The Money Trap

Escaping the Grip of Global Finance

R. Pringle

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9780230392755
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

The world economy is caught in a money trap. Existing monetary arrangements meet the needs neither of the ageing societies of the West nor of younger emerging economies. This in-depth analysis explains how the world got into the grip of global finance - and how it can escape, with a growing demand for reform.

Part I

In the Trap

1

Into the Danger Zone

Many of the underlying causes of economic weakness and high unemployment were due to faults of the global financial system (GFS), yet governments and central bankers were loath to acknowledge this.

A monetary failure

The failure of the world economy to recover fully from the financial crisis and recession was a monetary as well as a real phenomenon. Why did the climate for international business, trade and investment remain hostile? Why, years later, were many economies struggling to emerge fully out of recession? With governments desperately seeking to reassure financial markets that they could and would service their debts, the deterioration in the soundness of banks and other financial institutions was particularly alarming. Before GFC, there had seemed no reason to doubt the creditworthiness of most of the world’s major financial institutions, or governments’ capacity to control a financial panic if one should break out. Of course, banks had from time to time got into difficulties, currencies had swung around wildly and the so-called Asian crisis in 1997–98 had shown the damage that such financial panics could inflict on an increasingly global scale. It is also true that economic history is pockmarked with financial panics. But until GFC it was thought that we were learning how to manage such difficulties. International institutions such as the IMF and World Bank had accumulated expertise through learning from such experiences and advising governments around the world in a wide variety of different circumstances. Economists studied them exhaustively; whole libraries of scholarly books were devoted to them. We seemed to be making progress. But GFC and the stuttering recovery from it sent a different message. Almost, it seemed, out of a clear blue sky, a storm had descended that laid waste to wide areas of the financial landscape. No bank, it seemed, could be relied on to stand on its own feet. Governments’ resources – their balance sheet strength – were drained in fighting the collapse and the recession that followed. Efforts to repair private and official balance sheets were a drag on demand. Another recession was feared, and that would cause another wave of sovereign and commercial defaults and more losses for banks.

Because banks and other financial institutions are central to the running of a capitalist economy, this deterioration in their soundness generated fear. Like a new virus, this rapidly spread to all parts of the global economy, speeded by advances in communication. The 24-hour news machine ensured every businessman and woman in the world could reasonably ask: is my business safe? Savers asked: are my investments safe? What can I do to protect myself and my family? Whom can I trust? Businesses and households everywhere became ultra-cautious.

Lack of trust in money and monetary institutions was at the root of GFC and of the anxiety of senior officials about the prospects. On 6 October 2011, Mervyn King, governor of the Bank of England, said it may be the worst crisis ever; and a few days later Jean-Claude Trichet, then president of the European Central Bank (ECB), said, ‘it is a historical event of the first magnitude, the worst crisis since the Second World War.’¹A deeper slump had been averted by dint of extraordinary expenditure of money to sustain demand, and the only way to service the interest on that borrowing was to maintain growth; yet, given the lack of confidence, where was the demand to come from?

Governments twisted and turned this way and that. One favoured remedy after another was tried – banking reform, new regulations, fiscal stimulus, monetary stimulus – while the cries of rival groups of advisers almost drowned out reasoned debate. All to no avail: the diagnosis was monetary failure, something as life-threatening to the economy as heart failure is to a human being.

The underlying problem

This book treats these controversial topics from a distinct angle, that of the GFS as a whole. The general approach can be stated simply: a few years ago, around the start of the new millennium, the process of economic and financial globalization reached the limits compatible with existing international monetary arrangements. Fixing parts of these arrangements, such as raising bank capital requirements or introducing so-called macro-prudential risk oversight (see Chapter 10), would not solve the problem, as they treated symptoms rather than the real causes of stress. That was the mistake leading nations were making; essentially, they were attempting to return to ‘business as usual’ – recycling the set of policies and style of policy-making and institutional set-up that they had worn to death over the previous half-century. Numerous initiatives were taken to reform regulation and other bits of the policy apparatus but these fell short of the major recasting of arrangements that was needed to restore confidence. Finance would escape from these attempted constraints. Banks would always be one step ahead of the regulators. This excessive flexibility of the finance system is what has led us into so much trouble – or at least had been a major contributor to it, as is argued in more detail later. Within the existing GFS, governments could respond only by applying yet tighter restrictions – higher capital ratios and so on – which would actually cramp the recovery rather than control the bankers. So recovery would stall, or even go into reverse, and this was indeed happening.

True, some areas and countries of the world economy seemed to be able, for a time, to shrug off what was happening in the West. China and India, in particular, continued to bowl along at high, albeit more moderate, growth rates. Much of the rest of Asia and some other emerging economies were also doing well. Yet the longer the problems of the GFS continued to weigh down the West, the harder it was for these areas to retain dynamism. There were limits to their resilience. They would be severely impacted in time by loss of export markets, volatile capital flows and exchange rates, and the higher cost of finance – to mention just a few of the links connecting ‘the West’ with ‘the rest’. The world economy as a whole was being cramped by the GFS.

These links pointed to some of the basic faults within the GFS itself. The interaction between credit expansion, capital flows and volatile exchange rates had been a key factor in the build-up of successive international financial and economic booms and busts well before GFC (including the developing countries’ debt rescheduling of the 1980s and the Asian crisis of 1997–98). GFC demonstrated how that same mechanism was undermining the financial systems at the core of capitalism, in the US and Europe.

Regime change would be necessary. But it was not even on governments’ radar screens. Nor was it on the agenda of the G20. Could one not expect, after such a cataclysm – the equivalent of a Richter scale 9 earthquake and tsunami – that leading nations would at least make an attempt to design a new set of defences, a better sea wall? In the monetary field, the most famous of these took place after the Second World War, when agreement on an international monetary order was reached at Bretton Woods (see Chapter 3). But this was not the only example of constructive engagement at the international level; when the Bretton Woods regime broke down in the early 1970s there followed sustained international attempts to construct a new order better adapted to the economic circumstances of the time. Not all such attempts succeeded, and the failures as well as successes will be analysed in subsequent chapters. But in 2008–12, in the aftermath of the near collapse of the GFS and the worst recession for 70 years, there was no comparable effort. This was on the face of it surprising. As will be argued in more detail later in this book, the US, Europe, China and other major powers had ample reason to be dissatisfied with the functioning of the system. Many smaller countries were already highly discontented. Above all, it was no longer clear that the US benefited so unambiguously from the dollar’s role as the leading reserve currency that it would automatically be expected to veto any such fundamental review of the system.

Governments’ feeble response

The G20 discussed a wide range of reforms designed to put the GFS back together again,² but the proposals were at best limited changes to existing arrangements. Essentially, governments and the international institutions were sending the message that the system had been developing along the right lines, but that further improvement was being hampered by a few factors, notably a lack of political will. More ‘political will’ was needed to lift international cooperation onto a higher level. If this could be achieved, then the international institutions such as the IMF would have the authority needed to make the system function satisfactorily. That would require endowing the international community through the IMF and the G20 or a successor body with greater influence on the policies of important economies. In the circumstances of 2011 this was code for measures to reduce the fiscal deficit of the US, and to increase domestic demand and exchange rate flexibility in China. These were seen by most western governments as designed to ensure that China’s growth relied less on exports and more on domestic consumption

But few observers expected that countries would be prepared to show the political will – that is, sacrifice perceived sovereignty – needed to make a real difference. At that point, governments ran out of ideas. The political imperative was to resume growth, even though the defects in the GFS, left untreated, would ensure that such growth could only be short-lived. With unemployment remaining high in advanced countries and the need to absorb the millions entering labour markets in emerging markets, recovery and growth were, naturally, the priorities. What the exercise led by the G20 group of leading countries amounted to in practice was a massive, coordinated, fiscal and monetary stimulus. No country by itself was large enough to give the world economy the injection it needed to kick-start demand; and none was prepared to risk the deterioration in its external payments that would take place if it acted alone. So they agreed on a collective heave – but this too soon ran out of puff.

The reasons for the narrow focus of reform and the lack of drive behind it lay elsewhere. The GFS, especially when oiled by official injections of cash, suited the short-term interests of major players (analysed in Chapter 2). So governments put about the dangerous half-truth that GFC had very little to do with faults in the international monetary system (the reality being it had a great deal to do with faults in the GFS). So they proposed only limited reforms to make existing arrangements work better, including reductions in budget deficits, and even greater exchange rate flexibility (while many senior officials had little confidence in the sustainability of the system, they could not voice these doubts publicly).

Lack of imagination – or lack of courage?

There was also a lack of intellectual courage. Economists, stunned by the ferocity of the financial hurricane, generally retreated to well-established positions. In this they behaved like governments. The same applied to professional financial regulators and central bankers. They pulled their familiar ideological and professional clothes more tightly around them. Central bankers declared their confidence in their monetary policy regimes. Regulators said that what was needed was, of course, better regulation – and they could be entrusted to deliver it. Bankers said that they accepted the need for new regulation and higher capital (the costs of which would be passed on to customers), but that they would regard tougher measures as vengeful and warned that this could prompt them to relocate from London and New York to more friendly jurisdictions. To the bemusement of the public, governments were reduced to pleading with bankers – employees of the very same institutions that the public had bailed out at vast cost – to reduce the size of their bonuses: and could you, please, increase lending to small businesses?³ What these responses had in common was a domestic focus.

Behind the political failure of nerve, behind the failure of ideas, behind even the growing infiltration of politics by finance, yet another factor was involved: the globalization of finance itself. This continually ran ahead of the extension of political agreement on ‘rules of the game’ that would be necessary to harness it and make it serve the public good. This had been a constant theme of the growth of international banking and finance since the freeing of financial markets from post-war controls during the 1960s and 1970s. It was what lay behind the power of financial lobbies on issues such as remuneration. To see the situation from the bankers’ point of view, if their competitors in other countries could pay their executives what even they (privately) thought were excessively generous pay packages, they would feel obliged to follow suit.

If there was one professional group to whom, it might be hoped, one could turn for an objective, internationalist view of systemic problems, it would be central bankers. Traditionally, they formed in many ways a separate caste, with their own ethic of public duty and responsibility. Distanced from the pressures of day-to-day politics, with a privileged, bird’s-eye view of their financial institutions and those of other countries, with traditions of discreet cooperation and backed by economics research departments, surely they could be relied on to draw attention to defects in the operations of GFS. After all, they were specialists in analysing financial system stability.

Why most central bankers have tunnel vision

Yet central bankers’ enthusiasm for reform was distinctly circumscribed – with a focus on the need for regulatory change and ‘macro-prudential’ oversight (the need to take a view of the financial system as a whole). An analysis of the political economy of central banks suggests the reason for this. Despite what many would see as major policy errors in the run-up to GFC, and their failure to manage it well, central banks emerged from it with additional powers. They were the key players in official plans to strengthen the oversight of payments, banking and capital markets. Their greater responsibilities necessarily came with greater accountability to governments and/or parliaments. That might have been inevitable when committing public funds to support the banking system required the authority of political leaders. But the interconnections between politicians, civil servants and central bankers became even closer in the aftermath of GFC. These changes were making them even more wary than usual of rocking the boat. Thus when they talked about the international monetary system, their focus was limited; in essence, it often amounted simply to telling China to revalue its currency.

Unfortunately, the central banks’ cherished independence predisposed them to support ...

Table of contents

• Cover
• Title
• Part I In the Trap
• Part II Searching for Ways Out
• Part III Four Key Issues
• Part IV The Power of Global Finance
• Index