Why stimulus packages will come back to bite us: Kohler

The Bank for International Settlements has four specific ideas for ensuring that this sort of thing (the global financial crisis) doesn’t happen again.

They come at the end of a fascinating and erudite discussion of the causes and effects of the GFC, possibly the best yet, in which the BIS warns that governments may have got themselves into a pickle with all their fiscal stimulus.

Essentially, the bank cautions that the stimulus may provide only a temporary pick-up for the economy, followed by protracted stagnation, while at the same time making it harder to take the actions necessary to restore the health of the financial system and requiring very difficult exits.

And action to restore the financial system is the most important thing, says the BIS: “A healthy financial system is a precondition for a sustained recovery. Delaying financial repair risks hampering the efforts on other policy fronts.”

Meanwhile: “Officials will face a number of difficulties in exiting from the various crisis-related policy interventions.”

This applies to Australia as much as any country. A graph on page 112 of the report shows that this country’s fiscal stimulus is the third largest in the world after the US and Korea (about 4.7% of GDP – “total ex ante cost of discretionary fiscal packages over the period 2008-10, as a percentage of 2008 GDP”).

However, the graph also shows that Australia’s public debt is the lowest in the world and that its 2009 GDP growth forecast is the second highest, after Poland.

The basic message of the BIS annual report is that governments have been focusing too much on fiscal and monetary stimulus, and not enough on repairing the financial system. What they have done on that score has been largely ineffective or misguided.

“Overall, governments may not have acted quickly enough to remove problem assets from the balance sheets of key banks.”

“The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.”

Unfortunately the bank’s four specific ideas are not highlighted very well, and you have to hunt through the annual report to the end to find them, but here they are:

1. Treat financial instruments like drugs. Some would be available without a prescription, some you would need a prescription for, others would be tightly controlled and only available to a few pre-screened individuals, and the fourth category would be illegal, like narcotics.

2. Introduce mandatory ‘central counterparties’ to over the counter markets that currently only operate bilaterally. The CCPs would be perfectly hedged and require participants to hold flexible margin accounts. The CCP should be combined with an organised central exchange as the trading platform to ensure price transparency.

3. Impose a ‘systemic capital charge’ on banks. This is to account for the risk associated with the correlation between bank balance sheets. Capital generally only reflects the risks to the institution itself and is too low to account for systemic risks as well. An SCC would be designed to create a distribution of capital that better reflects the systemic risk posed by individual failures.

4. Impose a ‘counter cyclical charge’. These would require institutions to build up defensive buffers during good times that could be drawn down in bad times.

All good ideas, especially the one about treating the things as pharmaceuticals, but the question is: who is going to do it? The G20? They can barely agree on the blandest of communiqués, let alone genuine reform. None of the other ‘G’s’ are broad enough. The BIS has no regulatory authority.

It must come from President Obama. The United States remains capitalism’s headquarters and the only jurisdiction that could impose real regulatory reform on the financial world.

But as Clive Crook of the Financial Times wrote damningly yesterday, the US President is “choosing to be weak”. Not only have he and Treasury secretary Tim Geithner failed to adequately deal with the banks’ problem assets, their financial reform package is hopelessly inadequate.

The BIS annual report can be read as a critique of those proposed reforms.

This article first appeared on Business Spectator.