Bookmark and Share Dr Stephen Spratt is Director of nef‘s Centre for the Future Economy.

The predictable crisis in the global system is the most important sign yet that a new economics is emerging. The tragedy is that the crisis-ridden financial system has long since failed to do the basic job required – to underpin the productive economy, and the fundamental operating systems upon which we all depend. These have been variously neglected, taken for granted or cannibalised by finance. They include the core economy of family, neighbourhood, community, and society, and the natural economy of the biosphere, our oceans, forests, and fields.

Worse, even when the financial system has been working at full throttle, it corrodes the real economy by its sheer profitability and faulty measuring and dominates the policy priorities of politicians.

If nothing else, the crisis provides an opportunity to rebuild a financial infrastructure which does the job, which means investing – not just bailing out failed banks – but in loan facilities for an interdependent network of productive local economies that genuinely underpin life and works within the tolerance levels of the natural environment. This is now possible because the state owns a large slice of the financial system.
The priority of politicians is to restore the normal functioning of the banking and financial system. A rapid return to ‘business as usual’ is the plan, which will hopefully be accompanied by an ‘upside’ for taxpayers as governments are able to sell their equity stakes at a profit when normal market conditions return.

This is all very comforting of course, but is it actually such a good idea? After all, it was ‘business as usual’ that got us into this mess in the first place. We now have a unique opportunity to pause and consider what the financial sector is actually for and to put in place institutional and regulatory structures that enable it to perform these functions well.

new economics regards finance as a means to an end: to support inclusive, equitable and sustainable economic activity that creates real value – economic, social and environmental. It is difficult to argue that much of what the financial sector has been focusing on relates positively to these factors, or that a return to ‘normality’ would change this.

If our current system does not support these outcomes, the question arises as to what would. The following six principles are the starting point for rebuilding the financial system so that it supports, rather than corrodes, the real economy.

1. Scale
The financial sector is just too big. It is too big internationally and it is too big in many nations, particularly in the UK. It dominates the real economy and skews policy. Major institutions are also too big. We have created financial conglomerates that are both ‘too big to fail’ and riddled with conflicts of interest.
Regulators need the tools that were removed in the name of deregulation. To regain real regulatory control, all activities need to be brought onto the balance sheet and regulated appropriately. This means the Government must:

  • CREATE regulators with real power, making sure banks have more stringent capital ratios that vary to reflect changing risk, and force disclosure of lending and deposit-taking both by income level and geographic location, along the lines of the Community Reinvestment Act in the USA. This will guarantee some degree of financial inclusion and stop any more Northern Rocks from abandoning their core market and the local economy in pursuit of ever greater paper profits.
  • REDUCE the dominance of the financial economy over the real economy by reducing leverage ratios and putting in place regulatory triggers that can ease situations of financial over-extension.
  • BREAK up the big accountancy firms and credit rating agencies responsible for auditing banks and financial assets and end their reliance on selling consulting services to their accountancy clients. These institutions should be providing a public good, which is distorted by the drive for private gain.

2. Distance
The further removed investors are from real assets, the less knowledge they have about them, and the more their behaviour is driven by the psychology of the herd. The historical practice where banks knew and understood their sector, location and customers over the long-term is largely a thing of the past.
We need to reconnect investors and investments, and this is best achieved when finance is as local as possible. The principle of subsidiarity should apply. This requires regulators to have the freedom to control entry into different markets, including the targeted use of international capital controls where appropriate.
That means the Government must:

  • PROVIDE the appropriate level of lending to the most local level viable. This means rebuilding a local lending infrastructure, including community finance development institutions (CDFIs) and credit unions, and a new mutual sector to replace the one hollowed-out by demutualisation for short-term profit over the past generation.
  • TURN Northern Rock into a national loan board for low-cost housing and public works, along the lines of the US Government’s National Mortgage Association, Ginnie Mae.
  • GROW the post office network into a national banking system that delivers stable, accessible and dependable services to the public and to businesses, along the lines of the post office banks in Italy and New Zealand. It stands to be one of the best guarantees underpinning economic resilience, promoting financial inclusion and allowing people to invest and save with confidence and security.
  • REPEAL the Basel II rules which encourage self-regulation and give cheaper capital to the most leveraged and reckless banks, and replace it with flexible regulation that is tighter in boom times (see below).
  • USE flexible capital controls as an active tool of economic policy to exert democratic control over destabilising flows of finance without having to resort to emergency legislation, and reject international agreements that discourage other countries from doing likewise.

3. Stability

Booms and busts are inherent to financial markets and devastating to real economies. A related factor is maturity, with short-termism an endemic problem. Regulation could offset these forces by tightening controls in booms and loosening them in downturns, and by discouraging short-term speculation. For example, capital requirements could increase in upturns and fall in downturns, while a small financial transaction tax would discourage high-frequency, short-term trading, but leave longer-term investments unaffected. That means the Government must:

  • SET a sliding scale for regulation: from the smallest and most local institutions enjoying light-touch regulation, to the biggest having the strictest rules and severest controls. The current situation is the opposite of this. It has allowed big corporates and financial institutions the greatest freedom while suffocating small enterprise.
  • TAX financial returns on investment on a variable basis when they mature to privilege long-term investment over speculation. This would assist the sort of infrastructure and energy-usage change whose long-term benefits the short-term speculators are not interested in. This could also be done with a financial transaction stamp duty.
  • SET a Currency Transaction Tax to avoid destabilising runs on entire economies and to discourage the short-term, speculative movement of paper assets and to encourage long-term, sustainable investment. This will raise revenue and calm the speculative financial markets.
  • USE counter-cyclical capital controls which demand more safeguards from banks over savings and deposits in booms but enable them to support the economy during recession.
  • CO-OPERATE to investigate the establishment of a new global reference currency to underpin the global economy – along the lines of the bancor proposed by Keynes at the Bretton Woods summit – and back it by a basket of commodities. Re-establishing the link between money and a finite resource is a key step in reining in the financial sector and putting it at the service of the real economy.

4. Diversity

As institutions stopped specialising and became financial conglomerates, they converged on the most profitable activities. During the boom this was largely trading or speculative activities which paid handsome rewards but also fuelled the boom itself. The flipside was that less profitable activities – such as maintaining a branch network and providing financial services for low-income people – become ever more marginalised.
We need financial institutions to focus on specific functions and to do these well, not to chase the latest bandwagon. Formally segmenting the system by function ensures this diversity, but also allows us to regulate appropriately in each sector. That means the Government must:

  • USE their control over the high street banks to reverse the era of banking mergers, separating banks into core functions and specific markets, providing genuine competition for local business in the high street.
  • INVEST in social housing, including purchasing properties from defaulting mortgage-holders and renting them back to them at affordable social rents. Act to reduce the price of housing in the future, providing the means whereby local authorities and housing associations can buy land, and setting up Community Land Trusts to keep the cost low.
  • BUILD a network of complementary currencies to provide credit and independence to regions, towns, cities and neighbourhoods, and to provide low-cost or free credit to support sustainable local economies.
  • CO-ORDINATE international action to avoid a ‘race to the regulatory bottom’.

5. Value
Real value is not always the same as financial value, and may even be destroyed in the drive to create it. We need a more holistic view. Financial returns should not come at the cost of economic, social and environmental value, but should accurately reflect long-term improvements in these underlying factors. To achieve this we need to find ways to build in robust measures of social and environmental value. That means the Government must:

  • LICENCE and bring onto the balance sheet every special financial vehicle and every exotic financial instrument. All derivative products and other exotic instruments should be transparent and inspected as accountancy requires of all other assets. Only those approved should be permitted to be traded. Anyone trying to circumvent the rules by going offshore or on to the internet should face the simple and effective sanction of ‘negative enforcement’ – their contracts would be made unenforceable in law.
  • INCORPORATE triple bottom line valuations on a significant proportion of future loans, and more sophisticated measures of viability, including Social Return on Investment measures.
  • INTRODUCE new methods of local investment, including ‘People’s Pensions ’, linked to investment in local infrastructure, to provide secure savings vehicles for retirement, and local bonds as a secure investment vehicle for savers that also helps to finance essential investment and new infrastructure for a more environmentally sustainable Britain.

6. Democracy and participation
The crisis has highlighted the need for institutions that can take a global view but we also need these to act in the interests of all, not just the most powerful groups. This requires new mechanisms for real political participation at the supra-national level. Locally, we need different ownership models, such as mutuals and co-operatives, that work in the interests of their members, owners and local communities, rather than simply seeking out the highest returns. This adds diversity to the financial system and also enables local priority setting, accountability and participation.

We need a more pluralistic system of ownership, designed intelligently to align the interests of financial institutions with the broad public interest, locally, nationally and internationally. None of this will just happen. Left to their own devices, financial markets tend towards greater size and homogeneity of ownership and practice, rather than to appropriate scale, regional or sector specialisation or to a plurality of ownership forms. That means the Government must:

  • END the use of tax havens, many of which are actually British Crown Dependencies, and tackle corporate tax avoidance.
  • INSIST that the IMF and World Bank are governed as mutuals, with one member one vote not as profit seekers with one share one vote, because – just as governments and central banks around the world are showing – the profit motive is not able to extricate us from this mess and central banks and multilateral financial institutions must prioritise stability over returns.
  • INTRODUCE a moratorium on crash-related home evictions, and radical innovations to prevent a repeat of destructive house-price inflation. The credit crisis is inseparable from distortions in the housing market. While the Banks, which are at fault, have been bailed out to a previously unimaginable degree by the tax payer, thousands of hard-working home-owners face the daily insecurity of potential eviction as the recession makes it harder to meet repayments. This is deeply unjust, destabilising and imposes a huge burden on society. Evictions could be stopped and in their place could be put long-term plans for restructuring householders’ mortgage debts.

We need to combine these measures with an ambitious ‘Green New Deal’ which allows us to tackle the combined financial and climate crises in a co-ordinated way; to fight the recession whilst tackling energy insecurity and climate change.

A key test is how, in economically stressed times, affordable finance can be made available in a targeted way to kick-start new, low-carbon, energy, transport, food and housing sectors and to provide much-needed jobs. One of a number of useful precedents is the example of South Korea. Over many years it channelled lines of low-cost credit to strategic parts of its economy. The success of this policy can now be measured by how many of the sections of South Korea’s industry which benefited are now ‘world leaders’. We need similar vision today.

While the UK Government is not sitting down with a blank piece of paper to design an optimal financial system, it is closer to this position than at any other time in living memory.
We have a unique moment of opportunity.

If we want to draw a line under the mistakes of the past and build a financial system that supports equitable and sustainable economic activity, we need to take this opportunity, for it surely will not come again. The Government should reconfigure ownership and diversify the financial sector to appropriate scale to make sure that it becomes a driver of real and sustainable value creation that ensures we will not be condemned to repeat the mistakes of the past.