Having been the chief economist of the International Monetary Fund (IMF), among other things, Simon Johnson has had a ringside view of officials from Ukraine, Russia, Thailand, Indonesia and South Korea go hat in hand to the Fund when their economies experienced a balance of payments crisis. Typically, powerful elites in these countries had overreached and took risks in over-borrowing — a tale that always ends badly. The efficacy of IMF medicine that was administered depended on these elites taking a hit.
The US economic and financial crisis since 2008-09 is reminiscent of these emerging market episodes but this superpower is in no danger of being given the typical IMF treatment. Although the American financial oligarchy has had a major role in creating this crisis, there is also no prospect that it will be squeezed since the government seems helpless or unwilling to act against it. The oligarchs have tremendous influence to prevent or dilute reforms needed to pull the economy out of crisis.
More generally, the huge influence these oligarchs have in the advanced economies to thwart reform has made their financial sectors “potentially dangerous to societies” is a major argument of a chapter by Johnson and Peter Boone in this recently released book from the London School of Economics, The Future of Finance and the Theory that Underpins It. No one is willing or able to take them on — thanks to the revolving door between the government and high finance in the US and elsewhere.
Thanks to this clout, governments have built up huge contingent liabilities due to the implicit guarantees that they have provided to finance capital over the years. US and European taxpayers, thus, back around $65 trillion or 250 per cent of their GDP in implicit obligations, all of which contributes to the development of moral hazard in lending all over the world. In these troubled times, the IMF, too, is considered as another source of moral hazard with its bailout packages.
There is a clear and present danger of these implicit liabilities snowballing out of control as governments bail out the too-big-to-fail financial institutions whenever they are in trouble. This sort of distorted incentive structure encourages costly risk taking and renders the financial sector prone to “catastrophic collapse”, they argue. Disturbingly, the financial sector reform process underway in the leading countries is unlikely to make a difference to this state of affairs.
The bad news is that the next crisis is already looming. As in 2002 and 2003, the US Federal Reserve is advocating the need for lower interest rates to recapitalise banks and encourage risk taking. So, too, is the European Central Bank. If Europe stabilises, the system will be flush with cash and the good times will roll once again. Loose credit and money will generate growth and surplus savings in fast-growing emerging economies and a scenario like the recycling of petrodollars in the 1970s is imminent.
According to Johnson and Boone, there is a likelihood of such capital flowing to major international banks that are implicitly backed by US and European taxpayers. For example, savers in Brazil and Russia will deposit funds in such banks and these will, in turn, be lent to borrowers around the world, including Brazil and Russia. As the boom goes on, there will be more risk taking in lending to borrowers who have a crony capitalist relation to the state — a tale that ends often at IMF’s door!
“The leading borrowers in emerging markets will be quasi-sovereigns, either with government ownership or a close crony relationship to the state. When times are good, every one is happy is to believe that these borrowers are effectively backed by a deep-pocketed sovereign, even if the formal connection is pretty loose. Then there are the bad times — think Dubai World today or Russia in 1998… we have failed to heed the warnings made plain by the crises of the past 30 years,” add the authors.
What is to be done to avert such a looming “disaster on an epic scale”? For starters, there is a need to recognise that finance capital cannot be reined in by national and antiquated regulatory systems. Countries with so-called tough regulators will only see capital flow to the less regulated economies as rival banks bid up interest rates and take more risk. In this milieu, there is inevitably a race to the bottom as regulatory standards in the industrialised countries are relaxed to maintain competitiveness.
The upshot is that the world’s financial system is at greater risk than it has ever been. The ongoing efforts to reform the system through changes in national regulations are unlikely to work since the political power of the financial sector remains intact. The authors, therefore, forcefully argue for an international treaty organisation along the lines of the World Trade Organisation for finance. It would call for simple rules, including large capital requirements. It would also need a body like the IMF or the Bank for International Settlements to monitor implementation.
THE FUTURE OF FINANCE
And The Theory That Underpins It
Adair Turner and others
288 pages; £14.99