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Time for a new paradigm

A number of well known and respected economists, central bankers and commentators are starting to call for a complete re-think of Western economic and financial policy. The US and the Eurozone have chronic deficits and tiny interest rates, yet despite such stimulative fiscal and monetary policies, both areas are facing the very real possibility of a double dip recession.

A recent paper by Andrew Haldane, Executive Director of the Bank of England’s Financial Stability division puts it down to psychology. He says, ‘Memories of financial disaster are now fresh, as after the Great Depression, causing an over-estimation of the probability of a repeat disaster. In these situations, psychological scarring is likely to result in risk appetite and risk-taking being lower than reality might suggest. Risk will be over-priced. Today, the very disaster myopia that caused the crisis may be retarding the recovery.’

He continues, ‘As long as aversion to risk-taking is causing financial congestion, growth will remain sluggish. The public policy question, then, is whether anything can be done to allay the fear factor, speed the repair of balance sheets and stimulate risk-taking. With fortuitous timing, there is a new tool in the box, a third arm of macro-economic policy. This is so-called macro-prudential policy. As its name implies, this policy tool is intended to meet macro ends using prudential means.’

Richard Fisher of the US Federal Reserve recently said something similar, noting, ‘Non monetary factors, not monetary policy, are retarding the willingness and ability of job creators to put to work the liquidity that we have provided… Those with the capacity to hire American workers – small businesses as well as large, publicly traded or private – are immobilised. Not because they lack entrepreneurial zeal or do not wish to grow; not because they can’t access cheap and available credit. Rather, they simply cannot budget or manage for the uncertainty of fiscal and regulatory policy…

In his blog, Paul Mason, the editor of the BBC’s influential ‘Newsnight’ programme, sums up, ‘There is, in short, a zombified situation well known to small businesses and households. Nobody wants to spend, or invest because they cannot predict the future.’

The result of the continuing fear factor is that throughout the Western world, whilst large corporations and fund managers are stuffed with cash which they are not investing in growth, other, smaller companies, which would like to grow, are suffering a credit shortage. It is the cash piles of large, cash rich companies and funds that are piling into Treasuries, gilts, gold and Swiss bank accounts – looking for safe havens and risk aversion.

At least to some extent, the way to encourage renewed growth therefore seems to lie in once more encouraging banks to take risks – but that of course goes against the increasingly prudential capital and liquidity requirements being put in place by the Basle committees as well as individual nations.

Haldane suggests that one way of encouraging risk taking is through regulation such as a counter-cyclical capital buffer for banks, based on deviations in the ratio of credit-to-GDP from its long-term trend.

Mason goes much further. He speculates that we are close to a ‘Minsky moment’ with Hyman Minsky’s work potentially containing the kernel of what a twenty-first century structural change might look like.

He says ‘Minsky argued: socialise the banking system, rip up regulation for the private sector non-financial economy so it can grow, and abolish welfare, making the state the employer of last resort but forcing the unemployed to work.’

He continues, ‘By socialise, he meant: reduce banks to the basic function of collecting and lending the savings of the population, in a variety of non-speculative businesses. Today that could be mutuals, nationalised banks, Landesbanks, credit unions etc. The difference between this and Glass Steagall is that you actively discourage the existence of a financial speculation sector.’

In a way of course, the massive government bail-outs of the banks by the tax-payers of the US and the EU in 2008 were nationalisations, but they were not socialisations in this Minsky sense.

The recent Interim Report by the Independent Commission on Banking, published in the UK in April 2011, pointed to the externalities and hence market failures of a purely private banking system.  ‘The failure of a systemically important bank which provides critical financial services and which is heavily connected to the rest of the financial system and the wider economy, has particularly high costs. Because not all of the costs of a bank’s failure are borne by its owners, creditors and managers, banks are likely to take on more risk than is good for society as a whole, unless their structure and conduct is carefully regulated… Banks will in general not act precisely in the public interest. Prudential regulation is intended to bring the behaviour of banks more closely into line with what is best for society.’

This suggests that even the authorities are considering moving towards a Minsky solution, although they will be reluctant to call it socialisation.  

Another strand of policy that Haldane suggests is to communicate about risks to the system to better enable these risks to be priced. He says, ‘If risk is over-priced, and agents over-pessimistic, communicating that might help in correcting overshoots in risk appetite. That was precisely the role played by Roosevelt’s inauguration speech in 1933. It provided an alternative, more optimistic, popular narrative for financial markets. It aimed to reduce the risk of psychological contagion. It worked. Risk appetite and real activity recovered between 1933 and 1937. A more optimistic popular narrative might have a role to play in helping correct today’s market pessimism.’

Unfortunately, in today’s world, part of the market pessimism is arising because players perceive that the politicians are digging their heads in the sand, refusing to communicate the gravity of the situation to their voters, and refusing to grasp innovative solutions – relying on the old Keynesian and Friedman versions of fiscal and monetary policy that have evidently failed. Any major political leader who gives a speech saying ‘The country is fine and I am revising up our growth forecasts – you all just need to believe me  and go out there and borrow, invest, spend……’ is likely to face a very rough judgement.