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Time for New Rules

7 May 2010

We are publishing From Crisis to Recovery, a new book from the OECD Insights series here on the blog, chapter-by-chapter.  This book traces the roots and the course of the crisis, how it has affected jobs, pensions and trade, while charting the prospects for recovery.

These chapters are “works in progress” and their content will evolve.  Reader comments are encouraged and will be used in shaping the book.

Is there – to misquote William Shakespeare – something rotten with the state of capitalism? In the wake of the financial crisis, many people seem to think there is. According to a poll commissioned by the BBC World Service of people in 27 countries, only around one in ten believed capitalism works well. In just two of the surveyed countries did that number rise above one in five – 25% in the United States and 21% in Pakistan.

Unhappy as people were, the poll showed little appetite for throwing out capitalism altogether – fewer than one in four supported that notion. But people do want change – reform and regulation that will check capitalism’s worst excesses.

That view is shared by many political leaders. In 2009, Germany’s Chancellor Angela Merkel and the Netherlands’ then-Prime Minister Jan Peter Balkenende argued that “it is clear that over the past few decades, as the financial system has globalised at unprecedented speed, the various systems of rules and of rules and supervision have not kept pace”. In the United States, President Barack Obama declared that “we need strong rules of the road to guard against the kind of systemic risks that we’ve seen”. In the United Kingdom, Prime Minister Gordon Brown said that “instead of a globalisation that threatens to become values-free and rules-free, we need a world of shared global rules founded on shared global values”.

But what form should those rules and values take? How can we best harness capitalism’s power to deliver innovation and satisfy our material needs while minimising its tendency to go off the rails from time to time.

This chapter looks at some of the themes that have emerged in reform and regulation since the crisis began, focusing on three main areas:

►Regulating financial markets

►Tackling tax evasion, and

►Creating a “global standard” for ethical behaviour

3 Responses leave one →
  1. Max Kummerow permalink
    May 10, 2010

    One insight worth mentioning is that it is entirely rational for lenders (and insurance companies) to cut prices and underwriting standards to increase market share in good times. That is the way to make money. However, that “unsound drives out the sound” dynamic ensures that eventually there will be a crash. During which the opposite strategy becomes rational. So countercyclical policy should tighten up bank capital requirements as booms progress and asset prices rise.

    Secondly, it is important to understand the concept of insurable versus uninsurable risks. Credit default swaps to a significant extent, aim to protect investors from systemic risk. This is not an insurable risk. So swaps are really an abuse of strong balance sheets (or outright fraud if not backed by strong balance sheets). So I think it would be wise to simply outlaw them. It is hard enough to price risk first hand. Trying to price risk second on third hand is simply impossible. The failure of ratings agencies and the willingness to peddle trash as treasure conclusively prove that there are no fixes for transactions that simply can’t be priced by the parties involved. Clearly the shadow banking system needs capital requirements to prevent undue risk taking and leverage. Reinstating Glass-Steagal would be a very good idea.

    The next step, of course, now that government is the lender of last resort and source of liquidity for the private sector, is that the government will fail. When that happens, there will be considerable wailing and knashing of teeth. The historical experience to look at is Argentina and Japan. The U.S. is headed towards a fiscal black hole (where taxes can’t be raised enough to pay interest) where default or hyperinflation are the only options.

    All the other things you mention are important too–bankers paying themselves too much, etc. The chapter on Warren Buffet’s frustration with the culture of Salomon Bros. in his biography is quite interesting in that regard.

  2. May 17, 2010

    Rules may not be enough. We may have to go further into the basics of the impact of the superstructure of investment finance on the transaction costs in the real economy, and the ability of elected governments to regulate within the election cycle. So far, U.K. seems to be on the right lines in terms of thought, but action is still far away.

    In other words, utility banking must be separated from ‘casino’ banking, and the latter publicized as such, with lots of small casinos networked together to provide the requisite leverage that the participants need. And then, fiscal policy and economic regulation to be separated from politics. Again, easier said than done.

    Goal: Investment must carry unhedgable risk, and the ultimate price of bad risk should be the liquidation of the firm without any adverse affects on anyone but the risk-takers.

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