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Social Business and Economic Growth

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB,
Executive Summit on Ethics for the Business World,
Vatican City, 16 June 2011

It is my pleasure to be able to speak at this conference on business ethics in contemporary society and to present a central banker’s perspective.

Economic analysis illustrates that the maximisation of the general welfare of a society does not correspond to the sum of each individual’s utility functions, particularly because negative externalities can arise from individuals’ behaviour. This is why a society must put rules and institutions in place, whose objective is to minimise such externalities. One might ask whether the same applies to the area of ethics. In other words, one can ask whether it is enough that individual actors follow shared ethical principles, in particular in the field of business, in order to find an ethical balance that is sustainable at the social level.

I would like to begin by looking at the key factors that triggered the financial crisis, in particular in the United States. Put briefly, the main cause of the crisis was excessive credit demand from households, especially less affluent ones. This demand was, for the large part, indulged and encouraged by the financial system, which had developed sophisticated techniques ­– albeit not always transparent – to streamline, manage and distribute risk in an environment in which there had been a general easing of regulation, as requested by actors and granted by the political system. This excessive debt created a speculative bubble, which, after bursting, initiated a chain of repercussions on the financial system and the real economy.

The responsibility for this is widespread and systemic. It is so widespread that it is possible, one way or another, to justify each contributing element, including in terms of individual behaviour. Every family dreams of buying a home in order to improve living conditions and to integrate into American society. Even if many households knew that they were taking excessive risk by spending beyond their means, they trusted in the future increase in the value of the property they had purchased, which they had inferred based on the trend of the preceding years. Borrowing – even in difficult periods – in order to buy a home, send the children to a better university, maintain one’s standard of living: this was no different from what entire generations of Americans had been doing for decades. This was the “American dream”.

Looking at the problem from the perspective of the financial markets and individual market participants, the deregulation of the system in order to “democratise” credit and make it available even to the weaker members of society was an objective shared by all political actors in the 1990s and 2000s. It was considered the task of the financial institutions to develop new instruments, including the more sophisticated ones, to support the economic system. Shareholder dividends were considered an objective benchmark for measuring value and the quest for ever increasing dividends the best way to improve the efficiency of the system.

From a political perspective, the growth of the financial and housing sectors is beneficial for economic growth and contributes to the country’s public finances. The deregulation measures – which aimed to enable the less wealthy to purchase houses and to facilitate the functioning of the financial system, and which consequently made an ever increasing contribution to the public purse – seemed to be fully justified.

In short, excluding a few specific cases (such as Maddoff for example), it is difficult to support the idea that the large majority of actions that ultimately created the imbalances at the core of the financial crisis were not in line with the legislation and shared ethics held by society at that time. Even the generous bonuses awarded to investment bankers, today frowned upon, were considered prior to the crisis to be an appropriate reward for a complex and specialised profession which attracted the top university students.

Something was clearly wrong. Expectations of a continuous improvement in living standards – on which the growth in credit demand from US households was based – were not sustainable because technological changes and the process of globalisation permanently changed the growth potential of advanced economies. The belief that growth would continue in recent years at a similar pace to that seen in the past was the fruit of a collective illusion. A similar illusion was widespread in financial markets, where the quest for ever higher returns in a context of asymmetric information prompted borrowers and lenders to underestimate risk and to become overleveraged. Attracted by the short-term benefits in terms of higher economic growth and fiscal consolidation, politicians attached less importance to the long-term risks associated with excessive private sector borrowing. Reliance on self-regulation, fuelled in addition by the academic world, led to the public authorities relinquishing responsibility.

Nevertheless, this was not the first financial crisis. We know, and experience confirms this, that targeted prudential rules are necessary to counteract pro-cyclical behaviour and externalities in the financial system. Financial regulation must therefore be strengthened, reversing the tendency that emerged in the years leading up to the crisis for the effectiveness of the rules to be reduced.

We also know, however, that one of the objectives of the financial system is to continually innovate in order to create new instruments to manage risk or to increase returns. Those engaged in financial activities tend to find a way around regulation in order to “beat the market”. In a dynamic environment like that of the financial markets, the simple application of the rules is not enough to minimise the externalities that result from the pursuit of individual interests and to reduce the risks of unstable dynamics.

Let me give you an example. The development of sophisticated instruments, such as credit default swaps (CDSs), helps to better safeguard against certain risks and to propagate the use of certain financial instruments. It is easier to invest in a government bond from a risky country if it is possible to get protection against the risk of insolvency. CDSs therefore increased the liquidity of the market to the advantage of both the issuer and the investor. CDSs can be purchased even without holding the underlying bond. This means being able to safeguard against the risk of default by a company, a bank or a country, even without having invested in them. This creates an incentive to bet on the failure of companies, banks or entire countries. When the number of market participants using such instruments increases, in the short run ceteris paribus premia rise, signalling an increase in the possibility of default and, in turn, sparking greater demand.

In the summer of 2008, for example, shortly before the bankruptcy of Lehman Brothers as well as in the weeks following, each financial market participant tried to survive the market collapse through speculative operations which essentially consisted of bets on the failure of other market participants that were in difficulty. This created a spiral effect that contributed to the worsening of the crisis.

In short, in today’s markets, you not only decide which financial activities to invest in, but also which ones to invest “against”. Moreover, the probability of success depends on the capacity to mobilise other forces in the same counteractive direction in order to induce the price of the bond to fall until bankruptcy is declared. It is therefore no surprise that key investment companies make public their opinions on the quality of various types of investment, perhaps with the intention of encouraging others to do the same.

The fight to survive, which in a capitalist system should reward the company with the best product, is changing in nature. Particularly in a period of economic difficulty, when returns are limited, those who survive are those who bet on the failure of others and who manage to convince the market that such a failure is inevitable. It is no longer about Schumpeter’s “creative destruction”, but “destructive destruction”, where the one who survives is the one who bets, rather than the one who innovates and produces.

The same is true for countries, on which one can bet and cash in the premium in the event of default. The probability of collecting the premium is greater, the more there are who bet against the country. Default by a country brings economic depression, with severe consequences for society and the democratic structure.

This system creates incentives to behave in a manner that is not in line with the set of ethics on which the capitalist market system is based. It is no longer (only) about concentrating on one’s own activities and seeking to perform better than the others, but (also) about identifying the weaknesses of others, betting on them, and convincing others to do the same in order to bring about their collapse. Whether the recessionary impact is systemic matters little, since the cost, for the most part, will be dumped onto taxpayers.

How can these destabilising market dynamics and their devastating effects on the real economy be thwarted?

As I mentioned earlier, simply applying the rules is not enough, since in the majority of cases the rules are backwards-looking and are thus not in a position to regulate behaviour and innovative instruments. Moreover, the rules are largely designed to regulate market phases of relative stability and not exceptional circumstances which necessitate the ability to carry out discretionary interventions.

Individual ethics is an important discipline, but it is a discipline that is based on the principle of self-regulation. Particularly in phases of market turbulence, market participants that are not in a position to achieve higher returns than others, or to minimise their losses, are at risk of being pushed out. If the majority of market participants intensively use destabilising financial instruments, those who do not, risk failure.

The role of the regulators, such as the central banks, is thus essential. They have a medium-term perspective and the capacity to intervene autonomously to amend the rules, or to suspend those in force, in order to combat the short-term, pro-cyclical behaviour of market participants and to dampen the destabilising consequences. In order to be able to do this and to be able to act in the face of pressure from those who benefit from the absence of rules in the short term, independence and autonomy are key.

There is a wealth of literature on the independence of public institutions, particularly those called on to regulate financial markets and safeguard the value of money, such as central banks. It seems appropriate to recall some of the characteristics of independence because they are closely related to certain fundamental ethical values. It is no coincidence that central bankers have adopted Saint Thomas More as their patron saint, who, with his independence of thought and his firm conviction in the supremacy of the public interest, managed to resist pressure from King Henry VIII – for whom he was the closest adviser prior to being appointed Lord Chancellor – until he was forced to resign, imprisoned and then condemned to death.

On this subject, I would like to quote from Pope Benedict XVI’s speech, given in Westminster Hall in September 2010:

“I recall the figure of Saint Thomas More, the great English scholar and statesman, who is admired by believers and non-believers alike for the integrity with which he followed his conscience, even at the cost of displeasing the sovereign whose “good servant” he was, because he chose to serve God first.”

It may seem bold to compare a central bank to the Church, but that is precisely what Heinrich Mussinghoff, Bishop of Aachen, did two weeks ago today in his address on the occasion of the awarding of the Charlemagne Prize to Jean-Claude Trichet:

“Financial matters have an element of public service. This also applies to the euro, which is helping to realise a shared vision of a united Europe in the spirit of humanism. It is in this spirit that the European Central Bank […] and we members of the Church must fulfil our shared task for the people of this continent and beyond.”

Fortunately, central bank independence no longer depends on the heroic actions of its exponents. In Europe, the Maastricht Treaty provides for and safeguards the independence of the ECB and the national central banks, which together form the Eurosystem. At the start of monetary union, the euro area countries brought the regulations governing their own central banks into line with the Treaty. Subsequent amendments also underwent close inspection by the ECB to ensure their compliance with the Treaty.

There is now a laid-down set of principles for assessing central bank independence according to four key criteria:

  • functional independence, which requires the setting of a clear objective – price stability – and making available the appropriate instruments in order to achieve it;

  • institutional independence, which prohibits the decision-making bodies of the central bank from seeking or taking instructions from other bodies or governments and prohibits the latter from seeking to influence the decisions of the central bank;

  • personal independence, which ensures the security of tenure of the members of the decision-making bodies for the whole term of office (eight years in the ECB’s case and a minimum of five years for the national central banks) and safeguards against their arbitrary dismissal;

  • financial independence, which allows the central bank to have access to sufficient financial resources to carry out its mandate.

These criteria have been key in safeguarding the central banks from attempts to influence their actions, including during the crisis. Indeed, it is sorely tempting to offload onto monetary policy the burden of intervention in fields that are the responsibility of the fiscal authorities, such as budgetary support for countries in difficulty. The ongoing debate about the Greek adjustment programme and ways in which the private sector can be involved in the financing of the country shows how, even in a context where there is a tradition of respect for the autonomy of the central banks, it is possible for the temptation to monetarily finance the government budget to resurface. Asking the ECB, as has been the case recently, to extend the maturities of the government bonds it holds or to accept as collateral bonds from a state that is considered to have defaulted for the re-financing operations of the banking system is a violation of the principle prohibiting the central bank from monetarily financing the treasury, a prohibition explicitly laid down in the Treaty. Any pressure whatsoever of this kind flouts the regulations on independence that protect the ECB.

In advanced societies, which are based on sophisticated financial systems, the sum of optimised individual behaviour does not necessarily lead to greater collective prosperity. The ethic of individual responsibility is insufficient. We need to construct an institutional order that better aligns the incentives of individuals, which are oriented primarily towards the short term, with the collective well-being in the medium to long term, and which also takes account of the interests of future generations. Ethical considerations do not only apply, therefore, to individuals, but also apply collectively and to the institutions that represent the continuity of collective interests, beyond the short-term political cycle.

The European Union has recently taken important steps in this direction, such as the strengthening of the fiscal rules provided for by the new European economic governance structure and the creation of new supervisory authorities. The experience drawn from this crisis can serve to strengthen our institutions, which are the basis for a fairer society and a revival of trust.

I would like to conclude with the words of Bishop Mussinghoff from 2 June this year:

“The ECB was able to create a climate of trust, even in difficult times, and has contributed to the realisation of this great European vision… Joining together with those who share our humanist vision of Europe encourages us in this direction. Together we will win back trust, because trust conquers.”

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