Greece will not be fixed by populist measures
By John Plender
Published: February 23 2010 17:01 | Last updated: February 23 2010 17:01
In pondering their responses to the financial debacle, policymakers would do well to heed the wisdom of the American writer HL Mencken. For every problem, he said, there is a solution that is neat, plausible and wrong. Sure enough, neat solutions abound, as politicians on both sides of the Atlantic demonstrate an unerring capacity to address symptoms rather than causes.
First, consider Greece. Of course the country has been a fiscal bad boy and is a prize candidate for a welter of economic reforms. Yet to argue, as so many German politicians do, that the difficulties of such southern European countries can be solved by a stringent dose of fiscal austerity and the equivalent of an International Monetary Fund programme is plausible but utterly wrong.
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All these countries suffer from poor cost competitiveness, exacerbated by the overvaluation of the euro. What they need is more external demand for their goods and services while they try to address problems of fiscal excess and overblown unit labour costs.
Yet much of northern Europe, with Germany in the lead, seems to think it can continue with its structural savings surplus and export-led growth model while Portugal, Italy, Greece and Spain are throttled. Not only is this a recipe for eurozone stagnation. The real return on the savings they plough into southern Europe will probably be negative. Indeed, one of the striking historic features of the German balance of payments is how mountainous trade surpluses have delivered mouse-like or negative returns on the resulting foreign investments. Expect lower trade surpluses and worse returns.
Then there is the natural post-crisis enthusiasm for blaming and bashing private bankers and regulators. As I argued here on January 19, this misses the more important target of central bankers. The really powerful underlying causes of the crisis are global imbalances and an asymmetric approach to managing interest rates, whereby policy is loosened when asset prices plunge but policymakers remain indifferent to asset price bubbles until they burst.
Bankers’ bonuses are probably the area where self-deception and simplistic remedies are most in evidence. In the days of yore when the Bank of England was still in charge of UK banking supervision, novice supervisors were encouraged to ask whether bankers really knew where their profits were coming from. Too few have lately asked the old-fashioned supervisors’ question.
As Andrew Haldane of the Bank of England has pointed out, bank profits ceased in the mid-1980s to be boring as the banks appeared to have discovered a money machine. While the return on assets, which reflects management skill in extracting profits from a pool of assets, was mediocre, the return on equity, powered by luck and leverage, soared. At the same time, larger polygamous financial institutions were allowed by the Basel capital regime to run with lower capital buffers than their smaller monogamous partners. Now this bias in favour of size has been made worse by crisis-induced mergers.
We are left with a financial system in which over-leveraged banking behemoths operate as an off-balance sheet adjunct of the public sector, while nurturing many profit centres that are increasingly oligopolistic. In wholesale finance, super-profits are generated by a handful of giants in opaque over-the-counter markets. In retail finance, there are numerous areas where oligopoly and customer inertia underpin excess profits.
It follows that bankers in the boom were being paid bonuses not for brilliance but for excessive risk taking via leverage and for oligopolistic super-profits. Now they have been offered a state safety net and a steep yield curve, whereby they borrow at low cost to invest in higher yielding assets. This guarantees easy, low-risk profits, on which they nonetheless expect bonuses.
There is a populist clamour to whack bonuses with arbitrary caps. But the lesson here is that if bonuses were adjusted for risk, they might cease to be politically controversial, or even cease to exist. A more fundamental point is that if greater competition were introduced into the industry both the problem of conglomerates that are too big or too interconnected to fail and of big bonuses would become an irrelevance.
The causes and ramifications of this crisis are complex. Inevitably, many of the remedies will be too. A tougher capital regime will be the single most important component of the response to excessive size and excessive risk taking. And any attempt to tinker with bonuses and incentive structures must address the asymmetry whereby traders, managers and shareholders have limited potential for loss and unlimited potential for gain.
None of this will be neat or high in populist plausibility. To misquote another American sage, too bad the only people who know how to run the economy are busy driving cabs and cutting hair.
John Plender is an FT columnist
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