What “Great Transformation”?

Martin Wolf’s suggestions for an overhaul of our economic system are sensible, but fundamentally insufficient for the Great Transformation we need.
Jakob Vestergaard
30 January 2012

The headline for the 2012 World Economic Forum in Davos called for “new models, bold ideas and personal courage to ensure that this century improves the human condition rather than capping its potential”. No sign of such achievements have yet emerged from the Swiss mountains. Martin Wolf’s essay on the seven ways to fix our economic system – which he launched in the run-up to Davos – was an omen that this was the way things would go. I am a great admirer of Wolf’s work, I read his columns week after week. He is in my view the most eminent observer and commentator of the global economy we have. Yet, I agree with Simon Zadek that while strong in its diagnosis of problems, Wolf’s essay is weak in terms of proposed solutions. The measures suggested by Wolf are sensible, but fundamentally inadequate. Even if all implemented, they would not effect a Great Transformation of the kind needed to avoid prolonged global economic stagnation, persistent high unemployment and rising social tension and upheaval.

To get serious about this much needed transformation of capitalism, we need to fundamentally rethink the creation of credit, and how it is best governed to serve the interests of citizens - and, indeed, the interests of capitalism itself, as a sustainable economic system. Only by wisely and decisively governing the creation of credit may a great transformation of capitalism be achieved – and only then may the global economy chart a new direction, towards green and socially inclusive economic growth and prosperity.

One cannot appreciate the importance of this new approach to the governing of credit creation without first understanding the severity of the current deadlock in our thinking about the governing of banks (which is where the vast majority of credit creation takes place). When the leaders of the Group of 20 first convened in the autumn of 2008, they identified the re-regulation of banking as one of the most immediate objectives, and decided that this was to take the form of a revision of the international standard in banking, the so-called Basel 2 accord. A new accord, Basel 3, was endorsed by the G20 leaders at the Seoul summit in November 2010. Although praised by many as a major accomplishment, it was in reality little short of a disaster.

In its own terms, Basel 3 achieved almost nothing. Much can be said about the insignificance of the Basel 3 accord, but I shall limit myself to three points here. First, Basel 3 raises requirements for so-called Tier 1 capital to 8.5%, which is below the 10% held on average by US banks in recent decades, as noted by Simon Johnson, former chief economist of the IMF. This modest requirement does not match well with US Treasury Secretary Timothy Geithner’s repeated emphasis on “capital, capital, capital” as the appropriate response to the crisis. Second, and perhaps more importantly, the agreed capital reserve ratios are considerably below what the emerging consensus in mainstream financial economics would suggest. Scholars and central bank analysts alike argue that between 15 and 20% Tier 1 capital should be held by banks in good times. Andrew Haldane of the Bank of England stresses that “even once Basel 3 is in place, an unexpected loss in the value of a bank’s assets of 4% will be enough to render it insolvent.”

Third, irrespective of this problem of their modest size, relying on capital reserve ratios as a measure to re-regulate banking is completely off the mark. Capital reserve ratios may be sensible as a microprudential tool in the regulation and supervision of individual financial institutions. But as a governance tool in relation to the banking sector as a whole it is completely ineffective. It’s like trying to cut your bread with a spoon. The current European predicament well illustrates the problem: Sarkozy and Merkel announced a few days ago that the modest increases in capital reserve requirements agreed upon earlier will now be relaxed – in order to not risk pushing European banking further into the quasi-insolvency mess that it’s already in. It’s not that this decision does not make sense, it does. If capital reserve ratios are not relaxed, banks will most likely meet them by cutting back their lending (rather than by increasing capital), thus adding to already strong recessionary forces in Europe. The crucial point to get across is that capital reserve ratios are completely useless as tools of banking sector regulation, not to mention macroeconomic management. The solvency of the European banking sector can only be sustainably restored by mandatory recapitalization by public funds. 

And yet, such recapitalization would only take us half the way towards the transformation we need. The second big change needed would be for countries to start governing credit creation. In popular perception, banks are merely intermediaries between savers and borrowers, but in reality banks lend out many times more than the deposits savers trust them with. But more importantly, as the system is currently configured, it is the lending decision of the banking sector that determines how much credit is created, leaving central banks with only limited and indirect influence. The perhaps single most important macroeconomic relationship – namely that between credit growth and economic growth – is for all practical purposes outside the reach of central bank policy. This makes us passive bystanders to the boom and bust cycles that result from periods of excessive credit creation in the banking sector. There is nothing inevitable about this state of affairs, however. On the contrary, we could easily reform the monetary and banking system so as to achieve a serious steering capacity with respect to the relation between credit growth and economic growth. Moreover, as Richard Werner and colleagues argue, such reforms could easily be coupled with new practices for increased political influence on the direction of credit creation. In the current system, banks face such incentives that “often lead them to favour lending against collateral, or assets, rather than lending for investment in production” and – as a result – credit is “more likely channeled into property and financial speculation than to small business and manufacturing, with profound consequences for society”. In a reformed monetary and banking system, the credit creation process could be governed by political authorities to meet objectives such as macroeconomic stability, development and growth of key prioritized sectors, such as green technologies, etc.

Reforms along such lines are not on Martin Wolf’s agenda, unfortunately. In the interest of fairness, I should say, though, that Wolf has in fact persistently criticized the Basel 3 accord. It was Wolf who sarcastically discussed its key outcome as a “capital inadequacy ratio” – and ridiculed the Basel Committee as a “mouse that did not roar.” This criticism is to the point and important. But other than supporting higher capital reserve ratios, what does Wolf have in mind for fixing the problems of the banking sector? “Regulators should watch the build-up of leverage”, he says. This proposal, in my view, is desperately inadequate. No matter how intense, any amount of watching will change outcomes only marginally, if at all.

In outlining the contours of an alternative way of thinking about and governing credit creation, I have talked about a new approach. In reality, there is nothing new about it. The intelligent governing of credit has been crucial in a number of Asian ‘growth miracles’ in the post-WW2 period, not least that of Japan. I am no expert on the Chinese economy, but I would be surprised if a key element of the spectacular economic growth in China in recent decades was not also in large part related to an intelligent governing of credit. Indeed, it may be the further rise of China that will force us to, eventually, reconsider our views on the ‘proper’ relations between state, credit and business – thereby taking what is a sine qua non step towards overcoming our current refusal to grow.

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