Lorenzo Bini Smaghi: Lessons of the crisis - ethics, markets, democracy
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at Unione Cristiana Imprenditori Dirigenti (UCID), Milan, 13 May 2010.
* * *
The events of recent weeks, particularly the Greek crisis, show that the period of economic
and financial instability which began almost three years ago is not over yet. The first phase of
that instability, starting in August 2007, occurred mainly on the financial markets, ranging
from the money markets to the stock markets. With the failure of Lehman Brothers in
September 2008, the crisis spread to the real economy, causing trade, consumption and
investment to fall worldwide. The economic policy authorities have tackled the recession with
massive injections of funds to support the economy. Public deficits have risen to
unprecedented levels, driving up the debts of all the industrialised countries: the International
Monetary Fund has described the current situation as a "wartime debt, without a war". We
have moved into the third phase of the crisis in which the financial markets have begun to
question the sustainability of economic policies, in particular as regards public finances and,
consequently, the sustainability of the economic recovery itself.
This third phase of the crisis has hit Europe first. Financial markets consider, rightly or
wrongly (in my view more the latter, but I won't dwell on that point) that in countries where
there is a perfect overlap between the monetary and fiscal authorities the risk of insolvency is
limited because the central bank can print money and create inflation to reduce the burden of
public debt. However, the euro area, which cannot monetise its debt, has to tackle the
problem immediately and ensure that each country is solvent without a monetary
contribution. If the euro area is able to overcome the current difficulties and restore its public
finances in time, it will exit from this "public" phase of the crisis before others.
The crisis, in its later stages, has revealed a number of common issues to which, it seems to
me, insufficient thought has been given, and even less action taken.
At our last meeting, in October 2008, shortly after the collapse of Lehman Brothers, I
examined the problems facing modern democracies in making decisions that require citizens
to make short-term sacrifices for long-term gains. Lehman Brothers was left to go bankrupt,
with devastating effects on the global economy because the US Congress - under pressure
from voters a few weeks before the election - refused to provide the US administration with
the funds necessary for the rescue. That refusal, which was also confirmed during the vote
on the Troubled Asset Relief Program, a few days after the failure of Lehman, even though
the markets were already falling, fully reflected the deep feelings of American taxpayers who
did not want to pay out of their own pockets to save a financial institution that had hitherto
enriched its shareholders and managers beyond measure. The common sentiment was that
it was not "right" to save Lehman; those who had made mistakes had to pay. Those
taxpayers and their representatives in Congress and the administration did not think that the
failure of Lehman would infect the global financial system and endanger their own savings.
That short-sightedness cost much more than it would have cost to save Lehman.
It was not however the first time that the American people reacted that way. In 1995, at the
time of the Mexican crisis, the US Congress refused to disburse funds to support the IMF's
USD 50 billion programme. The US administration found in the labyrinth of the budget a
foreign exchange stabilisation fund that did not require Congressional approval to use on that
occasion. The facts have shown that without that intervention Mexico would have been hit by
a severe crisis which would also have overwhelmed the United States. Although just a few -
with the benefit of hindsight - have considered the administration's decision wrong,
Congress subsequently adopted a budgetary control act to prevent that budget item being
reused without the consent of Congress.
The most recent phase of the crisis has shown Europe to have the same problems as the
US. Taxpayers in some European countries have opposed the aid package for Greece, a
country guilty of having fiddled its accounts, without thinking that bankruptcy would have led
to a crisis with even more serious consequences for those taxpayers. Finally, despite the
difficulties, Europe was able to reach a decision. The respective countries have approved the
aid package for Greece. The approval has however taken time and involved debates and
discussions - processes that are fully justified, indeed essential, in a democracy - and yet
they have fuelled uncertainty about the final outcome and thus prompted market participants
to quickly liquidate their investments in Greek securities. This resulted in an increase in the
budget deficit and the need for an even larger support package. There is no doubt that the
total cost of funding to Greece would have been lower if decisions had been taken more
quickly, for example, immediately after the agreement between the European heads of state
and government on 11 February, when they promised support to Greece provided it took
measures to cut its deficit by 4% of gross domestic product. Indeed, Greece took the steps
required in less than a week, but in the meantime in some other countries the popular
consensus in favour of the support measures was weakening. Only the signs of a general
crisis across the euro area would justify their contribution. For this reason, assistance from
the IMF was requested, attesting to the global nature of the crisis and the support. At the
same time, the elections in some countries have delayed the IMF's intervention in order to
avoid having to decide on support for Greece in an election period.
It seems that the people, their democratically elected representatives, and institutions
operating in that context, sometimes need to "see" the crisis approaching in order to realise
the dangers and take the decisions necessary to tackle them. This is particularly the case in
societies which are based on economic stability, such as Germany, and which are not used
to managing crises, especially those of a financial kind. In the global world in which financial
markets move rapidly, there is a risk that the reaction times are too slow and that people may
sense a crisis looming when in fact it has already hit. To prevent such a risk we need great
leadership by those who govern, and we need institutions to convince people to look beyond
the short term and take account of the impending crisis. Alternatively, automatic defence
mechanisms are needed which permit a rapid addressing of problems before a crisis breaks
out.
In the euro area, mechanisms have to be created to respond more quickly to the financial
needs of states, even with emergency measures, or to supply funds to support those facing
speculative attacks that threaten to undermine the very solidity of the states. It is unclear to
me how these mechanisms can be shaped in a way that is compatible with our democracies,
which in particular require parliamentary scrutiny of taxpayers' money. But it is clear to me
that without these mechanisms our democracies risk getting hurt and being unable to deal
with crises that can undermine their foundations, as shown by the speculative attacks against
the sovereign debt of the industrialised countries.
We need not only to reflect on these issues but also to find concrete solutions - rapidly.
Let me turn now another problem, which has arisen from the ongoing financial crisis, a
problem which, I think, has so far received scant attention. It concerns the functioning of
financial markets.
The crisis has forged a broad consensus: financial markets are not always efficient. They do
not always use the available information in such a way as to correctly value the assets that
are exchanged between financial market participants. Recent experience has shown that
there is a natural tendency to underestimate risk when markets are euphoric and to
overestimate risk during crises. These behaviours are derived from the incentive that the
market participants have to maximize the return on capital employed, on their own account or
on behalf of their clients. There is now a large body of literature that explains why, even with
rational agents, markets cannot be efficient at the aggregate level, and in particular give rise
1
to speculative bubbles.
The reforms of the financial system that are currently under discussion in the various bodies
that report to the G20, like the Basel Committee, the Financial Stability Board and the IMF
are intended to establish or strengthen existing rules that reduce pro-cyclical behaviour, for
example, through the banks' capital requirements, accounting rules, the mechanisms that
determine managers' remuneration, the specific constraints on major financial institutions.
The effectiveness of the new rules and of the supervisory authorities that will implement them
will depend on their ability to affect the incentives of individual market participants and
financial institutions. Some have expressed misgivings about it, because it is difficult to
change the incentives of financial market participants. Some people think that crises are
inevitable in advanced financial systems. As Alan Greenspan, the former Chairman of the US
Federal Reserve, remarked: "The crisis will happen again but it will be different. Crises are all
different, but they have one fundamental source. That is the unquenchable capability of
human beings when confronted with long periods of prosperity to presume that it will
continue."2 In other words, financial crises are part and parcel of our society.
The question is whether human nature can and wants to change in order to prevent crises
like the present one from recurring. On the one hand, it is to be hoped that the current
experience will push the financial community to exercise greater caution in future, especially
in risk assessment. On the other hand, the incentives to resort to behaviours like those that
preceded the crisis are so ingrained as to constitute an obstacle to change. In particular, it is
difficult for an individual market participant to act in an anti-cyclical way, that is, to go against
market trends, if the valuation parameters are based on the average trend of the market.
During favourable market phases, for example, a less pro-cyclical, i.e. more conservative,
behaviour than the average generally leads to lower yields compared with that of other
market participants. Since, for an outside observer, it is very difficult to see if this is the result
of greater prudence or of lesser ability, that observer will tend to favour the latter
interpretation. Those who act in a less pro-cyclical way thus risk being marginalised, and
exiting from the market, since they are considered less competent.
The pro-cyclicality of market participants arises because, as Keynes brilliantly explained over
70 years ago, winning strategies are those that manage to anticipate market trends, even
though those trends are disconnected from the real economy for some time. An individual
market participant behaves like someone in a beauty contest who has to bet on who will win
the contest, and that depends on his ability to understand the preferences of others rather
than on his aesthetic senses.
One point on which there has so far been less reflection concerns the incentives for
individual market participants, not only in trying to predict the behaviours of others but in
trying to influence them. To go back to Keynes' analogy, if some market participants manage
to communicate to others how they would vote in the beauty contest, they can create a
critical mass which others would join, thereby steering the vote in the desired direction.
These behaviours constitute in some cases violations of specific market rules, which can be
penalised, or violations of ethical rules, which tend to relate to codes of conduct or
selfregulation.
We know that markets will function effectively if they are competitive, that is, if every market
participant takes a position according to the information available and if that participant does
not try to influence others. A key aspect of the difference between theory and practice on
which I would like to focus is the dissemination of information among market participants.3
Markets are competitive if each participant is large enough not to be able to change prices
unilaterally. Collusion between market participants to try to steer prices in a certain direction
are prohibited, and are monitored by supervisory and anti-trust bodies. However, it is very
difficult to detect collusive positions in financial markets, for two reasons. The first is that
these markets are moving non-stop and so it is not easy to prove that there has been
collusion on investment strategies. The second reason is that any similarities may result not
only from ex ante agreements between market participants but also from herd behaviour,
which is typical of a market where neither ideas nor investment strategies can be patented. If
a market participant manages to act as a herd leader, and to influence the behaviour of
others, it can gain an information advantage and influence the markets, which become less
competitive and more prone to instability.
A financial market participant can act as a herd leader if it can convince others that it has
superior information and greater capacity for analysis so as to obtain better returns on its
investments. A herd leader can thus influence, through communications either with the public
or with some market participants, the behaviour of others and point the way for the herd.
Indeed, major banks and financial institutions, and now hedge funds, publish or disseminate
rapidly via e-mail their analysts' views, particularly regarding the assessment of specific
companies or countries, and in some cases reciprocal assessments too, e.g. between banks.
These assessments also contain recommendations to sell or buy shares or bonds or
currencies. In theory, the published analyses are independent. They should not be linked to
the investment strategy of the institution. Indeed, financial institutions say that their
investment strategies are independent of their analysts' opinions, and may be based on other
information. If the herd leader wants to continue playing this role it must keep some of the
available information to itself. Whether the opposite is true is unclear, that is, if the analysts'
opinion which is widely publicised is independent of the investment strategy followed by
traders of the same institution. It is surely not the case for investment funds or hedge funds,
which do not even say if Chinese walls exist between their research and operational arms.4
In recent years the use of market information for "promotional" purposes has grown
considerably. In the mass media, i.e. newspapers and television, the opinions of the analysts
of the major banks are often sought. Since information is scarce and should have a monetary
value for a financial market participant, one may wonder why it is made available to all free of
charge. One hypothesis is that this contributes to the market participant's reputation,
attracting new clients. But clients should prefer insider information, the information that
others do not have. The alternative, more credible, hypothesis is that with their considerable
presence in the media market participants seek to steer the entire market, i.e. acting as herd
leader.
Let's look at an aspect that interests me particularly: monetary policy. The opinions
expressed by analysts on monetary policy decisions often concern not only the impact of a
given decision on the markets, but the substance of the decision, namely whether it is
appropriate or not. The parameters according to which the analyst expresses his/her views
are however not transparent. It is unclear, in fact, if the analyst is expressing an opinion
based on an objective function which is the same as that of the monetary authority - price
stability in the ECB's case - or based on his/her specific interest, particularly his/her
investment choices. One might ask, for example, if a decision to increase interest rates
would be judged right or wrong by a financial market participant based on the outlook for
inflation - or based on the speculative position that the market participant itself has taken.
What, then, should we think of the views that are expressed even before the central bank
takes its decision? What are the criteria when a financial market participant expresses an
opinion on what the central bank should do? Do the criteria depend on the speculative
positions it has taken or on other, more general criteria?
I'll take a concrete example, which is not related to the decision on interest rates but on the
collateral the central bank accepts in exchange for funding provided to the market. On
Monday 3 May the European Central Bank decided to no longer follow the rating agencies
when assessing the sovereign debt of a country that has an adjustment programme with the
IMF and the European Union - a programme which the ECB has judged positively. It was a
logical decision for several reasons.
First, while for a company or a bank the rating agencies' analyses may include information in
addition to what the central banks have, it is less clear as regards the countries, especially
those in the euro area, whose macroeconomic and budget figures are well known. The
agencies - there are only three of them - have recently lost their credibility, contributing, with
significant conflicts of interest, to the overvaluation of the creditworthiness of asset-back
securities, particularly the sub-prime mortgages that caused the financial crisis.5 However,
the recent downward revisions of sovereign credit ratings raise many doubts. Some of these
revisions were not based on macroeconomic data or new budgets, but on the assessments
given by the market for sovereign bonds and the possibility of contagion. In this way the
agencies have not given an independent assessment, but one linked to market's reaction.
One might even ask if they have in some cases an interest in pushing the market in the same
direction that it has already moved in, contributing to the pro-cyclicality and the phenomena
of distorting prices. For example, an agency reduced its rating for Greece just after the first
deficit adjustment measures by over 4% of gross domestic product, indicating that, although
the measures taken were adequate, the adjustment depended on the reaction of the market.
Another agency reduced its rating for Greece three days before the agreement with the IMF
was concluded, without knowing the contents of the adjustment programme.
Given that these behaviours are not always clear, it would have been a mistake for the ECB
to continue to depend on the judgements of rating agencies. Having helped to draft the
programme, the ECB - along with the IMF and the European Commission - is better able to
assess the risk posed by Greece than the rating agencies.
The opinion of some analysts on the ECB's decision was negative. Their thesis is that the
ECB risks losing credibility and embarking on too lax a path. It is interesting to note that
those same analysts had previously regarded the ECB policy as being too strict. Why this
sudden change of opinion? Reading carefully what these analysts had written before the
ECB's decision, one notes that many had considered the support programme for Greece as
inappropriate, and saw a restructuring as inevitable. In other words, they had recommended
selling Greek securities and the ECB's decision to maintain the eligibility of such securities
went clearly against their interests. So it's no surprise that their response was negative.
The media are often unaware of these conflicts of interest and report the opinions of financial
institutions without clearly stating that they have probably taken speculative positions in one
direction or another. This approach may undermine the credibility of the media.
The same applies to the views of many professional commentators, and even academics,
who are consultants to the financial institutions from which they get information and with
which they interact. It is rare to see in a footnote that Professor So-and-So - who evidently
does not write for academic purposes, but to influence the opinions of specialist readers - is
connected in some way with financial institutions, particularly through consultancy contracts.
I was very surprised in the days before the completion of the adjustment programme for
Greece to read articles by distinguished professors, many of them consultants to investment
banks and - coincidentally - with very similar opinions to those expressed by the same
banks, but without any reference being made to the relationship in the articles. I'm not asking
for opinions to be censored, but at least there should be transparency and disclosure of any
conflicts of interest, then readers are in the picture.
Doubts are raised even by some decisions to publish opinions that all go in the same
direction right in the middle of periods of great turbulence, as was the case with Greece.
These opinions, often with limited analytical content, were repeating the same mantra: the
adjustment demanded of Greece requires too great a sacrifice, so there is only one solution:
insolvency or the restructuring of Greek debt. Nobody had made clear what kind of sacrifice
the insolvency of a state involved. Nobody had explained the impact on the financial system,
contagion to other countries, and if that sacrifice was greater or lesser for the people than the
alternative hypothesis. There was talk of a limited default, as if such a concept existed and
had been tried out. Ridiculous comparisons have been made with Argentina.
Another aspect that is surprising to read in the media is the lack of precision on some news,
especially when they are false and obviously put into circulation to create uncertainty. Let me
offer another example related to the recent crisis in Greece. On 4 May the Greek government
announced that it had hired a French investment bank, Lazard, for advice on its debt
management. In the early hours of that day, the rumour spread in the markets that Lazard
had been hired to restructure Greek debt. It was officially denied by both the Greek
government and Lazard. It was also absurd because Greece had just received a financial
support programme that explicitly excluded restructuring. Despite the denial, a leading
financial newspaper ran the headline the following day "Athens calls in the default specialist".
And while sensationalist headlines are a commonplace vice, unmerited for sensitive topics,
the content of the article did nothing to dispel the doubts: since Lazard has long-standing and
undisputed expertise in the default field, suspicion was justified. The reasoning is absurd and
raises doubts in other areas.
The payment of funds by the financial community to politicians, generally in order to obtain
favourable treatment from the legislature for financial institutions, is well known. These
payments are declared to some extent. It is estimated that the US financial sector spent
more than USD 5 billion between 1998 and 2008 funding lobbying activities to Congress and
the US administration.6 Less is known about the payments made to other influential sectors
of our society, such as the media, opinion makers and academics.
This is a subject on which our advanced societies do not have enough information and,
above all, on which they have not reflected enough. In the light of what I said at the outset,
we should not underestimate the risk that the consensus needed in our democracies to
effectively address financial crises may be distorted in favour of special interests. The ethical
question relating in particular to the operation of markets and the use that is made of
information does not concern only individuals but has a broader dimension that touches on
the functioning of our democracies.
In other words, it is in the general interest that the euro area countries adopt appropriate
fiscal policies, reflecting not only the development of their economies but also the
sustainability of public debts. However, it may be in the interest of some financial market
participants for some states with budgetary difficulties not to pay back their debts and
therefore fail, regardless of the impact this will have on the citizens of that country and those
of neighbouring countries. It is in their interest if they have taken speculative positions in this
regard and therefore can gain from the bankruptcy of a state. And since the probability of
bankruptcy depends in part on the democratic process in the country itself, and on the other
countries that may help the one in difficulty, it may be useful for financial market participants
who bet on the failure of countries to use part of their future earnings to convince people that
there is no other way possible, that an "orderly" failure that puts public finances back on track
is better. The more people who are convinced of it ("As Greece is going to fail, help is
useless"), the more likely becomes the outcome desired by financial market participants,
although it is not in the general interest.
These issues raise ethical and moral questions that have been widely discussed, but from a
limited point of view. The appeal to ethics and individual morality is an important starting
point to correct the distortions that I mentioned above. But it's not enough. The experience of
recent years has shown that self-regulation and self-discipline do not suffice to prevent
market distortions. This stems from the fact that the measure of individual performance,
which is the economic result, can be appropriate in a theoretical context of perfect and
complete information, particularly about how that result was obtained. Financial markets are,
however, characterised by information asymmetries that make it very difficult to identify the
source of profit, especially if it has been achieved thanks to the ability of the individual market
participant (known in the jargon as alpha) or due to the risk it has taken and that may be
improperly measured, precisely because of the informational asymmetries in the financial
services available to the client. Other financial market participants and supervisory
authorities are not always able to adequately identify the relative contribution of the two
factors and therefore to punish unethical behaviour.7
However, not all unethical behaviour which shows a conflict of interest is directly punishable.
In some cases it is considered that the reputational loss of the market participant who fails to
live up to ethical principles is a sufficient incentive to ensure fairness. But if the gain more
than compensates for the loss of reputation, the incentive to continue to violate the ethical
principle remains, perhaps in a more effective manner. If the unethical practices make it
possible to obtain higher returns, those who do not follow them are likely to be penalised. In
other words, those who comply with the dictates of ethics may not perform economically so
well as those who do not, and so may find themselves out of the market.8
Self-regulation works if everyone respects the rules and if that compliance is easy to monitor.
Since the financial market information asymmetries make it very difficult to distinguish
between those who observe the rules and those who don't, the individual appeal to ethical
principles is not enough. It can even penalise those who respect them, pushing them out of
the market.
Ethical issues are therefore to be addressed in general terms and must concern all markets
and participants. That's not easy, considering the global scope of the financial markets.
Finally, I would like very briefly to summarise some lessons from the crisis, which call for
greater reflection.
1. By intervening to support the economy and financial system, the economic policy
authorities have avoided a depression, but they have postponed the problem, which
is beginning to become weighty.
2. The timing of the adjustment may have to be shorter than that of the economic
policy authorities, especially if financial markets are not convinced of their
determination.
3. The financial market consists of two types of market participant: those who are
afraid of uncertainty and those who gain from it, and from the uncertainty about the
position of a country's finances. The latter may have an incentive to feed this
uncertainty.
4. Financial markets are pervaded by a myriad of conflicts of interest, particularly
concerning the use being made of information.
5. These conflicts of interest may have an impact on the media and the academic
world.
6. Democratic systems have difficulty coping with financial crises effectively because of
the conflicts that such crises produce between short-term individual interests and
collective long-term interests.
7. Financial markets and the conflicts of interest that pervade them can infect our
democracies and weaken their foundations.
8. The global dimension of the markets makes it difficult to identify specific solutions to
these problems.
In conclusion, the financial markets are the "brains" of the economy. It cannot do without
them, but if the brains do not work well, the rest of the body is at risk.
Thank you for your attention.