Ignacio de la Torre. Professor. IE Business School
14 May 2013
In order to build a world with less systemic risk, it is essential to use long-term tools to enable savings to reach the real economy.
There’s a story that tells how when one of Napoleon’s ministers asked him what the meaning of life was, Bonaparte replied, from deep within his cabinet, “It’s politics, stupid!” It’s worth thinking about what has happened over the last two hundred years and then asking yourself what kind of answer Napoleon would give his minister today. I’m pretty sure the answer he would give now would be “It’s finance, stupid!”
The difference between the two answers have deep implications. In my opinion democracy and politics stop working when debt levels are disproportionate. There are plenty of obvious examples. In Spain the Popular Party is taking decisions that are utterly incongruent with its electoral manifesto, and totally in line with the demands of its European partners that have lent the Spanish state 40,000 million Euros. When Berlusconi refused to cut back an interim government was forced on Italy, and the new government has no alternative but to follow Brussels’ orders. In Cyprus, when the parliament refused to approve the bailout agreed by its government with Brussels over the weekend, the European Central Bank threatened to cut off Cypriot Banks, and worked out a new agreement that did not go through parliament.
Hence, the questions we should all be asking is how can we build a world with less systemic risk and more effective democracies without resorting to demagogy? The answer obviously lies in reducing debt and ensuring that savings are channeled into the real economy using long-term instruments. Let’s not kid ourselves. In order to sustain social spending it is essential that we generate economic growth, and without finance for the real economy that is not going to happen. Low growth will not produce the tax revenues needed to lower sovereign debt, and democracies will therefore not only continue to be powerless, but will also face even greater difficulties in terms of sustaining their social spending.
Moreover, although our common sense tells us that assets should be bought when they are cheap and sold when they are expensive, today we are seeing the paradox that savings are heavily concentrated in government bonds, which probably constitute one of the greatest bubbles of the century. Prices for the majority of said bonds are at their highest level in history, which means that a vertiginous drop in bond prices similar to that of 1994 could cause a new banking crisis. Also, regulations have accelerated this suicidal trend, causing banks, insurers and pension funds to further fuel the bubble, creating greater systemic risk and leaving long-term funding with very little resources, which further hinders growth. Lastly, the government bond bubble has affected credit markets, where enormous masses of liquidity have been concentrated in search of profit. The result could very well be a new underestimation of credit risk that will lead to another systemic crisis.
It gets worse. While banks continue the deleveraging process, thereby restricting the real economy’s access to credit, governments are trying to mitigate fiscal deficits by means of spending cuts focused mainly on investments, which is limiting future economic growth (the nine largest world economies are investing $11 trillion when they should be investing around 20 trillion to sustain a growth trend that will permit sustainability of the system). Finally, an ageing population will mean that savings are increasingly concentrated in shorter-term assets, reducing still further the amount of funding available for the real economy.
In short, it is paradoxical that regulation was supposedly designed to bring financial stability at the cost of funding the economy, when in reality, both objectives should be compatible. A recent study carried out by G30* which examined possible solutions aimed at making savings flow into the real economy, produced the following suggestions:
First, regulation should not discriminate against long-term investment made by insurers or funds, like it currently does by favoring short-term investments.
Second, the fiscal authorities should address the current asymmetry between the tax treatment of debt and of variable income. It would be a good idea to eliminate tax deductions for interest on debt and lower the marginal corporate tax rate to compensate.
Third, debanking could help mobilize funds in the medium term for investment projects. The average maturity date for bonds is four years more than that of bank loans, so regulators should speed up the system so that the funding of firms and projects through capital markets will enable the mobilization of private investment, and, therefore, economic growth. In particular, capital markets should offer businesses medium-term tools like corporate bonds, project bonds, and trading capital.
Fourth, banks, governments and regulators should work on plans to offer loan packages for SMEs. This requires the support of public organisms so that liquidity and bank solvency are immediately improved, providing an incentive to lend to small firms.
Fifth, regulation should promote international investment flows in the long term (direct foreign investment) rather than short-term portfolio investments. A current account deficit is far less dangerous if it is funded using long-term tools rather than short-term ones.
In the nineteen seventies Hyman Minsky came up with a theory of financial instability, according to which banks accelerate cycles, both upward and downward, when really they should do the opposite. The greatest recession that we are now experiencing is the best and saddest example of his prediction. If we think first and implement some of the ideas expounded above, we could probably avoid Minsky being right again. Our children, democracy and the sustainability of the system, will no doubt be very grateful.
*Long-Term Finance and Economic Growth