[Corp. Watch] Forbes: "Laissez-faire capitalism has failed"

[Corporation Watch]

Laissez-Faire Capitalism Has Failed

  By Nouriel Roubini

(Forbes, Feb. 19) -- It is now clear that this is the worst financial  
crisis since the Great Depression and the worst economic crisis in the  
last 60 years.

	While we are already in a severe and protracted U-shaped recession --  
the deluded hope of a short and shallow V-shaped contraction having  
evaporated -- there is now a rising risk that this crisis will turn  
into an uglier, multiyear, L-shaped, Japanese-style stag-deflation (a  
deadly combination of stagnation, recession and deflation).

	The latest data on third-quarter 2008 gross domestic product growth  
(at an annual rate) around the world are even worse than the first  
estimate for the U.S. The figures were - 6% for the European Union  
(EU), - 8% for Germany, - 12% for Japan, - 16% for Singapore, and -  
20% for Korea. (The U.S. was - 3.8%.)

	The global economy is now literally in free fall as the contraction  
of consumption, capital spending, residential investment, production,  
employment, exports and imports is accelerating rather than  
decelerating.

	To avoid this near-depression, a strong, aggressive, coherent and  
credible combination of monetary easing (traditional and unorthodox),  
fiscal stimulus, proper clean-up of the financial system and reduction  
of the debt burden of insolvent private agents (households and non- 
financial companies) is necessary in the U.S. and other economies.

	Unfortunately, the EU is well behind the U.S. in its policy efforts  
for several reasons. The first is that the European Central Bank is  
behind the curve in cutting policy rates and creating non-traditional  
facilities to deal with the liquidity and credit crunch.

	The second is that the fiscal stimulus is too modest, because those  
who can afford it (Germany) are lukewarm about it, and those who need  
it the most (Spain, Portugal, Greece, Italy) can least afford it, as  
they already have large budget deficits. And third, there is a lack of  
cross-border burden-sharing of the fiscal costs of bailing out  
financial institutions.

	With its aggressive monetary easing and large fiscal stimulus putting  
it ahead, the U.S. has done more -- except for two elements, both key  
to avoiding a near-depression, which are still missing.

	The first is a clean-up of the banking system, which may require a  
proper triage between solvent and insolvent banks and the  
nationalization of many banks, even some of the largest ones.

	The second is a more aggressive, across-the-board reduction of the  
unsustainable debt burden of millions of insolvent households (i.e., a  
reduction of the face value of the mortgages themselves, and not just  
mortgage payments relief).

	Moreover, in many countries, the banks may be too big to fail but  
also too big to save, as the fiscal/financial resources of the  
government may not be large enough to rescue such large insolvencies  
in the financial system. (Traditionally, only emerging markets  
suffered -- and still suffer -- from such a problem.)

	But now such government risk, as measured by the "sovereign  
spread" [the difference in ratings between bonds issued by various  
countries], is also rising in many European economies -- Iceland,  
Greece, Spain, Italy, Belgium, Switzerland and, some suggest, even the  
UK -- whose banks may be larger than the ability of the government to  
rescue them.

	The process of socializing the private losses from this crisis has  
already moved many of the liabilities of the private sector onto the  
governments' books. Among these liabilities are banks, other financial  
institutions, and soon, possibly, households and some important non- 
financial corporate companies.

	At some point a national bank may crack, in which case the ability of  
governments to credibly commit to act as a backstop for the financial  
system, including deposit guarantees, could come unglued.

	Thus the near-depression scenario is still quite possible (I'd give  
it a 30% probability), unless appropriate and aggressive policy action  
is undertaken by the U.S. and other economies. This severe economic  
and financial crisis is now leading to a severe backlash against  
financial globalization, free trade, and the free-market economic model.

	To paraphrase Churchill, capitalist market economies may be the worst  
economic regime -- apart from the alternatives. However, while this  
crisis does not imply the end of market-economy capitalism, it has  
shown the failure of a particular model of capitalism.

	Namely, the laissez-faire, unregulated (or aggressively deregulated),  
Wild West model of free market capitalism with lack of prudential  
regulation, supervision of financial markets, and proper provision of  
public goods by governments.

	There has been a failure of ideas such as the "efficient market  
hypothesis," which deluded believers about the absence of market  
failures such as asset bubbles, and the "rational expectations"  
paradigm that clashes with the insights of behavioral economics and  
finance.

	The notion of "self-regulation of markets and institutions" clashes  
with classic issues of agency in corporate governance -- which are  
exacerbated in financial companies by the even greater degree of  
asymmetric information. For example, how can a chief executive or a  
board monitor the risk-taking of thousands of separate profit and loss  
accounts?

	And this is to say nothing of the distortions of compensation paid to  
bankers and traders.

	The crisis also shows the failure of the idea that securitization  
reduces systemic risk, rather than actually increase it -- in other  
words, that risk can be properly priced, when the opacity and lack of  
transparency of financial firms and new financial instruments leads to  
unpriceable uncertainty rather than priceable risk.

	It is clear that the Anglo-Saxon model of supervision and regulation  
of the financial system has failed because it relied on several flawed  
factors: self-regulation that in effect meant no regulation; market  
discipline that does not exist when there is euphoria and irrational  
exuberance, and internal risk-management models that fail because, as  
a former chief executive of Citigroup put it, when the music is  
playing, you've got to stand up and dance.

	Furthermore, the self-regulation approach created rating agencies  
that had massive conflicts of interest and a supervisory system  
dependent on principles rather than rules. In effect, this light-touch  
regulation became regulation of the softest touch.

	Thus, all the pillars of the 2004 Basel II banking accord have  
already failed even before being implemented. Since the pendulum had  
swung too much in the direction of self-regulation and the principles- 
based approach, we now need more binding rules on liquidity, capital,  
leverage, transparency, compensation and so on.

	But the design of the new system should be robust enough to counter  
three types of problems with rules. First, a tendency toward  
"regulatory arbitrage", as bankers can find creative ways to bypass  
rules faster than regulators can improve them.

	Then there is "jurisdictional arbitrage," as financial activity may  
move to more lax jurisdictions. And finally, "regulatory capture," as  
regulators and supervisors are often captured -- via revolving doors  
[executives who move back and forth between government and the private  
sector positions] and other mechanisms -- by the financial industry.

	Any new rules will have to be incentive-compatible -- that is, robust  
enough to overcome these regulatory failures.

---------------------

Nouriel Roubini is a professor at the Stern Business School at New  
York University