Financial Reform Watch

This week, more than forty heads of state are meeting in Davos, Switzerland for the annual meeting of the World Economic Forum. The title of the deliberations is forward looking, although unclear how exactly HOW forward looking: "Shaping the Post-Crisis World.” No doubt, the proposals for financial regulatory reform discussed on these pages in the past weeks will be on the Davos agenda.

On both sides of the Atlantic, those working on getting financial markets out of crisis and those planning for the post crisis world are dealing with fundamental structural issues surrounding monetary policy, fiscal policy, and market regulations. While the emphasis points shift depending on time and location, significant issues are in play in European capitals and in the United States and those issues overlap in myriad ways.

In the EU, the decades-old discussion of the common currency is entering a new phase as some countries participating in the Euro are considering pulling out and others who have opted out are thinking about joining it. At the core of the issue for those considering dropping out are the fiscal and monetary constraints on Euro members, which may limit to a politically unacceptable level the ability of governments to respond to economic crises.

A leading US economist, Martin Feldstein, George F. Baker Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, on 26 January, published an article saying that:

“In these circumstances, it is possible that one or more countries might actually withdraw from the Eurozone. It is clear why some national political leaders – or would be leaders – might consider such an option. Doing so would allow their reinstated national central bank to choose an easier monetary policy. The national central bank could also create the currency needed to act as a lender of last resort to national commercial banks. The country’s fiscal authority would no longer be bound by the restrictions of the [EU] Stability and Growth Pact and could therefore pursue a large fiscal stimulus. The international value of the currency could adjust to make local products more competitive.”

Paradoxically, however, some EU states are in the process of reconsidering their refusal to adopt the Euro. In the UK, the Euro-debate has been re-ignited among the elites with 31 leading British business leaders, academics and opinion-makers recently publishing essays arguing that the current UK “no” should be reconsidered. Peter Sutherland, who currently serves as chairman of both BP and Goldman Sachs International and a former EC Commissioner, ended his essay by concluding:

“Gordon Brown and Alistair Darling have put much weight on the need for international co-ordination of the monetary and fiscal policy response to the crisis. And rightly so. We have learned the hard way through the course of 2008 that the interlinked global economy fares better with co-coordinated policies. The same logic applies to the even more closely linked EU economies, and recognition of this fact means there is likely to be better co-ordination of fiscal policy in the Eurozone in future. Outside the Euro, the UK will be outside that process and will not be shaping the rules. The UK’s current leadership in discussions of the international economic and financial architecture will prove ephemeral if the country insists on remaining outside the most relevant part of the framework of co-ordination for its own economy.”

As for the central European EU Member States that have not yet adopted the Euro, they are having to cope with increasingly difficult policy choices. Part of the process of adopting the Euro involves demonstrating that a country’s currency has been stable for a long period of time, which, in effect, rules out devaluations even in cases where currency depreciations would help cushion the impact of the crisis. Recently, Poland, Hungary, the Czech Republic and Romania allowed their exchange rates to slide as the emphasis of monetary policy changed towards providing support to the real economy. In contrast, however, Bulgaria and the three Baltic States, that all have fixed or pegged exchange rates, find themselves in the same position as Ireland and Greece and thus unable to counter the recession with a weaker exchange rate.

In the United States, where concerns on monetary policy are taking a backseat to the perceived need to shore up financial markets and stimulate the economy, the Federal Reserve appears poised to undertake broad new regulatory responsibilities that would significantly alter its role -- even beyond the significantly increased role it has played recently as a direct lendor and guarantor. There is a potential the Fed, with backing from the Obama Administration, will assert broad new authority to oversee financial markets so it is easier to "connect the dots" in the financial sector and prevent future crises. Taking these steps would create a significant new role for a body that lacks the political and public accountability normally associated with the Treasury or the Securities and Exchange Commission. Congress, particularly House Financial Services Committee Chair Barney Frank (D-MA) appears poised to legislate in this area as well and may place new requirements on the Fed to be more transparent in its deliberations. This would accelerate a trend Fed Chairman Ben Bernanke began cautiously when he lifted the curtain somewhat on meetings of the Federal Open Market Committee.

Of course, all of these issues and all of these players come together at Davos. We will be observing closely the deliberations there and reporting further on them in future editions.