A well thought out financial regulatory framework, economic system, and policy decisions that can stand the test of time needs to be evolutionary, and requires a certain level of debate, discussion of ideas and possibilities. A strategy and approach that has gone through an evolutionary process, and is proactive, tend to have a greater chance of success than a policy decision or measure that is more or less reactive. And that’s just common sense. But during the financial crisis of 07/08, and in its immediate aftermath, we were hit by a barrage of half baked ideas and measures that came out of a reactive decision making process, and although the aim of the exercise were well intended, and in some case temporary in nature, they haven’t made the markets or the global economy any more safer than they were before.
Also the existing reactive measures put in place to deal with the financial crisis can only be defined as an experiment. And even in a post crisis world, we continue to operate in the experiment mode, be it, the ultra loose monetary policy experiment to support the markets and the economy or the hard core regulatory environment aimed at avoiding future financial crises. Making it a hot topic of debate, and the possible outcome or outcomes of this ongoing experiment are being discussed around various quarters. But the end result still remains somewhat unknown because quite simply there are no precedent, so all we have is, best guess estimates, and theories to help us navigate through the unknown terrain.
Having said that, we are at a better place today than during the financial crisis of 07/08, but even after being 5/6 years on the road to recovery, the global economy is still not firing on all cylinders, and there are obviously a number of reasons for that. In my own view, we will only be able to get a better assessment of the strength of the economy after the unconventional monetary policies are taken offline (exit), as there are still many UNKNOWNS out there. The record high stock markets is not fully reflective of the real economy, and although the global economy is in a much better shape than during the financial crisis, parts of the economy are still not firing on all cylinders. A large percentage of the people on the main street are still stretched as evident from the lack of wage growth. And the ongoing geopolitical instability will most likely have an impact on the markets and the economy especially the EU states. The Euro area is still in a very precarious situation, and it is quite likely that the year 2014 will turn out to be a lost opportunity for Euro Zone nations especially if the leadership in the EU fail to get their priorities right. And going forward, we may see significant monetary policy divergence among developed nations especially between the EU, UK and the United States because the respective economies are already in different speed gears. Also major economies like China are going through a transition period, in other words, a gear shift which needs to be managed well through policy changes as we all know that running a car in a wrong gear for a long period of time can pretty much ruin the car’s engine. So the Central bank in China as well as major world economies including of the US and UK will need to manage the gear change efficiently. And this is why, it is important to create a mechanism that allows greater policy coordination in the global financial system going forward.
And though, there are still many unknowns, but what we do know, and have learnt so far especially in the immediate aftermath of the financial crisis of 07/08 is that, the financial markets and the economy are anything but efficient, and this may be contrary to what some may believe. The fear of the unknown will always trouble the market participants, and as a way to better understand the road ahead, people will make their own projections, which at times could raise more questions than answers.
So while taking a stock of the overall situation, may be its time, we look ahead , and find a way to revisit some of these experiments to help us better understand, and improve the existing structure of the economy and the markets going forward. And with this in mind, I thought, I will take the liberty, and share my own two cents worth on the subject.
To start with, I believe, we can all agree that the financial crisis has revealed to us the vulnerabilities of our existing economic system and financial infrastructure. And, if we are to attempt to find a way to upgrade the system then we will need to explore ways to remodel, the whole financial infrastructure, in order to make sure it’s sustainable over a long run. So here is an outline of the broader idea, which is based around creating an ” emergency only use spare money supply capacity ” in the system, that could be tapped into during an exceptional situation ( a financial crisis type event ). This could be a possible solution to mitigate or address some of the underlying solvency related concern on a sovereign nation.
And here is how it could work, first and foremost, the utilisation of the newly added capacity will have to be approved by a country’s parliament, second the whole process could be monitored by a global financial stability board or a body under the IMF, and third the market should have a clarity about the rules. So the assumption is, if the markets know or knew that a country could tap into its inbuilt safety mechanism put in place or in other words utilise a back up facility under a defined set of rules in case of emergency then it is less likely to speculate about a potential bankruptcy of that country.
The overall premise is based on a common sense approach that an efficient and sustainable system should have a back up or IN CASE OF EMERGENCY provision put in place to be used under exceptional circumstances. So for example, in event of a tyre puncture, you would use the spare tyre that comes with your vehicle or in case of a power failure, you will switch on a back up generator, in same way the emergency money supply pool ( as a spare capacity ) could be tapped into or utilised during an exceptional financial crisis type event. So under the proposed framework, a country could be allowed to print emergency money equivalent to up to 10% of its GDP, and this new money supply will automatically cease to exist within a period of let’s say 5 years, and could be linked to the overall GDP growth. In others words, the money supply by design will be created with a limited shelf life, to be used under extreme and exceptional circumstances. And the assumption here is that a five year cycle should be a sufficient transition period to help the economy rehabilitate.
Also linking the temporary additional money supply to the GDP growth creates a balance. So the overall idea works more or less like the rocket booster engine system that are used to take spacecraft into space, they do a job and then cut off (burn out ). We are taking about, creating a provision that will allow a country to tap into its spare capacity, a builtin safety mechanism that could kick in, in case of emergency. And since the provision will have a defined set of rules, the debate around a possible exit, and its outcome will not have to factor in many UNKNOWNS, making the outcome somewhat certain. So we know what happens, and at what level.
And beside the concern over sovereign risk, the other big issue item are the large financial institutions considered too big to fail. Asking the institution to create a living WILL doesn’t really go far enough. So one of the idea worth exploring could be, creating a mechanism that will allow troubled large ( too big to fail ) financial institutions to temporarily come under the protection of the central bank. The limited protection will not be for a period longer than 2.5 years, and the restructuring and unwinding process could be monitored, supervised by a special committee reporting directly to the central bank.
The experimentation with unconventional monetary policies like QE created uncertainty causing extreme volatility, and the problem was not the QE but the perception of QE, and what it will do or has done to the overall economy. Unconventional monetary policy tools like QE aren’t really a complete idea, and just like any human idea they need to reach a level of maturity through evolution. Also by design, the current structure of our economic system makes it prone to crises so if you are operating in a global financial system that has inherent builtin inefficiency then there is always a good chance that any policy measure even with best intention or design may not have the desired result.
So creating a defined safety mechanism in the overall infrastructure of the financial system should hopefully go a long way in providing a level of certainty to the market. And here is an example, during the financial crisis, the uncertainty over whether a country would get bailed out or not, and on what terms sort of magnified the problem.
Also an investment or a business model can only factor what is known, and what can be seen so a decision making will always have an element of risk involved. But knowing that there are many UKNOWNs keeps us honest and wise. So going forward, what we need to admit, and fully understand is that ,the journey to creating an efficient financial system will come with failures, and we may not have all the answers so being open to all and any good ideas makes all the sense. A Market economy is nothing but a human idea, and it has to go through an evolutionary process, and one of the reasons why the financial markets go through boom and bust is simply because the undefined rules creates an environment for extreme uncertainty leading to speculation.
That said, striving to create a financial and economic system that is 100% efficient, is quite impractical ( at least for now) . Also it must be said that inefficiencies do create opportunities, which allows entrepreneurs to add value, and in the process profit from it. Money or capital has no NATIONALITY so people will chase opportunities where ever they can find, and I believe thats a fair game because it encourages economies and businesses to compete for capital.
However, as a part of the evolutionary process, and over time, we have learnt to make safer cars, planes, and made tremendous progress in making various manufacturing process safer, transformed the telecom industry. And we have also made significant progress in many other fields including of space exploration among others, but our innovation in financial markets hasn’t really made the economy or the markets any safer.
So its about time that we focus our efforts on not only making the economy and the financial markets safer, but also on making it work better by improving the overall design of the existing system, and take measures to manage the future financial crises better, in order to minimise the financial hardship on people in the Main Street as well as on the nation states during the time of an exceptionally damaging financial crisis that leads to broken people, broken families as evident from the financial crisis of 07/08. This will be a journey of knowing the unknowns.