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10 proposals to rebuild finance and monetary macroeconomics

Rethink monetary policy and its objectives, reform our accounting and prudential environment, review the return on equity standards, regulate the prices of certain assets...

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It is time to redefine the terms of our economic system and its functioning, but also question a number of tenets in the financial markets industry. This is 10 proposals to rebuild our economic and financial environment.

We are all inundated with articles, records and speeches explaining the solutions to overcome the crisis and the necessary and sufficient conditions for the establishment of balanced growth and sustainable development.

What we want to write here, is that before proposing solutions to crisis (often by those people who were in charge of economic and political duties and have never seen anything coming and never been able to resolve anything), it is time to redefine the terms in which our economic and financial system will take place but also questioning about a number of dogmas in the financial markets and the conduct of economic policy.

To this end, we present in this paper (and we’re not the only and first to do so) 10 proposals to reestablish our economic and financial environment.

1. Put in place mechanisms that can deal with a solvency problem, not just a liquidity problem

If one refers to the current crisis in the Euro zone, this means that the insolvent countries in the Euro area are in this situation because their economic expertise cannot generate any external surplus (no specialization in the export industries, but economies exclusively specialized in non-exportable services); the public or the private sector or both are therefore structurally indebted.

By setting up solutions to maintain liquidity, the crisis is just delayed in time. It is therefore necessary to rethink about the solutions to end the crisis and consider structural issues: Policies aim to improve the potential growth (long-term issue); Implement a true fiscal federalism (politically difficult); Debt restructuring or partial defaults (to minimize systemic risk); Exit from the Euro Zone for some countries (electorally rewarding, but economically suicidal)

I am preparing a study on this subject by recalling some historical experiences of restructuring and some sovereign defaults of the past twenty years and by learning from them, to understand the current crisis of the weak countries in the Euro Zone.

2. Question the monetary policies promoting moral hazard and thus removing the responsibility of investors

It will therefore end the indiscriminate funding of mismanagement and poor management. It will empower investors, all investors rather than constantly seeking the taxpayer, which means that we must question the existence of a lender of last resort or even a buyer of last resort, in order to help many investors understanding that best is to invest with their eyes opened, and not because the ratings about the investment assets are claimed quality investment grade or because the market consensus are positive.

The best illustration of investors disempowerment was the securitization, at least the way it developed in 2005-2007 (with a lot of leverage and unnecessarily complex arrangements). Indeed, this period has led banks to be less and less cautious about the credit risk when the asset is transferred since it was almost done systematically. The decoupling between the credit originator and the counterparty bearing the risk has significantly reduced the incentive for assessing and monitoring risks

3. Redefine what is commonly called inflation targeting central banks

Remember the lessons of the crisis is a way to rethink and redefine the fundamental missions of a central bank, which leads us to reject the ultra-accommodating monetary policies of the FED and the BOE, but also at the other end, the too dogmatic character of the ECB.

We had finally lived the idea that the credibility of central banks had been strengthened and that the consequences were a sharp reduction in the variability of business cycle: growth, inflation, interest rate. All means to stabilize the expectations of economic agents and thus create conditions for sustainable growth. In fact, it was only illusions as there was a delay in the variability of the assets prices with excess liquidity and the repeated crisis associated with bursting of bubbles in asset prices.

It will therefore be about reviewing and improving the traditional inflation target for the prices of goods and services:

  • Need to add new objectives (credit, asset prices and we will come back to this point in the fourth proposal)
  • The fact that central banks have solely watched the inflation have led since the late 1990s to more accommodative monetary policy and therefore to lower rates for a long period, with the consequences we know: bubbles in asset prices, excess debt.
4. Fight as much against the overvaluation of assets as against the undervaluation

- Regarding the undervaluation : this amount to setting goals to address during certain periods destabilizing dynamics of price formation on the assets traded in the markets: forced asset sales related to accounting constraints, prudential and regulatory requirements.

- Against the overvaluation: it is known that excess liquidity generates bubble and disconnection between the growth of the real economy, and the financial assets prices developments.

This proposal is therefore in line with proposition 3, since this means that central banks have among their objectives the control of financial assets prices (and not solely the prices of goods and services).

In any case, we would like the investors do not buy financial assets at inflated prices and do not maintain bubbles and thus the risk of solvency crisis for these players when the prices of these assets will correct violently.

It is true that it is quite complex to define what may be a high price and no one is omniscient enough actually to do so. There is also the risk of moral hazard that could disturb the more or less balanced daily activities taking place in the markets, and also taking responsibility away from unwary investors (see proposition 2)

It is however necessary that these imprudent behaviors do not destabilize the financial system and hence the real economy.

Therefore (regulator or central bank) regarding certain asset classes and instruments, overvalued areas must be clearly defined: for example, credit spreads unrelated to risk premium.

It is also necessary (regulator or central bank) "to get rid" the markets of overvaluation disconnected from fundamentals, which requires a development of certain prudential and accounting rules (we will talk it during the presentation of the proposal 10)

5. Use several types of instruments beyond the setting of key rates to ensure financial stability

- Asset purchases (to change the interest rate on long-term loans for example, or the price of some financial assets), which means a quantitative or qualitative easing with a constraint stronger than what has been practiced since 2009: supervision of these actions in terms of growth in money supply, thus implementing the so-called partial sterilization of money creation

- Use of reserve requirements (both on deposits than loans), an instrument widely used today by the Asian central banks.

- Establishment of a ceiling for the famous loan-to-value ratio for mortgage in order to limit credit risk in case of housing market downturn.

In the same vein, establishing a ratio of Debt service / income, which should avoid granting loans to customers with poor credit rating. Indeed, we remember the subprime crisis. The crisis involved a segment of the U.S. housing market for a few creditworthy customers on which the system worked on the basis of floating rates with a guarantee indexed on the property financed. This was ideal when the two conditions were met : the continuing rise in the housing markets with interest rates kept permanently at low levels; that one of these conditions and the beautiful building collapsed.

- Monitoring of some ratios and limits of banks’ balance sheets (capital requirement ratio, size of the borrowed resources and levels of interest-rate gaps and liquidity)

- Monitoring of excessive risk-taking to restore profitability of capital. if they retain the same requirement regarding the return on equity as it was established before, many financial intermediates will choose the riskiest assets, for the same capital consumption.

6. Strengthening the international monetary cooperation by setting up new indicators

We envision two types of indicators:

- Implementation of a measure of growth in money supply at a "global" scale so that the individual decisions of central banks leading to a global excess of liquidity does not disrupt the effectiveness of monetary policy to other central banks

- There is no international organization that protested when the exchange rate policies of countries are clearly non-cooperative (China, United States, United Kingdom...)..

For example the FED quantitative easing creates liquidity, which will certainly fund the U.S. debt but will also invest in emerging markets assets (currencies, bonds and stocks) and commodities; the planned depreciation of the dollar and the appreciation of emerging currencies have led central banks in Asia to create its own liquidity by issuing the national currency to be sold against the dollar (emerging competitive forces). These currencies such as Euro, which play the role of adjustment variable via an appreciation beyond what the area economy cannot support. It is necessary to use all the power available in France in particular and Europe in general to define stable exchange rate while being flexible

7. For a better prevention of systemic risk

The supervisory authorities should conduct a real supervision macroeconomic policies of countries and establish indicators of systemic risks to the macroeconomic precisely.

Central banks must be able to play a major role in managing stress tests applied to the banking sector with the establishment of simultaneous unfavorable scenarios in terms of macroeconomic risks:

  • Sharp drop in GDP
  • default rates of borrowers
  • inverted yield curve
  • violent upturn or downturn of financial and housing assets
  • Erratic and non cooperative change in exchanges rates

The main objective is to make the link between macroeconomic systemic risk and banking systemic risk, which has never been truly realized.

8. Redefine the objectives the profitability of banks' capital by considering better the reality of the growth potential of economies

On these issues, central banks also have an enormous responsibility: Prevent banks from increasing risk-taking, most of those risks being useless to finance the economy, seeking against all odds to maintain a shareholder return excessively high.

We must therefore review the requirements of return on equity that have led to excessive risk-taking, with the introduction of highly leveraged strategies and the emergence of financial innovations poorly controlled.

9. Stabilize the liquidity situation of banks

In order to stabilize the liquidity situation of banks and avoid the race for deposits and panic which could penalize the interbank market, we agree with the proposals of many economists on the establishment of a generalized system of assurance to all bank resources (this will secure the investments of investors and promote stability of bank liabilities).

Funding for this system could be easily provided by the establishment of an appropriate tax credit.

10. For a smarter accounting and prudential environment

It is imperative to review the accounting (IFRS) and prudential (Bale3) standards too pro-cyclical

First, we know that changes in asset prices destabilize the economy through wealth effects. So why should they not simply give up the mark to market for some markets supports and for some market participants ?

Second, it is necessary to limit the importance of certain positions in certain complex and illiquid financial assets by penalizing them for example in terms of capital or reserves requirements. This naturally means restricting certain speculative positions that are not related to fundamentals and destabilizing the market prices

Third, regulators must be able to know exhaustively the detailed structure of the investor’s portfolios (and especially the understanding) and in addition they should have a correct vision of what are approximately the "fair" value for several financial assets (the markets are not better on this subject when we see the monstrous errors of pricing on several financial assets in recent years). admittedly the regulator should not be operating on the markets and if we can only agree with the idea of separation of functions between the market and its regulators, it is important to avoid the division between knowledge and skills.

We know that many recent crises on the markets have been complicate do manage precisely because of complexity of growing techniques and financial instruments (second generation option, securitization-based derivatives, leverage in CDO structures...). And especially because the structure engineer in the markets was a step ahead of the regulator (in other words the regulator was one step behind). It is time to put an end to these mismatches.

Mory Doré , June 2011

Article also available in : English EN | français FR

See online : Mory Doré’s column

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