Sunday, February 22, 2009

Europeans tell us to eat our spinach; their recipe

European rhetoric soars but fails to fly...

The European leaders of the G-20 have met in Europe and spun a fine tale of what they are doing and sung their own version of , "What the World Needs Now."

It's not 'love, sweet love.' or even 'Love, tough love.' It's some version of Euro-smackdown.

The Europeans have peppered their communique with the usual boiler plate. You can tell it's pie in the sky since they start by congratulating themselves for timely action. Right. Remember that Chancellor Merkel who headed this Euro love-fest was the one that chided the various stimulus plans initially, saying that 'stimulus was not a contest.' She eventually came on board with a second round of stimulus herself for Germany.

In fact, Europe has been slow. The ECB has dragged its feet in cutting rates and only joined the first round of central bank rate cuts using cooperation as cover. It was still apoplectic over its then ongoing inflation overshoot. Only the UK authorities have been quick and arguably that is because the UK financial sector is so large. So when the European G-20 ministers (E-G-20) start patting themselves on the back you know it must have to do with the need to burp instead of being an authentic act of congratulations.

The Euro-leaders agreed that "the banks ought to create additional buffers of resources in good times, so that they are better equipped for any bad times the future may bring."

Good idea - except how does that work? Banks that do stockpile capital in good times will find their financial results under perform in good times when the rest of the world is booming. What incentive will banks have to add to capital and reduce their return on capital (and assets) when times are good and when they 'think' they don't need as much capital? The Maastricht agreement was supposed to get European countries to do the same with their national debt and it has been unsuccessful. So the E-G-20 members said, let's take that same failed model and apply it to banks where the competitive pressures will make such a thing appear ludicrous! Good idea!

The E-G-20 has also said that protectionism should not used. Yet within Europe there has been a good deal of controversy about the stop-gap measures used to prop up industry. Europe was angry with Ireland at the outset of the financial mess for guaranteeing bank deposits. More recently France has been criticized for its support of the auto industry. Europe does not have its own house in order yet its proclaiming virtue for the world audience.

The E-G-20 "want to devise sanctions to safeguard ourselves better against dangers emanating from uncooperative jurisdictions, including tax havens." In view of the troubles that the US is having with UBS this makes me wonder if Switzerland is 'on board' with this. Swiss bank secrecy certainly seems to be one thing that is on the outside of this declaration.

Europeans having already ceded a lot of their authority to supra-national bodies are more willing to concoct new powers for new international agencies. I don't think that the US experience with WTO has been good enough to make that a plan that the US will embrace. The IMF is an institution that is particularly toothless and one whose programs of 'conditionality' have fallen prey to criticism. While it is clear that more international cooperation will be needed, it is unclear how far the US will be willing to go in that direction.

The communique also makes reference to reviving Doha. There is clearly a lot of angst over the ongoing failure at Doha. But Doha has been dead for some time. Doha has nothing to do with the financial crisis. Yet here it appears in the communique, as does a reference to climate change. Everyone's pet rock of a project gets mentioned. That is hardly a good sign.

Europe did endorse more resources for the IMF. That is one provision likely to get more support.

On balance we know that a consistent global approach to regulation will be needed. The previous BIS rules had seemed adequate at the time - they were comprehensive -but the capital they required was not enough. Our measurement of the degree of risk and its cross correlations was poor. Partly this failure is a technical failure of measuring key ingredients improperly and assessing risk correlations incorrectly. But the failure here is more than technical. On closer look there were was just too much willingness to unleash more risk by stripping the system of safeguards that had been in place for well over 50 years. Financial engineering was applied even where it was know to be flawed. We had a small scale melt down of LTCM and failed to learn from it. The entire system overused leverage to boot.

It is not clear even now what lessons have been learned. Few on Wall Street seem to be deeply repentant for what they have done. The eventual remedies probably will involve more emphasis on changing the structure of banking than on who does the regulating. But getting everyone on broad will also be very important.