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Lorenzo Bini Smaghi, a member of the ECB Executive Board, penned an op-ed in the FT today entitled "It is better to have explicit rules for bail-outs." Given the relative simplicity and directness of such a title, one would expect the piece to lay out the logic behind such a statement. Instead, what follows is largely nonsense,and self-contradictory blather.

Let's begin:

"One of the many lessons we can draw from the financial crisis... is that economic agents do not always behave rationally, especially when they take decisions affecting others. Research has shown in particular that agents are not only motivated by self-interest, as economists are keen to believe, but also by considerations of fairness."

A strong start - I'm with you so far, Lorenzo.

"Such attitudes make it difficult for governments to act consistently in times of crisis, especially when elections are close. This was notably the case in September 2008, shortly before the US presidential election, when Congress, despite the gravity of the situation, rejected the government's bail-out plan until Lehman Brothers' failure made it apparent that the risk of financial collapse would have devastating effects for all."

Mmmkay - not the best example. Congress rejected the government's bail-out plan not out of considerations of fairness, but because the Democrats tried to ram it down the throats of Republicans too blinded by ideology and obstructionist predispositions. Maybe our author is trying to be polite.

Regardless, he believes that democratic governments cannot be relied upon to react swiftly to address crises:

"Systems and institutions with specific crisis-resolution mandates thus need to be established to permit rapid responses."

Therefore: clearly established, fixed procedures for bailing out (woops, "resolving") an institution in crisis to prevent contagion is the way forward. Would this not create moral hazard? Would not this not allow the clever folks at large banks, investment firms, and hedge funds to find ways around the fixed rules, just as they have consistently done in the past? Would it not be better to provide regulatory bodies with resolution powers that are both broad and ambiguous enough to create uncertainty for financial actors as to when/how they might get bailed out in the future? Would this not go some distance to preventing them from gaming the system just as they have consistently done in the past?

Lorenzo's argument seems to be that elected officials should not be trusted to solve problems in the heat of the moment. There is some truth to this: it's messy and leaves you vulnerable to political cycles and populism. Ad hoc crises resolution efforts at the national level can also make things worse at the international level - we saw this with Ireland's unconditional guarantee of bank liabilities back when the crisis was as its worst.

But it does not follow that iron-clad rules need to be laid out in all cases. Fixed rules based on the last crisis are almost certainly not going to be well-suited for the next one - we do not want to train our generals to fight the last war. Smaghi does not seem to have grasped this fundamental lesson from history at all:

"Moral hazard should ... be addressed by establishing institutions and procedures that allow for incentive-compatible solutions (carrots as well as sticks). This means, in particular, that financial assistance, if needed to avert a major systemic crisis, can be granted on strict conditions that aim to prevent any recurrence of the problem."

Really? Any recurrence of the problem? Please don't insult your readers with this drivel. Finally:

"[M]oral hazard cannot be tackled simply by assuming that crises will not occur. Nor can it be assumed that letting an institution or a country fail is always and everywhere the most desirable solution, as the post-Lehman experience has shown. Decision-makers in both the public and private sectors must thus be ready to deal with worst-case scenarios and make sure that they are not prevented from delivering the appropriate decisions."

Aside from stating the blindingly obvious, I read this last paragraph undermining Smaghi's argument entirely. Given the fact that the next crisis will not be identical to the previous one, flexibility is key. "Explicit rules for bailouts" is not flexibility, and is certainly not going to equip decision-makers with the capacity to deal with worst-case scenarios. Indeed, explicit rules may very well prevent them from delivering appropriate decisions.

*deep breath*

Flexibility essentially means power. The debate that we should be having is over how much power financial regulators should have/are able to use effectively. How much should we be able to rely on this power? Will it dampen the inherent moral hazard of future government bailouts?

Smaghi's argument is not so much an argument but rather a vague collection of statements that are tenously linked together, not particularly convincing, and seemingly self-contradictory. He has contributed nothing but confusion.

Expect some big financial news out of Washington today: it looks like President Obama is set to publicly support the "Volcker banking plan." Paul Volcker has been pushing this approach for some time (Mervyn King has been doing something similar in the UK), but this is the first time he appears to be getting public support from his boss. Broadly speaking, Volcker's goal is to split the potentially contradictory activities of major banks:

"On the one hand, they are commercial banks, taking deposits, making standard loans and managing the nation’s payment system. On the other hand, they trade securities for their own accounts, a hugely profitable endeavor. This proprietary trading, mainly in risky mortgage-backed securities, precipitated the credit crisis in 2008 and the federal bailout..... Under the new approach, commercial banks would no longer be allowed to engage in proprietary trading, using customers’ deposits and borrowed money to carry out these trades."

Simon Johnson provides some cheerleading; Tyler Cowen provides a list of questions to ask yourself when the new plan emerges. Should be fun.

UPDATE: oh my goodness, oh my goodness, oh my goodness! Press release is here.

Bernanke's speech in Atlanta last week spread throughout the blogosphere like wild fire, and the reaction was not positive. The Fed chief defended US monetary policy in the run-up to the financial crisis and claimed that lax regulation, not interest rates, inflated the housing bubble. A chairman of the Fed defending the bank's record and competence against a backdrop of political hostility and regulatory reform is not surprising. Bernanke's position that prolonged low interest rates played no role in the housing bubble is more so.

But after reading the Fed staff working paper that accompanied Bernanke's speech, the folks at Free Exchange believe that, interest rate correlation aside, the Fed's worldview has been quietly transformed. The Fed's analysis featured three names: Shiller, Kindleberger and Minsky. For those unfamiliar with these men, they are three of most prominent advocates of the idea that markets are imperfect, unstable and subject to psychology (hence the title of Kindleberger's book Manias, Panics and Crashes). This is downright antithetical to the Fed's prevailing ideology, and their acceptance could represent an important shift in the Fed's understanding of markets and its role in influencing them. I can assure you that Alan Greenspan would have neither reached nor endorsed their conclusions, and a search of the Fed's website by Free Exchange found only two previous references to Minsky and just one to Kindleberger.

Paul Krugman agrees with Bernanke that there were compelling reasons for 2002-2006 monetary policy. But this doesn't mean that the policy didn't contribute to the housing bubble, or that the Fed failed to act on the warning signs. Krugman faults Bernanke for not acknowledging the inadequacies of the Fed's prevailing wisdom before the crisis and admitting that they all missed the housing bubble. On this measure his speech was disappointing, particularly for those of us who support a second-term. But by digging beneath the headlines, Free Exchange has highlighted an important shift in the Fed's institutional understanding of markets, regulation and monetary policy, one that is hopefully diffused throughout the policy and academic establishment.

- Prospect gives its list of the 25 most influential intellectuals during the financial crisis

- From the above list, Simon Johnson's The Quiet Coup. Not sure how I missed this one back in May, but it's a good read for those looking for a Big Picture view of the financial crisis and its implications.

- Free Exchange discusses the same WaPo review of the Fed that I tackled below; suggests that Fed is better equipped to deal with inflation than regulation: "It's time to learn a lesson here. An institution that missed a brewing crisis of this magnitude is an institution not set up to detect and prevent a brewing crisis of any magnitude. Something else is needed."

- Underwater robots help reveal history

- LOLFed takes stock of TIME magazine's love affair with Ben Bernanke

- Failure by global leaders to tackle global warming leads to new investment opportunities

Well blow me down. I don't think one needs three dozen interviews to figure that one out: it's pretty obvious that the various US financial regulatory bodies didn't see this coming, nor did those in the other major financial centres. However, as Arnold Kling points out, neither did most of the suits at the very banks within which the risks were being taken. I think it's fair to say that it has been a learning experience all around.

But exactly what kind of lessons are we learning from this crisis? It's very important that we learn the right ones. Even if we acknowledge that there was a collective cognitive failure on the part of our regulators, there are a couple of different ways to run with this.

If we're of the mindset that we should see bankers hanging from Blackfriars bridge, or have their heads on pikes or whatever, I don't think the discussion will go very far. Despite the obvious excesses of financial sector, I am still waiting for evidence that performance bonuses to Goldman Sachs employees has been the cause of our financial crisis.

But let's agree that the Fed F'd up. What should we do about this? One option is to use this argument to argue against the re-appointment of Ben Bernanke as Chairman because of his obvious failures to mitigate the crisis. While there is merit in digging up all the mistaken decisions by the Fed in the past decade, scapegoating will not address the problems of tomorrow. John Maynard Keynes is reported to have said: "When the facts change, I change my mind. What do you do, sir?" When the facts changed for Bernanke in late 2008, he also changed his mind. Although late to the party, the Fed's willingness to adapt to the crisis over the last 16 months has been a crucial part of slowing the economy's decline and stimulating what is, to date, modest signs of recovery. (I think Rory agrees) (wait, so does TIME)

But even if we accept that the Fed has learned from some of its past mistakes, this has not addressed the fundamental problem with financial regulation: the regulators don't have the capacity to know everything that's going on. They never will. The people who work at investment banks, hedge funds and the like are too smart and too motivated. There will always be loopholes, and those loopholes will be found. That said, it should still be possible to avoid the kind of crisis that we just experienced, with huge sums of money (your money, my money) being used to prop up the balance sheets of our financial giants. I see at least three possible avenues for the future:

First, concentrate the US regulatory system into fewer bodies. I couldn't find the organizational chart I wanted, but you can get a sense of it from this summary. Compared to many other industrialized countries, this is madness. Having one financial entity regulated by so many different government bodies will leave gaps in coverage. It's hard enough for one government entity to share information with itself - multiplying entities will multiply the problem.

But with a more concentrated financial regulator, the information-gathering problem will not disappear. This is why I find Paul Volcker's vision for the US banking sector to be persuasive. Since we cannot prevent financial innovations and we cannot expect our regulators to understand all the risks associated with them, we should at least prevent our "systemically important" financial institutions from playing with them. The risks and rewards should be realized by firms which are able to fail.

Third, let's beef up the regulatory standards for our core financial industries - the ones we can't afford to see fail. The Basel Committee on Banking Supervision recently released its list of five suggestions for doing just that. This is an excellent place to start the discussion, and efforts to coordination internationally will help address concerns about competitiveness.

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I think that it's crucially important to learn the right lessons from this financial crisis and avoid being side-tracked by the promise of a quick fix (think: banking bonus supertaxes or the Tobin tax). From where I'm sitting, one of those key lessons will focus on cognitive limitations - the limited ability of our government officials, regulators, banking execs and individual investors to understand complex realities of the markets they interact with. Once we accept this, we can begin to build buffers against the problems that will inevitably arise.

Now if you'll excuse me, in recognition of my own cognitive limitations, I have a stack of holiday reading to attend to.

That was Paul Volcker's message to the Future of Finance Initiative, delivered earlier this week. Responding to what he viewed as timid proposals from the private sector on how to go about their business, Volcker proceeded to lay out what he saw as the key priorities. I can't find a useful way to cut this down, so I will quote it as a whole:

Let me just suggest, if I may, the way that I would go about this. I am not alone in this, and in fact I think that I am probably going to win in the end.

First, let us agree that we have a problem with moral hazard. I do not think that there is any perfect answer in dealing with it, but I would suggest that we can approach an answer by recognizing that elements of finance have always been risky and that's certainly true of the commercial-banking system.

I think we need the commercial banking system for more than automatic teller machines. Commercial banks are still at the heart of the system. In a crisis, everybody runs back to the commercial banks. They, after all, run the payment system. We cannot have this global economy without commercial banks operating an efficient payment system globally as well as nationally. They provide a depository outlet for individuals and businesses, and they are still big credit providers for small and medium-size businesses, but they backstop most of the big borrowers as well. The commercial-paper market is totally dependent on the commercial banking market. They are an essential financial institution that has historically been protected. It has been protected on one side and regulated on the other side.

I think that fundamental is going to remain. People are going to think it is important, it is important, it needs regulation and in extremis it needs protection—deposit insurance, lender of last resort and so forth. I think that it is extraneous to that function that they do hedge funds, equity funds and that they trade in commodities and securities, and a lot of other stuff, which is secondary in terms of direct responsibilities for lenders, borrowers, depositors and all the rest.

There is nothing wrong with any of those activities, but let you nonbank people do it and you can provide fluidity in markets and flexibility. If you fail, you're going to fail, and I am not going to help you, and your stockholders are going to be gone, and your creditors will be at risk, and that is the way that it should be.

How can I be so blithe about making that statement? We need a new institutional arrangement which I believe has a lot of support. We need a resolution facility. What can that resolution facility do? If one of you fails and has systemic risk, then it steps in, takes you over and either liquidates or merges you, but it does not save you. That ought to be a kind of iron cross.

In other words: Old Man Volcker is back and he's handing out detentions to the unruly schoolchildren. This is the kind of ballsy speech that only someone with Volcker's authority and experience could pull off.

I find this vision very compelling. There is no obvious reason why "too big to fail" financial institutions should have the competitive advantage of government guarantees while at the same time being free to dive head-first into the riskiest types of financial tools that may or may not be beneficial to the economy. We've just seen what the downside looks like, and it is ugly.

As Simon Johnson explains, this could well be Volcker's moment. It's true that his vision is glossing over the challenging details that would need to be worked out, but so be it. If Volcker can shift the public consensus in his direction, he will have accomplished a great deal.

Transparency International has released its Corruption Perceptions Index 2009 (CPI), which measures the perceived level of public sector corruption in 180 countries around the world. It has become something of a gold standard for measuring corruption, as it is both independent, and reflects the sentiments of actual economic and political actors.

Huguette Labelle, Chair, introduces this year's CPI below:

Last week I highlighted so-called 'CoCo bonds', and worried aloud that they are a sign of lessons lost from the financial crisis.

Well, apparently, things are a lot worse than I thought: mortgage-backed securities are rising from the dead.

I barf.

Securitization is not inherently bad, or systemically risky, and its financial utility can be quite large. But these particular instruments, the actual trigger of the financial crisis, are ticking timebombs that propagated the perverse incentives and speculation that boosted the housing bubble and sunk financial institutions around the globe. Their resurrection is an ominous sign that 'business as usual' is returning to the market, and the regulatory response thus far has failed to address the very issues that got us to this point.

And remember, banks never shed these assets, they instead sit as worthless weight on the balance sheets of the biggest recipients of taxpayer bailouts around the globe. When new mortgage-backed products enter the marketplace, and spur new lending within the housing market, the value of the old assets will rise, bringing with them a potentially massive windfall for banks and investors. This will be a tremendous boost to the market for these products, and reinforce the incentives to create them.

That's a problem.

One day, we might look back at this article as an ominous sign that all lessons were lost, regulatory reforms insufficient and incentives misaligned following the crunch.

The banking industry looks coo-coo for CoCo bonds. Sophisticated debt instruments are back.

The World Bank has released its annual Doing Business report, which looks at the ease of doing business around the world.

Doing Business ranks economies based on 10 indicators of business regulation that record the time and cost to meet government requirements in starting and operating a business, trading across borders, paying taxes, and closing a business. The rankings do not reflect such areas as macroeconomic policy, security, labor skills of the population or the strength of the financial system or financial market regulations.

It is a narrow measure of a country's economic prospects, but an important one in a globalized economy, particularly for country's dependent on foreign investment and trade. Amidst the creeping protectionism, rapid decline in international capital flows, and poor credit availability of this crisis, you might expect such indicators to plunge. However, the World Bank found 2008/09 to be a record year of reform. Surprising? Perhaps not:

-Singapore was ranked #1 for ease of doing business for the fourth year in a row. This is no surprise (small, open, and highly integrated economy).

-Two-thirds of the recorded reforms were in low- and lower middle-income countries. This isn't that surprising either, as the threshold for these countries is typically low (any concerted reform agenda will drive these countries high up the ranking), and crises tend to disproportionately affect smaller, less-diversified economies heavily dependent on exports and commodity prices. Amidst these conditions, either external (IMF, WB, etc.) or electoral (regime change) factors tend to provide a strong impetus to reform.

-Rwanda was the biggest reformer across almost all indicators, a first for a sub-Saharan African economy, but again, not a surprise. President Kagame has vigorously promoted foreign investment to diversify the economy away from commodity exports (coffee and tea), and with donor funds accounting for almost 50% of the budget, Rwanda has a strong external commitment to reform.

The biggest point, but if you know your history perhaps the least surprising, was the following statement:

'The financial crisis has also prompted governments to act in areas where regulatory reform may be more difficult and require more time.'

I have noted on a number of occasions over the past year that despite the massive destruction caused, global crises also present the biggest opportunities for reform. Often, interests are realigned, reformers and technocrats elected, and economies and foreign investment regimes restructured. The latest Doing Business report reaffirms this trend.

So while there is justifiable pessimism over the protectionist slide of many major economies, we should take comfort in knowing that on at least one measure, globalization pushes on.

It has been a very busy week for news, even if it hasn't been busy on the blog. A quick review:

- Protests in Iran: This is what can happen when you insult a large portion of your population with blatant electoral fraud. You might not have thought a couple of weeks ago that Iran was about to provide a lesson in Civil Society 101 for the rest of the world, but this week's protests have been impressive. You need more than a little courage to take to the streets in largely non-violent protests facing riot police, tear gas and gunfire.
(UPDATE: The BBC has some shocking raw footage of just how ugly this thing is getting)

- The white paper on US financial regulatory reform was released this week. I have no intention of actually reading the thing, but Felix Salmon does point to an interesting tidbit: the policy wonks have inserted legislation forcing opt-out, rather than opt-in, retirement plans for corporate employees. This is a nod to the lessons of behavioural economics, which have shown that people will resort to the default, even on important decisions like saving for their retirement. If successful, this legislation will make retirement plans the default option, and Americans are therefore more likely to save. Score one point for the nanny state!

- The BRIC Summit. Brazil, Russia, India and China had their inaugural summit this week, and most reviews suggest it mainly produced rhetoric and little of substance (just for fun, let's compare this to the G8 in early July, shall we?). Some of the rhetoric on the US dollar did seem to have an impact, however. President Hu's 4-point plan was pretty high-level, but certainly hit on the main issues.
It remains to be seen if this summit is a one-off deal or if it will evolve into something with teeth. The first G-somethings were born out of shared economic interest in the 1970s; it's less clear to me that the BRICs have enough similarities (aside from export-led growth) to produce anything more than statements and photo-ops. But I'm holding off judgment for now.

Don't you just love a healthy debate? The New York Times Economix blog questions whether the Canadian banking system is really all it's cracked up to be. At almost the exact same time, Robert Zoellick, president of the World Bank, is praising the Canadian system for its financing and suggesting that any country would happily trade spots with their economy (but not their weather!).

For more detail, see our previous post on this topic.

Determined to avoid yet another G20 yawn-fest, the French are now threatening a walkout. Their finance minister has indicated that she will not sign the final communiqué should their demands for "deliverables" not be met (re: a global financial regulator, conceived and implemented by the end of the week).

Spicy stuff. I'm not familiar enough with international diplomacy to answer this with confidence, but is France operating on such a different plane that it can threaten not to sign the G20 document, sign the document four days later, and suffer no significant reprecussions? Because if not, it's not clear to me what this publicity stunt will achieve. If the leaders summit was going to agree to set up a global regulator, the G20 finance deputies and their sherpas would have already have laid the groundwork for one. The leaked draft communiqué shows no signs of any truly "global" regulator, only a more integrated collection of national ones.

So if the French aren't likely to get what they want by Friday, what do they stand to gain?

The relative health of the Canadian banking system has been getting a lot of attention these days. Yves Smith notes with approval the "decidedly retro" nature of the system while referencing a NYT op-ed that praises "The Great Solvent North." On a bigger scale, the Europeans seem to have latched on to the success of Canadian banking system as a guide for banking reform - they may very well use it as a stick with which to beat the Americans over the head while promoting their new joint economic agenda for the G20. Finally, with the World Economic Forum recently ranking it the soundest in the world, the boys of Bay Street have become the envy of the global financial system.

It's easy to understand why. After witnessing the fallout from what happens when the world's largest banks leverage their assets 30-, 40-, or 70-1, some policymakers are positively drooling at Canada's cautious reserve requirements. And if it weren't enough that their levels of market capitalization now rival their major American counterparts, some of these cheeky Canuck banks are still making profit! In a recession!

So why have Canadian banks so far remained (relatively) insulated? From the NYT article:

The five major chartered banks, the few regional banks and handful of large insurance companies are all regulated by the federal government. Canadian banks are relatively constrained in the amounts they can lend. Canadian banks are required to have a bigger cushion to absorb losses than American banks. In addition, Canadian government regulations protect the domestic banks by limiting foreign competition. They also keep banks broadly owned by public shareholders....

The... horror. I think Italy is the only other major industrialized country with such heavy protective measures over its financial community - a factor which also seems to have insulated them from the crisis somewhat. But it's important not to overstate things. The op-ed continues:

Canadian banks are known to be risk-averse, and this has served them well. While their American counterparts were loading up their books with risky mortgages, Canadian banks maintained their lending requirements, largely avoiding subprime mortgages.... The big five Canadian banks... [have] survived the recent turmoil relatively unscathed.

I think those points deserve a few qualifications. First, I don't think the full impact of the US economic collapse has filtered across the border yet: several of Canada's top 5 expanded their operations into the US and so remain exposed to the fallout. Secondly, anecdotal evidence suggests that some of the banks were decidedly less cautious when it came to investing in the subprime market - and their clients are feeling the pain. Finally, it's not clear where future profits are going to come from given the nasty global environment - there are worrying signs already.

So maybe this model has a few blemishes after all. It's also worth noting that many banking execs had been lobbying very hard for Canada to alter its regulatory structure to allow its domestic banks to compete with their international rivals. Their relative failure to achieve this has proved to be their saving grace. But before the Europeans and Americans rush headlong into imposing Canadian-style banking regulations, they should take a good hard look at the social, political and institutional reasons for why those lobbying efforts had limited success - it wont be easy to re-create that environment at home.

But one thing does seem clear: Canada's financial regulators have the eyes of the world upon them. It will be interesting to see how they choose to deal with the new-found attention.

(photos: Mike Manalang's & Mister V's photostream)