Thorvaldur GylfasonThorvaldur Gylfason

JVI Policy Research Conference

Vienna, 22 March 2010

Begin in Barbados Dealing with small size through trade

Shared sovereignty in the Caribbean Common currencies (East Caribbean Dollar) Shared diplomatic services and central banks Common judicial systems, even supreme courts

Canada: “World’s soundest banking system”

Almost 200 U.S. banks have failed since early 2008, but not a single Canadian bank has

Delinquency rate in December 2009 for home mortgages in the U.S. was 9.5%, but 0.5% in Canada

International best practiceCareful federal

financial

supervision

Canada had no major bank

failures during Great

Depression, and did not

establish its Deposit

Insurance Corporation until

1967

How about the U.S. next

door?

StabilizationStabilization worked as

intendedPerhaps bank regulationregulation

during Great Depression also

helped stabilize GDP

Germany, France,

Scandinavia, others: Same

story

Not quite as clear, but standard deviation of per

capita growth fell from 3.1% 1831-1945 to 1.8%

1947-2003

Financial crises follow man like pandemics, with persistent regularityAbout every 20 years or so in United States at

least from 1792 until Great Depression 1929-39

Then, long-lasting stability, with intermittent minor crises Confluence of two forces: Stabilization and regulationConfluence of two forces: Stabilization and regulation

And then, following ambitious deregulation, serious threat of another big one in 2008 following collapse of Lehman Brothers

A big one was avertedBy fiscal stimulus and a promised return to

sound regulation, against stiff opposition

In 1970s, criticism in academic circles against active stabilizationstabilization policiespolicies Practical and theoretical grounds

Government intrusion into private markets Discretionary stabilization policies can be self-

defeating on a day-to-day basis, so … … monetary rules replaced fiscal discretion

In 1980s, similarly motivated criticism of regulation, esp. financial regulationfinancial regulationSignificant reversal of 1930s financial

regulation Commercial vs. investment banks: Firewall torn down

in US in keeping with Europe’s universal banking No particular attention was paid to Canada’s

experience

Plausible to infer that deregulation encouraged banks to take excessive risksSubprime loans in US, housing bubble, etc.

Willingness to apply fiscal and monetary stabilization policies was still in placeConcerted, massive stimulus by industrial

countries turned the tideSome think they should have done even more

Consensus on need for reregulationHow exactly remains to be worked outAsk the Canadians!Beware of warnings against lesser efficiency

Paul Volcker, Chairman of the Fed 1979-87, said 8 December 2009 at a conference organized by the Wall Street Journal: ““I wish someone would give me one shred of I wish someone would give me one shred of

neutral evidence that financial innovation has neutral evidence that financial innovation has led to economic growth – one shred of led to economic growth – one shred of evidence.”evidence.”

He added that in the U.S. the share of financial services in value added had risen from 2% to 6.5%, and then asked: ““Is that a reflection of your financial Is that a reflection of your financial

innovation, or just a reflection of what you’re innovation, or just a reflection of what you’re paid?” paid?”

Thorvaldur Gylfason

JVI Policy Research Conference

Vienna, 22 March 2010

1. 1. Need legal protection against predatory Need legal protection against predatory lending because of asymmetric informationlending because of asymmetric information

Like laws against quack doctors, same logicPatients know less about health problems than doctors,

so we have legal protection against medical malpractice

Same applies to some bank customers vs. bankers, especially in connection with complex financial deals

2. 2. Do not let rating agencies be paid by the Do not let rating agencies be paid by the banksbanks

Fundamental conflict of interestAlso, prevent accountants from cooking the books

3. 3. Need more effective regulation of banks and Need more effective regulation of banks and other financial institutionsother financial institutions

Work in progress, Paul Volcker in charge

4. 4. Read the warning signalsRead the warning signalsFour rules, or stories

The Aliber RuleCount the cranes

The Giudotti-Greenspan RuleDo not allow gross foreign reserves held by the

Central Bank to fall below the short-term foreign debts of the domestic banking system

Failure to respect this rule amounts to an open invitation to speculators to attack the currency

The Overvaluation Rule Sooner or later, an overvalued currency will fall

The Distribution Rule• The distribution of income matters

Source: Internal Revenue Directorate.

Shift of tax burden from the rich to the

rest

Iceland

5. 5. Do not let banks outgrow Central Bank’s Do not let banks outgrow Central Bank’s ability to stand behind them as lender – ability to stand behind them as lender – or borrower – of last resortor borrower – of last resort

6. 6. Do not allow banks to operate branches Do not allow banks to operate branches abroad rather than subsidiaries, thus abroad rather than subsidiaries, thus exposing domestic deposit insurance exposing domestic deposit insurance schemes to foreign obligationsschemes to foreign obligations

Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300.000 British depositors and 100.000 Dutch depositorsMay violate law against breach of trust

7.7. Central banks should not accept rapid Central banks should not accept rapid credit growth subject to keeping inflation credit growth subject to keeping inflation low low

As did the Fed under Alan Greenspan and the Central Bank of Iceland

They must restrain other manifestations of latent inflation, especially asset bubbles and large external deficits

Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth 

8.8. Erect firewalls between banking and politicsErect firewalls between banking and politicsCorrupt privatization does not condemn

privatization, it condemns corruption9.9. When things go wrong, hold those When things go wrong, hold those

responsible accountable by law, or at least responsible accountable by law, or at least try to uncover the truth: Do not cover uptry to uncover the truth: Do not cover up

In Iceland, there have been vocal demands for an International Commission of Enquiry, a Truth and Reconciliation Committee of sorts

If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself

Public – and outside world! – must knowNational Transport Safety Board investigates every

civil-aviation crash in United States; same in Europe

10. 10. When banks collapse and assets are When banks collapse and assets are wiped out, protect the real economy by a wiped out, protect the real economy by a massive monetary or fiscal stimulusmassive monetary or fiscal stimulus

Think outside the box: put old religion about monetary restraint and fiscal prudence on ice

Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth Physical capital (typically 3 or 4 times GDP) and

human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP)

So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less

11.11. Shared conditionality needs to become Shared conditionality needs to become more commonmore common

As when the Nordic countries providing nearly a half of the $5 billion needed to keep Iceland afloat imposed specific conditions on top of the IMF’s conditions

This may come up again elsewhere E.g., in Greece if the EU and the IMF are called on

to support Greece together For this, clear and transparent rules tailored

to such situations ought to be put in place 

12.12. Do not jump to conclusions and do Do not jump to conclusions and do not throw out the baby with the bathwaternot throw out the baby with the bathwater

Since the collapse of communism, a mixed mixed market economymarket economy has been the only game in town

To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized

Even so, it remains true as a general rule that banking and politics are not a good mixbanking and politics are not a good mix

But private banks clearly need proper regulation proper regulation because of their ability to inflict severe damage on innocent bystandersinnocent bystanders

Do not reject economic, and legal, help from abroad