Global policymakers and financial regulators as barriers to ending financial crisis

The Guardian ran an interesting column by Ha-Joon Chang in which he examined the role of Eurozone policymakers and financial regulators in perpetuating the financial crisis.

... Nevertheless, France has some grounds to be aggrieved [about losing its AAA-rating], as it is doing better on many economic indicators, including budget deficit, than Britain. And given the incompetence and cynicism of the big three exposed by the 1997 Asian financial crisis and more dramatically by the 2008 global financial crisis, there are good grounds for doubting their judgments. 

However, the eurozone countries need to realise that its Friday-the-13th misfortune was in no small part their own doing. 

First of all, the downgrading owes a lot to the austerity-driven downward adjustments that the core eurozone countries, especially Germany, have imposed upon the periphery economies. As the ratings agencies themselves have often – albeit inconsistently – pointed out, austerity reduces economic growth, which then diminishes the growth of tax revenue, making the budget deficit problem more intractable. The resulting financial turmoil drags even the healthier economies down, which is what we have just seen. 

Apparently, the same theory of trying to 'cut your way to profitability' that doesn't work for companies also does not work when extended to nations.

Even the breakdown in the Greek debt negotiation is partly due to past eurozone policy action. In the euro crisis talks last autumn, France took the lead in shooting down the German proposal that the holders of sovereign debts be forced to accept haircuts in a crisis. Having thus delegitimised the very idea of compulsory debt restructuring, the eurozone countries should not be surprised that many holders of Greek government papers are refusing to join a voluntary one. 

When the financial firewall is built not to protect bank book capital, but rather bank depositors, the idea of forcing holders of sovereign debt to accept haircuts is not only legitimate, but expected.

On top of that, the eurozone countries need to understand why the ratings agencies keep returning to haunt them. Last autumn's EU proposal to strengthen regulation on the ratings industry shows that the eurozone policymakers think the main problem with the ratings industry is lack of competition and transparency. However, the undue influence of the agencies owes a lot more to the very nature of the financial system that the European (and other) policymakers have let evolve in the last couple of decades. 

First, over this period they have installed a financial regulatory structure that is highly dependent on the credit ratings agencies. So we measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential. 

The Americans have actually cottoned on this problem and made the regulatory system less dependent on credit ratings in the Dodd-Frank Act, but the European regulators have failed to do the same. It is no good complaining that ratings agencies are too powerful while keeping in place all those regulations that make them so. 

The Eurozone policymakers are right that transparency is the key to reducing the influence of the rating agencies.  However, it is not transparency into how the rating agencies reach their conclusions.

Rather it is transparency where all market participants have access to all the useful, relevant information in an appropriate, timely manner.  Were this type of transparency in place, rating agencies would not have access to information that is unavailable to the rest of the market participants.  As a result, the rating agencies would become just another market participant with an opinion.

Most fundamentally, and this is what the Americans as well as the Europeans fail to see, the increasingly long-distance and complex nature of our financial system has increased our dependence on ratings agencies. 

In the old days, few bothered to engage a credit ratings agency because they dealt with what they knew. Banks lent to companies that they knew or to local households, whose behaviours they could easily understand, even if they did not know them individually. Most people bought financial products from companies and governments of their own countries in their own currencies. 

However, with greater deregulation of finance, people are increasingly buying and selling financial products issued by companies and countries that they do not really understand. To make it worse, those products are often complex, composite ones created through financial engineering. As a result, we have become increasingly dependent on someone else – that is, the ratings agencies – to tell us how risky our financial actions are. 

This means that, unless we simplify the system and structurally reduce the need for the ratings agencies, our dependence on them will persist – if somewhat reduced – even if we make financial regulation less dependent on credit ratings. 

Please re-read the highlighted text because it makes a very important observation about how we have moved from a transparency based financial system where everyone did their own analysis to a regulator embraced, opacity based financial system where everyone is relying on third parties for analysis.

The way to move back to the system that worked is for the regulators to embrace transparency.

The eurozone, and more broadly Europe, is slowly strangling itself with a toxic mixture of austerity and a structurally flawed financial system. Without a radical rethink on the issues of budget deficit, sovereign bankruptcy and financial reform, the continent is doomed to a prolonged period of turmoil and stagnation.