Publicat în 12 iunie 2013, 19:26 / 264 elite & idei

Daniel Dăianu – When economic models crumble: A template for rethinking them

Daniel Dăianu – When economic models crumble: A template for rethinking them

By Daniel Daianu

As the effects of the 2008 economic crisis still linger on, Romania’s former Finance Minister Daniel Dăianu suggests 10 financial models that are ready for change because otherwise they are likely to succumb to external pressures.

The economic crisis has brought enormous strain to Europe and the whole world. Healing will take quite a while, for much is damaged and adjustments and repairs at macro and micro level are time consuming. The crisis also challenges the models so many organisations, big and small, private and public, have relied on. Much of the rethinking of models is induced by the role played by finance in this crisis. Rethinking of these models will be forced on them by outside pressures and this article sets out ten of them that are ripe for change.

1. Reform of the regulation and supervision of financial markets 
The light touch regulation model has brought havoc to the financial industry. Business models have proved massively inadequate with their overemphasis on trading and speculation, the use of fancy (and often toxic) derivatives and their neglect of risks. Regulators and supervisors succumbed to the reasoning that a low inflation rate is equivalent to financial stability and that the spread of derivatives was a means for diminishing risks. Instead, we ended up with rising inter-connectedness that along with the consequences of light touch regulation has crippled robustness and resilience. Systemic risks have skyrocketed, compelling central banks and their governments to rescue banks to avert financial meltdown.

The overhauls of regulation and supervision of financial markets now underway show that an integrated model (like in the UK) was not superior to sectoral, or “twin peaks” models that distinguish between macro-prudential oversight and the supervision of business conduct. Contagion was favoured by the break-up of Chinese walls between investment and retail operations and by increasing cross-border transactions, but what in the end brought all these organisational patterns into disrepute was the blatant misunderstanding of risk – as the latter were entailed by expanding financial markets. The problem, therefore, is to deal with the very object of regulation and supervision and, consequently, tame financial markets.

2. Revision of financial organisations’ business models 
Not long ago, many extolled the virtues of large and integrated entities able to provide a wide-range of services and engage in all kinds of operations. The mood changed once the present crisis erupted. Not only is “too big to fail” (and “too big to save”) a formidable challenge to governments and central banks, but complexity and size itself are a challenge to management. Complexity and size are not a given, and they should be dealt with in order to enhance the robustness of organisations, of economies. More simple and smaller organisations (by using anti-trust legislation and splitting large organisation, by ring fencing retail from trading operations) would be a step in the right direction, arguably. More own capital and less reliance on debt (contrary to the Modigliani-Miller theorem that where capital comes from does not matter), lower leverage, rules that prohibit the use of depositors’ money for the own trading of banks (the Volcker rule) would contribute to making systems more robust. The démarche to align incentives and to limit pay, to link it with performance and the interests of shareholders is part of these reforms. Bailing in creditors in moments of difficulties does make sense, but not at the expense of weakening governments’ promise to make good on insured deposits. To relinquish this promise would send banking and economies into the wild.

3. Risk modelling needs to change      
Risk modelling by banks and other financial entities’ needs to be made more trustworthy and transparent. The current VAR (value at risk) enables banks to fudge numbers and assume too high risks. The way large banks have been fiddling with their risk positions and evaluations, with reporting to regulators, even years after the eruption of the crisis, is quite telling (J.P. Morgan’s treatment of its big trading loss in London comes to mind). This would suggest that Basel III, too, is overtaken by events and the very logic of VAR is weak. At the same time, it shows that misreporting to regulators, shareholders and investors is a serious challenge. This challenge goes beyond banking, for there are hedge funds, brokerage houses, etc. that were in breach of trust, that provided incorrect information and used their clients’ resources unlawfully. Compliance rules and supervision need to be strengthened in the financial industry.

4. More suitable cognitive models are needed
The present crisis is likely to be the great watershed and wake-up call telling us that quantitative models which underestimate tail events and rely on linearity are flawed. It appears that the golden boys, the “quants”, in building increasingly high octane models, had brought about unintended bad effects. They made their bosses turn a blind eye to the need to never put qualitative analysis, nose-metrics on the shelf. But this was clear since the LTCM (a hedge fund) episode, when the models concocted by two Nobel Prize laureates were made irrelevant by unexpected events. One can argue that what hedge and private equity funds use in their modelling is their exclusive business; that banks and insurance companies are in a different league, which would and should make them objects of public scrutiny and regulation when it comes to risk modelling. But hedge funds and other asset management funds, and the shadow banking sector in general, create systemic risks through operations that can be huge and can destabilise markets. Therefore, they too should be regulated and supervised. When it comes to the economy as a whole and systemic risks, financial stability comes prominently to the fore. Monetary policy is bound to pursue price stability, but this goal cannot be divorced from the stability of financial institutions. And even if overall financial stability would be under the oversight of a special body, central banks’ modelling would have to internalise it.

5. Downsizing the financial sector makes sense
Events in Cyprus have captured much attention, notably the attempts to work out and implement a bailout plan. Cyprus, like Ireland, Iceland and the UK, epitomises a fragile economic model. This model has favoured the expansion of finance, of the banking sector, at the expense of other sectors, which has resulted in an over-dependency on it. Once the crisis hit, the fragility of this model has come vividly into the open. A downsizing of the financial sector makes sense in not a few economies, though it will not be easy at all to achieve it. One reason is that this kind of adjustment is very difficult and painful. At the same time, because there are vested interests which would oppose it. The Cyprus episode of crisis fuels the discussion on whether tax havens (and off-shore banking) should be accepted in the eurozone (in the EU), worldwide, apart from money laundering and tax evasion considerations.

6. Economies need to be more balanced to enhance their robustness and resilience
Another model under question is linked with insufficient attention paid to tradable sectors, to external imbalances. This model relies on the tenet that markets know best and their failures are negligible. The boom and bust dynamics in the eurozone, some new member states, and in other emerging economies, indicate that public policy has a role to play in mitigating destabilising capital flows and in enhancing better resource allocation. If that is possible under the rules of the single market is something to be seen because the free flow of capital has a key role in the European Union and EU level policies are quite weak in this respect (structural and cohesion funds are useful, but not a sufficiently powerful instrument). Some say that the downhill capital flows model has been validated in Europe in terms of economic convergence. This is the gist of a recent World Bank study (“Regaining the Lustre of the European Model”). And it is correct to notice that Spain, Ireland, Portugal have achieved substantial catching up after they joined the EU. Some catching up has happened with network management systems (NMSs) too. But this conclusion has, nevertheless, to be nuanced considerably. For threatening divergence in economic performance has taken place in the eurozone after the introduction of the euro. And boom and bust dynamics did happen in several NMSs, which has caused a major setback in their convergence trajectory. This remark is not meant to favour the uphill flow model, which has been practiced by Asian economies after their 1997-1998 crisis as a means to accumulate hard currency reserves and forestall shocks from outside. Instead, it is an invitation to see things in the wider picture of pluses and minuses of international finance, of the organisational and policy rules in the eurozone, and of the need to improve governance structures in the EU as a whole.

7. Globalisation may have gone too far, so corrections are needed
A study by McKinsey consultants notes a substantial reduction in cross-border financial flows during the crisis years. Some decry it as a sign of the reversal of globalisation, with a malevolent foreboding. But it would be, arguably, better to see it as a healthy phenomenon to the extent that we acknowledge that: a dangerous overexpansion of financial flows took place in many regions; that there are limits to openness (which is not the same as limiting an “open society”, in Karl Popper’s terms) and there may be an optimal degree of openness and of reliance on external supplies of goods and services (as a means to control vulnerabilities); that rediscovering home and closer to home markets is a way to regain robustness in view of the risks entailed by proliferating tail events and chain links disruptions, etc. If globalisation is unmanaged it puts reversal forces into motion; it may backtrack as open international regimes did at the end of the 19th century and in the interwar period of the 20th century, with spreading protectionism and the formation of rival commercial alliances

8. Models of economic integration need re-thinking
This is particularly true in Europe. The eurozone crisis provides plenty of evidence that its design and policy arrangements were and still are inadequate, that a one size fits all monetary policy should have been accompanied by a fiscal union from the start. The eurozone is, currently, more a single currency area than a monetary union and the way it operates is more rigid than the gold standard regime of the interwar period, in spite of the existence of automatic stabilisers. We know where that international policy regime has led to. Therefore, we should be quite worried about the eurozone crisis. It is fair to remember that not just a few economists were warned, before its inception, that its sub-optimality as a currency area was a major weakness of the eurozone. But more to blame are its design and policies. The banking union may be an exit out of the current troubles to the extent fiscal arrangements are mended and a fiscal capacity (as Herman van Rompuy put it) will come into being. But there is too much procrastination and lack of resolve to move on all fronts in order to achieve this union. Without it, it is likely that the European project will be crippled further and exits from the eurozone will happen.

9. The relationship between governments and society needs to be repaired
The current crisis in many countries has entailed a rejection of traditional policies, the rise of extremism and an erosion of the social contract. All this is demanding an overhaul of public policies, a redesign of the relations between the public and the private sector, the fostering of more individual self-reliance simultaneously with measures to preserve social solidarity and a sense of fairness. Democracy can be undermined as a societal model by the disconnection between politics and citizens and the distortions caused by the over-expansion of finance, and thus a simplistic economic paradigm that sees public policy and the public sector as a nuisance. Whenever income inequalities become excessive, social strain takes its toll; and this can happen both in democracies and in more authoritarian forms of capitalism.

10. Revisiting the rules and institutions of the international regime is a “must” 
The rules of the international regime should also be overhauled. When the IMF, which years ago was a staunch promoter of unimpeded capital flows, makes a turnaround and says that capital controls may be useful, one needs to pause. Students of finance and international relations know that to achieve simultaneously exchange rate stability, free capital flows, and monetary policy independence is an impossibility – the so called “impossible trinity”. The experience of the eurozone shows that the relinquishing of monetary policy by member states needs to be accompanied by fiscal integration.

In world finance, it may be the case to revisit the Bretton Woods arrangements for the sake of preserving a relatively open trading system. And this can happen provided financial markets are tamed. The Financial Stability Board (FSB), the Bank for International Settlements (BIS), specialised public institutions in the U.S. and the EU, the BRICS as major voices in G20, can all play an essential role in this respect. The governance of the IFIs should heed more the concerns of the emerging economies, and this should be reflected by their governance structures. Big players in the global space must be made aware of the externalities that their actions produce.

Daniel Dăianu is a former Finance Minister of Romania

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