2. The Role of the Financial System

Atif Mian

There is a story we like to tell about the role of finance, and it goes as follows.

Ordinary people save out of their incomes but do not have the time to deploy these savings into productive investments. So they turn to financial firms such as banks that specialise in the ability to hand over the savings to productive entrepreneurs. The entrepreneur makes a healthy profit on average and shares the proceeds with savers and bankers. Thus everyone wins and lives happily ever after.

It is a feel-good story about finance and its role in the economy. But is it true?

There is no doubt that elements of the story are real. For example, at the start of 2020, U.S. banks had lent 2.35 trillion USD to firms as “commercial and industrial loans” to be utilised in the business of production. However, this traditional role of finance has been playing an increasingly shrinking role over the last few decades.

For example, total lending in the United States amounted to a whopping 47.4 trillion USD in the start of 2020. A relatively small fraction of it was used to finance productive investments of the sort we tell in our traditional story. Most of the outstanding lending, or debt, was used for non-productive purposes like financing consumption. And the share of debt used for non-productive purposes has been rising over time. Not only is the standard narrative about finance an inaccurate portrayal of reality, but it is becoming an increasingly irrelevant one.

So what is going on with finance? Since 1980 there has been a massive expansion in the U.S. economy’s dependence on finance. Total debt was 142 percent of national output in 1980, and rose to an unprecedented 254 percent of national output by 2019. If all this additional credit were to be used for productive investment as the traditional story goes, we should have seen an explosion in investment. Instead investment share of national output declined from an average of 24 percent during the 1980s to 21 percent during the 2010s.

The story of the rise in finance despite stagnation in investment can only be understood in light of arguably the most important “structural break” in American society: the rising share of income going to the top 1 percent. Economists Thomas Piketty, Emmanuel Saez and Gabriel Zucman estimate that the post-tax share of income going to the top 1percent rose from 9 percent in 1980 to 15 percent in recent years. In a new working paper (Mian, Straub and Sufi (2020a), we show that the rise in inequality naturally leads to an expansion in finance because the very rich tend to save a much larger fraction of their income.

Distributional national accounts combined with consumption data show that saving by the bottom 90% of the income distribution has fallen significantly since 1980 while saving of the top 1 percent rose. We show that the financial sector intermediated this process by channelling the additional saving by the top 1 percent as household debt to the bottom 90 percent till 2008. Since 2008, the saving of the rich has increasingly been used to finance the expanding fiscal deficit.

The broader picture that emerges from this analysis is that the traditional framework of “saving equals investment” can be misleading. If investment at the macro level is not responsive to increasing availability of credit and lower interest rates, finance must find alternative mechanisms to absorb additional savings. In the past, this has happened through increased borrowing by households and governments for generally consumption purposes.

However, there is a natural limit to how far this process can go. Borrowing for consumption purposes is “non-productive” in the sense that it does not generate additional return. Hence in the absence of sufficient income growth for the borrowing population, interest rates must continue to fall in order to keep debt servicing manageable and enable borrowers to borrow more. The trouble starts when interest rate gets close to zero and it becomes harder to push on this mechanism further – at that point the economy might fall into a recession or a long period of stagnation. There are increasing signs that the global economy is suffering from such a problem.

All this raises some very important questions for researchers. How should we change our macro-finance models to better incorporate the key fact of increasing funding of non-productive demand side by the financial sector? How are structural forces such as inequality and the rise in finance related? This calls for explicit modelling of where the supply of savings comes from and the various investment and consumption margins that might facilitate absorption of these savings.

Another very important related question is figuring out why investment has not responded to both the greater availability of credit, and the large fall in long-term interest rates. Should this be seen as a “failure of finance”, or is it driven by a lack of investment demand? Finally, an expanded view of finance, that opens up the possibility that a large share of finance might be used to fund non-productive spending, has important implications for tax policy, fiscal policy and monetary policy. We discuss some of these issues in Mian, Straub and Sufi (2020b), but there is a lot more that deserves attention.

Mian, Atif; Ludwig Straub and Amir Sufi, 2020a. “The Saving Glut of the Rich and the Rise in Household Debt”, working paper.

Mian, Atif; Ludwig Straub and Amir Sufi, 2020b. “Indebted Demand”, working paper.

Jean-Claude Trichet

With the benefit of hindsight, we can see that the crisis resulted from the interactions of at least five features of the world economic system. First, the extreme sophistication of financial instruments and the development of securitisation, the generalisation of derivative markets, the rapid growth of shadow banking, and the emergence of highly-leveraged institutions. We had a new financial environment that was very obscure in many respect and very difficult to decipher.

Second, we had increased interconnectedness between all financial and non-financial institutions, enabled and encouraged by the advance of information technologies, giving rise to new, untested properties of global finance. At the same time, we had what appears to be strange now, a sentiment of excessive tranquillity and confidence both in the public and private sectors due to sustained growth (even at a low level) with low inflation.

Third, we believed that were justified to speak of a Great Moderation, a permanent reduction in the volatility of business cycle fluctuations thanks to institutional and structural change.

Fourth, and linked to the Great Moderation, consensus in the international community on the efficiency of markets in almost all circumstances, justifying large deregulation. The belief that the financial system could never be far away from a single optimal equilibrium. This implied that the possibility of multiple equilibria could be neglected by market participants.

Fifth, generalised excess leverage was totally neglected by the international community before the crisis.

The first two reasons are forgivable. It was hard to capture the emerging properties of the new world until the crisis came as a kind of stress test. What is unforgivable was to be that calm when we were accumulating so much debt. And we are still vulnerable, perhaps more vulnerable at a global level today than we were in 2007 if we look at global debt to GDP ratios.

The major response to the crisis was unconventional quantitative policies, quantitative easing and the like. At the European Central Bank (ECB), and elsewhere, we had to accept that we were in an extraordinary situation. These measures were designed to combat directly, and very aggressively, a crisis creating a major disruption of all markets. That had nothing to do with the level of interest rates. It was because the markets themselves were signalling an absence of functioning. The specific actions in the United States and Europe were different because of our different financial structures. In Europe, we focused on the banks. In the United States around 75 percent of the economy was financed through markets and only twenty-five or twenty through banks, so the Fed had to provide liquidity massively to financial institutions. One consequence of the crisis could be the idea of maintaining permanently the capacity of public authorities to substitute when needed for the private sector.

A striking feature of this response to the crisis is the acceptance that you have measures that are off-balance-sheet for central banks. Telling commercial banks you can have all the liquidity you need provided you have the eligible collateral means that there is an implicit off-balance-sheet commitment of the order of four trillion euros, the amount of eligible collateral. Only a small fraction is utilised, but the commitment is there and was so extraordinary that it was neglected by observers and market participants.

The crisis saw convergence of views on the role of central banks. Before 2007, the dominant school of thought was that banking surveillance should be independent, particularly of the central bank. During and after the crisis, it was accepted that the central banks could have good reasons to be at the heart of banking surveillance or close to it. The United Kingdom changed its approach, Europe gave this responsibility to the ECB, and the US Federal Reserve System’s important role was acknowledged. Convergence is not total, though, since it does not include Japan.

The second element of convergence concerns the prevention of systemic risks. Before the crisis, this was not seen as the very important concept it is now.

A third point is a change of view on monetary policy. It might seem bizarre ex-post that the dynamics of credit we are not considered important before the crisis. Nobody would claim today when deciding overall monetary policy that you can neglect the consequence on price stability of the accumulation of indebtedness.

Central banks have all converged towards much more active communication, and because of the crisis press conferences are generalised now. You have to explain tirelessly what you're doing and why you're doing it.

The last element of convergence concerns the definition of price stability. The central banks that issue four of the five currencies in the IMF’s Special Drawing Right have the same definition of price stability. This has consequences in terms of stability of the international monetary system when you have different medium and long-term real growth rates.

A final issue concerns not the crisis as such, but the tools that economics gave us to understand and deal with it. In 2010, I said that as a policy-maker during the crisis, I found the available models of limited help and that in the face of the crisis, we felt abandoned by conventional tools. As the crisis unfolded after the collapse of Lehman, the figures we had were demonstrating a collapse that was out of all the ranges of traditional modelling. The models were not showing us even approximately where we were.

New non-linear considerations have to be introduced into our models. I was impressed by the fact that some things I could see with my own eyes in the financial world and in the real economy were closer to phenomena you observe in physics than what you normally observe in economics. Dynamic stochastic general equilibrium models have difficulty in capturing phase transitions for example, such as the way spreads changed suddenly after the collapse of Lehman. It was not that the market was totally disrupted, it was that the perception of risk had changed overnight. It is clear, too, that the efficient markets hypothesis cannot be accepted ex ante in all cases. We could learn a lot from econophysics in these respects.

Is the financial system still vulnerable? The pace of additional leverage at a global level has continued as before the crisis, driven by the emerging economies. In an interconnected global economy, leverage is a vulnerability indicator as to systemic instability. Today, this indicator is not reassuring.

“10 Years after the failure of Lehman Brothers: What have we learned?” NAEC Conference, OECD, 13-14 September 2018, http://www.oecd.org/naec/10-years-after-the-crisis/

Thomas Coutts

Most are familiar with the concept of Peak Oil, the point at which we reach the maximum rate of petroleum extraction globally. The investment industry may be experiencing a peak of its own, in this case the point of the maximum rate at which it extracts value from its clients’ assets. Let’s call it Peak Gravy.

If such a peak is indeed reached and the investment industry sees its profits fall, we would regard it as unambiguously good. Such a comment may sound odd coming from a fund manager, but we have never held the wider investment industry in high regard. It seems to us that most funds’ fees are too high, most so-called investors’ time-horizons are too short, and most firms focus on their own interests rather than on their clients’.

The financial industry itself creates little of value. It is a facilitator, a lubricant for the economy, helping savers to earn a good return on their money and providing financing for investment opportunities, from the funding of a new car to the construction of a spaceship. Those of us who work within it should be humble about the role we play. Rather than “masters of the universe”, financiers should aspire to the sort of role in society described by John Maynard Keynes in his 1930 article, Economic Possibilities for our Grandchildren: “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”

That investment managers haven’t yet managed to reach the level of dentists has several causes. One is that investment strategies are to some degree seen as Veblen Goods – the higher the price, the better the quality – even though studies suggest this not to be the case. In addition, fees are typically struck relative to the level of assets under management. So while firms trying to win business will take risks, holding out promises of differentiation and genuinely active management in order to attract clients, once those clients have been won, the manager’s emphasis shifts to protecting what they have in order to hold on to the assets for as long as possible. The simplest way to do this is to avoid taking risk by staying close to the index. While doing so may minimise the likelihood of poor relative returns, it also, of course, minimises the likelihood of good ones, condemning many clients to expensive mediocrity in their investment results.

Perversely, the current structure of investment management fees leaves the manager’s reward guaranteed, at least for a period of time, and the client bearing the risk of an uncertain outcome. The rule of thumb seems to be that asset managers should reasonably share around a quarter of the gross value added above the benchmark return. In the isolated case of an individual firm managing to add value over the long term, that doesn’t seem excessive. But there is a fallacy of composition here: an approach that appropriately rewards one successful investment firm means at the same time that the active management industry in aggregate delivers returns after fees that fall short of the benchmark return.

The industry should, in my view, evolve to a model based on a low base fee, sufficient to cover costs so that an asset management firm can continue to invest during the inevitable periods when its results are poor, combined with a sliding, and capped, performance fee. The base fee might, for instance, be 20 basis points, and the performance capture a fifth of the total above 1 percent. Instead of the hedge fund industry’s infamous ‘two-and-twenty’ (an annual fee of 2 percent of assets under management, plus 20 percent of profits above a certain benchmark), we would end up with something closer to ‘point-two-and-twenty’, striking a far better balance between the interests of client and manager.

The costs that clients pay matter hugely of course, but only in the context of total returns – as in so much else, we need to make a clear distinction between price and value. At present, the investment industry in aggregate does a poor job and does it expensively; no wonder our clients’ focus has shifted largely to price. Like the US grocery industry in the 1960s when Sam Walton started Wal-Mart, there are too many people charging too much. There is a large pool of investors that just wants simple products at a low price, and they should seek out the investment equivalent of Wal-Mart. And there is a part of the market that is willing to pay slightly more for a significantly better product. Genuinely differentiated investment strategies that deliver long-term value for their clients should not be sold at discount-store prices.

It should be smaller. There are currently too many spoons in the bowl, too many managers extracting rent from the assets belonging to long-term savers. As in any other industry, firms offering me-too products or failing to add value for their clients should go out of business.

There should be a decent proportion of assets allocated to passive managers, who offer a low-cost benchmark for the active industry to beat. But the whole industry can’t go this way: at one level passive investing isn’t really investing at all, it’s buying cheap market access.

The industry should bear more of its own costs – and those costs should increase as it invests more in in-house corporate governance and investment research functions. Combined with lower fees this means it should become less profitable. The foot-dragging attempts by many asset managers to avoid paying for broker research themselves under the EU’s Markets in Financial Instruments Directive (MiFID II) shone an unflattering light on their approach to these things.

It should encourage positive behaviour at the companies in which it invests. The investment industry has explicit costs, but it also has hidden ones from the corporate behaviours that it incentivises. And these hidden costs may be even more damaging to society. The most damaging of these behaviours are short-termism, a fear of uncertainty, and a narrow focus on shareholder value. By acting as if the next quarter is more important than the next decade, the investment industry discourages companies from investing for long-term value creation. By emphasising shareholder value ahead of the interests of all stakeholders, companies risk losing their social licence to operate. This is not how capitalism is supposed to work.

And a plea in the opposite direction: if our societies are to continue shifting the responsibility for savings onto individuals, those individuals must be educated about the decisions they are taking and make sense of the deluge of information that at present serves only to confuse, not enlighten. Perhaps simple, clear investor education should be our next endeavour.

Logic dictates that alongside the greater emphasis on the way listed companies are governed we need to ask, ‘Who guards the guards?’, and scrutinise the governance, culture and motivations of investment firms themselves. The relationship between an investment manager and its client should be genuinely symbiotic; that it is currently seen as more parasitic in nature is a challenge our industry itself needs to address.

William Janeway

Not all bubbles are alike. The credit bubble of 2005-08 leading to the global financial crisis was radically unproductive. A mountain of leverage was built on a tiny amount of capital, so when asset prices declined slightly, the collapse in credit was extreme and starved the real economy of working capital. On the other hand, the 1990s dotcom bubble not only funded the building of the infrastructure of the internet, it also funded the first great wave of exploration of what to do with this infrastructure. When this bubble burst, the economic consequences were limited and contained within the scope of conventional policy. The critical factor was the relative lack of leverage by public market investors buying tradable securities.

Asset prices are backward looking and tell you something about what’s going on. They are also forward looking because they’re an inducement to action. The response to the price signal changes the signal, what George Soros calls reflexivity. That is fundamental in the financial market. But it leads to locally rational behaviour producing an incoherent systemic breakdown. The signature of a bubble is that the demand curve inverts and instead of demand declining as prices rise, demand increases.

Finance theory tells you that there is a fundamental value of every share, the expected net present value of the future cash flows. But as prices move, the arbitragers, the investors who are supposed to rationally know what that fundamental value is, don’t dare sell shares that are rising too high or buy shares that are falling too low because if they do it too soon, they’re behind the market. Then their investors will take their money away. Up until the 1960s, stock prices were twice as volatile as the underlying cash flows of American business. Since 1990, they have become six to ten times more volatile. The people managing other people’s money can afford to be wrong for a shorter and shorter time.

These volatile valuations in the market play a critical role in governing the flow of investment into the real economy. It’s a game where speculators and entrepreneurs respond to each other’s signals. The entrepreneur sees the speculator bid the price up and concludes that the speculator knows something about the future to take advantage of. Capital is becoming cheaper, so the entrepreneur invests. The speculators see that, think the entrepreneur knows more about the market than they do, and try to get in on the business. So the game goes back and forth, and is likely to be played more intensely during periods of intense technological or institutional change. Really risky start-ups may require a bubble to get funded at all, because only then are investors likely to believe that they can get a return even if it’s by selling shares to others before they have to find out whether the company is worth anything.

The bubble, by creating an environment in which risk-taking is rational, solves a co-ordination failure. If I’m invited to be the first round investor in your start-up and I know that you only want five-million pounds now but you’re going to need 25 million pounds to have a hope of getting a positive cash flow, how do I know there’s going to be the next 20 million or even the next 5 million behind me? In a bubble you stop worrying about whether there is going to be more money behind you. The co-ordination failure through time is eliminated. That is the functional role that bubbles can play at the frontier of the innovation economy. Some bets will fail, others will pay off. Most start-ups that were founded during the dotcom bubble at the end of the 1990s failed completely, but those that succeeded, succeeded very well.

This has been the case historically, too. Every decade from 1825 to the First World War saw some kind of maniacal bubble on the London Stock Exchange. These financed what would turn out to be highly productive core innovations such as the railways, but then London seemed to become vaccinated against speculating on risky new technologies. This may be why leadership in the innovation economy passed to the United States. Although most of new auto firms launched on the New York exchange soon went bust, some went on to become giants, just as PC firms would nearly a century later. Electrification is another illustration. During the 1920s, the mobilisation of capital overcoming that co-ordination failure led to massive investment in electrification in the United States. Electrification is an extreme example of the challenges to rational investors. It needs enormous capital just to produce anything, a flow of electrons. The marginal cost of the incremental electron is zero, similar to the incremental bit being moved across the internet.

If you have competitive conditions and prices move to marginal costs, the player with the most money wins because everybody else goes bankrupt along the way. They can’t service the debt incurred to build the generating plant or the distribution network to deliver a service whose marginal cost approaches zero. However, in a bubble, the first movers will win and during the 1920s, the hottest stocks were the new electricity companies. Before the frenzy ended 13 to 33 million kilowatts were installed and delivering electricity across the country, the way the internet now delivers bits.

The killer app of electrification in the home was radio. This leads us to the often-ignored role of the government in building platforms. The United States Navy and the Department of Commerce assembled all of the patents to fight what appeared to be British dominance through the Marconi patents and produced an American company, RCA, capable of winning. RCA became the dominant technological player over the course of 60 years, first for radio and then for television.

Billions of government dollars also played a major role in the great wave of innovation that started in the early 1960s. If you took money from the government, you had to license your patents even to your fiercest competitors at a fair and reasonable price. If you sold something to the Defense Department that mattered, you had to put a competitor into production. This was how national security trumped conventional economics, and arguably accelerated the computer revolution by a generation and created a reservoir of accessible technology available to entrepreneurs and the venture capitalists who backed them.

Even when they burst, productive bubbles leave a useful legacy. The infrastructure for e-commerce and rail transport still serve us.

NAEC seminar “Doing Capitalism in the Innovation Economy”, OECD, 24 May 2018 http://www.oecd.org/naec/events/doing-capitalism-in-the-innovation-economy.htm

NAEC seminar “Productive bubbles”, OECD, 8 February 2016, http://www.oecd.org/naec/events/productive-bubbles.htm

Simon Zadek

Financing the Sustainable Development Goals (SDGs) and the Paris Agreement commitments on climate requires trillions of dollars per year. Much of the finance needed will have to come from private sources, yet inadequate private capital is being deployed in ways that are aligned to these goals and commitments. Ample evidence exists that the financial system is out of step with its core purpose of ensuring that finance flows support the long-term needs of balanced, sustained growth. Policy and market failures were spectacularly in evidence as drivers of the financial crisis in 2008.

The Inquiry into the Design of a Sustainable Financial System was initiated by the UN Environment Programme in 2014, and completed its mandate in 2018, but many of its work streams will continue in other forms. The Inquiry aimed to shape a narrative that demonstrated the need for system change in finance in pursuit of sustainable development, echoing the experience coming from many countries, market actors and collaborative platforms. It looked at how to address policy and market failures and turn the global financial system around to deliver the financing needed to transition to sustainable development. It focused on the ‘rules of the game’ governing financial and capital markets, and therefore the roles of central banks, financial regulators and standard-setters, stock exchanges and the like.

In 2014, a sustainable financial system meant focusing on resilience to financial crisis rather than capital allocation aligned to wider environmental, social and economic goals. Now, a sustainable financial system has a more profound meaning –a financial system that serves the transition to sustainable development. Sustainability is becoming part of the routine practice within financial institutions and regulatory bodies. A growing number of commitments to action are being made, matched by the beginnings of the reallocation of capital.

Some take-off has happened in areas such as investment in renewable energy, green bonds, fiduciary duty and risk-based disclosure. But substantial lags remain in large parts of the system, for example, in housing finance, often the largest asset class in banking portfolios, and infrastructure investments. There has been a fourteen-fold increase in labelled green bond issuance from USD 11 billion in 2013 to USD 155 billion in 2017. Key to this growth has been the market-creating role of public authorities, including key development banks. Such progress needs to be set against the scale of the global bond market of around USD 100 trillion. On the other hand, divestments in carbon-intensive assets reached an estimated USD 5 trillion in 2016, versus around USD 710 billion investments in coal, oil and gas.

National action is critical, but some national plans catalyse, broader international action. For example, China’s “Guidelines for Establishing a Green Financial System” are the world’s most comprehensive set of national commitments, covering priorities across banking, capital markets and insurance; and the EU High-Level Expert Group on Sustainable Finance has laid the foundations for a comprehensive action plan on sustainable finance. The global number and range of policy measures to advance aspects of sustainable finance has increased. At the end of 2013, 139 subnational, national-level and international policy and regulatory measures were in place across 44 jurisdictions. Most of these were first-generation efforts to improve disclosure in securities markets and by pension funds. Four years on, the number of measures has not only doubled – to 300 in 54 jurisdictions – but the pattern of activity has changed, with a substantial rise in system-level initiatives, which now account for a quarter of the total.

There has been a striking growth in international initiatives to share experience, stimulate action and promote co-operation on key rules and standards, such as the recent formation of a network of some of the world’s leading central banks to contribute to fighting climate change. Other structurally significant initiatives include the Financial Stability Board’s private sector-led Task Force on Climate-related Financial Disclosures (TCFD) as an industry-led initiative to draw up voluntary guidance on reporting by business and financial institutions.

National priorities as a starting point for a wider wave of changes is more effective than blueprinting change in a more formulaic manner. For example, building a digital infrastructure for greater financial inclusion in Kenya has also enabled the more effective deployment of clean energy and improved access to health services. While the Inquiry focused on countries with larger, evolving financial systems, especially emerging markets, because of their desire to influence traditional international rule-setting institutions in pursuit of national development priorities, countries with only modest financial systems can be influential by virtue of their willingness to innovate beyond the norm.

Some capital is flowing to the new economy, but far more is supporting the old economy, through an inability or unwillingness on the part of owners and intermediaries to redeploy it. The next phase in sustainable finance will be about making the shift from acknowledgement to alignment. It will be multidimensional and non-linear. It will involve mainstreaming but also replacing the mainstream by new, better ways of doing finance. It will encompass a sense of purpose for the financial system matched by a decentralised model of delivery. All this will mean new performance metrics that measure the extent to which sustainability is really part of the process of finance as well as its outcomes.

The Inquiry’s work with the World Bank Group in producing the ‘Roadmap for a Sustainable Financial System’ enabled it to identify developments needed to accelerate the flow of sustainable finance. Some actions can be taken by market actors, such as disclosure, but even these may need policy or regulatory interventions to advance at scale and speed. Other measures require policy interventions in the broadest sense, which would include a combination of policy, regulatory, standard-setting, judicial and fiscal actions, often working in concert with, and supportive of, market innovations and broader developments. The Inquiry has helped to link the financial system with sustainable development. The evidence indicates the potential for a strong next wave of action.

NAEC Seminar “Inquiry into the design of a sustainable finance system”, OECD, 30 September 2015, http://www.oecd.org/naec/events/inquiry-into-the-design-of-a-sustainable-financial-system.htm

“Making Waves: Aligning the Financial System with Sustainable Development”, UNEP, 2018 http://unepinquiry.org/making-waves/

Angus Deaton

We should be careful not to confuse inequality with unfairness. It is the perception of unfairness that is driving populism, while some kinds of inequality seem acceptable. For example rags-to-riches stories seem to confirm that the American Dream can become a reality, even if the rising net worth and access to privilege of the person who succeeds contribute to inequality. To understand inequality, we have to consider the economy as a set of processes and policies whose interactions produce various outcomes, including inequality. Some of these processes are good, some are bad, and only by sorting the good from the bad can we understand inequality and what to do about it.

History shows that some societies with little or no inequality had little or no economic growth either, and it is possible to find examples of various combinations of high/low growth/inequality. In The Great Escape: Health, Wealth, and the Origins of Inequality, I show that periods of great progress are usually periods of rising inequality. So rising inequality can be a sign of real progress, but that is not what is happening now.

One of the main causes of rising inequality today is rent-seeking. Mancur Olson said that this is what would happen in mature capitalism, and you could make an argument that this has been happening all along except for a brief period when the Second World War stopped it for a while. If monopolies are unregulated, they can be very effective at squeezing profits out of consumers and workers. That’s a process of rent-seeking which would transfer resources upwards, from relatively-poor people to people who are much better-off, thus increasing inequality but also slowing economic growth and making the market less efficient. Under those circumstances you would get a correlation between inequality and slower growth, but it is the monopolies that are causing both, not one causing the other.

Rent-seeking does not have to redistribute upwards—when there were powerful unions, there was a fair amount of redistributing downward, to autoworkers in Detroit for example when there was little competition. Now big companies are not sharing the rents with the workers anymore and one of the reasons people are worried about inequality is that rent-seeking is now almost entirely in favour of the elite.

As a consequence, the living standards of the working class are not rising anymore. This is not just an economics issue. We are seeing “deaths of despair” from drugs, alcohol and suicide that Anne Case and I have been analysing - people dying in middle age. In Mortality and morbidity in the 21st century, we find that while midlife mortality rates continue to fall among all education classes in most of the rich world, middle-aged non-Hispanic whites in the United States with a high school diploma or less have experienced increasing midlife mortality since the late 1990s. This is due to both rises in the number of deaths of despair and to a slowdown in progress against mortality from heart disease and cancer, the two largest killers in middle age. The combined effect means that mortality rates of whites with no more than a high school degree, which were around 30 percent lower than mortality rates of blacks in 1999, grew to be 30 percent higher than blacks by 2015.

The increases in deaths of despair are accompanied by a measurable deterioration in economic and social wellbeing, which has become more pronounced for each successive birth cohort. Marriage rates, labour force participation rates, and other indicators linked to well-being such as various forms of social participation, fall between successive birth cohorts, while reports of physical pain, and poor health and mental health rise.

Some aspects of globalisation and technological change, like outsourcing and robotics, also suppress worker wages while benefiting the rich. But these alone cannot explain why median incomes have stagnated for half a century, while incomes at the top have grown. The answer lies in a series of unfair economic and social processes that propagate inequality.

Healthcare financing. Each year, the United States spends a trillion dollars (USD 8000 per family) more than other wealthy nations on healthcare costs, with worse outcomes. Healthcare jobs grew the second fastest in 2017, but wages were largely flat, leading hospital workers to unionise for higher pay. Healthcare financing cuts wages for the average American too - most employer-sponsored healthcare benefits are actually taken out workers’ pay rather than being paid for by the company.

Mergers. Many industries, like tech, media, and healthcare, are now run by a few, large companies. But mergers rarely boost the wages of workers. Because of hospital mergers, hospital prices have risen, while hospital wages have not. Big companies have an easier time manipulating public policy to accrue profits, instead of making money through innovation and investment.

Low federal minimum wage. The federal minimum wage, at USD 7.25 an hour, has changed since 2009. According to a 2017 YouGov Survey, 66 percent of US adults would like to see the minimum wage raised to USD 10.10. But the policy change usually faces resistance in Congress, where wealthy firms exert disproportionate influence.

Diminishing worker power. Twenty percent of workers sign non-compete clauses. This used to be restricted to employees with access to exclusive information or expertise, but now even blue-collar workers doing low-skill service jobs are being asked to sign, thereby reducing their incomes and bargaining power by preventing them from taking on other work. This is in fact is illegal but the law is not enforced. What’s more, over half of non-union, privately employed Americans - some 60 million people - have signed mandatory arbitration agreements, which means they can never sue their employers.

The rise of temporary contracts. Companies are increasingly replacing full-time, salaried workers with contractors. Janitors, servers, and maintenance staff who once worked for wealthy companies now work for independent service corporations that compete aggressively against each other over pricing. Working conditions are precarious, without benefits, and with little opportunity for promotion.

The stock market. While the stock market rewards innovation, it also incentivises companies to shuffle resources from labour to capital. As median wages have stagnated, corporate profits relative to GDP have grown 20 percent to 25 percent. That number would be even higher if executive pay was tracked as profits instead of salaries.

Corporate influence on politics. Both the Consumer Financial Protection Bureau and the 2010 Dodd-Frank legislation are under attack. President Trump plans to attack 75 percent of regulations, and may roll back a rule that requires money managers to prioritise their clients’ interests. The US Supreme Court has ruled that corporations can act as political entities, spending unlimited amounts to support candidates and the legislation they will eventually push.

Michel Aglietta

The concept of money implies a profound reversal of the way the economy is represented. Neoclassical economists postulate a generic individual, with a specific property, utility, that does not depend on the utility of others. Utilities are exogenous. The market is the exclusive mode of co-ordination and this makes it possible to define an intellectual project that is ideological: a discipline independent of the social, whereas in reality economic and other human activities are integrated by a link with the collective we can call society. If society is your starting point, the relationship of the individual to the collective is fundamental. Money is the concept that expresses this generic relationship in the economic order. It is a specific language, a language of numbers. A language gives meaning to others. The meaning for others determined by money is what will be called value. Money and value are intrinsically linked. The functions of money will come as a characteristic of the process by which value is determined, because value is determined only by the generic relationship of economic actors to money, that is, payment. The generic process of co-ordinating a society in which individuals exchange objects in the form of value must be determined.

We do not need a metaphor to define co-ordination. Co-ordination is objective, and observable: it is the payments system. Money as an institution produces rules for the issue of means of payment, rules for clearing and settlement from which an overall co-ordination of exchanges takes place. The payment system is an institution and cannot be appropriated, but it must be guided by policy, so money is essentially political.

In the history of money, there has been a debate going on for centuries formalised in the opposition between the currency principle and banking principle. The opposition centres on two characteristics: endogenous and exogenous money.

The orthodox view is based on an exogenous hypothesis of external money or money as a specific commodity defined only by quantity. Market exchange co-ordination occurs through market discovery mechanisms (and not through the payment system). The real demand for money is derived from the theory of utility value: real wealth and opportunity cost. In market equilibrium money is neutral: it doesn’t impinge upon equilibrium real prices. Money equilibrium determines only its own price.

According to the alternative, endogenous hypothesis of internal money, or money entirely related to the credit system, money is created as the counterpart of debt. The trade of debt is a trade of promises which can be plagued by uncertainty. Money is the fundamental institution (a way that we encompass a social contract within society). The payment system precedes the trade, clearing and settlement of debt. The finality of payment through the settlement mechanism of all daily payments ratifies the exchanges that have ratified value.

So, for the exogenous hypothesis, value is absolute and logically precedes the function of money, while in the endogenous hypothesis value is relative and is a pure social relationship. The value of money logically precedes the value of goods.

Endogenous money cannot be neutral, by nature. The link between exogeneity and neutrality of money is intrinsic. Hence the strong opposition between these two characteristics. In a concept of neutral money the bank is not a creator of money. It is only a transmission belt of the central bank, resulting in a monetary multiplier (a function of the interest rate), itself modulated by the behaviour of money seekers. In this exogenous conception of money creation, under the assumption that the demand for money is a stable function, Friedman can claim that inflation is always and everywhere a monetary phenomenon, caused by the public authority in charge of monetary creation. The 2008 financial crisis and its aftermath proved otherwise. Central banks created huge amounts of money (in the order of USD 10 trillion). If the currency were neutral, there would have been hyperinflation because the supply of money would have been in enormous excess of stable demand. If you offer a huge amount of money that nobody wants, you create inflation. In fact, the problem has been to avoid deflation. Reality refuted the monetarists’ hypothesis.

As well as being an institution and a language, money has something that makes it ambivalent, that makes it appropriable. Liquidity is appropriable and therefore exchangeable. In this form, the value appears condensed, and disconnected from the public institution that is the payments system. Liquidity means you can make money with money. Through liquidity, money becomes the social form of wealth. Any particular wealth is only reflected in the amount of liquidity to which it could be equivalent. Contrary to the neoclassical conception, money is demanded because others demand it. This externality of demand violates the rule that prices are related purely to the desires of the individual independently of others.

When we look at the international financial system, we see that there is a global economy but no global currency. If capital did not circulate, there would be no problem since capital controls would maintain separate currencies. But with globalisation, an organisation is needed. In the nineteenth century, the gold standard was a way of tackling the question of an international currency, even if the convertibility of gold remained under the control of nations. The Bretton Woods system after the Second World War was an international institutionalised monetary system that established the preponderance of the dollar, as part of a set of common rules and procedures administered by an international institution, the IMF. Capital controls allowed this international arrangement to function because it preserved sufficient monetary autonomy for nations. The collapse of the Bretton Woods system removed international monetary rules. Monetary relations become directly dependent on exchange of liquidity on foreign exchange markets, and thus on unstable private arbitrage, which is reflected in exchange rate fluctuations.

Why elect one currency over another, a national currency that other nations will accept? The answer lies in the realm of hegemony and geopolitics.

NAEC seminar “Currency: between debt and sovereignty”, OECD, 18 May 2016 http://www.oecd.org/naec/events/currency-between-debt-and-sovereignty.htm

La Monnaie entre dettes et souveraineté, Michel Aglietta, Pepita Ould Ahmed, Jean-François Ponsot, Éditions Odile Jacob, 2016 https://www.odilejacob.fr/catalogue/sciences-humaines/economie-et-finance/monnaie-entre-dettes-et-souverainete_9782738133830.php

Entretien avec Michel Aglietta, Adrien Faudot, Revue Interventions économiques, 59, 2017 http://journals.openedition.org/interventionseconomiques/3958

Edite Ligere

One of the roles of the insurance sector is to contribute to financial stability by enabling natural and legal persons to take risks they otherwise may not be able or willing to take. Insuring against business interruption is one example of cover offered by insurance providers, as well as Lloyd’s of London, the oldest insurance market in the world. Founded around 1686, Lloyd’s has weathered losses arising from triggers varying from earthquakes to terrorist attacks, yet it has never been faced with so many business interruption claims on a global scale simultaneously as now.

The societal and economic impact of Covid-19 is testing the capacity of the global insurance sector in an unprecedented way. This could lead to higher capital requirements for insurers, much higher premiums, the widening of risks excluded from insurance cover, tighter limits on insurance cover, or perhaps an increasing reluctance to underwrite certain risks. It could also lead to changes in how the industry is regulated and governed.

The Financial Stability Board (FSB) was created after the 2008 financial crisis to co-ordinate the work of national financial regulatory authorities; develop and promote the implementation of effective regulatory, supervisory and other financial sector policies under the auspices of the G20 and on the recommendation of standard setting bodies such as the International Association of Insurance Supervisors, and the Basel Committee of Banking Supervision. The FSB’s decisions do not have force in international law. It is a member driven organisation which forms judgments of risks to financial stability. Where possible, it agrees international standards or approaches to policy. National authorities ultimately decide whether and how to implement such standards.

While the FSB is a process more than an institution, it is important to appreciate the practical significance of the political comity (mutual recognition) which generally exists among members. Considerations of comity contribute to the evolution of views and approaches to financial regulation among national supervisors; and to the likelihood that national supervisors will act according to the recommendations of the FSB. Such political comity is likely to make the work of the FSB increasingly relevant to identifying and mitigating systemic risks to the global economy.

Unlike many other countries, insurance in the United States is regulated on a State rather than a federal level. The National Association of Insurance Commissioners, established in1871, provides a forum for State insurance regulators to co-ordinate their activities. The Financial Stability Oversight Council’s (FSOC) mandate under the 2010 Dodd-Frank Act includes identification of systemic risks; promoting market discipline; and responding to emerging threats to the financial stability of the United States. Systemic risk is defined as “a risk of an event or development that could impair financial intermediation or financial market functioning to a degree that would be sufficient to inflict significant damage on the broader economy”.

Apart from monitoring the financial services marketplace to identify potential threats to US financial stability, FSOC’s duties include recommending to its member agencies general supervisory priorities and principles; recommending to primary financial regulatory agencies to apply new or heightened standards and safeguards for financial activities or practices that could create or increase risks of significant liquidity, credit, or other problems spreading among financial companies and markets; and designating non-bank financial companies for supervision and regulation by the Federal Reserve, including the application of prudential standards.

There are fundamental differences in the business models and balance sheets of banks. For example, the long-term nature of some insurance liabilities and the consequent risks to the global economy posed by such liabilities are different from the much shorter-term liabilities of banking institutions and the greater risks such liabilities pose to the wider economy. The 2008 financial crisis was mainly caused by systemic risks in the banking sector rather than traditional insurance activities.

In July 2013, FSOC designated AIG and GE Capital as the first non-bank SIFIs – systemically important financial institutions. Prudential was designated in September 2013 and MetLife in December 2014. All three US non-bank SIFIs have since been de-designated. In 2017, President Trump directed the Secretary of the Treasury, who chairs FSOC, to review the non-bank SIFI designation process and make recommendations for regulatory or legislative changes to the process. The Treasury’s report concluded that FSOC should focus more on identifying systemically risky activities than on designating individual firms; consult with regulators of companies engaging in such activities to address systemic risk; and designate individual companies only as a last resort. The activities-based approach to the identification and mitigation of systemic risk is intended to enable FSOC to identify and address potential risks and emerging threats on a system-wide basis and “reduce the potential for competitive market distortions” that could arise from designating specific entities.

Products, activities, or practices to be reviewed include those related to the extension of credit; the use of leverage or short-term funding; the provision of guarantees of financial performance; and other key functions critical to support the operation of financial markets. Examples of markets FSOC would monitor include corporate and sovereign debt and loans; equity; markets for other financial products, including structured products and derivatives; short-term funding markets; payment, clearing, and settlement functions; new or evolving financial products, activities, and practices; and developments affecting the resiliency of financial market participants. If FSOC identified a product, activity, or practice that could pose a systemic risk, it would consult with relevant financial regulatory agencies to determine whether the potential risk merited further review or action.

The ambitious aim post-2008 was to create a global regulatory level playing field for the “too big to fail” and other global financial institutions. Will one of the objectives of the post-Covid-19 regulatory effort be to attempt to reverse some of the consequences of globalisation? In a systemic crisis such as Covid-19, the nation state is still the ultimate arbiter and protector of the fate of its citizens and others within its territory. In the context of global financial groups operating across multiple jurisdictions, the development of a harmonised, legally enforceable framework for the identification and mitigation of systemic risk is a Herculean task. While there continues to be increasing discussion among supervisory authorities and broad political consensus in respect of the shape of the principles regarded as conducive to global financial stability, the legal implementation and enforcement of such principles remains the responsibility of national authorities. But for how long?

John Llewellyn

There was no single cause of the 2007-2008 crisis. The crisis was systemic, with fear and greed interacting with the prevailing macroeconomic conditions, macroeconomic policies, and the regulatory framework to break down both confidence and trust. The abolition of the US Glass-Steagall Act did however play a major part. That Act separated commercial and investment banking to eliminate conflicts of interest that arise, as they did in the 1930s, when the granting of credit – lending – and the use of credit – investing – were undertaken by a single institution. With the abolition of Glass-Steagall, the stage was set for these conflicts to come back.

Equally important, however, were the ways in which behaviour unfolded. Savers, seeking yield, were relaxed about moving into assets that historically had been risky. US investment banks borrowed extensively on the wholesale money market, lending massively to households through mortgages and loans, further fuelling the property boom. Mortgage mis-selling aided the process, with sellers being paid per sale, while bearing no responsibility for the consequences. Investment banks invented complex, highly geared investment vehicles, many of which they funded on the wholesale money market and then sold on to other parties so that they did not appear on the banks’ balance sheets. The explosion of leverage was boosted by the ‘shadow banking’ world of hedge funds, private equity firms, and other unregulated financial companies, the demand side of the trade in collateralised debt obligations (CDOs), mortgage-backed securities, credit default swaps (CDSs), and the like.

When asset values turned, confidence and trust collapsed and leverage, which had been everybody’s friend, turned into a savage enemy. Various factors explain why so few people realised what was happening, or acted to stop it.

Incentive structures encouraged traders to make unwarrantedly risky bets, but all traders have individual risk limits and banks’ managements set those limits.

Poor corporate risk analysis. Within the investment banks, some risk managers were concerned that the risk models did not adequately take underlying macroeconomic risks into account. Many senior risk managers were reluctant to admit that they did not really understand their banks’ risk models. And most managements did not appreciate that sponsors would not be able to avoid responsibility for their supposedly off-balance-sheet products.

Undue reliance on Value at Risk (VAR) analysis. This statistical technique has two serious limitations: information at the extremities – where catastrophic risk lies – was sparse, particularly after 15 years of exceptionally low macro volatility; accommodating framework conditions that evolve requires a structural framework, which a statistical distribution alone does not provide. Sometimes the model simply may not describe reality at all.

Unwillingness of corporate management to act.

Poor corporate governance. Boards of Directors proved too weak, or too ill-informed, to challenge ‘successful’ CEOs. Managements appear increasingly to have run companies for themselves, and shareholders proved unwilling or unable to rein management back.

‘Grade inflation’ by the credit rating agencies implied, for example, that a mortgage vehicle rated as ‘triple A’ carried the same risk as similarly-rated major-country government bonds. CRAs became conflicted, accepting fees for certifying that the new vehicles were high grade. At root, the CRAs’ business model contains an unresolvable conflict: the people who pay for their services are not those who use them.

Regulatory Authorities did a poor job. They relied too heavily on companies “doing the right thing”, with too few checks; and they failed to achieve the basic separation of risk from reward; and financial regulation from financial activity.

Capital ratios proved to be inadequate, given the leverage the SEC permitted. The total amount the financial sector wrote off after August 2007 was over 100 times its collective VAR assessment of 18 months previously.

The pro-cyclical impact of “mark-to-market” valuation techniques exacerbated the capital inadequacy of banks. When crashing “fire-sale” values are used by auditors to value a bank’s assets, they induce fire sales to spread, thereby deepening the crisis.

A deficient understanding of corporate self-interest led regulators to believe that managements would always have their company’s survival as their primary objective, and so would avoid actions that would unduly jeopardise survival. This faith however underestimates management’s personal short-term objectives; the unawareness of many CEOs of the scale of the risks of macroeconomic origin to which they were exposed; and the degree to which competitive pressures obliged each to do broadly what all the others were doing.

International organisations failed to press the point. The Bank for International Settlements sounded alarm bells and the IMF and the European Central Bank expressed concern, but in the policy world as a whole, much as in the investment banks, no one wanted to hear.

A number of broad policy proposals might have reduced the likelihood, or at least the severity, of the crisis. (Whether they would help with the next crisis, however, which will be different, is another matter.)

Macroeconomic policy:

  • Pay greater attention to imbalances.

  • Direct policy at any major macroeconomic variable that departs significantly from any historical relationship.

  • Agree a better method of identifying bubbles. Minsky, for example, identified bubbles as any occasion when large numbers start trading in markets they don’t understand.

Regulatory policy:

  • Require the Regulatory Authorities to report on the potential financial sector implications of macroeconomic imbalances.

  • Establish ex ante the conditions whereby it is appropriate to take over a distressed bank, ideally when its net worth is still positive, so that it can continue as a going concern.

  • Raise capital adequacy ratios, at least for any bank that operates with its deposits guaranteed.

  • Require banks to operate a pro-cyclical reserves policy.

  • Oblige the CRAs to recover from their conflicted failure. There may be a case for two types of credit rating agency, one to carry out legislated supervisory responsibilities, the second undertaken for business for profit but with no role in supervision.

  • Discourage off-balance-sheet activities and put the onus on the proposer to explain why they are in the public interest.

We often hear that “nobody saw it coming”, but there were pointers. At Lehman Brothers we had a tool called Damocles for predicting financial crises in developing countries. A Damocles reading above 75 implied a one-in-three chance of a financial crisis over the coming 12 months, and a reading above 100 implied a 50-50 chance. Almost as a joke at first, we also ran the United States through the model. We concluded that while G10 economies can “get away with” poorer scores, and for longer, than emerging market economies, the US score had been between 75 and 100 over the 10 years before the crisis. Moreover, the United States ranked second, between Iceland (worst) and Romania (third). The main negative signals were coming from external debt, the current account, and credit.

NAEC Conference “10 Years after the failure of Lehman Brothers: What have we learned?”, OECD, 13-14 September 2018, http://www.oecd.org/naec/10-years-after-the-crisis/

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