A Guardian
column by Will Hutton provides an excellent summary of the solvency crisis that we have been in since 2008. He highlights how bailouts and extend and pretend policies have not worked. Finally, he calls for a bold solution to address the crisis.
Regular readers know that the bold solution needed to address the crisis is full implementation of the FDR Framework and its underlying disclosure requirement.
It is only when the market participants have the facts that a path forward can be confidently selected. That confidence comes from the knowledge that everyone knows who is currently solvent and who is insolvent. Everyone knows what is being done to either return the insolvent to solvency or, in the case of financial institutions, to wind them down.
My framework is called the FDR Framework because it was under his leadership that the philosophy of disclosure was brought to publicly traded stocks. What is needed now are leaders who are willing to combine this philosophy of disclosure with 21st century information technology and apply it equally to all financial instruments.
What we have witnessed is a mass global flight from risk and an accompanying hoarding of cash on a huge scale. It was the worst week in the financial markets since the dark days of autumn 2008 at the height of the implosion of the western banking system – itself one of the worst periods since the early 1930s.
But in important respects this week was worse. At least in 2008, governments could put their national balance sheets behind their respective banking systems to restore confidence. Now the fears are more deep-seated and far harder to counter.
As the bailouts transformed a banking system solvency crisis into a solvency crisis for the host counties.
The markets have lost confidence that western governments can successfully manage the legacy of vast private debt and broken-backed banks without imposing huge and nameless costs.
They don't know what the costs will be – perhaps a series of chain defaults on government debt starting in Europe, perhaps worldwide debt deflation, or even helplessly printing money to pay off public and private debts, so generating unmanaged and volatile inflation. But they know the costs will be huge. And unpredictable.
It is not surprising that markets have lost confidence in western governments' ability to fix the solvency crisis. The governments used their information monopoly to hide the extent of the solvency problem and instead engaged in a variety of extend and pretend policies.
As discussed previously on this blog, gambling on redemption has a number of problems. This includes that the prayer for a miracle might not be answered prior to the underlying solvency problems re-emerging.
Compare this to implementing disclosure under the FDR Framework. It lets market participants know exactly what are the costs and provides insight into how long it will take to fix the problem.
After all, Greece's eurozone creditors, who were part of the EU deal two weeks ago, accepted that Greece might not be able to pay its public debts in full. What about other countries in the eurozone, such as Italy and Spain, with even bigger public debts? Will their creditors be similarly hammered if the contagion spreads?
And if individuals, companies and governments have collectively got too much debt that they cannot repay, whether inside or outside the euro, what prospects for the banks – and indeed any of their creditors – who lent the money? What is the extent of their writedowns or even potential bankruptcy?
This is not a new credit crisis, but a continuation of the solvency crisis I predicted that began in 2007.
The markets have known these truths for some months but have trusted that policymakers in Europe and the US also knew the risks and also how to respond. In any case, it was hoped, global growth and the steady rebuilding of western banks' balance sheets would gradually allow the world to lower its massive debts and banks to remain solvent. But events of the past few weeks have shaken that faith to the core.
Because the markets do not have access to all the useful, relevant information in an appropriate, timely manner, market participants are forced to trust the policymakers.
It was these policymakers choice to gamble with financial stability by abandoning mark to market accounting and not requiring banks to retain 100% of pre-bonus earnings.
The scale of the economic challenges that the western industrialised countries now confront may be impossible to handle.
With disclosure, the scale of the economic challenge would be known and market participants could move forward.
Without disclosure, the confidence of market participants is steadily eroded.
"No major advanced economy is doing anything to promote growth and jobs," says George Magnus, a senior policy adviser to investment bank UBS. He is right.
Wherever you look, it is an economic horror story. Put bluntly, too many key countries – the UK in the forefront, with private debt an amazing three and half times its GDP, but followed by Japan, Spain, France, Italy, the US and even supposedly saint-like Germany – have accumulated too much private debt that cannot be repaid unless there is exceptional global growth.
That looks ever more improbable. Yet without growth there are only three ways out.
The first is to increase public borrowing to compensate for the collapse of private borrowing. Private spending is bound to be depressed as individuals and companies lower their borrowing – so for a time exports (as long as other countries are buying) and growing public debts are the only reliable avenue to promote economic growth.
But now there is a veto on growing public debt – due to the Tea Party movement in the US, the collapse in confidence in the euro and Britain's conservative government – and export demand from Asia is slowing.
The lessons from history are clear. Without publicly or privately generated growth there are only two other ways forward to pay down private debt after credit crunches: default or inflation, either containably managed or dangerously unmanaged.
What has unnerved the financial markets is that if the world cannot grow we are moving ineluctably towards these options. In the US, where the recent downward revisions to its economic growth statistics show how alarmingly weak its recovery has become, there has already been $300bn (£183bn) of private debt write-offs, according to McKinsey Global Institute's research. Now the Tea Party movement has vetoed any creative action by the federal government to stimulate growth, the pace of writing off consumer and mortgage debt can only accelerate. The impact on the American banking system, house prices and consumer confidence is bound to be serious.
In Europe the interconnectedness of public and private choices over debt is even more obvious – and being made more invidious with every hesitation by the EU's leaders about how to restore confidence in the euro.
In July, the EU at last seemed to have come up with an effective response, proposing a nascent European Monetary Fund to police the economic policies of euro members and which could, alongside the European Central Bank, lend to governments and banks in trouble.
But having risen to the occasion, which heartened me, Europe is now moving at stately pace. To be told by the EU commissioner for monetary affairs, Olli Rehn (who at least broke off his holidays to engage with the crisis), that the technical work would start in September while the German government simultaneously insisted that no more need be done, reassured nobody. There is no political leadership, and worse, a paucity of original ideas about what to do even if there were.
This is where adopting the FDR Framework and disclosure come in. As discussed above, with disclosure market participants move from the fear of the unknown, just how bad is it, to knowledge of what the true dimensions of the solvency problem are.
With knowledge that can only come from the combination of disclosure and the market participants' analysis of the disclosed information, governments and market participants can select a path forward.
This path can be chosen because market participants know which sovereign debt obligations have to be restructured and the size of the restructuring; which banks are solvent and which are insolvent; which insolvent banks are in a position that will allow them to earn their way back to solvency and which insolvent banks need to be closed.
The markets' reaction is made worse by herd effects – magnified by the many instruments, so-called financial derivatives, that have been invented supposedly to hedge and lower risks but which in truth are little more than casino chips.
Long-term saving institutions such as insurance companies and pension funds now routinely lend their shares – for a fee – to anybody who wants to use them for speculative purposes. The financial system has become a madhouse – a mechanism to maximise volatility, fear and uncertainty. There is nobody at the wheel. Adult supervision is conspicuous by its absence.
Mr. Hutton has just described a market without disclosure. Without disclosure, market participants are betting blindly.
What is required is a paradigm shift in the way we think and act.
The idea transfixing the west is that governments get in the way of otherwise perfectly functioning markets and that the best capitalism – and financial system – is that best left to its own devices. Governments must balance their books, guarantee price stability and otherwise do nothing.
This is the international common sense, but has been proved wrong in both theory and in practice.
Financial markets need governments to provide adult supervision. Good capitalism needs to be fashioned and designed.
Under the FDR Framework, the way governments provide adult supervision is by ensuring disclosure of all the useful, relevant information in an appropriate, timely manner to all market participants. Since the market participants are at risk of loss from their exposures, they have an incentive to analyze this disclosure. Governments can combine this analysis with their own internal analysis to provide yet another level of supervision.
Financial orthodoxy can sometimes, especially after credit crunches, be entirely wrong. Once that Rubicon has been crossed, a new policy agenda opens up. The markets need the prospect of sustainable growth, along with sustainable private and public debt.
The only way to achieve this is to reach back to a solution that was first adopted in the 1930s at the time of a similar economic crisis. That solution was disclosure.
Disclosure needs to be update and adopted to a world with 21st century information technology.
