Getting the Economy Back On Track

Robert Rubin: 

Financial history suggests, in my view, that markets have an inherent and inevitable tendency—probably rooted in human nature—to go to excess, both on the upside and the downside. The systemic risk caused by this susceptibility has now been greatly increased by the size, speed, complexity, and global nature of modern capital markets and financial systems. The answer, however, is not to abandon our basic economic model, including a market-based financial system, but to make the regulatory regime as modern as the markets.

Given my views as to the causes of the crisis, I would recommend the following:

• There should be greatly increased capital and margin requirements for derivatives and other instruments of financial engineering to create a greater cushion when trouble develops and to reduce risk exposure. I developed this view during my many years of working with derivatives before entering government, as described in my 2003 book, In an Uncertain World.
• Standard derivative contracts should trade on an exchange to increase transparency. Transactions that are custom designed would not be exchange traded but would be subject to the same capital and margin requirements as listed transactions. Disclosure requirements could be considered for customized transactions, to provide private counterparties and regulators with the transparency to understand the risks.
• There should be two sets of more stringent leverage limitations for systemically significant institutions, one defined by risk-based models and the second by much simpler measures, since mathematical models can't capture the full range of real-world possibilities.
• There should be significant constraints on off-balance-sheet financing; for example, institutions must retain ownership of a portion of off-balance-sheet assets.
• We need a change in accounting systems to avoid the artificial effects of mark-to-market accounting for illiquid assets on balance sheets and on markets. There are other accounting approaches that would better reflect long-run values for these assets.
• We should also provide effective mechanisms for dealing with systemically important nonbank financial institutions—including bank holding companies—that get into trouble, to mitigate "too big to fail" concerns, but practical ways to do this need to be developed.
• There should be greatly increased protections, both to safeguard consumers and to reduce systemic risk. The elements should include readily understandable disclosure, suitability requirements, prohibition of practices or instruments inherently susceptible to abuse, and, if some practical way can be found, personalized advice for the most vulnerable consumers.

Each one of these actions would be tremendously complex. The perfect should not be the enemy of the good, however, and reform, once begun, can always be adjusted for difficulties or for market changes. The economy and financial institutions would all benefit from greater focus on the long term in corporate earnings, compensation, and other areas.

Let me now turn to the three long-term policy challenges the market-based economic model must address in order to realize its potential.

First, there must be sound fiscal and monetary policies. The United States faces projected 10-year federal budget deficits that seriously threaten its bond market, exchange rate, economy, and the economic future of every American worker and family. Those risks are exacerbated by the context of those deficits: a low household-savings rate, even after recent increases; large funding requirements for federal debt maturities every year; heavy overweighting of dollar-denominated assets in foreign portfolios; worsened fiscal prospects in the decades after the current 10-year budget period; and competing claims for capital to fund deficits in other countries.

The conventional concern here is that private investment will be crowded out, which would result in a reduction of productivity, competitiveness, and growth. In addition, the very early 1990s showed that unsound fiscal conditions can have a symbolic effect that broadly undermines business and consumer confidence. But finally, and far more dangerously, our bond and currency markets could react with severe distress to fears about imbalances in the supply and demand for capital in the years ahead or about the possibilities of inflation. Those effects have been averted so far by a number of factors: large inflows of capital from abroad into Treasury securities; concerns about other major currencies; the low level of private demand for capital; and the psychological state of the market. But this cannot continue indefinitely, and change can occur with great force—and unpredictable timing.

The American people are growing increasingly concerned about deficits, creating a public environment more conducive to political action. And the Obama administration, in my view, has a deep understanding of the critical importance of addressing this issue. But the substance and the politics of returning over time to a sound fiscal position are very difficult, and the timing is even more complicated because of the current economic circumstances.

Second, public investments and other policy measures must deal with areas that are absolutely critical to growth and widespread income participation that markets will not adequately address, such as education, health-care coverage and cost constraint, a sound energy regime, basic research, infrastructure, fair labor markets, equipping the poor to enter the economic mainstream, and much else.

Third, sound international economic policy is critical. Most immediately, as President Obama and the other G20 leaders warned, restrictive trade measures in response to the current crisis could lead to highly destructive trade wars. For the long run, we should continue pursuing the open markets that the Peterson Institute for International Economics, a Washington think tank, estimates have added $1 trillion to America's current GDP. But the United States must make an even greater effort to reduce trade-distorting practices in countries less open than ours. And the U.S. must increase its savings rate over time, while countries with trade surpluses must reduce theirs and increase domestic demand to reduce global trade and financial imbalances.

Open markets in today's transforming global economy—with new technologies and the rise of developing countries such as China and India—create both new opportunities and new pressures on competitiveness and wages. This makes it even more important that the U.S. political system rises to meet its challenges. For American workers, sustained growth is the most powerful force for higher wages and greater personal economic security. But more must be done, including ensuring greater public investment, fair labor markets, a progressive tax structure, affordable health-care coverage, and an adequate social-safety net.

The dynamism of American society, its flexible labor and capital markets, its entrepreneurial spirit and the sheer size of its economy, are great strengths for succeeding in a rapidly transforming global economy. But like any country, the United States will only realize the potential and the benefits of its market-based model by addressing the lessons of the crisis and by enacting policies that effectively promote competitiveness, growth, widespread sharing of that growth, and increased economic security. In the United States, this will require far greater willingness to work across party and ideological lines, to base decisions on facts and analysis, and to make sound decisions on politically tough issues that may be difficult in the short term but provide long-term gain.

Finally, in an increasingly interdependent world, transnational issues key to all of us can only be addressed through effective global governance—which is a lot easier to proclaim in communiqués than to accomplish. Thus the ultimate challenge for the market-based economic model, perhaps somewhat ironically, is effective governance in each country and internationally.

Posted via email from Jim Nichols