How Capital Flight Drains Africa: Stolen Money and Lost Lives

Léonce Ndikumana

James K. Boyce

Financial scams often cheat working people. In most cases, the victims simply lose their money. In Africa, some lose their lives.

Sub-Saharan Africa experienced an exodus of more than US$700 billion in capital flight since 1970, a sum that far surpasses the region’s external outstanding debt of roughly US$175 billion. Some of the money wound up in private accounts at the same banks that were making loans to African governments.

Inflows of foreign borrowing and outflows of capital flight are closely intertwined. As we document in the book Africa’s Odious Debts, there is a strong correlation between the two. For every dollar of foreign borrowing, on average more than 50 cents leaves the borrower country in the same year.

Decent Work 2.0

Frank Hoffer

Last month, Juan Somavia, the long serving Director-General of the International Labour Organisation (ILO) announced his departure in 2012.

As head of the ILO, he introduced the Decent Work Agenda in 1999 to re-focus the ILO and make it relevant for the 21st century. Twelve years later, the concept of ‘Decent Work’ is firmly established in the global debate and as an objective of national policy. It appears in many documents of the multilateral system, the G20 and national policy fora. It generates millions of Google hits. It is the subject of much academic research and debate. It is enshrined in several ILO Conventions and Declarations, and the international trade union movement introduced the annual Decent Work Day to campaign for workers’ rights. ‘Decent Work’ is so ubiquitous in ILO documents that some cynics say: "Decent Work is the answer, whatever the question!"

Is the Eurozone doomed to fail?

Jacques Sapir

The eurozone is currently undergoing a crisis of historic importance, which results in the accumulation of sovereign debt in eurozone countries and reveals the internal defects of the eurozone.

Since the beginning of 2010, the crisis in several EU countries has resulted in a faster growth of interest rates compared to those of Germany. This is known as interest rate “spreads” and has challenged the single real accomplishment of the eurozone: the relative convergence between countries on the debt market that began in 2000. This has been fuelled by the huge growth of sovereign debts in the wake of the 2007 crisis. But even this development could be linked to the euro as prior to the crisis it allowed a downturn of interest rates, which then facilitated the build-up of the large debt, both private and public, in most eurozone countries.

Table 1: Situation at the beginning of the crisis (December 31 2009) 

Source: C Lapavitsas et alii, “The Eurozone Between Austerity and Default”, RMF-Research on Money and Finance, occasional report, September 2010, available at www.researchonmoneyandfinance.org

When the difference between the interest rates of one country and those of Germany exceeded 300 points (the Irish debt reached its peak at 399 points[1]), it was clear that the eurozone had entered troubled waters. The homogenization process had been suspended, and the rates in Greece remained very high. The growth of the rate spread was actually caused by the deterioration of the debt situation in Greece followed by Spain, Portugal and Ireland[2].

Beyond the “at risk” countries, we can see the process of interest rates divergence going one step further. For example, Italy resumed issuing futures on government bonds in September 2009 (a practice that was suspended in 1999 when the euro was introduced). This shows operators are seeking to prevent new problems in this segment of the government securities market[3]. The fact that Italy reverted to this type of emission indicates that the euro is fast losing its protective role. The same can be said about worries now openly voiced on Belgium.

Yet, advocates of the euro stressed this role during the crisis. They argued that the euro helped member countries to avoid the consequences of their currencies fluctuating violently against one another. Nevertheless, these fluctuations have been possible because of the long standing decision to move to complete convertibility (capital-account convertibility). Note also that the speculation on exchange rates has been replaced by speculation on interest rates. One wonders what would have been the outcome had capital controls been introduced. But capital controls have been strictly prohibited under the provision of Article 63 of the Lisbon Treaty.

However, it is important to note that the introduction of capital controls is recommended by the IMF[4] to fight speculation. They could have helped avoid currency swings while giving eurozone countries the possibility to adapt their exchange rate to the massive divergence in the real cost of labour experienced in Europe since 2002.

This openness has made countries totally dependent on the eurozone. The adoption of a single exchange rate and the overvaluation that has characterised the euro since 2003 has also increased the economic pressure on certain members.

The rigid pressure of the single currency “noose” forces some eurozone countries to resort to ongoing growth of their budget deficits[5], which raises questions on the competitive deflationary policy of the Stability and Growth Pact within the Treaty of Maastricht (1992) and might have serious recessionary consequences for Europe. We cannot exclude the possibility that some countries may leave the eurozone[6]. Even the withdrawal of one country would cause a strong speculative movement, which would make the participation of others ever more expensive and eventually impossible.

When the euro crisis broke in April 2010[7], it had two dimensions: momentary dimension (the debt crisis in Greece, Portugal, Spain and Italy) and a more important structural dimension. The crisis was triggered by the growing lack of confidence among financial markets that countries with large debts were going to be able to repay them. The crisis began in Greece and then attacked Ireland, Portugal and Spain. It is now obvious that Italy will be next, as it was already the target of speculative attacks in July.

The plan adopted on May 9–10 2010 was supposed to put an end to the crisis. However, the market response shows that the lack of confidence has increased. The plan has been revamped several times, but each modification has only served to push back problems for one or two months. Market speculation reveals the following:

(1) This plan does not announce a clear commitment by donor countries as a large part of the funds are just a credit guarantee.

(2) The total sum is not enough to cover the estimated financial needs of 900–1000 billion euro for the three countries already targeted by the plan (Greece, Ireland, and Portugal). This amount is clearly short of what would be needed if Spain were to be rescued too. The default rate on bank credit has already reached 6.2% of the credit amount. With the planned end of the unemployment benefit package by December 2011, the default rate is likely to surge even higher, maybe to 10%.

(3) Some countries, such as Germany, are not ready to commit to obligations.

This plan has clearly been designed as an attempt to gain time. The only relevant action has been the ECB’s decision to buy out government and private debt, but even this is not completely satisfactory: only monetization of some part of the debt could give real breathing space. In early May Greece asked for more money, and Portugal and Ireland are asking for a renegotiation of their interest rates.

What options are left?

Fiscal austerity plans are pushing some countries to their limits. The fiscal adjustment needed to stabilize the sovereign debt is too great to be swallowed by different countries. What is more, the deflationary spill over effect has not been computed nor introduced in various forecasts presented by governments or independent research centres.

The cumulative effect of these different fiscal adjustment plans is likely to plunge the eurozone into a previously unknown depression.
The only possible solution would be a default on the sovereign debt for some countries (Greece and Portugal and maybe Ireland). But the economic competitiveness of these countries cannot be rebuilt without a strong devaluation. On the other hand, the Russian experience of 1998 is showing that long-term benefits can outweigh short-term pain. 

Table 2: Fiscal adjustment needed to keep the sovereign debt at its 2010 level

Source: Author’s computations and CEMI-EHESS database

However, such devaluation could not be obtained within the eurozone: these countries are then bound to leave it, maybe momentarily.
Problems will not stop with Greece and Portugal. While some of the eurozone countries would not benefit from a possible devaluation (Germany, Netherlands, Finland), others would, such as Ireland, France or Italy. Large budget transfers have not backed the single currency system adopted for the euro. Germany continues strongly opposing the very principle of turning the single currency into a transfer zone. But, as the single currency has prevented adjustments of the exchange rate, this left fiscal adjustment as the only way open. Fiscal adjustments will not be sustainable.

The coming crisis could mean the beginning of the end for the euro.

[1] G.J. Neuger and S Kennedy (2009), “Crisis Spawns Drive to Fixe the Euro with More Rules, ties (Update 1)”, Bloomberg, Feb 17
[2] E. Ross Thomas (2009), “Spain Downgraded by S&P as Slump swell Budget Gap”, Bloomberg, Jan 19
[3] A. Worrachate (2009), “Italian Bond Futures offer Proxy to Hedge Greek, Irish Debt”, Bloomberg, Sep 11
[4] J. Ostry et al. (2010), Capital Inflows: The Role of Controls, International Monetary Fund Staff Position Note, Washington D.C.: IMF
[5] On the depressive effects of the euro, see J. Bibow (2007), “Global Imbalances, Bretton Woods II and Euroland’s Role in All This” in J. Bibow and A. Terzi (eds.), Euroland and the World Economy: Global Player or Global Drag?, New York: Palgrave Macmillan
[6] S. Keendy and T.R. Keebe (2010), “Feldstein says Greece will Default and Portugal May Be Next”, Business Week, June 30
[7] A. Moses and D.S. Harrington (2010), “Bank Swaps, Libor Show Doubt on Euro Bailout”, Bloomberg, May 11

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Jacques Sapir is Professor of economics and Director of the CEMI Research Centre at EHESS (Paris), which focuses on Russia and CIS countries and on international development. He is the author of several books on the Russian economy, international finance and economic theory, notably (2000) “Les trous noirs de la science économique. Essai sur l'impossibilité de penser le temps et l'argent”, Paris: Albin Michel and (2011) “La Démondialisation”, Paris: Le Seuil.

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Further references
P. Dobson (2010), “European Yield Spreads Widen on Concern Debt Crisis Deepening”, Business Week, June 30
F. Cachia (2008), Les effets de l’appréciation de l’Euro sur l’économie française, Note de Synthèse de l’INSEE, Paris: INSEE

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Taxing Finance

Toby Sanger

The financial and economic crisis has led to a long overdue re-evaluation of the role, regulation and taxation of the financial industry around the world.

The IMF estimated that the crisis would cost G20 countries over $1 trillion in increased deficits; costs citizens are now paying for through public spending cuts, austerity measures and consumption tax increases. This alone is a good reason for the unprecedented interest in introducing new taxes on banking and the finance industry. Despite this, the commitment by G20 leaders at their September 2009 summit that the “financial sector should make a fair and substantial contribution” towards paying for some of the costs of the crisis remains unfulfilled.

Following strong advocacy by civil society and labour organisations, a significant advance was made in June 2011 when the European Commission recommended a European financial transactions tax be introduced by 2018 at the latest. It estimated this would generate €37 billion (US$52 billion) a year to fund the European Union’s budget activities.

Beyond paying for some of the costs of the crisis, there are also a number of other compelling reasons for increasing taxation of the financial sector.

Financial sector is too big
Whether considered from a critical political economy or a more conventional neo-liberal perspective, there is broader recognition that the financial sector has grown “too big” for the good of the economy, as a recent IMF report suggested. Finance is an intermediary industry, and doesn’t directly produce products with end-use values for people, so it can divert resources from other more productive areas. Excessive salaries and bonuses paid to engineering graduates to create new financial products and derivatives instead of working to meet more fundamental needs reflects the human resources side of this equation.

Tax changes have provided large benefits and preferences for finance
Major tax changes introduced over the past decades inspired by supply-side economics provided large benefits to the financial sector and to highly-compensated individuals in the industry. These include: preferential tax rates for capital gains and investment income, increasing dependence on consumption-based value-added taxes (which largely exempt financial services), cuts to corporate taxes, reductions in higher income tax rates, as well as the growing use of tax havens.

Reducing incentives for excessive risk-taking
Even from a micro-economic efficiency approach, there is recognition that tax changes increase incentives for short-term speculation and excessive risk-taking in the financial sector, as the IMF and the European Commission have acknowledged. Bankruptcy and limited liability laws have limited downside risk for corporations for centuries. Following the financial crisis, there is also more focus on the damage caused to the entire economy by systemically risky activities, with the implicit public guarantee for “too big to fail” financial corporations.

Some have argued that the exponential growth of trading in financial derivatives — futures, options, swaps, etc. — has magnified financial instability instead of reducing volatility as they were supposed to. The value of financial derivatives outstanding now amounts to over ten times the value of annual global economic output. Clearly much of this involves investments designed to increase profit through leverage and risky speculation instead of hedging to insure underlying investments against economic fluctuations.

There’s been little effort to contain or control this. Financial derivatives have been largely unregulated; unlike transactions for most other goods and services, only a few countries apply taxes to a broad range, let alone any financial transactions; the growth in derivatives, hedge funds, private equity and increasing use of secretive tax havens has not only siphoned revenues from national governments, but also made them more vulnerable to the power of financial capital.

There should be little surprise that pressure exerted by popular groups for new taxes on finance, such as the Robin Hood Tax campaign, is now being supported by many politicians and political leaders from different sides of the political spectrum. The common appeal for international development, anti-poverty, economists and political activists is that new taxes on finance could not just to help pay for the costs of the crisis and provide funding for global social and environmental needs, but also to tame the financial industry and help prevent further financial crises.

The leading group on innovative financing for development has endorsed financial or currency transactions taxes at low rates to raise revenues at the global level to fight poverty and climate change. Proponents estimate that a broad-based tax at 0.05% on all financial transactions could generate US$200 to $600 billion a year in revenues globally — significant funding for global development and environmental priorities.

The idea of special taxes on banks and financial transactions is neither new nor speculative. In 1936, John Maynard Keynes wrote in his General Theory that “the introduction of a substantial government transfer tax on all transactions might prove to be the most serviceable reform available, with a view towards mitigating the predominance of speculation over enterprise in the United States.”

Nobel-prize winning economist James Tobin applied Keynes’ idea when he proposed an international tax on currency transactions “to throw sand in the wheels” of international finance, reduce speculation and cushion exchange rate fluctuations after the Bretton Woods monetary system broke down in 1972.

Many countries already have long-standing and effective taxes on certain financial transactions. The UK’s Stamp Duty tax, which includes a 0.5% tax on most equity transactions, has been in existence since 1694 and raises over US$5 billion in revenues annually. Switzerland also levies a tax on transactions of stocks and bonds. China levies a tax on trading in stocks, and adjusts the rate depending on how much they want to cool down or stimulate their stock market. Taiwan not only taxes transactions of stock and bonds, but a tax at a lower rate on transactions of financial derivatives such as options and futures. Other countries have financial transactions taxes, although a number have been eliminated since the 1990s.

Given this experience, there is no question that financial transactions taxes are not only feasible, but can be effective and raise decent amounts of revenue at a low administrative cost without much economic disruption. The greater interest now is in even broader-based taxes to also cover currencies and financial derivatives. Because much of this trading is global and highly mobile, financial transactions taxes in these areas would be much more effective if established through global or multi-lateral agreements.

Of the US$600 billion figure for a 0.05% tax on all financial transactions, about 80% is estimated to come from trading in derivatives. However, there is considerable uncertainty about the impact of a tax on trading on different types of derivatives and therefore on how much revenue would be raised. With a tax based on the notional value of the derivative contract, in some cases even a small tax rate could exceed the value of the actual premium paid. A global FTT might not raise US$600 billion a year and cure all the ills of the global economy, but it could certainly raise significant sums while improving the functioning of the economy. There is solid research showing that a tax at a rate of 0.005% just on transactions of major global currencies could generate over US$30 billion annually at a low administrative cost with little impact on markets. The G20 and other countries should join with the European Commission proposal to establish broader-based financial transactions taxes at the international level, but agree to direct half the funds generated to international development and climate justice priorities.

There’s also no reason why national governments can’t proceed with increasing other taxes on finance. There’s a strong argument for Financial Activities Taxes to compensate for the broad exemption of financial services from most national value-added tax systems. As proposed by the IMF, a 5% tax on profits and compensation in the financial sector would form a good proxy for value-added by the industry and could generate approximately significant revenues in many countries.

Tax preferences that have provided disproportionate benefits to the financial industry and even increased the incentives for speculative behaviour should also be eliminated. These include reduced tax rates for capital gains, stock options and other forms of financial investment income. There’s also solid justification for a higher corporate tax rate on bank and large financial sector firms given the implicit guarantee governments provide to rescue them from failure.

These tax changes will not fix all problems with finance, nor will they eliminate speculation and generate all the revenues we need for global poverty and environmental challenges. But at a time when governments have reacted to the financial crisis by penalizing people with cuts to public spending, increasing taxes on finance would not only be much fairer but also better for the health of the economy.

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Toby Sanger is a CCPA research associate and senior economist with the Canadian Union of Public Employees. He previously worked as principal economic policy advisor to the Ontario Minister of Finance and as chief economist for the Yukon government.

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Further reading
Toby Sanger (April 2011), Fair Shares: How Banks, Brokers and the Financial Industry Can Pay Fairer Taxes, Canadian Centre for Policy Alternatives

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Brazil, India and South Africa: Low Spill-Over, High Resilience of Financial Sector

Martina Metzger

The course of the global financial crisis displayed widespread flaws in regulation and supervisory failure. The financial sectors of advanced countries piled up systemic risk comprising almost all financial institutions. In addition, high cross-border exposure between the financial institutions resulted in a core meltdown when the bubble burst in 2008. The financial sectors of many advanced countries risked collapse, meaning unprecedented monetary and fiscal intervention by policy authorities was necessary to stabilise the situation.

In contrast, many emerging market economies weathered the financial tsunami not only better than expected in terms of financial and macroeconomic stability given their previous performances during crises, but also better than G7 countries. Against this backdrop, we begin to question which factors account for the low impact of the global financial crisis and which features might explain the strong resilience of emerging markets’ financial sectors. The countries under consideration here are Brazil, India and South Africa. Apart from being heavy weights in their respective regions and continents, the financial sectors of these three countries showed a remarkable resilience to the global financial turmoil.

LOW SPILL-OVER TO BRAZIL, INDIA AND SOUTH AFRICA
With the default of Lehman Brothers, the US subprime crisis transformed into a global financial crisis, also affecting the financial markets of emerging market economies. Apart from a short period of stress in the second half of 2008 resulting in steep stock market corrections and a strong volatility of prices, in particular exchange rates, financial sectors in Brazil, India and South Africa proved to be robust.

First round effects or direct impacts of the global financial crisis on emerging market economies in general and on Brazil, India and South Africa in particular were low, as exposure of their domestic financial institutions to toxic assets had been small. There was only minimal investment in complex instruments and marginal exposure to risky financial products – marginal to such an extent that it was not necessary for regulatory authorities to fall back on counter-actions.

In addition, the share of foreign banks with majority ownership in the domestic financial system is negligible in India and South Africa, while in Brazil it is still low compared with more affected emerging market economies or transition countries; hence direct spill-over from banking headquarters in advanced countries to host countries was limited.

However, there had been considerable second-round effects with the financial sector and more importantly the trade sector as main transmission channels. The real economy had to bear the major burden: in the wake of declining exports, industrial production, investment and employment fell and real growth was depressed. All three countries slipped into a recession with a sharp slump of real growth in 2009.

POLICY RESPONSES
Despite some differences in the magnitude of the spill-over and severity of the transmission channels, policy responses by fiscal and monetary authorities of the three countries under consideration were quite similar. First, central banks increased liquidity by cutting policy rates; in a second step central banks reduced reserve requirements and compulsory deposits to provide additional liquidity to credit institutions; a third measure covered companies and banks which were affected by the restricted access to international and domestic finance, in particular trade finance. All in all, there was a sizeable monetary accommodation to cushion liquidity shortages and credit crunches in order to stabilise the domestic financial sector. Additional to the monetary policy measures fiscal policy initiated a package of measures with discretionary counter-cyclical instruments to dampen negative impacts of the global financial crisis on domestic growth and employment.

The fiscal stimulus packages focused on stabilising the level of domestic demand. Governments provided finance to mitigate the most severe impacts on vulnerable groups, in particular poor and low-income households as well as small-and-medium-sized enterprises. On the other hand, the governments of India and South Africa extended pre-crisis infrastructure programmes and initiated new ones in order to strengthen their economies’ potential to grow and at best to increase the economic inclusiveness.

In contrast to previous times of crisis in the 1980s and 1990s, this time central banks and governments of the three countries disposed over adequate policy space to use multiple instruments, including non-conventional monetary measures and counter-cyclical fiscal measures.

FEATURES OF FINANCIAL SECTOR RESILIENCE
Conventional wisdom suggests that the capacity to manage a crisis mainly depends on what policy has realised during good times, e.g. the creation of sound financial institutions, the improvement of regulatory and institutional capacities, the deepening and broadening of domestic financial markets and the design of an adequate monetary and fiscal framework which allows the involved institutions to work out a consistent response to a crisis in a coordinated way. Even so, the low impact that the financial meltdown in advanced countries had on the financial sectors of Brazil, India and South Africa raises the question of whether and to what extent specific characteristics and features of their financial market architecture and regulatory approaches can explain such high resilience.

There are four outstanding factors which might claim to have insulated the financial sector of these three countries from the worst woes of the global financial crisis. First, one key problem of past crises has been high foreign debt and associated currency and maturity mismatches; balance sheet effects were a major factor which exposed developing countries and emerging market economies most to hazard with regards to macroeconomic stability and development. Accordingly, Brazil, India and South Africa reduced their outstanding foreign debt exposure over time and from the turn of the millennium also succeeded in increasing their foreign exchange reserves.

Second, the macro-prudential approach which is applied by the central banks of Brazil, India and South Africa is another distinguishing mark of their financial architecture. As experience has shown that financial sector-related crises are an important feature of market economies, their central bank policy takes into account financial stability considerations – a task which many central banks in advanced countries rejected due to a perceived conflict of interest with the objective of price stability.

Third, another aspect in the financial market regulation shared by the three countries is the rule-based rather than principle-based approach. A rule-based approach with universal standards entails less forbearance and enables less regulatory arbitrage; supervisors’ decisions are based on transparent and reliable indicators, e.g. equity capital, non-performing loans or credit ratios. Hence, regulation based on a rule-based approach is easier to impose and decisions can be taken quicker which is backing pre-emptive surveillance.

Fourth, Brazil, India and South Africa exhibit country-specific features in a narrow sense, which contributed to the resilience of their financial systems. With regard to Brazil, for instance, it is worth mentioning that the supervision covers all financial institutions, including hedge funds and OTC derivative markets; another particularity is the so-called Public Hearing Process for regulatory proposals concerning securities. India, on the other hand, developed a special framework for non-banking financial companies (NBFCs) with an explicit treatment and deliberate prudential norms of those entities. Furthermore, banks have to make provisions for a counter-cyclical Investment Fluctuation Reserve, which bears some resemblance to the currently debated liquidity buffers by the Financial Stability Board. In South Africa the regulation on collective investment schemes, including hedge funds, comprises a ban on leverage and short selling strategies. With the National Credit Act, South Africa also developed a broad spectrum of instruments to protect consumer rights. In case of complaints by consumers and disputes with credit providers, including banks, the National Consumer Tribunal enforces a hearing process at which end it can completely suspend the credit agreement to the disadvantage of the credit provider when proved reckless.

Taking these features into account it comes as no surprise that banks in the three countries are on average sound, and banking behaviour has adapted to legal restrictions and norms; they even hold reserves and liquidity in excess of regulatory requirements, something considered inefficient and non-innovative before the crisis. More importantly, at the time of writing, banks in Brazil, India and South Africa had not been infected by the notorious originate-and-distribute virus of granting loans, which was a major driver of the credit and securitisation bubble which finally resulted in the global financial crisis; instead, they still execute the original banking model with a buy-and-hold strategy based on thorough credit assessment and borrower supervision.

In sum, the combination of a reduction of foreign debt exposure, a macro-prudential approach in supervision and a rule-based approach in regulation, complemented by a variety of country-specific rules applied by these countries even before the crisis, together with non-orthodox monetary and fiscal policies during the crisis can be identified as the main features of economic success.

The high resilience of the financial sectors of Brazil, India and South Africa is a result of continuously strengthening financial sector institutions and adjusting the regulatory framework to the respective country’s needs and vulnerabilities. This is an ongoing process which started two decades ago. Crisis heritage has proven a major motivation for macroeconomic and financial sector improvements while at the same time Brazil, India and South Africa constructively turned the drastic experience into a cautious and thorough handling of financial sector-related issues. In the hostile environment of a global financial crisis, the specific art of supervision performed by Brazil, India and South Africa was put to test – and impressively passed it.

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Martina Metzger is the executive director of the Berlin Institute of Financial Market Research (BIF). Before joining BIF, she taught macroeconomics at several universities and worked with UNCTAD. Her areas of interest include financial market development in emerging market economies, macroeconomic stabilization and sustainable development.

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FURTHER READING:
Martina Metzger and Günther Taube (2010), ‘The Rise of Emerging Markets’ Financial Market Architecture: Constituting New Roles in the Global Financial Governance’, BIF Working Papers on Financial Markets

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Reform Options for Financial Systems

Rainer Stachuletz

Hansjörg Herr

The neoliberal globalisation project gained momentum in the late 1970s through free market policies in the United Kingdom and the United States. Domestic and international financial systems have been increasingly liberalised and deregulated with the following important results:

a) Integration of financial systems

The deeper integration of international financial markets resulting from the deregulation of capital flows, together with the switch to flexible exchange rates after the breakdown of the Bretton Woods System, created a new source of shocks and uncertainty, as well as a new field of speculation.

b) The increasing role of non-bank financial institutions

Non-bank financial institutions such as investment banks, hedge funds, and private equity funds, became important players. These institutions usually have a speculative orientation, look for high short-term returns and work partly with extreme leverages. Non-bank financial institutions did not only use their own huge funds for their speculative activities; they also tapped the commercial banking system to mobilise additional funds for diverse investments in and outside the financial markets. Thus, commercial banks became more exposed to extreme kinds of risk. In addition, - segments of the financial market which had once been sheltered, like the real estate sector, became fully integrated.

c) Development of a shadow financial system

A shadow financial system with a low level of regulation (or none whatsoever) flourished and became important. Scarcely regulated offshore centres became international financial centres facilitating tax evasion, money laundering and other internationally organised criminal services.

d) Securitisation, financial innovation and derivatives

Securitisation exploded after the 1970s: firms and financial institutions preferred to hold short-term marketable papers instead of bank deposits; economic units of all types issued a growing variety of debt securities to get funds; banks sold their rearranged credit portfolios to non-bank financial institutions whereas rating agencies without any legally binding mandate gave these papers high ratings. Any government supervision was put in a ridiculous dual position: first they were consulting how to design those credit derivatives, then had to evaluate their quality.

Derivatives are initially designed to reduce price-related risks of financial instruments, e.g. changing asset prices, the price of foreign currencies or changing interest rates. The pricing of those derivatives is relatively transparent and the derivatives are marketable. Default and other qualitative risks (climate, temperature, natural disasters) are evidently hard to price, thus less tradable. Nevertheless, those products – hard to standardise or even to value – were developed and actively traded on less-regulated Over the Counter (OTC) markets.

The fundamental problem with risk markets is that risks are not eliminated through trade - they are simply reallocated. As in many cases, both contract partners are speculators, the market is transformed into a big casino where governments and tax-payers become unwitting guarantors.

e) Powerless central banks and supervisors

Central banks became onlookers in the new financial system. In fact, the interest rate remained their only tool to control price level changes, asset price bubbles, exchange rate movements and GDP growth. Central banks do not have instruments to guide funds resulting from expansionary monetary policies towards productive investment. Due to unstable international capital flows, monetary policy in many historical episodes had to follow the primacy of external stabilisation.

As a consequence, price bubbles in all asset markets have become more frequent, with negative economic consequences. At the same time, exchange rate volatility and increasing current account imbalances added to the instability of financial markets.

Frequently, price bubbles went along with credit expansion, in many cases not financing real activities. The big picture is that indebtedness increased. For example, private household debt in percent of GDP in the US increased from below 50% in the 1970s to over 100% in the late 2000s; enterprise debt increased in the same period from around 75% to over 125% (1). Government debt to GDP in many countries also increased sharply over recent decades.

The deregulation of financial systems which began in the 1970s produced an unsustainable credit expansion for almost all sectors in many countries and a general layering of debts. Bubbles, unsustainable credit expansions, international exchange rate turbulences and growing current account imbalances indicate a more and more fragile financial system. Even the current crisis could be overcome - without fundamental changes a new bubble with probably even more disastrous consequences will necessarily develop.

As a fundamental reform option, we favour a financial system in the tradition of the Glass-Steagall Act and the original Volker Plan. These plans were much more radical than the watered-down legislation which was passed in the US in July 2010.

What could the blueprint of a stable financial system which serves economic development look like?

The financial system should be divided into banks and non-bank financial institutions. Such a regulation implies a distinctive wall between banks, being the major source of finance for firms, and more risk-oriented and even speculative non-bank financial institutions. Commercial banks are then forbidden to engage in proprietary trading, e.g. speculating with their own or borrowed funds; they are not allowed to own investment banks, hedge funds or private equity funds nor to give credit to those institutions and other non-banks. If the latter want to get funds for their businesses, they are forced to attract money held by households. These funds will create sufficient venture capital for start-ups and risky innovations which are not financed by commercial banks. Financial or any other business relations to institutions outside the regulated financial systems (e.g. offshore) are strictly banned.

The allocation of loans originated by banks should be regulated by the central banks. Loans to the real estate sector can be quantitatively restricted as consumption credit. Equity holdings for such credit could be discretionarily changed by monetary authorities. This would allow counter-cyclical equity holding in contrast to Basel II, which leads to unwanted pro-cyclical effects.

Real estate financing and large parts of the private equity industry with their specific social and financial dimensions could be considered a special case and permitted only to specialised and state-licensed institutions. The real estate market can be made a special segment with regulated credit relationships to the rest of the financial system.

Banks in a liberalised environment are triggered to follow aggressive and risky business strategies to defend or increase their market share. To reduce destructive competition between banks, in a regulated financial system, competition among commercial banks could be limited by fixing, for example, real deposit rates of commercial banks. Also, ceilings for interest rates could be given by central banks. In a very highly regulated system, the central bank could even fix interest rates and the quantity of credits the banks are allowed to give. The advantage of such a regulated credit rationing system is that restrictive monetary policy can be implemented without increasing interest rates.

Derivatives should be sold and bought only in regulated and controlled markets. Strictly controlled position limits shall exclude speculative attacks. Only certain standardised products which have been checked by a supervision agency should be allowed, and only certain agents with licences should take part in the market. Securitisation of credits should be possible to a certain extent. If the originator of a loan is forced to keep a substantial part of the loan in its books and derivatives are standardised, securitisation is harmless.

Last but not least, such a system needs international capital controls to give central banks instruments to control unstable international capital flows. Current account imbalances should be kept small. The debates during the Bretton Woods negotiations in the 1940s could be a starting point for the development of such a system.

A financial system outlined above is not imaginary. It existed in the US and most other industrialised countries after World War II. Even comprehensively regulated systems existed and partially still exist in different versions in all East Asian miracle countries after World War II. The Chinese financial system after 1978 also fits such a system. Financial systems in these countries offered sufficient and cheap credit for the enterprise sector and thus stimulated growth and employment without financial market instability.

For many, the above blueprint of a reformed financial system does not seem politically enforceable. However, the fragility of the financial system will continue. History may create a window of opportunity for a change. If such an opportunity comes, we should know what to do.

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Hansjörg Herr is professor for Supranational Integration at the Berlin School of Economics and Law and at his university the economic director for the MA Labour Policies and Globalisation of the Global Labour University.

Rainer Stachuletz is professor for Finance at the Berlin School of Economics and Law. Currently he is working as a consultant for the State Bank of Vietnam at the Banking Academy in Hanoi.

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Further Reading:
S. Dullien, H. Herr, EU Financial Market Reform. International Policy Analysis 2010, Friedrich Ebert Foundation, http://library.fes.de/pdf-files/id/ipa/07242.pdf

(1) Fed, Flow of Funds Accounts Database 2010

Taxing financial transactions: the right thing to do when you owe $600bn a year and have lost control over global finance

Pierre Habbard

For those who had placed some hope in the G20 process to start re-regulating global finance the result, so far, has been utterly disappointing. Governments and central banks have been as eager to bail out the bankers and take on their ‘toxic assets’ as they have been reluctant to move decisively on financial regulation. At every G20 Summit since the first one in November 2008 in Washington, we have been told that a revamped and enhanced Financial Stability Board (including the IMF, the OECD, the BIS and other key financial organisations) would lead the way with concrete deliverables to bring the focus of global finance back to the real economy. We have seen instead a long series of reports on what-went-wrong and “high level” principles and “guidance”, but with no teeth when it comes to enforcement. If anything, these reports reveal the extent to which supervisory authorities are exposed to a “significant lack of information” on “where risks actually lie” (FSB & IMF 2009). They tell us that, two years into the crisis, the “current state of analysis limits the extent to which very precise guidance can be developed” (BIS, FSB & IMF 2009) and that “considerable work remains” (SSG 2009) in the areas of banks’ internal controls and regulatory infrastructure.

At the G20 Summit in Pittsburgh (G20 2009) in September 2009 however, some hope emerged that at last something tangible could be agreed upon in the near future. G20 leaders called on the IMF to undertake research to determine a “fair and substantial contribution” that the financial sector could make to pay “for any burdens associated with government interventions to repair the banking system”. They further asked the IMF “to strengthen its capacity to help its members cope with financial volatility, reducing the economic disruption from sudden swings in capital flows.” Read together, the two mandates were seen as an opening to an old policy issue that had been long neglected by governments and international financial institutions: the creation of a global Financial Transaction Tax (FTT).

In its original proposal by James Tobin in the 1970s (TUAC 1995), the economic justification for an FTT starts with the acknowledgement of the harmful effects of short-term speculation producing strong and persistent deviations of asset prices from their theoretical equilibrium levels. Such “overshooting” in prices lead to speculative bubbles over the long run. A measured and controlled increase in transaction costs implied by an FTT (from 0,02% up to 0,5%) would slow down trading activities so as to align capital flows with economic fundamentals and the real economy, while freeing up new sources of financing for global public goods. Since then, the FTT has been developed in different ways by economists and civil society groups, each putting different weight on the twin objectives of curbing financial speculation and freeing up new sources to finance global public goods. In fact, some proposals had such a strong focus on financing for development that in most cases they explicitly excluded the initial objective of Tobin to curb speculation, targeting a minimalist tax rate of 0.005% to avoid “producing market distortions” (HILLMAN et al. 2007) or “disrupting the market” (SCHMIDT 2007).

Unlike in the pre-crisis literature, the FTT has now gained considerable traction, both as a financial stability instrument and as a solution for financing development. There is a strong case for this. Regarding financial stability, it would be hard to contest that at least part of the crisis we face today has been triggered by a speculative bubble in the derivatives markets and by global imbalances of current accounts between regions and within regions. As Stephan Schulmeister (SCHULMEISTER 2009) puts it, the size of the trading in derivative products is just much too big to be accounted for by its original purpose: to hedge against price volatility or credit default risk. On the revenue side, OECD governments still have to deliver on their past commitments to finance global public goods, including the Millennium Development Goals (MDG), but also on ‘new’ demands regarding climate change adaptation and mitigation measures for developing countries (the financing of which was a major contributory factor in the failure of the Copenhagen Summit). According to TUAC estimates (TUAC 2010), the global public good resource gap that would emerge would be in the range of $324-336bn per year between 2012 and 2017 ($156bn for financing climate change measures in developing countries, $168-180bn for Official Development Assistance to reach 0.7% of GNI).

To make matters worse, the very same OECD governments are running budget deficits at unprecedented levels as a result of the global crisis, including the bailing out of the banking sector. According to the OECD, the size of the fiscal consolidation that would be needed in the 2012-2017 period to bring deficits back to normal levels (below 2%) is projected at $300-370bn per year - on top of the above resource gap for public goods. Unsurprisingly, the OECD experts would want to fund this gap with cuts in public expenditure, “long overdue reforms” to public pensions and regressive tax reforms that would hit working people front on. In the absence of new tax revenues, such a fiscal scenario would have working families pay twice for the crisis: first through rising unemployment and falling incomes and secondly as a result of cuts in public and social services.

Against this background – “heavily indebted rich countries” whose supervisory authorities have lost control over global finance – then surely now is the time to take the FTT option seriously. This is what many unions have been campaigning for, together with social movements, as seen in recent initiatives in the US, Europe and Asia. For its part, the TUAC has been working on a paper (TUAC 2010) on the parameters of a FTT together with the ITUC. Based on recent contributions by Dean Baker (BAKER et al 2009), Stephan Schulmeister (SCHULMEISTER 2009), and Bruno Jetin (JETIN 2009), the paper shows that an FTT could be designed with different rates per counterparty (large banks, other financial institutions including hedge funds, and non-financial corporations) and per market (‘traditional’ foreign exchange markets, exchange-traded derivatives, over-the-counter derivatives). Such a multi-tiered tax regime would help hit where it really hurts and target the counterparties (e.g. large banks and hedge funds) and transactions (e.g. derivative products) that are more prone to speculative trading than others. The revenues generated would be in the range of USD200-600bn per year if the tax is applied on a global scale.

Following the G20 summit in Pittsburgh, the IMF was quick to publicly dismiss the FTT (IMF 2009) as an option to be considered in the commissioned report (forthcoming, April 2010). The sceptical reaction of the IMF is not surprising. Ever since 1995, when the Tobin tax became a “global issue”, the IMF has not seriously considered the issue. The main objections are with the negative impact that the reduction in trading volume would have on price volatility and market liquidity. Other objections relate to the potential transfer of the added transactions cost to “middle class investors”, the opportunities for tax avoidance or the more economic theory textbook argument that tax should apply to value added, not to transactions. Dean Baker (BAKER 2010) has published a solid set of responses to those criticisms as has Stephan Schulmeister. Overall, the single most important aspect to keep in mind in considering the pros and cons of an FTT is the need to look at the specific problems associated with the FTT (in contrast to generic problems that would also be encountered by comparable regulatory options). IMF and OECD concerns about feasibility clearly belong to the latter category: yes, implementing an FTT would be complicated, but would it be more complicated to implement than an alternative solution that would deliver comparable financial stability and global public good financing? On that, the IMF has argued for the creation of a “global banking insurance scheme” as an alternative to an FTT. However the two instruments differ in terms of both revenues (which would not be available for public goods under an insurance scheme) and the handling of risk. Regarding the latter, the insurance scheme in fact would be more onerous for regulators than the FTT. A pre-requisite for any insurance scheme is the ability to price the risk associated with the banks’ balance sheets, which in turn presupposes the ability of the insurer (the regulator) to conduct proper risk assessment of the insured (the banks) and to do so at reasonable costs. And yet it appears that such a basic requirement has become a step too far for financial authorities.

An FTT, unlike the insurance proposal, would provide governments with a powerful regulatory tool which would not depend on the ability of the supervisory authorities to price or assess risk. It would be no panacea for the much broader agenda on financial re-regulation, but it would offer government a ‘low-cost’ instrument for tackling volatility in asset prices and for downsizing the global banking industry, particularly at a time when the international financial supervisory framework is in tatters and will take a decade to reform. It would free up new sources of financing for global public goods at a time when public services and welfare are at threat.

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Pierre Habbard is a Senior Policy Advisor at the Trade Union Advisory Committee (TUAC) to the OECD.

The end of an era: What comes after financialisation and what will be the consequences for labour?

Ekkehard Ernst

The global financial crisis that started in 2007 is marking the end of an era. This era has been characterised by deepening financial markets, a growth process driven by the accumulation of household debt and the international financial dominance of the North. The disruption of financial markets and the shake-up of the world trading system, however, are likely to undermine this economic model permanently. As a result of the crisis, new regulation may be introduced, political and economic power is likely to shift from North to South and new actors will be entering the scene. Most importantly, the legitimacy of earlier policy prescriptions which have led to a rising trend in social inequality has been significantly undermined. Will this ring the bell of a new high era for labour as during the Fordist period? Or, in contrast, will distributional battles stiffen? What will be the new sources of growth and who might benefit from them most? The jury is still open as we are in the middle of the battle storm, but some new trends are already emerging that will shape the future ground for global governance.

To understand the dynamics of the recovery and get a better grasp on different exit strategies from the crisis, it is useful to widen the scope and take a politico-economical perspective. The main actors in this play are financial investors and their lobby groups, employers and employers’ associations as well as workers and trade unions. In the post-war era with its large companies and relatively uncontested markets, benefits from growth were shared between employers and labour, often at the expense of financial investors. This changed when power shifted during the era of financialisation to financial investors as a result of freer international capital flows and more open goods markets, and led to an erosion of labour’s bargaining power. Some of the factors that triggered that shift are still at work today. What has changed, however, is the legitimacy with which the community of financial investors has argued in the past for less stringent regulation and freer international capital flows: The crisis has undermined this position even in the eyes of the most favourable observer and this might result in a rebalancing of power and sharing of future benefits from growth.

Shifting power will be shaping the crisis exit and recovery on two levels over the coming years: At a first, immediate level, governments and lobby groups will clinch over how best to regulate financial markets in order to restore some sense of medium-term stability. This may imply stricter rules for banks to hold larger stocks of regulatory capital or additional taxes to fund a – government-sponsored – financial safety net. It may also entail new rules to curb international capital flows, in particular the more volatile, short-term speculation on currency markets, and to limit or prohibit the use of certain types of financial products, deemed particularly dangerous for the stability of the system. Quite naturally, the banking industry and financial sector lobby groups resist any attempt to such regulation or make only minimal concession. The absence of a single international coordinating body that could produce a new international regulatory framework – the Bank for International Settlements is only a voluntary body and the International Monetary Fund does not have a mandate wide enough to cover all of these aspects – helps such lobby groups in limiting governments in their regulatory ambitions. In addition, governments are increasingly constrained by financial markets in their quest for new financial sources to fund their rising public debt. Even though deficit ratios are likely to go down with the economic recovery, existing debt has almost doubled in size in some countries and will need to be (re)financed in the future, creating favourable margins for political lobbying by financial investors.

At a second, more remote level, different actors will strive for new sources of growth. Such a trend was already visible before the global crisis as several larger economies showed signs of exhausting earlier productivity gains. The debt-driven recovery during the 2000s was temporarily hiding these structural problems but is unlikely to be an acceptable or feasible source of growth in the future. New growth patterns require investment, however, and different views on what constitutes sustainable long-term growth will compete for scarce funds. One particular fault line will be whether these new growth drivers must be sought domestically or internationally, intensifying the use of export-led strategies. Clearly, a more sustainable long-term recovery of the world economy would require a stronger balance between domestic and foreign sources of growth. Strong interest groups, however, particularly in those countries heavily relying on external demand, have already started to push for policies to restore (price) competitiveness for faster export growth. Strengthening domestic sources of growth, on the other hand, would require reorienting private and public investment towards new sectors, such as environmentally–related industries (“the green economy”) or care services. To be fair, both sources – domestic and international – are not incompatible but the coming regulatory changes – especially regarding international financial transactions – will have implications for their relative importance in the recovery and over the medium-term.

What does this mean for labour? Will employment recover to previous levels? Can labour markets provide sufficient jobs to absorb a rising world labour force? And under which conditions can this be achieved? The different forces that are shaping the path to recovery from the crisis give rise to four scenarios that are conceivable on the basis of these two lines of conflict:

In a first scenario, finance wins on both accounts: Financial regulation will be minimalistic and international capital markets remain wide open. Governments are constrained by their lack of additional funding, making any attempt for reorienting the growth process towards new, more sustainable sources difficult if not impossible. In this scenario, job volatility will remain high, employment growth may recover to earlier rates but with the heightened risk of new periods of financial instability and crashes.

In a second scenario, finance dominates the regulatory process but sources of growth will be sought domestically. This may happen when protectionist reactions take over during the recovery phase. World trade will not return to earlier rates of expansion and global growth may remain below pre-crisis rates. In this scenario, employment may lose out on two grounds: Economic dynamics is lower and – due to the financial market dominance domestically – job volatility will remain high.

A third outcome might be that financial market regulation stiffens substantially but that international market openness continues to uphold. Such financial regulation may follow today’s best practice countries (e.g. Canada) and banks may be required to hold higher reserve margins or to participate in a country-wide stabilisation fund. Markets for goods and (financial) services remain open but the more restricted financial sector activity at home and the domestic quest for new sectors of growth improves the bargaining power of workers and creates new opportunities for employment. Destruction of jobs in declining industry may remain high but so will job creation in new sectors. In this scenario, transitory job and worker flows are likely to be large and governments will need to make sure they put policies in place to help this process.

Finally, a last scenario might be that governments manage to impose a search for new domestic growth drivers. World trade is gradually being scaled down both as the result of a more restrictive international financial regime and due to – possibly environmentally-related – tariff barriers. Bargaining power shifts back to labour, employment creation intensifies and profits will be shared more directly between firms and their workforce instead of being distributed to financial investors.

We are at the beginning of this process and it can only be considered a Herculean task to evaluate the likelihood of any of these scenarios. Being aware of them, however, can shape current and future policy debates so as to make sure that only those outcomes might be sought that promise the highest benefits to the real economy and ultimately translate into more and better jobs. What is emerging from these four scenarios is that domestic financial sector regulation is key for governments to shape the process of future growth. Even in the absence of international coordination, governments can gain the upper hand through carefully managed regulatory changes that reorient financial sector activities to support the real economy.

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Ekkehard Ernst is a Senior Economist at the International Institute for Labour Studies. He has previously worked at the OECD and the European Central Bank. His work focuses on the interaction of financial and labour market dynamics.

Global Financial Crisis 2.0

Raymond Torres

Recovery prospects are being seriously hampered as a result of risk of a return to pre-crisis policy settings. By the end of 2009, the world economy was slowly recovering, aided by stimulus measures implemented by governments since the onset of the crisis. However, recent pressures for a return to orthodox policies in the context of an unreformed financial system threaten these fragile achievements.

Fiscal stimulus measures helped put a floor on the global crisis…

The crisis led to a significant policy response by governments and monetary authorities. In advanced countries, interest rates were drastically reduced and have been maintained at a low level. Massive rescue packages to avoid a collapse of financial institutions were implemented – mainly in developed countries. And most countries that had a budget space implemented fiscal stimulus measures in the form of discretionary tax cuts, higher government spending or a combination of both. These fiscal measures were crucial to revive the economy given the weakness of monetary policy tools in a context of “deleveraging” in the private sector and among financial institutions. According to ILO estimates, the fiscal stimulus measures amounted to around 1.7% of world GDP.(1)

Overall, the measures have succeeded not only in supporting the economy but also in avoiding further significant job losses. Estimates are for an increase in world unemployment by over 20 million workers between the fall of 2008 and the third quarter of 2009, for the 51 countries for which data are available.(2) This is less than what had been feared at the start of the crisis.(3) For instance, in EU countries, the employment effects of falling GDP have been much less than was the case in earlier recessions.

This relatively favourable outcome reflects, first, the rapidity of the policy response. Research shows that, by adopting stimulus measures soon after the start of the crisis, countries could expect a significant positive impact on employment by mid-2010 (ILO, 2009). By contrast, a postponement of the measures by 3 months would delay employment recovery by 6 months –illustrating the disproportionate costs of inaction for employment.

Second, the fall in employment has been cushioned by the nature of the policy response itself, consistent with the ILO’s Global Jobs Pact(4) :

• In the majority of cases, crisis responses have focused on stimulating aggregate demand. In particular, an effort has been made to enhance social protection (Brazil, India), extend unemployment benefits (Japan, US), avoid cuts in minimum wages and adopt other measures for low-income groups. These interventions, by sustaining the purchasing power of low-income groups, have effectively boosted aggregate demand while alleviating somewhat the social costs of the crisis.
• In countries like France, Germany and the Netherlands, short-time working arrangements have been aided by government subsidies. In other countries like Australia and the US, part-time employment has surged. These policies have helped reduce job losses. In the face of growing credit constraints, an effort has been made to support otherwise sustainable enterprises (e.g. in the Republic of Korea). 
• Finally, in the face of growing long-term unemployment, an effort has been made to enhance active labour market policies.

Recourse to inward-looking solutions has been limited so far. A generalised use of protectionist measures has been avoided, thereby reducing the risk of a collapse of international trade and investment, which could have a detrimental impact on developing countries. Importantly, there was a risk that countries would engage in a spiral of wage cuts and worker rights curtailing in order to improve competitiveness. This would have been a self-defeating and indeed counter-productive policy, given the global nature of the crisis and the need for greater aggregate demand. In addition, attempts to make workers pay for a crisis which originated in the financial system and was preceded by a significant increase in income inequalities and falling wage shares would have been reduced public support for recovery packages.

In short, the global policy response has succeeded in kick-starting an economic rebound and the policy response had also succeeded in attenuating job losses.

… but a policy mistake was made by leaving financial systems unreformed, carrying the threat of a return to fiscal restraint and policy orthodoxy

Unfortunately, the policy response did not tackle the key factor behind the crisis, namely a dysfunctional financial system. The result is, first, that the practices that developed before the crisis will inevitably re-emerge, unless action is taken. In particular, a large share of the increase in profits has accrued to the financial sector – the financial sector’s share of total corporate profit reached 42% before the crisis, up from about 25% in the early 1980s. And the profits of non-financial firms serve to pay dividends rather than invest in the real economy. During the 2000s, less than 40% of profits of non-financial firms in developed countries were used to invest in physical capacity, which is 8 percentage points lower than during the early 1980s. Ever growing pressures for more and better returns have adversely affected wages and job stability in the real economy.

Second, the lack of financial reform is reducing the room for pursuing the job-centred stimulus measures. Indeed, insufficiently regulated financial systems make it more difficult to channel credit to the real economy –so, other things equal, the amount of fiscal stimulus needed to achieve economic recovery is greater than in the presence of a well-functioning financial system.

At the same time, insufficiently regulated financial systems tend to penalize governments that run larger fiscal deficits. As a result, there is a growing risk that governments prematurely remove the fiscal stimulus measures that helped avoid a deeper recession. Governments may feel they have to reduce quickly fiscal deficits in order to appear as credible as possible in the eyes of financial markets and reduce the risk of speculative attacks. This is illustrated by recent events in the Euro area: even countries with much lower public debts than Greece have had to adopt in haste fiscal packages that reassure markets. Importantly, an unpublished study by Reinhart and Rogoff on “growth in a time of debt” suggests that such moves lack economic foundation in countries where public debt is significantly lower than 90 per cent of GDP.

In addition, the type of fiscal restriction measures which are presently considered tend to focus on spending cuts, in particular in the area of social policy, rather than higher government revenues (including through vigorous fight against tax competition and tax fraud, and consideration of new revenue sources like green taxes). The risk is that welfare benefits, which proved so essential to ensure adequate income support to the innocent victims of the crisis, be cut. This would erode political support for the crisis response strategy, possibly leading to social unrest. In addition, by scaling back certain programmes, many jobseekers will be pushed out of the labour market, depriving the economy from valuable resources. Keeping well-designed programmes is in fact cheaper over the long term, given the favourable effects of these programmes on participation and skills.

Fiscal measures are still needed because the real economy is too weak to have gained an autonomous growth momentum, at least in developed countries where the process of “deleveraging” is far from finished.

In addition, countries also tend to move quickly to export-oriented strategies in order to improve the current account balance and build up foreign exchange reserves, thus reducing perceived risks for financial operators. The problem is that some countries have to import in order for others to export – and the US cannot remain the importer of last resort. Therefore, a quick return to export strategies would end up reducing the prospects for world trade and economic growth.

Altogether, we may be entering a new stage of the crisis where financial markets are adding pressure for an early exit from fiscal stimulus measures and for cuts in social protection and wages. This would strongly affect the world economy given the weak autonomous growth capacity of the private sector –partly due to continuously tight access to bank credit. It would also further prolong the employment recovery and erode social support for governments’ crisis strategies.

It is urgent to move ahead with the reform of the financial system while ensuring job-centred fiscal stimulus.

Rescue packages to financial institutions have reached unprecedented levels in countries where the crisis originated. The bill will be expensive for taxpayers and job losers. It is therefore essential to ensure that an end is put to those financial practices and irresponsible risk-taking that preceded the crisis. As noted by the BIS in its 2009 annual report, “a healthy financial system is a precondition for sustained recovery. Delaying financial repair risks hampering the efforts on other policy fronts”.

True, the financial industry has undertaken steps to modify its practices through the adoption of codes of conduct and other non-binding initiatives. But there is concern that new regulations will push the financial industry to other locations. The overall impression is that, unless action is taken soon, business-as-usual will prevail. In such an unreformed context, the practices that provoked the financial crisis will resume soon after economic recovery starts. The pressures would aggravate the situation in a deteriorated world of work, while raising the risk of later crises.

There are various options that can be considered in this respect. What is important is to address the root problems, in particular i) inadequate and incomplete regulation, and ii) inappropriate incentives for risk-taking and pay of bank executives and traders.

For the reasons outlined above, the approach should be as coordinated as possible –at least at the level of the G20. Otherwise free riding problems will inevitably arise. This, together with proper implementation of the Global Jobs Pact, will support economic recovery in the short run, while paving the way for a more sustainable world economy.

(1)ILO (2009), The financial and economic crisis: a decent work response, Geneva
(2)International Institute for Labour Studies (2009), World of Work Report 2009: The Global Jobs Crisis and Beyond, Geneva
(3)ILO (2010), Global Employment Trends, Geneva
(4)ILO (2009), Recovering from the crisis: A Global Jobs Pact, Geneva.

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Raymond Torres is the Director for the International Institute for Labour Studies at the International Labour Organization. He recently launched the World of Work Report, the new annual flagship publication from the Institute.

Profits, banks, and the state: How to get investment going again

(by Engelbert Stockhammer)

The world is still experiencing the worst economic crisis since the 1930s. While the economic forecasts have brightened up recently, the overall picture is still gloomy. The collapse has been stopped, but the recovery is likely to be muted. This is for three reasons. First, US households, which have been the most dynamic source of demand in the past decade, are deeply in debt – and their houses, the biggest part of their wealth, are worth a lot less. Thus they are not likely to resume spending in the near future. Second, the banks are still in a lot of trouble. The big bank crash after Lehman Brothers has been avoided, but their balance sheets are still loaded with dubious assets and most make their money from trading, i.e. speculating, rather than from extending credit to businesses. It will be hard to get credit for a while. Thirdly, government expenditures that have prevented the meltdown are being rolled back. After the panic of late 2008, normalcy has returned to economic policy making. And in a neoliberal world it is considered normal that states have to balance their books, rather than help the economy or the poor. In short, while the worst is over, the bad is still to come. In particular, unemployment is still rising and will continue to do so.

So how could we get the economy going again? The key component of growth in a healthy economy is investment. Investment is an important source of demand, but it also provides the capital stock needed for future production. There are two types of investment: private and public. Private investment depends on business expectations about demand and profitability and on the availability of credit. Given the extent of the present crisis, it’s unsurprising that businesses are reluctant to invest. Academic research has clearly identified demand as the single most important determinant of investment. Indeed, who would invest if they think they can’t sell the output? The lesson for policymakers is clear: stabilise demand or the private sector won’t invest.

Obviously capitalism is about making money, so firms are unlikely to invest unless they expect to make a profit. However, the importance of profits for investment is often overstated. Indeed, one of the great puzzles of the past decades is why firms (at least outside China) have not invested more, given their abundant profits. Looking at the USA and the EU, in 1980 around two thirds of profits were reinvested, while in 2007 only half were reinvested. Why don’t firms invest when they are sitting on all this cash? The short answer is shareholder value orientation and globalisation. Firms now distribute a lot more money to their shareholders through dividend payments or through share buy-backs. Firms are run to the benefit of shareholders. Globalisation means that a lot of firms outsource production, reducing investment at home. This has mixed effects in the countries of the South and the East: it increases production there, but this is often in enclaves that are badly connected to the local economies and it often increases inequality.

The take-home from this is that the problem is not a lack of profits. Profits have been buoyant in the past without much investment taking place. Wage moderation will thus not help investment. Indeed, it will make matters worse. In particular, in countries with a large enough domestic market, such as Germany, wage moderation will depress domestic (consumption) demand further, creating an environment that is detrimental to investment. In a recent study (with Özlem Onaran and Stefan Ederer) we found that in Europe a redistribution of 1000 € from wages to profits will lead to about 100 € more of investment, but to 35 € less consumption. (Stockhammer et al 2009)

Access to credit is a more legitimate cause to worry about for businesses. Banks with problems on their balance sheets will be reluctant to lend. Monetary policy has so far helped to restore bank profitability, but has not been effective in ensuring that banks lend. Simply put, banks can earn a lot of money now, taking credit from the central banks and buying government bonds. There is no need to bother with old-fashioned business credit. Perversely, governments in many industrial countries now own substantial parts of the banks. But they are reluctant to interfere with their policy. Instead they have provided capital for the big banks in need and now watch how they are run in the interest of shareholders again.

All this may sound like there is little that governments can do to stimulate investment. But this is far from the truth. There is not only private, but also public investment. In the 1930s, public investment projects were used on a massive scale to revitalise the economy. However, today there is great reluctance to do so. Indeed, the IMF and the OECD are eager to push governments to turn to a more restrictive policy. Now with the shock of the imminent collapse over, business is returning to normal – and this means a small state. As if nothing had happened in the past two years! Much of this approach is a legacy of the neoliberal domination that has preached the superiority of private investment over public activity. But the near-meltdown of the financial sector in the 2008 should have made it clear that the private capitalist sector does not possess the miraculous properties of efficiency. Sure, governments often fall prey to corruption and may serve petty interests, but so does the private sector. Remember Bernard Madoff? Or Enron?

How should public investment be financed? Of course the largest demand effect will arise if government expenditures are credit financed. However this will also increase public debt. If expenditures are financed by raising taxes, ways to do so in a progressive manner include closing tax havens, establishing wealth taxes and a financial transactions tax. All of these could raise substantial amounts without negative effects on demand. Closing overseas tax havens has been estimated to have the capacity to generate global additional revenues of US$100-billion (Cavanagh et al 2009). A recent study found that a (worldwide) financial transactions tax of 0.1% would raise about 1.5% of world GDP (Schulmeister et al 2008).

Thus the pragmatic question should be whether there is a material need for investment projects in public infrastructure that the private sector is unlikely to provide. And the answer is a clear yes. From modernising (or building) public transportation to investing in energy-saving technology and from spending on education to housing projects, there are plenty of areas where the social return to public investment is large enough to justify spending. Now is the time.

Further readings and references:

Cavanagh, J, Collins, C, Goldberg, A, Pizzigati S. (2009): Reversing the Great Tax Shift: Seven Steps to Finance Our Economic Recovery Fairly  http://www.ips-dc.org/getfile.php?id=356

Jetin, B, Denys, L, 2005. Ready for implementation. Technical and legal aspects of a currency transaction tax and its implementation in the EU. Berlin: WEED http://www2.weed-online.org/uploads/CTT_Ready_for_Implementation.pdf

Pollin, Robert, Heintz, James, Garrett-Peltier, Heidi, 2009. The Economic Benefits of Investing in Clean Energy. June 2009. http://www.americanprogress.org/issues/2009/06/pdf/peri_report.pdf

Schulmeister, Stephan, Schratzenstaller, Margit, Picek, Oliver, 2008. A General Financial Transaction Tax: Source of Finance and Enhancement of Financial Stability. Presentation at the European Parliament in Brussels on April 16, 2008 http://www.greens-efa.org/cms/default/dokbin/231/231075.a_general_financial_transaction_tax_sour@en.pdf

Stockhammer, E, Onaran, Ö, Ederer, S. 2009. Functional income distribution and aggregate demand in the Euro area.   Cambridge Journal of Economics 33 (1): 139-159. The working paper version can be downloaded at http://www.wu-wien.ac.at/inst/vw1/papers/wu-wp102.pdf

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Engelbert Stockhammer is working at the Vienna University of Economics and Business. His research interests include macroeconomics, income distribution, financial systems. He recently wrote "The Rise of Unemployment in Europe" (Elgar 2004) and "Wither Mainstream Economics?" (co-editor, Metropolis 2009).