Stress test

Why does mayhem in world financial markets continue without a clear sign of ending? Why recovery of real economies delays? Economists seem to join lemmings in the political market and to succumb to its guiding forces, populism and opportunism, in their proposals to implement tighter regulation of financial institutions and looser budgetary policies. Shouldn’t they rather stick to the basic body of their science?

When politicians slightly open the strings of their purses, it pays for the actors in private markets to delay their decisions in the hope for milking more generous subsidies and expenditure programs. That is why sound fiscal policy would now call for an end of constructing new such programs. The worldwide downturn will anyhow immensely deteriorate public budgets through automatic forces, by reducing tax revenues and increasing social transfers because of stalling production and enhanced unemployment. Thus lesson no. 1 is that a responsible piece of economic advice would not only limit public budgets to their present stance but would also kill the option to delay in taking private action.

In monetary policy, central banks have largely emptied their ammunition, steering rates of interest set at their historical bottom; quantitative easing remains, i.e., central banks buy unconventional assets from the banking system to directly create loanable reserves.

Only the ECB has room for additional maneuver in its steering rate. – You guessed it! I do not recommend the ECB to cut the rate of its main lending facility on April 2. In the current circumstances it is time for thinking about future; price developments in the euro zone, the harmonized index of consumer prices rising 0.4 per cent in the month of February, are not encouraging for a rate cut. The lags of monetary policy are notoriously long and variable. Sticking to the most basic lesson of monetary policy – inflation is always and everywhere a monetary phenomenon, lesson no. 2 – would kill the option to delay the start of lending by big banks.

The “too-big-to-fail” –doctrine is not economics but sociology of economic policy. Politicians and their economic advisors should abandon it in favor for admitting the fact that in mayhem, as the current one, all financial institutions are zombies if strict mark-to-market financial accounting were applied to them. Therefore no kind of discretionary cleansing of banks from their bad loans would make the system safer.

The banks were lured to risk taking by regulation itself, by the incentives that softened the impact of regulatory red tape on them. And, those incentives were hugely fuelled by the Fed’s lax monetary policy since Alan Greenspan’s acclaim “irrational exuberance” - acclaim because he did not act accordingly.

Banks are currently passing through a real stress test. Therefore it is irresponsible economic management by the ministries of finance and by the central banks if they try to benefit from the difficulties of the banks. Rather, I would see the ministries of finance advancing credit on equal terms to every bank regulated by the Fed and the ECB at the same interest rate as the governments can raise themselves. But after a two year’s grace period, a progressive penalty rate over the next 5-7 years need be applied to such loans to recover the taxpayers’ funds. Banks and individuals will react to changes in relative prices; so, lesson no. 3 is that let the markets decide which bank will fail and which stay.

Lesson no. 4 is to get rid of other kind of bank regulation, except for requiring the top managers and the major owners of the banks to be fit-and-proper professionals, in the first instance, and for preventing them from looting their banks in case a bank will walk plank. Part of such preventive rules would be to install a claw-back clause on the managers’ future compensations so that their remunerations will retrospectively - perhaps over the last five years before a bank failure - be reduced to a decent benchmark.

From Regulation Failure to Non-Regulation of Banks

Regulation of banks was never before based on such a sophisticated system as during the past 20 years, from the solvency rules of Basel I and Basel II to internal risk-metrics of individual banks. Yet we have seen banks gone bust as for centuries earlier. Also, there is nothing new in bailing out banks with taxpayers’ money.

Sveriges Riksbank, today’s central bank of Sweden, was in huge difficulties in the mid-1760s after having during the so-called Freedom Era extended credit to the merchants of Stockholm the most of which had gone sour. The difficulties were preceded by years of rapid inflation, credit growth and money printing. But, because the bank operated under the guarantee of the Parliament (Sweden had a parliamentary system at that time) it was of course gradually rescued by the taxpayers’ money. The years were politically stormy, two main parties competing for power. But in the end, a “third party” - the king party - won so that King Gustav III could again re-establish an authoritarian kingdom in a bloodless revolution in 1772.

Today the Federal system has assumed functions that traditionally do not belong to a central bank. It has purchased commercial paper issued by big US companies, for example. So the next “too-big-to-fail” institution may be the Fed; Obama’s Court, please be beware of! The situation in Britain and Ireland may essentially not be very different from the US quandary.

After regulation failure of the current scale, a tighter regulation hardly is the course to be followed as pointed out by immediate popular comments; tighter controls would not have prevented East Germany from collapse because German Democratic Republic did not exist.

If effective regulation of banks does not exist, why not consider shifting to a regime of non-regulation?

Regulate banks and other financial institutions only when they are granted their operation permit, but with the obligation to participate in the rescue of any failing member of banking business. This would internalize the costs from aggressive business strategies of one member. Any bank that walked over the bridge for lender-of-last-resort funds would know it to be the end of its business as an independent operator.

The banking business would thus operate under a mutual guarantee.

The task of the regulators would only be to promote transparency in banking, for example, by requiring banks and other financial intermediaries to publish their balance sheets every month in the main national and local newspapers.