very likely involve expenditure reduction and tax increases for most citizens. The undue rent extracted by the financial industry from the rest of the economy adds further burdens to such an inevitable adjustment. Unless it can be accommodated by wage rises, which themselves can entail vicious economic dynamics, there is also the threat of higher inflation as a form of taxation.
This higher inflation is partly due to an historical rise in the relative price of basic commodities as a result of the availability of exhaustible resources, climate change and rising consumption in Asia. But there is also the effect of quantitative easing (money printing), which has been done by the Fed and other central banks and which fuels inflation worldwide. A rise in social tension and possible political stalemate as a result of distributional struggles could bring about “programmed” bouts of inflation as a means of making the pains of servicing public debts more palatable in the years to come. What, decades ago, was portrayed as a feature of social dynamics in developing economies – in Latin America in particular – could visit the industrialized world in a surprising fashion. Let us remember that the US itself witnessed a period of double-digit inflation several decades ago. That inflation was stopped when Paul Volcker arrived at the helm of the Fed and interest rates of over 10 per cent were used to bring it down. But a consequence of that dramatic policy change was a sovereign debt crisis in Latin America.
Years before the eruption of the current financial crisis, Robert Reich and Larry Summers, both at Harvard University and former top officials in the Clinton Administration, warned about the dangers ensuing from an erosion of the middle class in the US. (Ironically, Summers supported financial deregulation while he served at the US Treasury.) In Europe, Anthony Giddens’ Third Way vision was driven by similar concerns. The current financial/economic crisis is hastening the erosion of the middle class in numerous western countries. In an insightful article in the International Herald Tribune, Christia Freeland cites corporate executives who say that the fortunes of their countries increasingly diverge from the fortunes of their companies. If the impact of the ecological crisis is factored in, things get more complicated still. During his tenure as chief economist of the World Bank from 2000 to 2003, Nicolas Stern said that the most egregious case of market failure in human history is the inability to take action against climate change.
The future of democracy
The power exerted by high finance and the erosion of the middle class are bad for the functioning of checks and balances, for securing the social glue and the social capital (in Robert Putnam’s words) that underpin a democratic order. When vested interests are excessively powerful they can easily capture public policy and turn it to their advantage. This is the cause of the waves of deregulation in the financial industry in recent decades, not to mention the influence of a cosmology that upheld the validity of efficient markets and neglected systemic risks.
When society becomes increasingly polarized, prerequisites are created that increase social fragmentation, compress the public sphere as a medium for social dialogue and achieving compromise, and foster political extremism. This can be seen in Europe and the US today against the backdrop of the current financial and economic crisis. The rise of xenophobia and chauvinism and extreme political polarization are harbingers of worse to come unless policies are formulated to counteract them.
The crisis also exposes a huge ethical problem. Big companies are fond of speaking of corporate social responsibility. But where is it when investment banks sell investors financial products that they are short-selling at the same time? Where is corporate social responsibility when companies that make billions of dollars or euros in net income pay almost nothing to national fiscal authorities? Did President Barack Obama appoint the CEO of GE to head a special task force because of such a “performance”? In the wake of the corporate scandals (Enron, Worldcom, Parmalat, etc) of the early 2000s, the then chief of the main French business association, Claude Bebear, wrote a book entitled Ils vont tuer le capitalisme (They are going to kill capitalism). Paraphrasing him, one might say the same of democracy.
Moreover, when rare events “Black Swans” as Nicolas Taleb calls them – multiply and overwhelm the capacity of governments to respond effectively, then fair burden-sharing is essential in preserving social cohesion. Adam Smith wrote The Theory of Moral Sentiments before his better-known The Wealth of Nations; later, Max Weber, and more recently, Kenneth Arrow and Amartya Sen underlined the role of moral values in sound functioning of the economy and society. When cynicism, recklessness, and disregard for others rule, social cohesion can be badly impaired. When economic conditions deteriorate and social despair rises while moral values are trampled on, democracy is threatened.
The claim that big government is the cause of the current financial crisis is false. The crisis originates, essentially, in financial practices that have gone astray. High finance has developed a raison d’etre that is increasingly divorced from the needs of the rest of the economy. Equally seriously, high finance seems to have captured public policy for its own purposes. While the financial crisis deepens the crisis of the welfare state, the latter precedes the former and has been caused by a hypertrophy of the public sector and demographics. To claim that the way out of the financial and economic crisis is the demolition of the welfare state is misplaced. The welfare state must be reformed and, in not a few places, downsized. To paraphrase President John F. Kennedy’s famous remark, citizens need to think more of what they can do, individually and as groups, for their society 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. The way financial markets have functioned in recent decades is not God-given. Public policy can and should change it, as it did after the Great Depression and World War II. Reform of the financial industry is badly needed in order to bring back a sense of fairness in society, which is critical for the functioning of democracy, especially during times of duress. Together with policies that enhance knowledge-based competitiveness, taming financial markets would help combat the erosion of the middle class and protect democracy.
A final word: the eurozone is mired in crisis not only because of the impact of the financial crisis and its sub-optimality as a single currency union, but also because of the absence of proper institutional and policy arrangements. Fiscal rectitude alone will not be enough. The eurozone urgently needs elements of fiscal integration (e.g. the issuing of EMU bonds), along with tools for dealing with asymmetric shocks (e.g. insurance for the unemployed via the EU budget) and a stronger means of encouraging economic convergence.