Reforming financial systems: building anew, or tinkering?

by Charles De Smet, Hayek Institute
25 April 2009


I. Apportioning blame

As always, gatherings of administrations bring together people with different agendas, varying calendars of elections and, too often, conflicting and antagonistic purposes. This spring however, the "crisis" jamboree of the G20 countries has brought together state executives with a common goal: how to use the recession to reassert the power of the states and roll back individual liberties. The leaders will try to convince their citizens that, even though they failed in their tasks in the past, they should remain in charge - and even more so - in the future.

In politics, you get more votes from consumers than from savers. In ancient Rome, consuls, senators, governors, were expected to patronize and lavishly fund the circus games and other orgies to gain support from the "plebs", and to entertain an army of scroungers, the "clientes". In modern so-called "democratic" states, the number of votes purchased by the artificial creation of income (social security, retirement, unemployment benefits, and an ever-expanding catalogue of hand-outs) are infinitely more numerous than the voices of the ones who will have to pay for that profligacy. These are, in any case, either foreigners (when you fund your circus games with external deficits) or unborn victims (when you borrow from your own citizens or when you increase retirement benefits while leaving today's contributions untouched).

The world is not short of professional gurus offering advice on how to reform the financial system. Most of the pronouncements come however from parties interested at preserving some parts of the system, while accepting to tinker with those components that are not part of their own field of activities.

Central bankers will not admit that the system built under the guidance of their "club", the Bank for International Settlements in Basel, Switzerland, was flawed from the beginning. The so-called "Basel Accords" I and II considered that imposing to the banks a minimum "capital adequacy ratio", i.e., an amount of capital equivalent to a specific share of their loan portfolio, would be enough to guarantee the "solidity" and "solvability" of the financial system. The "Accords" were nothing but compromises, largely dictated by the commercial banks themselves. Their purpose was more to limit competition amongst national regulations than to ensure the solidity and solvability of the whole.

But the central bankers' club has not been the only culprit in the system's failure.

Governments have largely contributed to the mess, in an infinite variety of direct or indirect interventions. The best known is of course the obligation for banks to allocate part of their portfolios to "underprivileged" parts of the population, i.e., to borrowers without the means to reimburse the credits. To allow the "Ponzi" scheme to continue, state-guarantees had to be granted, and funding provided, by "state-sponsored" institutions, whose failure has exposed the scheme. The actions of the US government in this respect did not differ from the behavior of now-defunct centrally-planned economies, where "credit" was directed at loss-making heavy industries without consideration for the giant destruction of resources. As Mises and Hayek have demonstrated, a rational allocation of resources in these economies becomes impossible.

In other parts of the world, other weaknesses have compounded the governments' mistakes. Wanting to build "national champions", rulers have supported acquisitions by local banks that failed to present any evidence of synergy, and lacked any strategy. To grow bigger became a purpose in itself. But, as in one of Jean de La Fontaine's fables ("The Frog who wants to make itself as big as the Ox"), one can swell oneself to death.

Sometimes, there was worse: some banks had public administrations simultaneously as shareholders and borrowers, as in the case of Dexia. This is not different from the situation found in central Europe in the phase immediately following the collapse of communism: the only groups able to subscribe to the capital of newly created "private" banks were large enterprises, mostly state-owned dinosaurs. But the funds were lent to the same enterprises by the same banks, resulting in financial institutions as useless as empty shells.

Conflicts of interests will not be limited to the states' recapitalization of the banks they already own. In fact, cases multiply where the states have to inject capital in several banks, raising serious questions about a weakening of competition and direct interventions of administrations in lending decisions. Doubts will increase on the conflicts of interests between the state as a supervisor (through a public authority), as a guarantor (through deposit insurance schemes), as a shareholder, as a participant in credit decisions (allocations by priority to public enterprises, "green" initiatives, "poor" neighborhoods), and as an employer (blocking necessary restructuring for fear of job losses).

National supervision agencies have failed to identify, anticipate, and solve the crisis. One will continue to argue whether these failures are due to the absence of coordination, or to individual failures, or to a lack of authority in imposing sanctions. Regardless of the explanation, supervisors, created to prevent crises, have been mostly inaudible in the deafening sounds of institutions crashing to the ground.

Banks themselves have not lacked imagination in inventing ways to generate income from operations kept "under the radar", i.e., off balance sheets. "Securitization" has been one instrument of risk-shifting, somewhere between "hide-and-seek" and "three-card-trick".

Merging insurance and banking has compounded the problems: selling risky investments through bank branches has been facilitated by the "coverage" of the risk by the seller/broker/insurer/banker. The seller's appetite was wetted by a remuneration that was certain and upfront. For the buyer, the risk was undefined, the reward unknown, and the loss could be total.

Rating agencies' role has been exposed over and over after the crisis, but not enough before the crisis. Remunerated by the borrowers, their excess of optimism before the disaster is only matched by their skepticism now that their paymasters have disappeared in the financial tsunami.

Last but not least, the depositors themselves, eager to increase their income, were often naive in believing that bubbles never ceased to grow, that there would always be a more gullible buyer in the future for their assets, and that higher rewards did not mean higher risks.

Reconstructing financial systems can be achieved by ignoring the evidence. The edifice will then only last till the next tremor. It can also be accomplished by accepting two premises. The first is that governments can be failures, or tend to behave in the ways of criminal organizations in the preservation of their own interests, to the detriment of their citizens. The second is that the objective of a private individual - or private enterprise - is to improve his or her own lot (ie., greed); if it remains the best engine for development, is also a danger for others when it turns to criminal behavior. A balance must therefore be found so that each of the two "would-be criminals" can control, limit, and discipline the other. It should be neither a "free-for-all" nor a "state-knows-best".

The following presents a few suggestions for the reconstruction of financial systems that would be efficient, stable and reasonably free of criminal activities and government meddling. It does not pretend to be complete and certainly calls for corrections and refinements. It would therefore be interesting to hear readers' objections and suggestions (1).


II. The reforms needed but eschewed

1. Licensing a bank to operate must remain the sole domain of a public institution, preferably the supervisory authority created by the state but independent from political interference and managed according to a clearly defined mandate. Allowing banks to be created by anyone would be an invitation to the criminalization of the entire economy. Here, however, the existing concept in Europe (a bank licensed in one country is supervised by the authority in its country of origin, and the country in which a branch is located relies on that supervision) should be corrected, as it has showed its dangers in times of crisis. After all, the government in the branch's country will be asked to protect the depositors in that branch.

Applying for a license (and the related supervision) should therefore be required in each country where the bank will operate, unless a common supervision agency exists for both countries. Should a European supervisory authority be created in the future, applying to that common authority should be the rule for any bank wishing to operate in more than one country of the Union (or the territory covered by the agency). This is not very different from the principles adopted in the United States, with its "national" and "state" charters. Maintaining state supervisory authorities have demonstrated in Europe the weaknesses, the limits, and even the perils of national systems pretending to control international banks (2).

The difficulties faced by various governments in attempting to put together rescue packages for banks active in more than one country is an indication of the degree of urgency.


2. The deposit insurance systems imagined for tranquil times have failed when needed, ie., in turbulent times. European governments have reacted chaotically: some raised the amount insured from 20.000 € to 50.000 or 100.000, or even to the full amount of all deposits. Some raised the limit for one year, announcing that they would revert to the original limit after the deadline. Other governments have raised their guarantee for some deposits, or some banks, but not others. In some cases, the amount covered by the blanket guarantee represents a multiple of the country's GDP, clearly unsustainable.

The entire concept of deposit insurance has to be reviewed from the ground up, considering four essential principles. The first is that the depositors do not have the possibility to evaluate the solvency and liquidity of a bank: a specialized agency has to do that for them. The second is that it is the assets of a bank (and not its capital) that guarantee the deposits in that bank. The third is that the limits of the reimbursement of a depositor (supposedly for the purpose of skimming the "rich" and favoring the "poor") introduces a concept of "distributive justice" that is at the same time senseless, ludicrous and ineffective. Not only does it not have any place in a banking system, but it creates new poors by downward equalization. The fourth is that a financial institution should be free to apply for insurance, and that its customers should be aware of the effects of that decision.

Any proposal for a deposit insurance system would have therefore to include the following elements:

The first one would be to make it an obligation for the banks to inform their depositors of the share of the bank's assets that the central bank would agree to refinance, according to a predetermined "floor emergency discount" ("fed") value. The ratio would fluctuate daily, with the liquidity of the assets. In the current crisis, we have seen in any case central banks fund banks indiscriminately, regardless of the assets' value, and sometimes based solely on the systemic risk they represent, ie, their size (3). The Basel I and II, tying the solvability of the banks to their capital as a fraction of their assets, and not the value (and maturity schedule) of these assets, did not guarantee the solidity of the system, as everyone is now painfully aware.

The second one would be to reestablish a coincidence between the "sovereignty" area (ie, the possibility for a given state to increase taxes to pay depositors) with the "risk" area (ie, the country in which the assets are located). It can not be justified, for example, to force Belgian taxpayers to pay for assets collected in Belgium by the subsidiary of an Icelandic bank but transferred to the head office in Reykjavik to be gambled on American mortgages. The pre-agreement for rediscount would also permit to insure the assets where they are, and avoid the dangers of "securitization" (4). In a rescue package, depositors in one country would be insured to the level justified by bank's assets in the same country: incidentally, European banks investing in assets in the USA would see the guarantee to their depositors reduced accordingly.

Combining proposals one and two would result in each depositor receiving, with each statement of account, a precise information on the proportion of his deposits covered by the insurance. This proportion should be a ratio of the total insured, not a ceiling of the deposits (so that the insurance does not become a "redistribution" mechanism). Finally, any bank that does not want to be insured should clearly indicate so on each statement. The central bank should also make information concerning the coverage ratios of all banks widely available on a day-to-day basis.

If a bank is facing a severe run, and calls for emergency rediscount, it may still be able to recall the assets later, and resume normal operations. When a run's amplitude or duration is so severe that the bank would clearly not be able to recover the trust of depositors, the bank's balance sheet has to be adjusted downwards. Unfortunately, the governments' fear of a breakdown in lending has led them to fund banks indiscriminately, maintaining alive banks that were clearly mismanaged (some of them being state-owned).

A reduction in the liabilities of the banks should be balanced by a reduction in its assets: taxpayers' resources should be used to shrink the balance sheet of the worst banks, not to maintain them alive. In the current crisis, the "once-size-fits-all" policy is clearly counter-productive: the more distressed the bank (ie., the worst managed), the more it has benefited from the gifts dished out by the states. A pernicious effect has been to force the well-managed banks to apply for "rescue" money as well.


3. Banks' closures have been haphazard, without any orderly appreciation of the degree of solvency of the assets. Proof of this disregard for the rule of law is clearly in the fact that, months after the recapitalisation and/or the provision of liquidity, discussions are still ongoing in all countries about the exact rules and size of a "bad assets bank".

A bank failing to meet the requirements or facing a run that can not be solved by the refinancing of assets should be wound down by the supervision authority, forbidding any state and political interference. If the face-value of assets is lower than the deposits received by the bank, using public funds to re-inject capital introduces distortions to the detriment of well-managed institutions, and destroys value. Recapitalising the bank should remain the sole decision of the private shareholders.

Forcing the valuation of assets at "market price" has clearly been a mistake, and should be recognized. In a global breakdown of trust, long-term assets have no value if banks were forced to sell.

In some cases, early in the crisis, states have chosen to nationalize a bank instead of closing it. If a bank has taken excessive risks, or has been mismanaged, it should not be rewarded by its nationalization, but penalized by its closure. The effects of these two solutions are indeed very different for the stability and efficiency of the financial system.

In the case of closure, the shareholders are losing their investment, unless they chose to avoid closure by recapitalizing the bank. Staff and management (who are generally responsible for leading the bank to its critical situation) are dismissed. But depositors do not suffer losses, and are free to transfer their assets to another - better managed - bank. In the case of a nationalization however, the taxpayers will be forced to fund the salaries of those responsible for the losses. A state-owned bank introduces severe distortions in the market, politically-oriented lending, and the frightening prospect of limitless losses.


4. Allowing prices and salaries to shrink.

When an economic sector experiences massive injection of resources, withdrawn from other uses, there should not be any cause for concern if the productivity in the new investments far exceeds returns in old industries, and if investments are effected with existing savings. When however, new investments are realized with credit, and the long-term productivity is dubious, the profits expected from a re-sale of the investment can not materialize without further injection of credit, and a bubble if clearly forming. The structure of production becomes distorted, and unsustainable. When the population is betting all future income on one single component (say housing) of its future needs, it is clearly wrong for the central bank to support the speculative frenzy with massive injection of credit.

A house that was worth 100.000 € in January 2000 had been estimated at 250.000 € before the start of the crisis in summer 2008 (the house-price index had increased by 150% in France, for example). But the overall GDP per inhabitant had only increased by 15%, excluding inflation. With no reason to believe that the household income would increase substantially in the future (gains in productivity, decrease in unemployment, new technical discoveries, etc...), the part of housing expenses in overall household income would rise from, say, 20% to 50%, a totally unrealistic assumption.

The price of the assets would therefore have to come down, to be back in line with the evolution of general income. In our example of a 100.000€ house, the "real" value of the same house should have been 125.000 €, as the overall income (real plus inflation) had increased over the same period by a total of 25% only. If the price reached at the height of the "irrational exuberance" (250.000€) goes down by 50%, it can hardly be labeled a disaster, as the "real" value of the house would be brought back in line with the price of other goods.

But strong resistance to such a realignment would come from the usual suspects, namely those who benefited from, and encouraged, "irrational exuberance", and lived from it. The group of hangers-on include not only the promoters, the construction companies, the real estate agents (these can accept their fate and find other ways of living), but, more importantly, the municipalities, departments, counties, ministries, and their menagerie of white elephants. These were addicted to the taxes collected from the sales, rising with the bubble, and allowing lavish lifestyles and useless investments. In France, for example, the additional people hired in public administrations to comply with the 35-hour maximum working week (11 people were needed to do the same job as 10 employees before the law), were funded largely by the taxes levied on "irrational exuberance".


III. Reforms that failed before and will be tried again


1. The states as saviors of industries

Entire industrial sectors are now clamoring to be "saved" by the injection of public money, or by new bank credits guaranteed by the state budget. Governments have a natural tendency to extend their reach, just as a criminal organization sees its own will as the sole limit to its growth. Administrations claim of course that their support will be "cyclical". But nobody has convincingly demonstrated that administrations are able to predict the duration and amplitude of cycles. In Europe, a maximum budget deficit of 3% of the GDP has been interpreted by some as a permission to maintain a permanent deficit close to that limit, even in periods of growth. Others have understood the rule as forcing them to fluctuate between equilibrium and -3%. A few interpreted that rule as allowing a cycle over a period of time (either between +3% and -3%, to maintain equilibrium over the cycle, or between 0% and -6% in the worst cases). In a depression, deficits systematically exceed the limit, and badly managed, spendthrift states live at the expense of virtuous ones, at least until the collapse of the common currency, if there is one, or a painful devaluation. Budget deficits should be banished altogether, and budgets should be based not on forecasts (always proven wrong), but on receipts effectively collected the previous year.

Not surprisingly, the worst offenders criticize the virtuous governments. If Luxembourg does not have to levy heavy taxes on its citizens (or foreigners' investments) it is undoubtedly due to the fact that it has rarely had a budget deficit. After all a "fiscal paradise" (5) can be defined as a country where public finance is well managed.

It seems that, in the profligate states, reality has difficulties translating into language. In France, a report had been commissioned with much media fanfare to suggest ways "to boost growth". The report, a catalog of micro-measures that should have been implemented half a century ago, to correct distortions introduced by the state itself, has been published in the first half of 2008. In the second half of the year, France entered in a prolonged phase of recession, and the GNP in 2009 is now foreseen to contract by 1%. The author of the report is still unable to face reality and talked recently of "the growth in 2008 being minus 1%"...


2. Providing liquidity indiscriminately

This has also been an obvious mistake. Banks may have long-term assets with very different creditworthiness. But the first applicants for the generosity of the central bank will be the banks with the worst assets. In the middle of an unfolding crisis, it is obviously difficult to set the rules for the refinancing of banks' assets, and this should have been defined long ago, with ratios established for all types of assets susceptible to be rediscounted, and the ratio of deposits covered by the insurance varying in accordance with the total "discountable" value of these assets.

Indiscriminate quantitative easing has been, so far, the only answer provided by the central banks. The term "quantitative easing" is another word for "cranking up the printing press". The massive injection of money into the system has predictable results; massive inflation, and the resulting destruction of financial assets. People with modest savings will see their value reduced to nothing, in order to maintain the value of houses purchased by people who knew they could not afford them.

Experiences of hyperinflation in Germany in the 1930s have been well researched. But the more recent occurrences have attracted less attention. Besides the sinking of Zimbabwe in a self-destructing spiral, one analysis of the hyperinflation caused by the Milosevic regime is even more interesting because it has been written by a liberal economist who became later the Governor of Serbia's central bank, and subsequently the country's finance minister. The title chosen for the English translation should sound as a warning. The author named his book in Serbian "The Economics of Destruction". The Serbian sub-title ("The Great Robbery of the People") has been replaced, in the English translation by "Can It Happen to You?" (6). To answer the question with today's slogan-based politics: “Yes it Can...”

It is not difficult to imagine that, had the Yugoslav central bank been truly independent from Milosevic's regime, there would not have been any Balkan war.

Providing liquidity in severe crises requires a central bank, a fact not always recognized by the most radical libertarians, but acknowledged by F.A. Hayek (7). It is true that Hayek has also advocated the abolition of the monopoly of money issuance, but, at the same time, he insisted that central banks might still be needed to insure the "elasticity of money". The legitimacy of the issuer is in the stability of the currency in its purchasing power (in terms of commodities). In this, mis-managed central banks can fail, but private issuers will fail even more, adding the problem of counterfeiting and fraud to the problem of erosion of value.


3. Discouraging savings

Most economists will agree that the current crises has been foreseeable, the savings ratio in the United States having fallen to zero in recent years. The Federal Reserve and other central banks are therefore implementing the wrong measures, discouraging savings by bringing the interest rate to zero. Lowering interest rates below the equilibrium level between the remuneration expected from savers and the expected productivity of investment raises demand but discourages savings. The battle goes on amongst academics on the definition of interest. It is worth quoting here three very different notions, the first one by someone who is a central figure in the current crises, the Fed's Chairman. The second by Hayek, and the third by someone who resurrected on April 2nd, J.M. Keynes.

In one of his many distinguished publications during his academic career before succeeding Alan Greenspan as the Chairman of the Federal Reserve, Ben Bernanke followed strictly the Keynesian definition of the interest rate. He wrote that the interest rate is simply the opportunity cost of holding money (8).

Based on that definition, it is not difficult to jump to the conclusion that "the Federal Reserve controls the nominal interest rate by changing the supply of money" (9) But even Mr Bernanke had to admit that the Fed can control the real interest rate in the short run only, and that, in the long run, the real interest rate is determined by the balance of saving and investment. Keynes, in his General Theory, gives two definitions of the interest rate: in one, the rate of interest is the reward for parting with liquidity. In the second, more roundabout, the rate of interest is the percentage excess of a sum of money contracted for forward delivery (10). In an annex to his Chapter 14, Keynes even addresses the very different approach adopted by Mises and Hayek, accusing them of confusing the marginal efficiency of capital with the rate of interest (11)

Hayek's answer, a few years after the fist publication of the General Theory, has clarified his meaning. It is worth quoting the entire sentence:
the rate of interest [...] is not a price of any particular thing. It is an element in the relations between the various prices of different commodities, a ratio between the prices of the factors of production and the expected prices of their products, which stands in a certain relationship to the time interval between the purchase of the factors and the sale of the product (12).

Hayek's definition refers to the cost of capital in the production process. But, as we have seen in the current crisis, the consumer (if we include in that definition the buyer of a house) does not relate to any "relations between prices", or "ratio between factors of production". In fact, the interest represents different things to the borrower and the lender. Just as Hayek described the price of a good as condensing all information for both buyers and sellers, the interest rate contains different components for lenders and borrowers.

For lenders, for example, it will comprise the cost of refinancing, the administrative expenses, the anticipated inflation, the level of trust in the borrower, the type of collateral and its "tradability" the overall macro-economic, legal and political environment, etc...

For borrowers, the interest rate must include some of these elements (with some variations due to difference in information, for example in the level of anticipated inflation). But the political environment has an opposite effect (the more troubled the environment, the more interesting to borrow, the less to lend). The estimate of the borrower of his own trustworthiness is, by definition, very different from the lender's perception.

The amount of research in the different ingredients leading to the expectations from both sides is very limited. But it should be obvious that the lowering of the rate of interest to levels close to 0% should mean that, for both borrowers and lenders, all of the ingredients leading to their decision are either canceling each other, or are also close to zero. It is difficult to imagine that everyone is anticipating a deflation (fall in prices), or trusting others more than themselves, or wishing to invest in enterprises generating losses.

With rates close to 0%, potential borrowers have massive demands for credit, because even unproductive investment are "worth" financing. Lenders (and savers) on the other hand, are withdrawing from the market, and prefer to salvage what they can from their belongings, in the knowledge that massive hyper-inflation necessarily follows an injection of 5 thousand billions US dollars (yes, 12 zeros...), unless governments brutally raise taxes to mop up the excess liquidity. If profligacy is not followed by austerity, the result is predictable: in 1923's Berlin, 5 thousand billion Reichsmark did not even buy a decent meal…

In the past, lowering the interest rate below the sum of its components has been a serious mistake. It has created the internet bubble, the housing bubble, the stockmarket bubble, and all other speculative follies in history. The liquidity injected in the system today should be priced correctly, to reflect the rarity of money, and to prevent it from becoming worthless.


4. Leaving civil servants irresponsible - and irremovable.

For decades, the depositors were required to fund the costs of institutions in charge of ensuring the stability and safety of the financial systems. These institutions have failed. Nevertheless, until today, no one has been fired.

Unfortunately, the G20 summit in April promised more of the same: the reform of the system is entrusted to the same institutions who have failed to correct the imbalances, fraudulent practices, and "irrational exuberance" when they appeared.

The International Monetary Fund (IMF) is given a strengthened mandate and additional resources to tackle the crisis. But IMF's massive brainpower has been powerless in the past, and some countries even declared it of little relevance only a few years ago. More to the point, even in cases when the IMF has correctly identified the appearance of a dangerous disequilibrium, its advice and warning have been ignored at best, treated with contempt at worst.

Already in its World Economic Outlook published in September 2005, ie., three years before the crisis, the IMF identified a major threat to the global financial system:

the swing in the saving-investment gap - from deficit to large surplus - in emerging Asia has resulted in an excess global supply of saving (a global saving “glut”) that has been channeled to the United States to finance its large current account imbalance.

In its typical roundabout style, the IMF wrote in the Outlook six months earlier (April 2005), about the same US current account imbalances:

Many observers, including IMF staff, have expressed concern that corrections to sustainable levels will likely require large exchange rate adjustments, especially against the U.S. dollar, with possibly disruptive effects on global financial markets and economic activity. In contrast, other observers are less concerned, arguing that a benign resolution of global imbalances is likely with today’s deep economic and financial integration.

And they were referring to studies mentioned already in September 2002. For more than six years, the US current deficit increased, warnings were given, and ignored. It is difficult to be hopeful today, and believe that the United States will in the future follow the IMF advice and accept to swallow the painful and bitter medicine prescribed.

Other countries less powerful than the United States have also ignored the IMF's prescription, and let their economies sink into spiraling deficits, either because oil revenues allowed them to be profligate (Venezuela) or because the regime's survival was more important than the well-being of the citizens (Zimbabwe, Argentina and countless others).

The G20 summit in April 2009 failed to say, in its final statement, how the IMF and other - still to be created - Financial Stability Councils - would be able to force governments - especially its major contributors - to accept prescriptions hitherto superbly ignored.


5. Plundering unborn generations

The political discourse in response to the reality of the greying of populations in Europe and Japan consists of three parts: hiding the problem, tinkering with existing systems, and robbing unborn children.

Hiding the problem consists of denying the reality that "Ponzi" schemes designed by Bismarck at the end of the 19th century (when life expectancy was so low and birth rates so high that the scheme did not cost a cent and was indeed profitable) faces bankruptcy with birth rates below replacement level, and life expectancy reaching well into the 80s.

When a small blimp appears in the birth rate (such as in France lately), clamors of victory are heard from politicians. Some have even speculated that, in Europe, France would soon be more populated than Germany (the latter declining faster). But the number of taxpayers born is still below the level needed to replace the dead ones. Furthermore, the so-called "revival" (or rather the slowing down of the demise) has to be put into perspective with other, more robust, birth rates in countries such as the DR of Congo, now the world's largest "francophone" country, and estimated to reach three times the size of France in 2050.

These trends in Europe and the pressures resulting from outside developments, have been known for years, but very few countries have acted to adjust their social security systems to the demographic realities. Continuing to promise retirement benefits without setting aside the vast resources needed to fund these future payments is not unlike criminal negligence (13).

Ant yet, funding retirement through private accounts could rehabilitate savings and find new roles for banks. Converting savings in rich but ageing economies into investments in countries desperate to find jobs for a young and growing population could also remove the incentive for the citizens of wretched countries to search for jobs in shrinking Europe.


6. Setting public rules for private rewards.

When taxpayers are forced to contribute to the rescue of private banks and companies, they become more sensitive to the rewards grabbed by managers who - by definition - have brought their companies to their desperate situation. Sometimes the governments have hastily produced regulations to forbid "excessive" remunerations in companies benefiting from the taxpayers' sacrifice.

While it is clear that nobody would deserve to be rewarded to ruin his company, the ceiling on bonuses on all companies is dangerously counterproductive, and has more damaging effects than positive results. If an excellent manager, with a proven track record, can demand a high remuneration in a healthy company, there would be no reason for him to accept to salvage a struggling state-supported enterprise for a fraction of the amount he estimates to be worth.

As a consequence, the companies supported by the state will only be able to attract the most mediocre of managers, those who will require the same salary, regardless of their results. This is a step toward collectivism, in the form applied in the former Soviet Union, with predictable results.

Rewards have to be tied to results, but, for governments used to rewarding the same way incompetent scroungers as well as hard-working and efficient geniuses, the principle of reward for result might be difficult to comprehend and implement.


7. Distorting the enterprises' legal and fiscal environment

The entire structure that has evolved around the legal fiction of joint stock companies needs reviewing, as it has been abused, to the detriment of the owners.

The reason for the fiction was to allow private persons to limit their responsibility in an endeavor, while sharing ownership and decision with others and group resources. For the outside world, the fiction of a legal person was created, able to contract, sue, hire, etc., with its liability limited to its capital.

From these simple beginnings, four developments have considerably altered the concept:

1)a company can become an empty shell, by repurchasing its own shares (some countries that were in the past forbidding this practice are now allowing it)

2)a company can purchase another by increasing the amount of its own capital, and paying the purchase with its own stock. Recent cases have shown that stockholders have little control on these operations, and a confused appreciation at best of the value of both companies. In the majority of cases, the total value of the new companies is lower than the value of its parts.

3)dividends are taxed, while the interests on loans and bonds are treated as expenses. This has introduced strong biases in favor of acquisitions through excessive financing.

4)the concept of owner/manager has disappeared, and a collusion will usually take place between directors and the largest shareholders (often themselves representing companies). Stockholders with smaller equity will be deprived of information and influence. Directors will be neither owners nor employees, and will promote their own interest against both parties.

Governments should address and redress the abuses of the fiction allowed by the law. A true reform of the enterprise's legal environment, and of the fiscal treatment of profit, should be implemented, either collectively, or, if not feasible, by one country leading by example.

Essentially, the reforms could include, for example:

1)the capital of a company should remain unchanged through one exercise;

2)the profits would be entirely distributed at the end of the exercise, with the possibility to subscribe to an increase in capital. Reinvested dividends would not be taxed. Distributed dividends would be taxed as income for the shareholders. There would be no company taxation in this case;

3)the repurchase by a company of its own stock would be forbidden;

4)the merger of two companies would require three separate steps: the liquidation of both, the redistribution of capital to existing shareholders, and the creation of a new company approved by all shareholders wishing to participate.


IV. Is there reason for optimism?

The haphazard solutions hastily cobbled up by individual governments will lead us necessarily to more state interventions, loss of freedom, increased taxation (or hyper-inflation) and distorted, inefficient economic systems. Injecting liquidity, capital and public funds in badly-managed banks does not improve governance, it just wastes more resources. Governments have promised to sell back their shareholdings in banks, but to whom and when? Governments hold shares and control in different banks, directing decisions and eliminating competition. Central banks have lowered their interest rates to the point where the demand should be limitless and the offer non-existent. When interest rate is zero, it should mean that you have to trust your borrower as much as yourself. Alas, today, trust has evaporated.

The cries from a wounded banking sector is, not surprisingly, for more self-regulation. There is no doubt that it is what Al Capone and his boys would have suggested to keep control of Chicago in the 1930s. In his article on ways to restore financial markets to health, the chief executive of a German Bank (14) suggested three solutions: "greater resilience via sophisticated market participants, as well as stronger market infrastructure and supra-national structures for the regulation and supervision of the global financial system." None of these addresses the main issue in the same article: illiquidity. And the fact that markets have contracted to the point of collapse has been due less to a problem of liquidity than to a complete breakdown of trust: central banks could flood the market with liquidity, trust will not be restored.

Europe could come out of this crisis with less government, better regulations, and more efficient financial systems. Or it could stagnate for several years, sink into a state-controlled economy, with punitive taxes, universal public support systems, and ultimately imitate the fate of the communist countries, ending up on the scrapheap of history. The choices to be made require administrations with courage and intelligence, willing to sacrifice themselves in the interest of their citizens' survival. The outlook is bleak indeed.

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notes :

1. Readers are invited to forward comments, critics and suggestions. E-mail: charlesdesmet at hotmail dot com .
2. Far from advocating yet another gigantic international organization, created from the top by grandiose inter-governmental gatherings, what is advocated here is the creation from the bottom up of a multilateral supervision agency without any of the tax-free perks and splendid isolation of current organizations.
3. By these a posteriori interventions, central banks and supervising authorities have moved from a "rule of law" to a system of ad-hoc (ie arbitrary) decisions.
4. Some, both in the central bankers' world and among bankers, will fiercely object to the return of a "rediscount window" at the central bank. To the first argument, the risks of inflation, it is answered that assets will have to be reimbursed at the latest when assets mature. To the second argument, the meddling of central banks in the banks' portfolios, it is answered that banks will remain free to apply for the facility. A relecture of Chapter VII of "Lombard Street" by Walter Bagehot (available on www.econlib.org) provides solid arguments by comparing one crisis without intervention of the central bank (where the system collapsed in a total breakdown of trust) and later crisis, when the Bank of England provided liquidity. But Bagehot correctly stresses that: "there is still a considerable evil. No one knows on what kind of securities the Bank of England will at such periods make the advances which it is necessary to make." This is precisely the core of the issue.
5. The French term for "tax haven" ("paradis fiscal") illustrates far better than the English wording the fact that, in fiscal terms, there can be "paradises" as well as "hells". It has always been the desire of those responsible for "fiscal hells" to eliminate "paradises".
6. Mladjan Dinkic, "Ekonomija destrukcije - Velika pljačka naroda, Belgrade 1995
7. "[W]hen everybody else wants to be more liquid, the banks for the same reasons will also wish to be more liquid and therefore supply less credit, [...] a general tendency in most forms of credit. These spontaneous fluctuations in the supply of money can be prevented only if somebody has the power to change deliberately the supply of some generally accepted medium of exchange in the opposite direction. This is a function which it has generally been found necessary to entrust to a single national institution, in the past the central banks. [I]f recurrent panics were to be avoided, a system which made extensive use of bank credit must rest on such a central agency.". F.A. Hayek, "The Constitution of Liberty", Routledge, 2005, pages 326-327.
8. Robert H. Frank and Ben S. Bernanke, Principles of Economics, 2nd edition, McGraw-Hill, New York, page 708
9. ibid., page 716
10. John M. Keynes, The General Theory of Employment, Interest and Money, Macmillan, 1964 (first published 1936), pages 167 and 222.
11. Ibid., page 193
12. F.A. Hayek, The Pure Theory of Capital, University of Chicago Press, Chicago, 1975, page 38
13. In this field also, the numerous IMF literature - and warnings - has received very little attention from the countries concerned. Quoting just from one study ("Public Pension Reform: A Primer" by Alain Jousten, IMF Working Papers, February 2007:
The resulting policy implications for assuring the viability of the system in the face of an aging process are equally easy to grasp. Though there is a myriad of ways that policymakers can react, all of these policies can be summarized to a simple observation of a need for benefit cuts to current and future retirees or contribution hikes for current and future workers. The most obvious, but politically rather unattractive, option would be to introduce explicit benefit cuts or contribution hikes to the system.
The emphasize (added) show that the interests of the governed and the governments are antithetical.
14. Josef Ackermann, "Lessons from a Crisis" in "The World in 2009", by The Economist, London.


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© Charles Desmet & Institut Hayek, 2009