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Re-Regulating Finance

By Robert Guttmann

(Hofstra University, Hempstead, New York)

1. Finance and Mainstream Economics

If we are to take mainstream economists at their word about finance, there would not be

much to worry about. Their treatment of finance, a three-pronged approach, shows its

presence to be uniformly beneficial. The first dimension of that neo-classical approach is

to treat finance as just another sector and bring an industrial-organization approach to the

analysis of its structure and behavior.(1) This analytical dimension focuses on the nature

of financial services, the technology of their delivery, synergies (e.g. economies of scope

in universal banking) , and asymmetric information issues. Much of that approach

stresses the dynamic nature of banks and other financial-services providers and the

dilemmas of their risk-return trade-offs.

The second approach in the mainstream analysis of finance, presented early on in path-

breaking fashion by Gurley & Shaw (1960), stresses the beneficial impact of financial

intermediation. Long recognized as making a crucial contribution to macro-economic

equilibrium by mobilizing savings for investments and equating the two through a

market-clearing interest rate, the Gurley-Shaw approach stresses the mutually feeding

relationship between financial development and economic growth. In this vision finance,

rooted in savings, makes a positive contribution to our economy’s balanced-growth path.

Finally, mainstream economists have recently focused on the behavioral characteristics of

financial markets, formulating in the so-called efficient-market hypothesis a benign view

of these markets as informationally efficient, inclined to find appropriate values, and

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inherently self-balancing.(2) This view mirrors what neo-classicals typically think of

markets, except that the value here is a matter of claims on someone else’s future cash

flows.

Taken all together, these three facets of mainstream analysis do not capture the essence of

finance as a mobilizer of credit and conduit for the accumulation of capital income in the

form of interest, dividends, or capital gains. On the contrary, following the age-old

division found in economic analysis between the “nominal” (i.e. monetary) sphere of the

economy and its “real” sphere (i.e. exchange, production), mainstream economists

evacuate money out of the economy to formulate essentially money-less equilibrium

conditions of barter-like exchange, physical production functions and balanced growth

paths. That approach also separates money from credit and in that fashion reduces finance

to a passive residual whose limited macro-economic role is viewed as entirely beneficial.

In that view there is no real room for financial instability other than as an exogenous

shock caused by some aberrant forces of interference disturbing the equilibrium

propensities of the market place. No surprise then that the vast majority of economists

had no clue in, say, early 2007 of the imminent financial crisis, even less so of its global

and profoundly disruptive scale. Their models, whether on a micro level or on a macro

level, simply do not have the ability to capture the behavioral characteristics and

destabilizing potential of finance as a crucial force shaping modern capitalist economies

to their core.

If we economists want to do better than that, we need to have more relevant ways to

integrate finance into our economic theories. A good way to start is to go back to

heterodox economists of yesteryear who made serious efforts at capturing the dynamics

of finance. I am thinking here in particular of Karl Marx and John Maynard Keynes who,

even though in many important ways using different approaches as monetary economists,

started both with the essential notion that money, credit, and financial institutions all had

to be integrated as engines of capital accumulation and economic growth.(3)

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2. Elastic Currency and the ‘Debt Economy’

Heterodox economists in the tradition of Marx and Keynes acknowledge that we live in a

cash-flow economy which renders any separation of nominal and real spheres moot. We

must instead start with the idea that all economic activities – exchange, production, credit

– are organized as monetary circuits. Those structure space in terms of social relations of

both conflict and interdependence (between buyer and seller, creditor and debtor,

capitalist and worker, et cetera) as anyone’s expenditure is someone else’s income. And

those circuits also structure time in terms of having to spend money now in order to make

more money later, thereby positing uncertainty which investors deal with by transforming

it into risk and then trying to manage that risk.

These complex socio-spatial and temporal dimensions of our cash-flow economy require

us to conceive of money not as an exogenous stock variable, the mainstream view of

money, but instead come to grips with it as an endogenous flow variable.(4) At the heart

of it is the money creation process which functions as an advance of income before it has

been earned and in order to earn it. From the point of individual economic actors, the

need to spend money now in order to make more money later – the heart of income-

producing investment activity – means that they have to bear the reality of facing cash-

flow gaps which can be bridged by borrowing excess funds from others. This has always

been the primary function of finance. On a micro level, individual actors wishing to

spend more than they have currently available and/or facing cash-flow gaps can go to

banks to cover such shortfalls. Under normal circumstances the banks will want to

accommodate that demand for loanable funds, since this is their major source of income.

As a matter of fact, it earns them income by transforming zero- (or low-)yielding excess

reserves into interest-yielding loans. That interest is a deduction of the income which

their borrowing clients will have been able to generate by spending those loans

productively. New money gets created when banks loan out their excess reserves, and

that combination of money creation and credit extension is a process of creating income

for both borrower and lender. It is this income-generating process that we need to think of

when trying to explain what is finance.

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That process known as finance also has a macro-economic dimension. Over the centuries,

starting in Renaissance Italy (14th century city-states), banks have perfected the system of

fractional-reserve banking whereby deposits gain them an equivalent in reserves, of

which they set aside only a fraction and then loan out the rest as excess reserves to

willing borrowers. This has meant that the banking system as a whole can loan out a

multiple of its excess reserves and thereby assure ongoing expansion of money supplies.

As long as we were on a gold standard, such money expansion was constrained by

available (and typically scarce) gold reserves, a constraint often expressed in violent

banking crises as overextended lenders had to shrink their overblown asset base back to

their metallic core. But in the course of the Great Depression, starting with the collapse of

the international gold standard in September 1931 followed by Roosevelt’s reforms of

money and banking in 1933/34, we freed ourselves from this “barbaric relic,” an apt

phrase coined by Keynes. Ever since we have had a banking system capable of creating

any amount of money ex nihilo and so meet any level of demand for bank loans, provided

it gets the accommodating support of central banks furnishing the system with adequate

amounts of (excess) reserves. Such an elastic currency has enabled the banking system as

a whole to feed a “debt economy” whereby key economic actors – producers, consumers,

governments, other financial institutions – have come to fund continuous excess spending

by means of easy access to low-cost loans. A considerable portion of aggregate demand

in the economy has thus come to depend not on already-earned income being expended,

but on loan-funded advances of income yet to be earned as they get spent.(5)

3. Post-War Credit-Money and the Stagflation Crisis

The new monetary regime put into place by Roosevelt’s reforms, later copied elsewhere

and given an international frame in July 1944 at Bretton Woods, worked remarkably well

for nearly a quarter of a century. During that period, one of rapid growth and relative

financial stability on a global scale, economic activity was strongly stimulated by ample

supplies of loanable funds at low interest rates. Governments could thus run chronic

budget deficits to fund their now-generous “Welfare State” programs while also helping

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to rebuild/modernize their national economies. Companies had the means to put into

place the facilities for mass-production technology. And consumers in America and

Western Europe could aspire to middle-class norms of consumption centered first on cars

and subsequently on home ownership. The international dimension of this regime, the

Bretton Woods system, also helped stimulate more rapid growth by facilitating first the

rapid reconstruction of other industrial nations (via mandated US capital exports) and

then their catching up with the United States through export-led growth that was greatly

helped by the chronic overvaluation of the US-dollar.

At the center of this global post-war boom from 1948 to 1969 was a tightly regulated

banking system. Commercial banks, engaged in taking of deposits and making of loans,

either were separated from financial markets (as in US under Glass-Steagall Act of 1933)

or suppressed bond and stock markets in order to maintain their privileged position in a

domestic power triangle of elites comprising bankers, government bureaucrats, and local

industrialists (e.g. Germany’s Hausbank, Japan’s keiretsu). Investment banking was

hence of secondary importance, as were the funds investing on behalf of individual

investors in financial instruments – a state of marginalization which only began to change

with the rapid growth of pension funds in US and UK. Central banks used a variety of

powers – setting their own short-term rates on loans to banks, mandated rate ceilings on

key bank deposits and loans, open market operations to target inter-bank rates, managing

government borrowing – to keep interest rates low. They also used a variety of credit,

exchange, and capital controls to direct the flow of funds within a national economy and

beyond. Complementing this set of controls were a range of structure and safety

regulations pertaining to banks and, to a lesser extent, other financial institutions. It is fair

to characterize this regime as one of nationally administered credit-money.(6)

Booms never last forever, and this one came to an end in the late 1960s. The ensuing

slowdown, lasting into the early 1980s, was most likely caused by overproduction

conditions in key sectors on a global scale, as Germany, Japan, and other industrial

nations caught up, as well as cost pressures arising from the collapse of the wage-

productivity balance. Both of these constraints squeezed profits. Governments’ capacity

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to run chronic budget deficits and boost money supplies prevented the crisis from ever

deteriorating to the point of depression. Instead it evolved more moderately, but also

more slowly, in the form of stagflation, which combined accelerating inflation with slow

growth and rising unemployment. At the heart of this stagflation dynamic was a nominal

accumulation process, which yielded stronger market participants a continuous source of

paper profits from the temporal separation of outflows and inflows (e.g. historic cost

accounting, paying off debt with devalued dollars, pushing up one’s own price above the

inflation rate). While these nominal gains moderated the decline of inflation-adjusted

(“real”) income, they set up tremendous tensions between debtors and their creditors.

Whenever the low-interest policy of central banks caused “real” interest rates to turn

negative, creditors would basically go on strike. Regulated banks would face massive

disintermediation, as savers would move their funds into unregulated, hence higher-

yielding alternatives (e.g. money-market funds). The stagflation crisis was thus

characterized by recurrent credit crunches - in the United States, for instance, during

1966, 1969, 1974/5, 1979/80, and 1982.(7)

In the face of this highly unstable dynamic banks intensified their efforts to loosen

regulatory restraints on their operations. Already in the 1960s banks had introduced a

variety of money-market instruments, such as negotiable certificates of deposit and

commercial paper, which enabled them to borrow more reserves on short notice and so

move their money-creating capacity beyond their deposit base that was under the control

of central banks. The most important of these so-called borrowed liabilities was the

Eurocurrency market. This global banking network, in which the world’s leading

transnational banks offered their favored clients deposits and loans denominated in key

currencies outside their original country of issue (e.g. $-deposits and -loans in London),

operated beyond the reach of any national central bank. Able to offer more attractive

deposit and loan rates than domestic banking due to the absence of regulatory costs, the

Eurocurrency system became an irresistible draw for multinational companies, rich

individuals, and a variety of financial institutions. As an easy conduit for inter-bank fund

transfers beyond national boundaries, the Eurocurrency market played a crucial role in

bringing down the Bretton Woods system in a series of speculative attacks on the

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overvalued dollar (August 1971), then forcing the deregulation of exchange rates (March

1973), and finally obliging the Fed and other central banks to accept the deregulation of

interest rates (October 1979). Since then that system of “stateless” money has morphed

into an engine of relentless financial globalization, serving more recently as launching

pad for several truly international financial markets (e.g. emerging-market bonds).

It was the combination of stagflation-induced financial instability and regulation-evading

financial innovation, which brought down the post-war regime of nationally administered

credit-money - one pillar after another. The deregulation of money’s prices in the 1970s

coincided with the proliferation of new money instruments (e.g. interest-yielding

checking accounts, money-market deposit accounts, consumer CDs) and was eventually

followed by removal of activity restrictions and structure regulations for banks in 1980s

and 1990s, as crystallized dramatically around the European Union’s Second Banking

Directive in 1989 or the Financial Services Modernization Act of 1999 in the United

States. While we, especially those on the Left, have usually blamed the ideological shift

to the right in the Anglo-Saxon world (first Thatcher in the UK after 1979, then Reagan

in the US after 1980) for the deregulation of finance, we should be aware that stagflation

and the banks’ innovation efforts also had a lot to do with forcing such deregulation onto

the system. Out of this process emerged a new type of financial system which put itself at

the center of capitalism’s growth dynamic as never before – a structural transformation

which I have analyzed elsewhere as “finance-led capitalism.”(8)

4. The Era of Finance-Led Capitalism (1983 – 2007)

Once the stagflation dynamic had been broken by determined central bank action and a

deep global recession in the early 1980s, the stage was set for a long and durable

recovery. The solid growth performance of most industrial countries (e.g. US, EU, Japan

until 1989) after 1983 was driven, apart from such factors as trade liberalization and a

technological revolution, by a profound transformation in the nature of finance which

greatly expanded access to loanable funds at affordable rates. A powerful combination of

deregulation, computerization, and globalization changed the way finance operated.

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While the old post-war monetary regime discussed above could be characterized as

nationally administered credit-money and was mostly anchored in commercial banks

taking deposits and making loans (“indirect finance”), the new system of finance

emerging out of the stagflation crisis in the mid-1980s was supra-nationally organized,

market-driven, and so more one of “direct finance” in which market-making institutions,

such as investment banks and various (pension, mutual, hedge, and private-equity) funds,

took away market share from commercial banks. The latter lobbied hard to have their

activity restrictions removed to meet this challenge. And when they were allowed to do

so, as in the aftermath of London’s Big Bang in 1986, with the EU’s Second Banking

Directive of 1989, and above all following the Gramm-Bliley-Leach Financial Services

Modernization Act of 1999 in the US, the larger banks took advantage of new-found

liberties to diversify their operations and reorganize effectively. This pushed the ongoing

transformation of finance and its strategic role in the economy to a whole new level.

4.1. Universal Banking: Financial deregulation in the 1980s and 1990s has allowed the

larger and more internationally inclined banks to turn themselves into universal banks

combining commercial banking, investment banking, insurance, fund management and

proprietary trading. In the process they have become much larger, perhaps five to ten

times as large as they used to be only a couple of decades ago when they were still mostly

just retail banks. And they have also become increasingly global in scale, helped in their

geographic expansion by revolutionary advances in information technology, the

systematic removal of controls on cross-border movements of capital, the 1997 WTO

Agreement of financial services committing national regulators not to discriminate

against foreign financial-services firms, and greater international harmonization of rules

on banks (via Basel Committee on Banking Supervision).

In this expansion the banks have not only aimed for greater economies of scale, thanks to

their automation a much bigger factor than in the 1960s or 1970s when they were still

essentially labor-intensive operations, but also other sources of efficiency gains.

Technology has given banks the means to explore new economies of scope, by combining

different activities and instruments into a high-value service package, as when they

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introduced integrated cash-management accounts for their wealthy customers in the late

1980s. Potentially large economies of scope arise when combining hitherto separate areas

of finance as occurred, for example, with growing interconnections between commercial

banking and investment banking. Scope economies are essentially experimental and thus

process-bound, having much to do with trial-and-error efforts at product development and

hence unpredictable. But they can have amazing effects, when they work as well as when

they do not. The use of credit-default swaps to facilitate the launch of securitization

products (e.g. collateralized debt obligations) or as alternative trading instrument for

entire portfolios, as if you owned the underlying combination of securities on which you

are betting yourself, is a good example. The aggressive search for scope economies in

financial-product development has pushed us, just before the crisis, towards the new

worlds of “structured finance” and “synthetic finance.” These promise to come back and

grow in the not-so-distant future as a whole new sphere of economic activity and social

engagement in cyberspace.

Building a myriad of inter-twined financing arrangements, today’s universal banks also

strive for network economies. They build networks by their very engagements with many

non-bank financial institutions that occupy crucial niches in their webs of financial

commitments (e.g. credit-rating agencies, hedge funds, insurers, et cetera). Networks also

get set up to the extent that they lend themselves usefully to the transfer of risk,

multiplication of capital resources, and escape from the supervision, taxation, or

regulatory restriction of governments. Once set up and off the ground, those networks

carry the promise of becoming self-perpetuating sources of bank income in the form of

various fees, commissions, trading profits, and interest earned. The universal banks

construct such networks innately when they search for partners, clients, and

counterparties. After all, what are financial markets if not networks of actors tied to each

other contractually and financially?

In the chase for scale, scope, and network economies, however, several hundred universal

banks have become today so large and so inter-twined that they are “too big to fail.”

Failure of any one of those would have potentially catastrophic consequences capable of

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seriously disrupting the entire world economy. To the extent that they know they are too

important to let go, these systemically important institutions will always be tempted to

jack up their returns by taking greater risks (in line with the risk-return trade-off logic

pervading finance) and then let the government help them out when they fail with their

bets. We have ended up with a profound moral-hazard problem, which gives us a greater

propensity for crisis and so necessitates ever-bigger bail-outs of profit-seeking banks

taking too many risks. That prospect, we now know (after the wave of costly bail-outs in

the US and the EU in 2008), is both politically as well as fiscally not feasible at all.

4.2. Financial Innovation: Deregulated financial institutions have combined their newly

found freedom to act with revolutionary advances in banking-related technologies to

intensify financial innovation in search of new opportunities for income gains. It is

important to keep in mind that financial innovation differs greatly from industrial

innovation. Consisting mostly of new contractual agreements and then making a market

for them, new financial products carry a lot smaller sunk costs and are far more rapidly

implemented than industrial innovations. Because of their intangible nature as marketable

contracts, they do not offer their inventors protection via the government’s intellectual-

property rights. For all of these reasons they are easily copied and give their initiators at

best a short-lived first-comer advantage.

Financial innovators thus have a vested interest in making their new financial services or

products opaque as well as complex so as to make them less easily copied. We have seen

this dual tendency of opacity and complexity play itself out in every major innovation-

driven financial-product category, be it highly liquid money-market instruments (e.g.

repurchase agreements), derivatives (e.g. credit-default swaps), securitization (e.g.

structured-finance arrangements securitizing further already previously securitized

instruments, such as collateralized debt obligations).

This double trend has made prudential supervision of banks nowadays that much more

difficult to do effectively, since it is hard to know in the face of such opacity and

complexity where the risks are concentrated, what can set them off, and how any such

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eruption of losses would spread through an inter-twined network. The crisis of 2007/08,

for example, revealed problems exploding to the fore, which nobody could have foreseen.

We will therefore be well advised to think of testing financial innovations for their

potential dangers as we do with food, drugs, and other products important to the health

and safety of consumers (e.g. cars). We should do so on a continuous basis, as part of a

system of renewable licenses subject to re-testing, as the new products evolve in the

course of their life cycle.

We should also acknowledge freely (and factor into our regulatory process) that banks in

particular have used financial innovation consistently to bypass regulatory restrictions

and, by circumventing those, render them ineffective to the point where they might as

well as be removed or replaced. As already mentioned, banks began to do this early in the

post-war period when introducing various borrowed liabilities with which to move their

lending capacity beyond a dependence on deposit liabilities. We have also noted in this

context already the Euro-market deposits and loans as enabling the larger banks to

operate beyond the reach of any strictly national regulators and central bankers. Another

great example of such regulation-evading innovation came with the imposition of global

risk-weighted capital standards under the Basel Accord of 1988 by the Basel Committee

for Banking Supervision prompted banks to keep high-risk loans on their books (for

which the regulatory capital charge was in effect too low) while getting rid of safer loans

for which that charge had been set too high by the risk-weighting classifications of the

BCBS. The banks achieved this dual strategy by means of two innovations. One was the

securitization of loans, which allowed them to get rid of specific loan commitments by

repackaging those into marketable securities that could be sold to others acquiring in this

way the underlying loan portfolio’s cash flows; the other so-called credit-default swaps as

insurance for the riskier loans kept on their books. Of course, this risk-seeking practice of

pruning safer loans and accumulating riskier loans helped encourage a fairly high number

of bank failures in the early 1990s. What we see here in effect is a fairly common

phenomenon best described as “regulatory dialectic,” whereby successful circumvention

(and erosion) of a key financial regulation through innovation would at first spur a large

source of income gains for banks, thus get pushed over the limit to the breaking point,

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and in the aftermath of a thereby triggered crisis be subject to regulatory reform

introducing new restrictions.(9)

4.3. Securitization: A profound change in the nature of finance has come with the shift

from loans to securities as primary form of funding. Corporate managers prefer issuing

securities to large numbers of market-mediated, hence distanced investors, whom they

provide well-defined bits and pieces of formalized information, instead of taking out

loans from their nosy and moody bankers with whom they have to engage in an intimate

and time-consuming relationship. The take-off of high-yield bonds, also known as “junk

bonds,” has given many medium-sized firms a convenient funding alternative to bank

loans. Corporate bonds are on the rise everywhere. Even governments of “emerging-

market” economies have moved away from depending for their funding support on local

banks, shifting after the Asian crisis in 1997/98 into an international bond market ready

for take-off (i.e. the Eurocurrency system’s “emerging–market bonds” and its widely

watched EMBI). Funding through markets is fast and imposes discipline, while giving

borrowers access to much more capital at lower cost. For the other side, the investors,

securities also appear far preferable to loans, because they contain an exit option.

Securities can always be sold to get out of a commitment, whereas with a loan you are

stuck until the end of the contract.

Banks themselves encouraged the move from loans to securities, starting already in the

1960s when they developed new money-market instruments which they used to tap funds

for faster asset growth than would have been possible with deposits alone. Starting in the

early 1980s banks further nourished that shift when they actively encouraged the

proliferation of financial derivatives (futures, options) and introduced loan-for-bond

swaps to get out of the LDC debt crisis (1982-87). As already mentioned above, the

capital-adequacy rules of the 1988 Basel Accord induced loan securitizations and credit-

default swaps as means of circumvention.

Banks have always had a vested interest in this structural shift from loans to securities,

not least as a supplementary source of income, from fees and commissions, that was more

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stable than the interest earned on their loans. Were they not to take part in that transition,

they would lose out to non-bank alternatives making those markets. This is exactly what

happened in the 1980s and 1990s when investment banks replaced commercial banks as

the key funding facilitators for corporate and government borrowers while all kinds of

funds (i.e. mutual funds, pension funds, hedge funds) became the primary channels of

savings for a growing middle class rather than the traditional savings deposit in the local

bank. The commercial banks, thus squeezed on both sides of their balance sheet from

less-regulated alternatives, pushed successfully to be allowed to meet their new

competition head on, on a playing field leveled by deregulation of their activity and

ownership restrictions. In that sense, the deregulation of bank activities in the late 1980s

and 1990s was a structurally necessary step, and as such hard to reverse.

Once commercial banks could fuse with investment banks and launch (or take over)

funds, the extraordinary growth and proliferation of securities markets we have witnessed

since 1982 became inevitable. We are now in the grip of this self-perpetuating machine

whereby banks feed loans for the boosting of prices and volume in markets, which they

have set up for fee income and from which they also profit as traders. The universal bank,

combining the entire range of financial services under one roof, thus makes loans, turns

these loans into securities, sells derivative contracts on these securities, and then trades

both of these. It earns thereby a seamless stream of interest income, fees, commissions,

user charges, and capital gains. A significant portion of this much-enhanced profit base

gets dedicated to bonuses for the human capital behind this machine to assure its

aggressive reproduction. What the crisis of 2007/08 has taught us, however, is how

dangerous this machine is in its tendency for overshoot.(10)

4.4. Financialization: Most private economic actors, starting with large corporations or

rich households but extending subsequently well beyond those to smaller firms and

middle-class families, have participated in this transformation of finance on either side of

the ledger. On the one side, they have typically gained a lot more access to different kinds

of debt and hence widely diversified their liabilities while ending up with much higher

debt levels over time. On the other side, they have committed a lot more of their income

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to the accumulation of financial assets for further income gains. Large firms do that not

least as part of a direct-investment strategy of external growth where they take equity

positions or fund long-term supply contracts to build global production networks with a

range of firms on whom their global supply chain relies. And they have also ended up

with an upward shift of their portfolio investments, often thrust into that role first because

of their pension-benefit commitments (especially in the US and Britain). Households,

especially to the extent that they have become rich enough to accumulate wealth beyond

their homes, look at financial assets as a sure way to supplement incomes and provide for

the future.(11) The financialization trend, just as much as the securitization trend to which

it is tied, was abetted by interest rates drifting gradually lower from 1984 onward all the

way to the mid-2000s, an environment propitious for price appreciation among securities.

It should be noted here, as a matter of appreciating the history of heterodox economic

thought, that both Karl Marx and John Maynard Keynes anticipated this evolution and

found it troubling enough. Marx discussed finance as financial capital to highlight its

income-creating capacity as motive for wealth accumulation. In the process he ends up

making the important distinction between “interest-bearing capital” and “fictitious”

capital as roughly mirroring the distinction in credit form between loans and securities.

His notion of fictitious capital implies income earned on the basis of capitalization of

anticipated future income streams without any direct counterpart in actual value creation

(e.g. stocks, but not corporate bonds). That absence of a direct tie between finance and

production, as would be the case if a loan was made to buy and refurbish a factory, has

the potential advantage of rendering the income streams of fictitious capital independent

of underlying profit flows and hence potentially rising far beyond. Keynes himself

warned how troubling such a development would be in his magnificent chapter on long-

term expectations where he distinguished between “speculation” and “enterprise.”(12)

The era of finance-led capitalism can thus be understood as driven by a deregulated,

restructured, and ultimately rejuvenated banking sector whose own super-fast expansion

rests on most actors in the economy, with few exceptions, leveraging up to higher debt

levels while also accelerating their accumulation of financial wealth. That expansion of

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finance is promoted structurally by the ability of universal banks to innovate, turn their

innovations into large markets, and then supply funding support for the continuous

expansion of these markets. This process, while locally grounded in the financial centers

of the world (London, New York, Hong Kong, Singapore, etc.), also operates supra-

nationally by means of global communication networks, which do not know national

boundaries. Finance in that sense has turned into the most fully globalized activity,

pushing along the other dimensions of globalization such as trade or direct investments.

5. Bubble-Driven Boom and Bust

Finance-led capitalism, with a market-driven financial system at its center, has distinct

advantages and disadvantages. By giving so many borrowers cheap access to external

funds while also boosting the income of investors, it certainly has the positive effect of

stimulating faster growth by facilitating or encouraging higher spending levels. But it

also feeds greater income inequality, by creating a growing class of rentiers (“financial

investors”) and a network of interwoven financial intermediaries serving them. This

coalition has the capacity of taking an ever bigger bite of a national economy’s income

pie, as evidenced for example by the increase in the share of total US corporate profit

going to the banks from a post-war low of 8% in 1980 to 41% in 2006.(13) Interest and

dividend are straight deductions from industrial profit and thus dependent on it whereas

capital gains, less constrained as the primary income source for fictitious capital, can be

pushed quite a bit further up by mass-psychological bouts of euphoria before

overshooting to the breaking point. And the human capital running the financial

intermediaries – bank executives, top-level traders, hedge-fund managers, et cetera – has

the power to impose large user fees and even higher “monopoly rents” in the form of

bonuses. That incentive structure creates a vested interest in talking up markets and

feeding constantly more liquidity into those to earn high levels of capital gains (and

bonuses) as long as possible.

This new market-driven system of finance contributed to the growth dynamic over the

last quarter of a century in three fundamental ways. For one, it played an important role

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in sustaining elevated levels of consumption in advanced capitalist economies (US, UK,

etc.) from 1983 to 2005 despite their steadily declining wage shares as relatively stagnant

wage levels lagged behind productivity growth. Apart from working more, households in

the bottom 80% of the income pyramid responded to this challenge of income stagnation

by working more, saving less, and taking on a lot more debt. Their cutbacks in personal

savings were greatly aided by a positive wealth effect, which arose whenever their assets

gained lots of capital gains. And a proliferation of new consumer lending instruments

fostered by an innovation-driven financial sector (e.g. credit cards, installment-payment

plans, student loans, car loans, home-equity loans) made it possible for households to

borrow much more extensively, as indicated by sharply rising consumer debt levels in

many industrial nations. The second contribution of finance was to give rise to asset

bubbles in a number of countries. These sped up growth by feeding larger income gains

and greater spending levels. And, finally, the global reach of the new finance made it

easier to channel capital transfers from rich to poorer countries, many of which managed

to turn into fast-growing “emerging market” economies.

These three growth contributions eventually fused into a global growth pattern which

came to dominate the world economy for almost a quarter of century, specifically from

1985 to 2007. At its core was the formation of what can be best described as a bubble

economy, an economy pushed forward onto an accelerating growth path by consecutive

asset bubbles. The reason why these bubbles were primarily centered in the United States

has to do with the world-money role of the US-dollar which obliged that country issuing

it to run chronic balance-of-payments deficits as the only effective means to supply the

rest of the world with needed dollars. Specifically, there were three US-based bubbles,

one per decade, all driven forward by key financial innovations, and each of those

fostering a key pillar of finance-led capitalism with global implications and lasting

beyond the burst of that specific bubble.

5.1. The Stock-Market Boom of the 1980s: The first bubble arose in the mid-1980s as a

bull market among US (and later other industrial-nation) stocks. So-called “corporate

raiders” used a new financing-mechanism, the high-yield junk bonds, to fund hostile

  17

take-over bids of undervalued corporations whose inability to trim costs adequately

amidst a brutal disinflation shake-out in the early 1980s had left them vulnerable. The

merger and acquisition boom, which these attacks triggered, accelerated industrial

restructuring in many sectors as well as corporate reorganizations. As the attacks brought

their initiators large gains, leveraged buy-out funds and risk arbitrageurs betting on who

would make the next takeover target flooded into booming stock markets to ride a wave

of ever-growing capital gains. Even though that bull market took a first hit in the global

stock-market crash of October 1987 and then came to an ignominious end during 1989, it

had several lasting effects. One was to legitimate stock funds in general, and hedge as

well as private-equity funds in particular, as key new investment vehicles. The other was

to establish shareholder value maximization (and the short-term obsession with equity-

boosting accounting profits) at the center of corporate governance, crowding out more

longer-term and/or socially oriented objectives of the firm. Successive waves of

privatization in Europe and elsewhere permitted US pension and mutual funds to export

the ideology and power structure of shareholder-value maximization to other places.

5.2. The Dot-Com Boom of the 1990s: A second bubble arose with the emergence of the

internet after 1994, sparking a dot-com craze all the way to the Y2K bug of 1999. A

combination of new venture capitalists helping to launch internet start-ups and initial

public offerings of internet companies, which the high-tech stock market NASDAQ

allowed to have listed before they had a proven track record of consistent profitability,

exploited the public’s fascination with this new medium to create a hysteric euphoria

about e-commerce. Fear of the Y2K bug in the approach to the new millennium deepened

the bubble by encouraging wholesale replacement of corporate computer systems. The

burst of the bubble in March 2000 created a global recession, but by that time the internet

had become a global infrastructure for a new cyber-economy specializing in the low-cost

production and distribution of numerous online services.

5.3. The Housing Bubble of the 2000s: The third bubble began already in the mid-

1990s, but really took off with resumption of recovery in 2003 – a historic real-estate

boom centered in the United States, but extending to a number of other countries where

  18

families suddenly could borrow more easily to purchase homes (Britain, Ireland, Spain,

etc.). Fuelling the huge wave of real-estate purchases and housing appreciation was the

rapidly spreading practice of securitizing mortgage-loans which enabled banks to get

loaned-out funds back right away for renewed lending and to transfer default risks to

others buying those mortgage-backed securities. Banks then managed to expand

securitization of loans greatly by securitizing further the mortgage-backed securities into

collateralized debt obligations, mixing higher-risk loans into these doubly securitized

pools, setting up structured-investment vehicles off their balance sheets to buy up these

instruments, and have those SIVs fund their purchases through issue of shorter-term

asset-backed securities. The success of this shadow-banking system, which led many

foreign banks and other investors to buy its instruments, made it very easy for a large

majority of American households to borrow money for housing purchases, refinance their

mortgages for extra cash, and even take out additional loans backed by their homes. All

this greatly boosted US consumption in the 2000s, further spurred on by large capital

gains used to justify lower savings. Americans became the world’s “buyers of last resort”

and so supported the export-led growth strategies of the rest of the world.

5.4. Cross-Border Capital Flows: Parallel to these three US-based bubbles you also had

massive capital transfers from the center to the periphery, which accommodated the need

to integrate three billion people into the capitalist world order after the fall of

communism and the end of post-colonial single-party states in the developing world. The

first of these transfers emerged with the initially successful recycling of petro-dollars

(OPEC’s surplus after the oil-price hikes of 1973 and 1979) to lesser-developed

countries. Even though many of those LDCs experienced a huge debt crisis after 1982

when the simultaneous double whammy of deregulation of US interest rates (making

their variable-rate loans in the Eurodollar market so much more expensive) and global

recession (depressing their export earnings) stifled their debt-servicing capacity, they

managed to come out of this crisis five to seven years later much strengthened, with

competitive exchange rates and important public-sector reforms. The second wave of

capital transfers took place in the 1990s and was driven by US funds diversifying their

portfolios globally while US multinationals built global supply chains for low-cost

  19

production. The beneficiaries of these investment flows were above all East Asian

economies, most notably China. Massive capital inflows set off speculation-driven

euphoria there until a botched devaluation of the Thai baht in July 1997 set off a currency

crisis in that region which extended across the globe to Russia and then Latin America

over the next couple of years. The reforms undertaken in the wake of this crisis, coupled

with significant currency devaluations, set many of those emerging-market economies

onto a successful path of accelerated export-led growth. Holding down the value of their

currencies, these countries ended up automatically recycling their current-account

surpluses to the US by buying up US-dollars and investing their rapidly accumulating

foreign-exchange reserves in US securities.

5.5. A Global Growth Pattern: Eventually the US bubbles and cross-border capital

flows merged into a global growth pattern where each side could grow rapidly despite

falling or stagnant wage shares. US excess spending, fuelled by rapidly rising household

debt in the course of a historic real-estate bubble, and export-led growth strategies in the

rest of the world were two sides of the same coin. The linkage between the two became

increasingly direct as more and more foreign investors ended up getting attracted to the

relatively high-yielding mortgage-backed securities underpinning the US housing bubble.

But ultimately that growth pattern was unsustainable and bound to reverse, with the

turning point emerging in early 2007 when a particularly dangerous category of US

mortgages, so-called “subprimes,” found themselves subject to a sudden wave of

defaults.(14) This triggered a chain reaction which paralyzed the entire securitization

architecture, spilled into the inter-bank market, triggered a series of runs on bank, and

finally - after the particularly fateful collapse of Lehman Brothers in September 2008 -

triggered the worst global crisis in eighty years.

That traumatic experience of bubble-driven boom and bust revealed a number of very

serious flaws in our financial system, which need to be addressed. For one, letting

universal banks decide for themselves how much capital to set aside, how much leverage

to pursue, and how much liquidity to assure proved fateful, especially when those

decisions are made in the context of a compensation system for bankers that rewards risk-

  20

taking and short-term returns. Moreover, such biased self-regulation occurred in a context

where all available checks and balances simply failed to do their job – the internal

controls and firewalls within the banks, the ratings agencies, the insurers, the supervisors

responsible for prudential regulation, and so forth. Another set of problems revealed by

that massive financial crisis pertains to the fragility of over-the-counter markets, which

banks set up and then manipulate for their own gains. In the midst of the crisis the

authorities also found that they did not have the means to deal effectively with all the

challenges they had to face, especially vis-à-vis investment banks and also in terms of

international cooperation in the face of cross-border failures. Finally, neither bankers nor

their regulators could look beyond individuated risk measures to get a sense of the whole

and identify the massive build-up of systemic risk until it was too late.

6. Financial Regulatory Reform

The shortcomings revealed by the crisis of 2007/08 have convinced policy-makers that a

new regulatory approach to finance was urgently needed, a conviction further reinforced

by the public outcry against taxpayer-funded bail-outs of irresponsible bankers and a

legacy of massive budget deficits in the wake of this crisis. New mechanisms of global

policy coordination, in particular the semi-annual meetings of the G-20 and its Financial

Stability Board, have pushed the idea of financial regulatory reform forward across the

world. Two years into the process we now see the fruits of these efforts. After the G-20

moved that topic to the center of its agenda from late 2009 onward and then met to that

effect in June 2010, major regulatory reforms were passed in short order.

•First came Obama’s overhaul of US regulations for finance in July 2010, known

as the so-called Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009.

•A month later, in August 2010, the European Union introduced a new regulatory

and supervisory infrastructure on a supra-national level by introducing three new pan-EU

bodies – the European Banking Authority (EBA), the European Securities Markets

Authority (ESMA), and the European Insurance and Occupational Pensions Authority

(EIOPA). These replace the hitherto strictly national regulation of financial markets and

institutions whose limited inter-governmental coordination practices had proven wholly

  21

inadequate as the global credit crunch of 2008 rippled in destabilizing fashion from

country to country within a (nearly-)single financial space that had emerged gradually in

the aftermath of the adoption of a common market 1987-1992.

•Finally, in September 2010 a compromise among the 27 member nations of the

Basel-based BCSB, operating under the auspices of the Bank for International

Settlements (BIS), to replace the Basel II system of risk management and capital rules

with a new set of rules for banks which toughened their capitalization rules, put limits on

their leverage, and required better liquidity protections.

These reforms have enough in common to mark the beginning of a globally coordinated

approach to financial re-regulation which would apply tougher standards on banking

behavior, require a lot more information from non-bank institutions as well as banks,

strengthen the resilience of financial markets, and change the logistics of crisis

management. While still not enough, they are a big step forward and address key

questions raised by this major systemic risk.

6.1. Basel III: At the heart of the emerging global financial-regulation regime will be the

new rules of the BIS’ Basel Committee for Banking Supervision. Even though many of

the specifics have yet to be fleshed out and there is a long phase-in period (until 2019),

we already have the contours of the deal. Centered as in all Basel agreements on a

capital/(risk-adjusted) asset ratio, banks will have to hold far more capital (4.5% of core

Tier One capital, instead of Basel II’s 2%). And they will have to build up an extra

capital cushion of an additional 2.5% in good times, which they can use for loss coverage

during downturns before corrective-action steps (e.g. suspension of dividends,

management changes) kick in. Systemically important banks will eventually have to hold

even more than the requisite minimum of 7%. Also important in this context is the

narrowing of what constitutes bank capital, focusing on common equity as the only true

loss-absorption buffer. Gone are the days, under Basel II, when banks could set their own

(wholly inadequate) capital levels and count all kinds of ephemeral hybrid instruments

towards their capital base (e.g. reserves, subordinated debt).(15)

  22

The new Basel III rules focus more decisively on the numerator (bank capital) than on the

denominator (risk-weighted assets). Concerning the latter, they continue the fateful

reliance on the largest banks’ own internal risk-measurement models first established in

Basel II. These models are not only biased in the sense of systematically underestimating

risk in favor of greater returns, but they are also inherently flawed by looking at risks

individually, without ever capturing how different risks interact and/or get transformed in

the course of a crisis. Equally unfortunate is Basel III’s continued emphasis on input by

the rating agencies in assessing risk weights to different bank assets, relying on the same

bodies that so grossly misjudged the securitized instruments at the heart of the 2007/08

crisis. This provision will make reform of the rating agencies, as being pushed by the EU,

a matter of high urgency. Finally, Basel III rules are also relatively permissive when it

comes to the banks’ off-balance-sheet entities, such as the SIVs, which played such a

huge rule in the build-up of the housing bubble and its subsequent collapse. This

omission strikes me as crucial, since the regulatory dialectic (identified in sub-section

4.2) will drive banks even more aggressively into constructing new kinds of shadow-

banking systems beyond the radar screen of regulators in response to tightened regulation

and supervision.

Still, the BCBS has acknowledged that its refusal to tighten or overthrow Basel II’s

approach to risk-weighted assets might leave us exposed to dangerous trends in banking.

No matter how you cut it, risk weighting of assets is inevitably a problematic exercise of

guesswork, since the future is inherently unknowable, hence subject to radical uncertainty

which cannot be approximated or replaced accurately by measurable risk. For that reason

Basel III rules include an alternative restriction, a kind of leverage ratio, which the US

has used ever since the FDIC Improvement Act of 1991. That ratio divides core Tier 1

capital by total assets, with no risk weighting and including also the off-balance-sheet

entities of banks. Unfortunately, the 3% target for that ratio as minimum is too low,

implying a 33-to-1 leverage which was pretty much what Bear Stearns and Lehman had

when they collapsed.

  23

A third key innovation included in Basel III concerns the eventual introduction of

minimum liquidity ratios by 2015. One of the crucial reasons for the subprime problem

morphing into a systemic crisis of epic proportions was the paralysis in many strategic

money markets, especially commercial paper and bilateral repurchasing agreements,

which deprived investment banks and aggressively managed commercial banks of crucial

funding support at a time when they were extremely vulnerable due to the crystallization

of massive losses on their asset side. To avoid this systemic-crisis trigger in the future,

banks need to have sufficient levels of crisis-proof liquid assets around which they can

get rid off under any circumstance. In the same vein, they cannot rely excessively on

potentially shaky short-term liabilities that may dry up. These liquidity rules will be

difficult to design, but work in that area is crucial for the safety and soundness of our

banking system.

6.2. Resolution Authority: In the most critical moments of the crisis, during September

2008, it was clear that the authorities lacked powers to deal effectively with key failures

among financial institutions, especially those that were not commercial banks, and were

therefore obliged to launch massive taxpayer-funded bail-out operations that provided

blanket assurances to the system as a whole. These are not only potentially very

expensive, but also politically extremely unpopular. And they reinforce the moral-hazard

problem to the maximum, inviting irresponsible high-risk behavior among financial

institutions in pursuit of greater returns. In light of this troubling experience regulators

have insisted on an alternative mode of crisis management vis-à-vis failing banks and

other financial institutions. America’s Dodd-Frank Act has taken one of the FDIC’s

approaches to failing small and medium-sized banks as a model. A failing institution will

now be taken over by the FDIC as a form of receivership, various creditors will face

prescribed losses, and salvageable assets will be liquidated as rapidly as is prudently

possible. The liquidation of Lehman Brothers serves in this context as an important

learning experience, and all systemically important institutions will be asked to draw up

“living wills” to guide their eventual liquidation if needs be.

  24

The EU has so far not been able to come up with a similar solution to the problem of

what to do when “too-big-to-fail” institutions actually fail. While Europeans often

intuitively resist copying what Americans do, the reasons for their hesitation may be

more serious than that. The key problem they face, one dramatically illustrated with the

failure of Fortis Bank in 2008, is that of cross-border coordination in the case of supra-

national financial institutions operating in the single-market space of Europe. Even

though they now have EU-wide regulators for banks, insurance companies, and securities

markets and even grouped those together in a new structure for systemic-crisis

management, the European Systemic Risk Board (ESRB), these four new bodies do not

(yet) have the powers of receivership or other bankruptcy provisions. And the EU is also

divided at this point between two possible approaches. One foresees use of so-called

“cocos” (i.e. contingent convertible bonds which turn into common equity when a bank

starts failing). The other stresses so-called “bail-ins” which impose losses on creditors

rather than on the state.

6.3. Systemic-Risk Regulation: The crisis of 2007/08 has confirmed that there are those

rare occasions when some incidence of financial instability sets off an avalanche of

ballooning destabilization threatening to bring down and paralyze the entire system. As

we have seen during the Great Depression in the 1930s and once again a couple of years

ago, such systemic crises are a necessary, but not sufficient prerequisite for depressions.

They need to be contained by effective crisis management before their contagion

potential triggers the much-feared debt-deflation spiral of mutually reinforcing

deleveraging, forced asset sales, and spending cutbacks.(16)

Once they are allowed to get going in the wake of a collapsing asset bubble, such

systemic crises are very difficult to contain. It is much better to prevent their occurrence

in the first place! American and European policy-makers have therefore warmed to the

idea of putting into place a systemic-risk regulator who will try to identify worrisome

trends pointing towards systemic crisis and then try to stop or even reverse them before it

is too late. Rather than answering the difficult question who among the policy-makers

dealing with money and credit may be best equipped to deal with the build-up of

  25

destabilizing trends that might result in major financial crises, be it central bankers,

banking supervisors, or financial-market regulators, legislators in both the US and the EU

have instead decided to set up a college comprising all of these agencies. See, for

instance, the so-called Financial Stability Oversight Council (FSOC) in the Dodd-Frank

Act ,which comprises the Fed, the FDIC, the Securities Exchange Commission, the

Treasury, and other more marginal regulators. This begs right away the follow-up

question as to how well those bodies, each with its own tradition, all with a history of turf

battles, will cooperate and complement each other. The problem of overcoming past

practices may play less of a role in the case of ESRB as it is made of essentially new

institutions (EBA, ESMA, and EIOPA) charged with overcoming national traditions.

The question of cooperation will extend across borders as the highly globalized system of

finance engenders dynamics of financial instability beyond national boundaries. A

second prerequisite for the effective functioning of this new system of macro-prudential

regulation relates to the need to know. Systemic-risk regulation necessitates complete and

up-to-date information about financial institutions and markets, both on the level of

individual firms as well as in the aggregate for a macro vision of what is building up

where. Regulators all over the world will from now on demand a lot more information

from a much larger number of parties involved - not just from commercial banks, but also

from all kinds of other financial institutions used to significant amounts of opacity, such

as investment banks, securities traders, hedge funds, or private-equity funds.

In the end, however, all the data in the world will not suffice unless you have a way to

interpret them accurately. And this in turn requires a theory of financial-crisis dynamics.

That is by no means a given. Even if we assume that policy-makers empowered as

systemic-risk regulators will want to step in during an economic boom to prevent its

overshoot, we cannot assume that they would know when to do so. The prevailing

paradigm, which most policy-makers share, has simply no place for systemic financial

crisis – a phenomenon it simply assumes away by believing in the “efficient market”

hypothesis as well as in the separation of finance and economics. We will need systemic-

risk regulators who understand the nature of systemic risk, because they have a sense of

  26

financial crises – how they come about, when they get triggered, the different kinds, how

each type feeds back to the rest of the economy. Economists can help by developing new

theoretical understanding to explain capitalism’s propensity for asset bubbles, credit

overextension, and debt-deflation spirals whereby a financial crisis becomes systemic. A

good first beginning in this direction has been made in the Dodd-Frank Act, which

introduced a new Office of Financial Research to study systemic-risk build-up and

identify its key parameters driving the process forward. Set up under the auspices of the

US Treasury, the OFR is to collect data which help regulators analyze complex new

financial products, monitor various risks emanating from the actions and decisions of

large financial institutions, identify patterns of fraud, and explore critical linkages

between important institutions and markets.

The councils and colleges of regulators empowered to deal with systemic risk will in

addition have to possess the tools to do something about potentially destabilizing trends

once those have been identified as worrisome. This implies powers of macro-prudential

regulation, such as imposition of selective credit controls, asset-growth restrictions,

moratoria on the use of certain practices or innovations. We are far away from actually

implementing new powers of that kind which prompts us to wonder what systemic-risk

regulators will actually be able to do pro-actively when they do identify signs of trouble

in need of containment.

Not only is the question of crisis prevention still an open one, but the Dodd-Frank Act

actually imposed new constraints on the Fed’s crisis-management capacity which make

you wonder whether certain financial crises can be properly managed in the future.

During 2008, when a number of US institutions became insolvent, the Fed made

aggressive use of its emergency lending powers under section 13(3) to save failing

institutions, including investment banks (Bear Stearns) and insurers (AIG). Even though

it thus avoided in all likelihood the explosion of systemic risk of the kind experienced

after the collapse of Lehman Brothers, the use of extra-ordinary bail-out powers by an

unelected government authority in support of individual lenders seen as key culprits

reawakened long-simmering antipathies towards the Fed on the political right, now

  27

sweeping the country through the Tea Party movement. It is perhaps in response to the

public outcry against taxpayer-paid rescues of much-maligned bankers that Congress

forbade the Fed from using these emergency-lending powers in support of individual

lenders in the Dodd-Frank Act. From now on Section 13(3) loans can only be made on a

broad basis, subject to approval by the US Treasury, cannot be extended to insolvent

firms, and must be backed by sufficient collateral. In other words, they can no longer be

used to deal with specific emergencies. Those will now have to be taken care of

differently, through a resolution procedure that entails preparation of funeral plans,

government takeover, and orderly liquidation. Any costs incurred by these orderly-

removal procedures will have to be borne after the fact by an assessment charge imposed

on other financial institutions. This too is problematic, since those payments are likely to

kick in precisely when many of the payees face heightened risks of getting hurt from the

contagion fever so typical of systemic crises. It would have been far better to have had

such reimbursement funds collected in advance, notwithstanding the conservative

counter-argument that such a-priori rescue assurance only feeds moral hazard.

While Dodd-Frank endows US regulators with new resolution authority and introduces

macro-prudential council to watch for the build-up of destabilizing forces, it is by no

means clear that these new powers can compensate for the prohibitions imposed on

traditional crisis-management mechanisms which, irrespective of populist resistance to

them, have proven effective so far. While there is still enough in place to deal with all

kinds of banking-related crises, there may be well be new types of financial instability

and systemic crises for which the prohibitions on the Fed’s and Treasury’s crisis-fighting

powers (no individual emergency loans, no taxpayer bailouts) will prove fateful.

•If, for instance, banks in their regulatory dialectic build new, better hidden

shadow-banking systems to escape regulations and supervision, then it may be difficult

for the authorities to respond sufficiently rapidly and with adequate targeting capacity to

any unanticipated rupture in that structure.

•Nor is it all clear what the authorities can do when there are panic runs in key

segments of the financial system, such as within the repo-based inter-bank market or on

  28

money-market funds, vulnerable parts of our financial system architecture that have

already shown a potential for great disruptability during the panic of September 2008.

•We also have dangerous exposure to market break-downs from counter-party

risk, whenever financial institutions holding large positions in strategic areas of the

financial market-place find their reliability in doubt. This source of financial crisis is

bound to become more important as regulators push for the reorganization of hitherto

informal over-the-counter markets through insertion of centralized clearinghouses as a

new intermediation layer for sturdier market structures than those bi-lateral ones that

depend entirely on mutual trust in each other. What happens when one of those

clearinghouses fails? The failure of insurer AIG, two days after Lehman’s collapse and

with $181 bn. in emergency funds the most expensive government bail-out of them all, is

a warning how overwhelming this type of crisis could be. One what would have thought

that the AIG experience alone would have convinced anyone that the first line of defense

in those highly contagious crises of confidence would be giving the central bank

unlimited and targeted funding power for emergency assistance to institutions in trouble.

•Rapid technological advances are changing the operating capacities of financial

markets, with huge volumes of automated trading programs becoming dominant. When

machines take over (fully automated) financial markets, then you can expect new types of

market shocks and failures with completely unprecedented chain reactions. This new

reality of technological crisis multipliers was powerfully illustrated in the so-called “flash

crash” of 6 May 2010 when a single order with unusual parameters for transaction speed,

denomination, and (in this case open-ended) price range triggered a 1000-point decline of

the Dow Jones in a matter of a few minutes. We should also take the recent appearance of

a computer virus, a malware worm called Stutnex which can subvert industrial-control

systems and seemed to have been launched for an attack on Iran’s nuclear facilities, as

the threshold for a new era of cyber-warfare in which sabotage attacks in cyberspace may

also be targeted to disrupt financial markets. Once again you may in such a case not want

to have the kind of lender-of-last-resort restriction in place that the populist sentiment

imposed on the lawmakers in Dodd-Frank.

  29

6.4. Strategic Reinforcement Reforms: At least the regulators in both the US and EU

have understood that, notwithstanding the politically touchy, yet macro-economically

crucial question of bail-outs, there was much to be learned from the latest systemic crisis

gripping the world during 2007/08 in terms of malfunctioning checks and balances within

the financial system which need urgent correcting. That crisis revealed some key

structural flaws, which, in their moment of dysfunction, made the crisis much worse. For

instance, one of the more hotly debated innovations of the Dodd-Frank Act concerned the

introduction of a Consumer Financial Protection Board, a new agency empowered to

demand of banks and other lenders to consumers higher levels of transparency, honesty,

and simplicity so that their scandalous behavior of fraud and negligence gets corrected.

Abuses, as occurred to dramatic and nefarious effect in the case of the subprime

mortgages, need to be prevented.

Another necessary target for structural reform are the ratings agencies, which suffer from

an inherent conflict of interest impairing their judgment when paid by those whose

products they rate. The EU in particular has pushed for consideration of a different

business model pertaining to how securities and loans should be rated. However we

ultimately resolve this question, greatly increased public access to timely and complete

information, rooted in much more stringent information-disclosure requirements for

financial institutions and markets must be at the center of a well-balanced and considered

risk assessment process.

The EU has also pushed hard for better oversight and greater transparency of hedge

funds, private-equity funds, and other alternative investment funds, all of which base

their typically high returns to a large degree on operating opaquely, with monopoly

control over key information items. These funds play a very important role in the riskier

segments of our various shadow-banking systems, where they help banks turn various

innovations into lucrative funding channels, as they did during the run-up to the crisis

with the take-off of “structured finance” (by buying the high-risk “equity” and

“mezzanine” tranches of collateralized debt obligations) and “synthetic finance” (via

credit-default swaps). Much of this push is culturally grounded in the long-standing

  30

European disdain for speculation and speculators which, by extension, serve as perfect

scapegoats. Obama’s regulatory reform also contains increased disclosure and licensing

requirements for hedge funds.

The most important structural strengthening effort will be reserved for derivatives, in

particular credit-default swaps and other customized instruments traded over-the-counter.

Such customization has given banks enormous information advantages over other market

participants as a source of enlarged profits for them. But that very opacity also created

systemic-crisis conditions in a hurry when a sudden rupture of trust among leading banks

at the center of the informal network would paralyze the market in the absence of reliable

pricing. If OTC derivatives, at least those that can be standardized reasonably well, were

traded on public exchanges there would always be a price and hence continuous trading.

Even a less ambitious alternative, namely the interjection of a clearing-house as counter-

party, would tend to make those markets more stable by interjecting a reliable

intermediary capable of keeping good records and completing commitments.

Other vulnerable areas of finance are bound to get strengthened as well. This is especially

needed for rebuilding of the securitization infrastructure which will come with imposition

of more stringent underwriting standards. As additional protection it might behoove

regulators to demand that banks keep a certain percentage of capital vested in their

securitization issues as an incentive against carelessness and excessive risk taking. Much

work should also go into reorganizing various money markets to make them less prone to

paralysis when trust evaporates among just a few dozen of the world’s leading banks

comprising the heart of the inter-bank market. Under normal circumstances that core of

transnational banks, referred to in the US as “primary dealers,” feed those money markets

with adequate liquidity, but they failed spectacularly to do so in key moments of the

2007/08 crisis.

Finally, there will also have to be further reform of the compensation practices for the top

managers and traders in large financial institutions. EU and US governments are pushing

for more payment in stocks and a longer vesting horizon to encourage a longer view and

  31

measure performance over an entire cycle rather than just (extremely short-term)

quarterly earnings. Dodd-Frank has also given shareholders in financial institutions a

powerful tool to express their sentiments to the board of directors about bonus payments

and other compensation aspects of a given firm. This is not only a politically sensitive

hot-button issue in the public arena, but more importantly in the long-run crucial to the

behavioral patterns and preferences of banks and other financial institutions at the center

of our highly financialized capitalist system.

6.5. Taxing Finance: Governments all over the world have managed the 2007/08 crisis

by taking on huge budget deficits for an extensive period of time, from a combination of

massive loss socialization in the financial sector, large fiscal-stimulus packages, and

extensive shrinkage of revenue sources. These deficits are bound to push up the national

debt burden before the aging baby-boomers add a whole new layer of automatic spending

pressures likely to persist for an entire generation. As more and more of the deficit-

spending by governments all over the world is financed through the international capital

markets, it cannot be allowed to spin out of control. The drama of Greece during the first

half of 2010 reminds us of the vulnerabilities governments face when bondholders decide

enough is enough. It is thus no surprise to see governments look for new tax sources,

especially those that are politically viable. Finance presents itself in that regard as an

appropriately fat target. Not only is it highly profitable, but it also has been a direct cause

of those exploding budget deficits and, in the process, has turned the public against it.

The first propellant for the imposition of new bank taxes came in early 2009 when the

resumption of huge bonuses in banks just bailed out created an angry public backlash

which astute politicians in America and Europe used to put steep excess-profit taxes on

bonus payments above a small minimum. Such a tax had the added advantage of

sharpening a needed debate over the extreme compensation practices in finance and their

impact on risk taking among traders and bankers. Obama then proposed a levy on banks

in proportion to their balance sheets which he justified as a pay-back mechanism to the

government for its earlier support. The same justification has been used in several EU

countries for similar levies on banks.

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Banking levies became an even hotter topic during the spring of 2010 when the American

and European legislators moved into the serious stage of regulatory reform discussions.

The idea of creating a new resolution authority came initially tied to the notion of a bank-

funded assistance pool which failing banks in need of help would be able to draw from.

But the public bought the conservative critique that such pre-funded schemes would only

amplify moral hazard by nourishing expectations among bankers of having automatic

access to future bail-out funds, and that tax idea was dropped in favor of ex-post funding

of assistance outlays by banks. The drive in favor of bank levies got further slowed down

when the G20 finance ministers failed to agree on a global levy due to resistance from

countries whose domestic banking systems had acted more responsibly and fared

consequently better (e.g. Canada, Brazil, Japan). In this context it is important to point to

the considerable lobbying capacities of the finance industry if we want to understand why

taxing banks is easier said than done. Add to this the argument that burdening the banks

with too many taxes and regulation costs would impair their lending capacity and hence

slow down economic growth. This combination makes for a politically powerful sector,

whose sway over politicians explains why subsidies granted them outweigh taxes asked

of them (to the point where the typically super-high income of hedge fund managers gets

taxed in the United States at the privileged level of capital gains, i.e. at less than half the

rate than normal income).

Given the difficulties of imposing bank levies, despite large international support for such

taxation (including IMF, leading central bankers), it may be useful to contemplate instead

a very different type of taxing finance. The so-called Tobin Tax or similar kinds of

financial transaction taxes have the advantage of punishing high leverage and short

investment horizons, both key characteristics of financial speculation, while being at the

same time barely noticeable to long-term investors and those using a lot of capital on

their own. Interest in such financial-transaction taxes has spiked worldwide since 2008,

justifying a concerted political effort to lobby policy-makers in their favor as has

occurred effectively in France. Public support in favor of such financial transaction taxes

can be reinforced by proposing to dedicate a significant proportion of such globally

  33

raised funds to global issues such as funding support for emerging market economies

making adequate contributions to fighting climate change.

7. Deeper Structural Reforms of Finance

While the reforms already passed mark a significant step forward in the necessary re-

regulation of finance, they arguably do not go far enough. They amount to tinkering on

the edges, but leave the essential structures, motivations, and practices of finance in tact.

It is therefore doubtful whether they will be able to alter the inherently unequal and

unstable growth dynamic of finance-led capitalism or, more broadly speaking, make a

dent in that system. For that kind of structural change in the nature of capitalism to

happen requires more fundamental reform. We have at this point only seen the

beginnings of serious efforts in that direction, but those give us already a good idea what

could or should be done.(17)

A noteworthy initiative in the direction of more fundamental reform of finance came

during the run-up to the passage of the Dodd-Frank Act when one of Obama’s key

advisors, former Federal Reserve Chair Paul Volcker, suggested that any commercial

bank offering federally insured deposits and hence enjoying the de-facto subsidy of a

blanket bail-out guarantee by the government should not dabble freely in high-risk

activities at the same time. Acknowledging at the same time that there was no way to

return to the pre-deregulation separation of commercial banking and investment banking,

Volcker nonetheless proposed introducing some serious activity limitations for

commercial banks. The so-called “Volcker Rule” would ban commercial banks from

proprietary trading on their own accounts and from either sponsoring or investing in

hedge or private-equity funds. What is remarkable is that, despite furious resistance by

the powerful bank lobby, Volcker’s Rule survived. The Dodd-Frank Act asks the new

Financial Stability Oversight Council to come up with rules as to the implementation of

the Volcker Rule’s key provision shortly so that full compliance with those are in place

by 2014. It should also be noted that the new FSOC can break up even non-bank financial

  34

institutions (e.g. AIG) which it deems as systemically important and in the process of

failing.

Several policy-makers, especially in the United Kingdom (e.g. Adair Turner, the head of

the Financial Services Authority), have gone further by calling up for super-sized banks

to be broken up so that none of them would ever be considered “too big to fail.” That

option is to be explored further by a commission set up by the new Cameron

Government. Even though its recommendations are unlikely to go that far, the idea of

breaking up excessively large banks into smaller units deserves discussion beyond the

“too-big-to-fail” dilemma in terms of what we want banks to do. How do we want the

modus operandi of our financial system to be restructured? While it is probably too late

to reinstitute the separation (in the Glass-Steagall Act of 1933) between commercial

banking and investment banking as a way of breaking apart universal banks, it may make

good sense to distinguish between the indirect-finance functions of taking deposits and

making loans, on one hand, and the direct-finance function of making financial markets.

The former is arguably a public good carrying large economic and even social benefits,

while at the same time endowing those intermediaries with special fiduciary

responsibilities as they deal in other people’s money. We have for good reason applied to

this intermediation activity of banks special government protections and controls, notably

deposit insurance. The objection to the current universal structure is that this gives banks

and their clients an opportunity to pursue high-risk, high-reward strategies of market-

making while enjoying unlimited backing of the public purse. The Volcker Rule is a first

step in the direction of acknowledging that government-backed banks should not have

full freedom to play risky games for extra gain. The Chinese government’s direct control

over China’s leading banks (ICBC, Bank of China, etc.) and spectacularly successful use

of that control in 2008/09 to demand higher levels of bank lending to privileged lenders

exemplifies the other side of that political equation, the benefits of treating commercial

banking’s deposit-taking and loan-making activities like a public utility which as such

should be either owned or regulated by the government. If you do not approve of direct

government ownership interests in banks, there are other property forms to assure a more

socially oriented public-good orientation for banking – as, for instance, with the giral-

  35

money systems wherever post offices serve as savings banks (e.g. France, Germany), or

the cooperatives (like the credit unions in the US), or the mutuals.(!8) And if we do not

want to break up banks, a difficult task in any case and one likely to be resisted by

bankers chasing scale, scope, and network economies, then we might think of alternative

structures obliging banks to put firewalls between their different operations, as would

happen when splitting these multi-product firms by function and/or region into separately

capitalized subsidiaries under the centralized umbrella of a bank-holding company.

Another area of reform has focused on money laundering and tax evasion, which became

more of a focus of attention already after 9/11 with EU and US governments’ perceived

need to identify channels of terrorist financing. Criminally collusive behavior by

employees of the Swiss bank UBS, at the time the world’s largest private-wealth manager

but also a bank rendered extremely vulnerable in the crash of ’08 by a number of serious

strategic mistakes as a good case study of the limits of universal banking, gave the US

government a shot at breaking the long tradition of Swiss bank secrecy, leading to the

disclosure of thousands of US clients at UBS. Safe-haven countries, like Switzerland or

Liechtenstein, have since then been obliged to sign on to a new conduct-and-transparency

code under the auspices of the 30-member Organization of Economic Cooperation and

Development (OECD). Most importantly, America’s new Foreign Account Tax

Compliance Act of 2010 requires automatic exchange of information between foreign

banks and US authorities concerning any foreign financial account held by a US person, a

legal tool which banks across the world will have to comply with lest they want to see

themselves excluded from operating in the crucial and lucrative US market. All this

portends the end of traditional bank-secrecy protection for the wealthy who as a result

will be obliged to pay a fairer share of their taxes during periods of record-high budget

deficits when governments across the globe are keen on more revenues. The two places

committed to maintain a high level of private wealth management protections are

Singapore and Hong Kong, competing for the prime spot as Asia’s financial center.

Singapore has the advantage of a successful and strategically located city state, endowing

its economic agents with full sovereignty protection, whereas Hong Kong no longer has

the advantage of its independence. Instead Hong Kong has gained a different comparative

  36

advantage, combining a currency-board arrangement of its currency (HK-dollar) with the

US-dollar and a strategic position in the gradual convertibility of the Chinese renmimbi

to assure a key future role in the transition to a multi-polar international monetary system.

The regulatory reforms of the post-crisis periods have not gone as far as transforming the

modus operandi of finance in any fundamental way. But they have made significant

progress towards greater disclosure of information, better safety cushions, and more

balanced crisis management strategies. For one, even the best formal regulations mean

very little if regulators do not enforce them well. We therefore need to shed more light on

the conditions for effective enforcement as they pertain to timely data interpretation,

coordination among regulators, communication with regulated institutions, and

maintenance of sufficient distance for counter-cyclical intervention. These informal

aspects of the regulatory process make all the difference, but are often given short drift.

They deserve much attention not least in light of the power of finance to capture its

regulators, the messy institutional structure of financial regulation in the US and EU, and

a regulatory dialectic whereby banks and other financial institutions use innovation to

weaken or altogether circumvent existing regulation.

Finally, it is also clear that financial regulation cannot be isolated from other strategically

important policy-making areas. It connects surely to monetary policy, not least because

both policies center around the behavior of the banking system as the transmission

mechanism for the money creation and credit extension process. The linkage between

financial regulation and monetary policy is probably even tighter now during a period of

unorthodox policies which aim to repair damaged financial institutions, rebuild partially

collapsed financial markets, and flood the clogged credit system with excess doses of

liquidity. In the same vein financial re-regulation also has deepened its connection to

fiscal policy as the asset-purchase programs of central banks mark a whole new level of

debt monetization at a time of extremely large budget deficits in many industrial nations.

This question has gained perhaps its sharpest focus in the European Union as its

sovereign-debt crisis of early 2010 obliged the European Central Bank to help national

governments in trouble by buying their bonds in disproportional (and hence explicitly

  37

crisis-bound) fashion. Finally, financial re-regulation, especially new rules applying to

the systemically important, trans-national banks, will unfold just as the world economy is

moving from a single (dollar) standard to a more complex, tri-polar system, based on

dollar, euro, and yuan, whose inherently centrifugal forces of monetary fragmentation

must be made to coexist in counter-balancing fashion with the centripetal pressures of

financial globalization. As the contextual policy connections of financial regulation with

monetary policy, fiscal policy, and the international monetary system are all in a state of

flux, it behooves us to study these connections in much more sustained fashion than has

been hitherto the case.

NOTES

1) A good example of this approach is S. Claessens (2009). 2) The most important protagonists of this EMH view are E. Fama (1970) and B. Malkiel (1973). 3) Apart from the masterpieces of either (K. Marx, 1867/1990; J. M. Keynes 1936) both wrote other, lesser known works integrating money, credit, and growth which are equally interesting, notably K. Marx (1857-8/1993) and J. M. Keynes (1930). 4) One of more important contributions by Post Keynesian Theory has been its notion of endogenous money. See, for instance, S. Rousseas (1992) or M. Setterfield (2006). 5) The notion of “debt economy” originates from J. Hicks (1974). For a more elaborate analysis of this concept and its implications for the growth dynamic of advanced capitalist economies, see R. Guttmann (1994). 6) For a good summary of how this post-war monetary regime was constituted and contributed to decade-long boom conditions, see R. Guttmann (1989). 7) Excellent analyses of the stagflation-induced sequence of credit crunches in the United States can be found in A. Wojnilower and M. Wolfson (1994). 8) See R. Guttmann (2008; 2009) in particular. 9) On regulatory dialectic see E. Kane (1981). 10) M. Wolf (2010) has characterized this new financial system in its tendencies towards inequality and instability as a ‘financial doomsday machine.’

  38

11) Other sources on financialization are G. Epstein (2006), E. Hein and T. Van Treer (2008), and E. Stockhammer (2004). 12) The discussion of “fictitious capital” can be found in chapter 29 of volume III of Capital (K. Marx, 1895/1991). For Keynes’ distinction between “speculation” and “enterprise” see J.M. Keynes (1936, chapter 12). 13) US Department of Commerce figures, cited for instance in S. Johnson (2009), show that the US financial sector never earned more than 16 percent of domestic corporate profits between 1973 and 1985. In the 1990s that number fluctuated between 21 percent and 30 percent before peaking at 41 percent in 2005. 14) Elsewhere (R. Guttmann, 2007) I have traced the chain reaction within a systemically fragile shadow-banking system which allowed a relative small problem, a wave of defaults among subprime mortgages, to grow into the worst financial crisis in eighty years. See also R. Dodd (2007) for illuminating details on this chain reaction. 15) A good summary and critical discussion of the major Basel III provisions can be found in A. Blinder (2010) 16) The original discussion of the debt-deflation spiral can be found in I. Fisher (1933). When it comes to analysis of financial-crisis dynamics, there is no better than Post-Keynesian economist H. Minsky (1982, 1986). 17) America’s conclusive investigation of the financial crisis will be published at the end of 2020 by the bi-partisan Financial Crisis Inquiry Commission. Until then see the interim report by the Congressional Research Service (2009). Britain’s Turner Review (see A. Turner, 2009) and the European Union’s De Larosière Report (2009) marked equally important contributions to the post-crisis debate surrounding financial re-regulation. 18) For a good summary of alternative, progressive banking arrangements see the Wikipedia entry on cooperative banking (en.wikipedia.org/wiki/Cooperative_banking).

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