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Old Tuesday, February 22, 2011
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Oversight of the global financial system


By Shahid Javed Burki
Monday, 21 Feb, 2011



AFTER a great amount of introspection and reflection economists and policy analysts have reached two conclusions about the causes of the just concluded Great Recession. They believe that there were basically two reasons of the downturn of the world economy that devastated so many economies around the globe.
The first was the malfunctioning of the financial system. The second was the use of the housing sector to bring about better distribution of wealth. The latter was adopted as public policy by the government in the United States in particular.

Both, Democrats and Republicans concluded that the public was not prepared to use fiscal policies to improve the distribution of income. During the 1990s when the American economy boomed much of the benefit went to the wealthy while the real incomes of the middle and lower classes stagnated. One way of dealing with this situation was to improve the distribution of wealth and housing was the best available asset for achieving this goal. But this approach was adopted at the time the deregulation of the financial system was being diligently pursued. The result was that banks were able to lend large amounts of money often by not bringing it on their books through the use of products that were not regulated at all.

Enormous amount of profits were made by a number of operators in the financial system while the institutions they controlled acquired extremely risk assets. When the economy came crashing down it was the poor and the lower middle classes – the very people the system was supposed to help – who suffered the most.

The Great Recession reached well beyond the borders of the United States and hurt many countries including Pakistan. It was agreed that a new financial structure was needed that would prevent the recurrence of these series of events.The United Nations appointed a commission under the chairmanship of Joseph Stiglitz, the Nobel Prize winning economist to suggest how a new system should be structured. Stiglitz was expected to recommend a system that did not put the developing world at any disadvantage. The report the commission submitted is now being discussed by many forums around the world.

The commission correctly maintains that financial markets are not an end in themselves as they became in many parts of the Anglo-Saxon world, in particular the United States and Britain. They are supposed to perform many functions which enable the real economy to be more productive.These functions include mobilisation of savings, allocating capital and managing risk. The last function is meant to transform risk from those least able to bear it and to those that have the means to shoulder it. However, the opposite happened as the global economy unraveled in 2008-09.

In America and several other rich countries, the commission says, financial markets did not perform well the functions mentioned above. They encouraged people to spend rather than save, bringing the domestic savings rates close to zero, they misallocated capital, and they left huge risks with ordinary people.Write the authors of the United Nations’ Commission: “These problems have oc curred repeatedly and are pervasive evidence that they are systemic and systematic. And failures in financial markets have effects that spread out to the entire economy.” A number of recommendations made by the Commission have relevance not only for well-developed financial systems but also for those that are less mature such as the banking system in Pakistan. “The deregulatory philosophy that has prevailed in many Western economies during the past quarter century has no grounding in economic theory or historical experience: quite the contrary, modern economic theory explains why the government must take an active role, especially in regulating financial markets.” At this point it is useful to recall that Pakistan under the stewardship of President Pervez Musharraf and its bank er-turned prime and finance minister pulled the state further back from overseeing the banking system and capital markets than was the case in many other emerging markets, including India. Pakistan’s neighbour kept much of the banking system under the control of the state; in Pakistan, on the other hand, fourfifths of the total banking assets was placed in private hands.

That was a good move. As the recent experience with such public sector enterprises as Pakistan International Airlines and Pakistan Steel Mills has shown state’s direct involvement in the management of public utilities and manufacturing enterprises can have dire consequences for the economy. However, private ownership has to be married with public regulation to be a positive contributor to the economy. According to the Stiglitz Commission:

“Government regulation is especially important because inevitably, when problems are serious enough, there will be bailouts; thus government is explicitly or implicitly, providing insurance. And all insurance companies need to make sure that either the premiums they charge for the risks are commensurate with the risks or that the insured do not take actions which increase the burden on the insurer”. In the publicly owned companies in Pakistan, the certainty that the government will come to their rescue encouraged irresponsible behaviour.

There has been considerable innovation in the financial sector but much of it was regulatory, accounting and tax arbitrage. There was a great deal of money to be made by developing products that took advantage of the differences in these three things. Financial markets failed to make innovations which would have helped individuals and the society to manage risk better. The regulators also failed to create an environment in which firms can compete with one another. Without competition capitalism does not deliver on its promise.

According to Stiglitz and his colleagues: “When a firm is bailed out because it is too big to fail, it is evident that competition laws have not been effectively enforced. Now financial institutions have become so big that they are almost too big to save. And in the process of addressing the current crisis, we are creating ever larger financial institutions, sowing the seeds for problems down the line.The high fees and other abusive practice of credit card companies is a result of anti-competitive behaviour.” After diagnosing the problem, the commission under the direction of Joseph Stiglitz offered a series of recommenda tions that, if adopted, would save the world from facing in the future disasters such as those that threw man parts of the global economy on the ropes.The main direction of these recommendations is to involve the government in putting in place robust regulatory systems. These existed before but were designed and managed in a way that did not save the financial system from taking excessive risks in the knowledge that if the risks turned out to too much for the firms to survive , the state will step in save the faltering firms.

An ideal system of regulation would serve at least five important functions. It will (a) ensure the safety and soundness of individual financial institutions and financial system as a whole, (b) protect consumers, (c) maintain competition (d) ensure access for all and (e) maintain overall economic stability. These are all laudable objectives but the question is whether governments in emerging societies have the competence and the political will to put together a regulatory system that would operate totally without interference from vested interests.

Pakistan’s experience with the Competition Commission is an interesting illustration of how a well functioning institution operating under a brave and independent head can be thwarted from carrying its legitimate role. In such situations the regulators themselves need protection from an interfering government. This could perhaps be provided by the judicial system if it is able to function independently of government influence.

The main criticism of the Stiglitz Commission’s recommendations is that the governments are not always virtuous and would at times be prepared to act in ways that could cause damage to the society.
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