Daniel Daianu, MEP, former finance minister of Romania
Speech in Nice- Eurofi conference, Sept. 2008

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What this crisis tells us

The significance of the current financial crisis is huge, and its policy implications are manifold – and one of those is that we need to learn from previous crises. I heard one leading central banker, not long ago, saying that the depth and magnitude of this crisis could hardly have been predicted a year ago. His is not an isolated voice. But such remarks are baffling for it is the job of a central banker to focus on the health of the financial system, and not just the stability of prices.

There have been various episodes of crises over the past two decade and there are people who learned from them. Some financiers and economists – such as Warren Buffett, Edward Gramlich, Paul Krugman, Alexander Lamfalussy, Nouriel Roubini, Paul Volcker and others – warned, years ago, that another crisis was in the making, underlining the menace posed to financial stability by new types of financial innovation. Studies of the Bank of International Settlements, the Bank of England had examined roots of the current crisis before it erupted. I would add here reports of the European Parliament (one in 2002, in particular) that pointed the finger at issues that are being widely debated these days. There is then a question that begs an answer: How is it that policy-makers overlooked strong warnings, analyses and the lessons of previous crises? I submit that vested interests played a role in this respect.

Some use the complexity of financial markets as a leitmotiv when explaining this crisis. But this is pretty much a self-serving argument, hard to accept without qualification. Not all financial innovation is sound. Not all products and services in an economy are, in the end, accepted by markets. And regulations and supervisor are needed to protect consumers and investors. Some financial products are better than others; some are flawed by design, among them those that underpinned the international quasi-Ponzi scheme that has enabled firms to report abnormally high profits that do not reflect revenues generated by their businesses. I am referring to the plethora of derivatives *CDOs and CDSs) that have made markets opaque and are of more then questionable value. It therefore makes sense to judge the nature of various financial products, and to regulate the financial industry as a whole.

Market structures should be re-examined and over-hauled where appropriate. We have undoubtedly seen a massive failure of regulatory and supervisory frameworks. Risk management, at both micro and macro levels, has failed miserably in countries that claim to epitomise good practices in banking and finance. Those who keep saying that things are better in Europe than in the US have to think twice about the national fragmentation of regulatory and supervisory structures in the EU, a fragmentation that clashes with the logic of single markets. Moreover, European groups have been involved in the very process of origination and distribution that not a few in Europe are blaming Americans for. The Lamfalussy process, which has been developing regulation of the financial service industry in the EU since 2001, needs much improvement if it is to cope with mounting challenges. Some argue that since the crisis started in the regulated sector of the financial system, its non-regulated area should be left alone. But this argument is ridiculous: banks have made use of loopholes and poor regulations to develop the non-regulated sector, creating a shadow banking sector.
The problem with hedge funds is that they contribute to increasing systemic risks.
The claim that it is the money of investors which is at stake is very little of the story. Very high leveraging and focus on short term gains increase overshooting. But what is even worse, the speculative nature of such operations produce instability, can damage financial stability. It makes sense to bring the activity of hedge funds (and equity private funds) within the territory of regulated financial entities. Leveraging should not be unconstrained. Likewise, hedge funds should provide the regulatory and supervisory authorities with full information on their transactions.


The current crisis is a stern indictment of the incentive structures in the financial industry, in investment banking in particular, which have stimulated reckless risk-taking at the expense of necessary prudence. Some banking turned into a “casino”-type activity, through the creation and selling of new types of securities. This asymmetric compensation scheme has to be corrected and the culture of investment banking has to change for the benefit of the economy as a whole. But inappropriate compensation schemes operate in other industries, too. There are numerous CEOs who receive incredibly high salaries and bonuses despite the shaky performance of their companies. There is a huge ethical issue here, one that needs to be addressed by politicians and policy-makers: How can we ask citizens to bear the brunt of painful adjustments when some of those who have been deeply involved in creating this mess are shunning responsibility, or are not accountable?

One of the questions posed by this crisis is about policies. As a rule, the pro-cyclical use of monetary and budget policies should be avoided. One can argue that price stability should play second fiddle when financial stability is at stake, but one has to keep in mind the effects of injecting liquidity into the system when inflation is on the rise. This crisis reminds us again about the risks of financial liberalisation when institutions are not congruent or when markets are not functioning smoothly.

Some claim that cheap money is at the origin of this crisis. But this is a very incomplete explanation. A lax monetary policy can lead to higher inflation and, ultimately, to a recession when its tightening takes a toll on the economy. But a lax monetary policy cannot, by its own, cause a meltdown of the financial system. This is the crux of the matter: structural features of the “new” financial system, including a breakdown of due diligence, have brought upon it the threat of total collapse.

The structuring of fiscal policies also has to change. It is, for example, quite odd to see Americans saving so little and their deficits being financed by emerging economies. Moving further along this line of reasoning one reaches the issue of policy coordination against the backdrop of financial globalisation: Is coordination appropriate? Do we have proper structures of global governance? Unless we manage globalisation adequately, rising nationalism (principally in the form of protectionism) and populism in policy-making could reverse the evolution toward more open markets. The quest for energy security and affordable food could easily make things worse.

This financial crisis, in conjunction with the “food crisis”, brings to prominence another issue: Is there an optimal degree of openness for an economy? The debates about international financial institutions, prematurely asking emerging economies to open their capital account, about energy dependency and about food dependency make glaring the question of the optimal openness of a market. In addition, open markets should not to be confused with deregulated markets; deregulated markets could easily backfire and cripple the functioning of a free society, one in which social cohesion and social justice are meaningful. Open markets, in order to operate as such, have to be accompanied by wise public intervention, which should consider both market and government failures. The bottom line is: Full openness is not necessarily advantageous economically and socially.

Arguably, the view that the market should be seen as the solution for all decision-making, a view that has much influenced policy-making in the last couple of decades, has been fatally wounded by this crisis. Modern economies do need regulations in order to be as civil as possible to their citizens, as they need public policies. As traffic needs rules and lights in order to protect people’s lives the same can be said of regulations that try to limit collateral damage and enhance the production of public goods, restrict negative externalities, in a market economy.

Regulators and supervisors are supposed to think about the good of economy/society and not pursue peculiar interests. And they are supposed to learn! They may espouse ideological beliefs (be more free marketers, or more interventionists), for none of us is devoid of intellectual kinship. But, even so, they are supposed to learn and think in terms of what is goo for society, have a good grasp of systemic risks. Vested interests can have a long arm and try to influence regulations and supervision (the mortgage industry pressed Congress in the US heavily to roll back state rules aimed at stemming the rise of predatory tactics used to place homeowners in high-cost mortgages). But this has to be strongly resisted, by all means. There is something which regulators and supervisor should know: financial markets are, par excellence, volatile and prone to instability. Likewise, the efficient markets hypothesis is a fantasy. In the real world we need regulators and supervisors who have a good understanding of how financial markets do function, who do not succumb to market fundamentalism. They should never underestimate systemic risks and be always alert when it comes to financial stability. I am not arguing that we can prevent strains and crises completely. But we can try to limit damage and for that to happen we need to learn from mistakes and build up better, more effective and comprehensive regulatory and supervisory setups.
It is high time to be pragmatic, open-minded and commonsensical. Open trade, markets and competition are good. But we need effective regulations and sensible public policies if the majority of our citizens are to benefit from free markets.

Correction is going to be painful, especially in the US, but Europe is not immune to economic downturn. Solutions should not be patchy and consider that markets are global. International coordination is needed in order to restore confidence.