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A call for radical financial reform

9 October 2013 By Edward Hadas

The governments of developed countries have the power to rescue economies from defective finance. There is a radical solution. It would be relatively easy and at least as fair as the current slow generation-long recovery from the 2008 financial collapse.

I have been suggesting massive “start from scratch” financial reform for several years. The response is usually a mix of incredulity (it’s too hard to do) and indignation (it would be unjust). A thought experiment might help deal with those objections. Pretend that the current situation – excessive debts and deficits, unprecedented and risky monetary policy, overly powerful banks, slow GDP growth and unacceptably high levels of unemployment – was the result of a recent war.

Under those tragic circumstances, it would not be strange to say that the prevailing financial order was a relic from a lost period. Perhaps the arrangements were effective and fair back then, leaders would say, but the old promises, practices and privileges are now helping the few, hurting the many and holding the economy back. So finance needs to be reconstructed.

The experience after the Second World War provides an encouraging precedent. Strong German and Japanese governments led the rebuilding of devastated economies. Surely the developed countries of today could manage the much easier task of rearranging financial obligations.

Here is a simple post-pretend-war agenda.

Recalibrate debts. Debt writeoffs are not ideal – obligations should normally be honoured – but it’s better to restructure national balance sheets than to allow excessive debts to discourage job creation and investment. Writeoffs can also serve social justice when the debts in question are owed by the relatively poor to the undoubtedly rich, so often the case in increasingly unequal developed economies.

Strong governments – perhaps under the auspices of an invigorated G20 – could organise a total balance-sheet restructuring to disentangle the current system. There would be two goals: to reduce the quantity of burdensome debts and to ensure that savers are not punished. It is hard to do both, since a borrower’s reckless and unaffordable obligation is often the lender’s prudent investment. The trick is to combine debt reduction with the maintenance of value for savers. The former requires a combination of writeoffs, writedowns and debt-for-equity swaps. The latter can be done by taking advantage of governments’ ability to create new money and place it directly in bank accounts.

There are many debts to be evaluated – sovereign, corporate, personal and financial – and a corresponding collection of assets. Each of the judgments of a right new value would undoubtedly strike someone as unfair, but the comparison is not with a perfect world. It is with the current arrangement of ultra-low interest rates for savers and unwarranted gains for many asset holders.

Make government promises affordable. The mountains of government debt are a big part of the financial overload. The debt recalibration would reduce them to manageable hills, but the debts would soon pile up again unless governments matched their entitlement programmes (for the old, ill and otherwise suffering) to their tax bases. A one-time shift, some combination of higher taxes and lower benefits, will be more effective and less unjust than the current approach, which amounts to a mix of tinkering and wishful thinking. The new arrangements could be introduced gradually – although Latvia has managed pretty well with a sudden, post-war-style shock. Gradually, but more decisively than the current policy agenda.

Reconfigure the financial system. Thanks to the debt explosion, the financial-political complex has become big and powerful in developed economies. It is now far more parasitic than productive. Strong governments would crack down. They would separate everyday finance from risky lending, divide big banks into little ones, strictly limit trading, favour equity over debt financing and ensure that financial markets were either sufficiently competitive or tightly enough regulated that bankers’ pay was not noticeably high. The existing financial reform project goes only a small way towards these goals.

Thankfully, there has been no war to justify such drastic plans. It is a matter of debate whether the current system qualifies for emergency treatment. Bankers and other beneficiaries of the financial status quo would argue that the economies are not working badly enough to justify taking the risks of radical reconstruction, which might well wreck the economy by destroying confidence in the financial system. That is a risk, although it is only fair to point out that confidence in current financial arrangements is low and that the economy is hardly thriving.

In reality, governments are neither courageous nor respected enough to consider anything like such truly drastic plans. Political authorities are stuck in ruts, when they are not engaging in pointless and possibly disastrous quarrels – for example, the current debt pyrotechnics in Washington. American politicians currently lead the global contest for ineffectiveness, but the race is close. And by post-war standards, even the relatively popular Japanese and German administrations are timid.

Governments sit at the centre of modern economies; their weakness is probably the greatest threat to global prosperity.


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