Recipe for Financial Order: A Rule-Based System for Future Prosperity

Article excerpt

We are in a crisis which has two faces: a severe disruption of the financial industry and a stark recession. How do we get out of this situation? For the long run, we need a reliable institutional arrangement that will prevent getting into a similar financial distress again. In the short run, we have to move out of the present recession.

It has long been a tradition of Germany's Freiburg school that a market economy--Americans speak of capitalism--needs rules. A prime example is a rule system guaranteeing competition against endogenous market tendencies to form monopolies, if these tendencies remain uncontrolled.

Institutional arrangements, including norms of behavior, laws, and other rules draw from negative historical human experience, mostly historical disasters. Some came into existence after the Thirty Years War ending in 1648 and after other wars and internal turmoil. Rules evolve in order to prevent human hardship and misery. Without rules, life would indeed be "solitary, poor, nasty, brutish, and short," in the words of philosopher Thomas Hobbes.

On a global scale, rules refer to the institutional arrangements among states. In specific areas and to a certain extent, sovereign states cede sovereignty. This leads to the establishment of a multilateral rule system, binding sovereign states and their citizens. In the economic sphere, we have accumulated experience with the institutional set-up that affects all aspects of the international division of labor, mostly in the World Trade Organization. We now are in the process of finding new rules for global environmental scarcity.

After our negative experience with the recent financial crisis, what are the essential elements of a rule system for financial stability? Here are some crucial aspects.

Inflation and hyperinflation can be avoided by an adequate institutional arrangement for the central bank and by an adequate monetary policy. A basic rule is that public budget deficits must not be financed by printing money. The independence of the central bank is of utmost importance. The position of the central bank must be strong enough to resist political pressure for an easy money policy and for simply financing the public budget.

In order to develop rules for the soundness of the financial system, one needs to look at the functions that the financial system has to perform: allocate savings to investment; finance transactions, investment and infrastructure; transfer, reduce, and manage risks; perform maturity transformation within reasonable limits; and send reliable signals through prices. These functions should be performed without causing financial disturbances.

Balance sheet truth is essential. The Enron case in the United States in 2001 has made clear that stock markets cannot successfully intermediate between savings and investment if the balance sheets of firms are false.

Under such conditions, share prices are distorted; when the fraud is revealed, stocks are depreciated, stock owners are betrayed and the reputation and credibility of the financial market--a crucial precondition for market economies--is devastated. Financial markets cannot function correctly if they do not provide reliable information.

Balance sheet truth also applies to the banking sector. Bank balances should reflect risks adequately. Risks should not be put off the balance sheet. In securitization, the originator of a loan should retain part of the original risk, say 10 or 20 percent.

The bank's risk management has to ensure the sustainability of the institution. It has to anticipate how the bank's environment will change, including the probability distribution of risks. It has to be aware of risks in the tails of a probability distribution with low probability, but large damage, also known as "black swans." Capital adequacy requirements--a bank's capital in terms of shareholders' equity and retained earnings as a percentage of its risk weighted credit exposure--must take into account the long-run sustainability of a financial institution. …