Regaining Financial Stability: Taming Financial Markets Is a Must - A Focus on NMSs

The need for a radical overhaul of the regulation and supervision of financial markets has been acknowledged in all advanced economies. And yet, there still is a line ofreasoning which argues that the main source of the current financial crisis is the cheap money of the past, which would have caused large global imbalances as well.But another, that I share, is that something wrong has been occurring with overall financial intermediation in recent decades. This is like saying that structure has been no less important in derailing economies than misconceived policies and unavoidable cyclical dynamics. By structure we mean the configuration of rules and practices in the realm of regulation and supervision, on one hand; and the evolution and practices of financial institutions, including securitization and the growth of the so-called shadow banking sector (which has escaped regulations), on the other hand. Structure has, arguably, influenced policies in view of the relative neglect of systemic risks and the almost blind belief, by some, in the self-regulatory virtues and clairvoyance of financial markets. For a long time financial stability was relegated, de facto, to a second tier policy priority – especially in advanced economies. The current crisis has brought this concern back, with vengeance, and relates it to structure. The “great moderation” reveals itself as a “great misperception” period, which compels a rethinking of regulations and practices, of monetary policy itself (of inflation targeting, too), of the linkages between various domains of economic policy. Nothing seems to be certain any longer, in an increasingly stochastic world. Just think about the huge difference between how Spain and Ireland were judged before and after the eruption of this crisis – with a sharp deterioration of public finances and drastic economic downturn. The economies of EU new member states (NMSs) in Central and Eastern Europe have been most hardly hit by this financial crisis, a fact that has intrigued observers. Because these economies’ exposure to toxic products was quite minimal and their budget behaviors, with some exceptions, were not profligate. And yet, apart from Poland, their economic downturn was, on average, the most significant among emerging economies. What this paper argues is that this dynamics can be explained by considering implications of deep financial integration. The latter can bring benefits and rapid growth, which did take place in the Region until 2008, but it can also harm unless proper institutions and policies operate. Moreover, the impact of the current crisis on NMSs illustrates the role of Structure, of the rules of the game in the EU (complete capital account liberalization), the nature of regulation and supervision, and, not least, massive cross border operations. The case of NMSs is all the more significant since these economies imported capital on a big scale as a means to foster growth – while in Asia and Latin America, the episodes of crisis of the past two decades induced countries to attach a high premium on the accumulation of foreign exchange reserves and the reduction of current account deficits. NMSs look like they have tried to defy the lessons of previous crises by betting on the virtues of deep financial integration. This paper looks at their case and probes into future possible developments. This discussion is couched in a broader context, of the need to reform structure (rules and arrangements), in the EU, too. A key argument is made: in order to regain financial stability, at the international level, a return to the initial logic of the Bretton Woods arrangements is needed. The financial policy trilemma (the impossible trinity)3 would ask for releasing monetary policy and trade flows from the vicissitudes posed by unconstrained financial flows. The currency war underway and rising protectionism are additional indications that new international arrangements are badly needed if an open global system is to be preserved. Finally, the paper puts forward a range of issues which need further scrutiny in order to make policy more effective.