Financial cycles sovereigns bankers and stress tests

Public Debt Dynamics in Europe and the US 2014The Changing Role of Central Banks 2013 Breaking Up the Euro: The End of a Common Currency 2013 Household Finance: Adrift in a Sea of Red In

Financial Cycles

Public Debt Dynamics in Europe and the US (2014)

The Changing Role of Central Banks (2013)

Breaking Up the Euro: The End of a Common Currency (2013)

Household Finance: Adrift in a Sea of Red Ink (2013)

Quality Control Applications (2013)

Basel III, the Devil, and Global Banking (2012)

Sovereign Debt Crisis: The New Normal and the New Poor (2011)

Business, Marketing, and Management Principles for IT and Engineering (2011) Energy, Environment, Natural Resources and Business Competitiveness (2011) Education and Employment in the European Union: The Social Cost of

Business (2011)

Cloud Computing Strategies (2011)

The Business of Europe Is Politics (2010)

Risk Pricing (2010)

Capitalism without Capital (2009)

Financial Boom and Gloom: The Credit and Banking Crisis of 2007–2009

and Beyond (2009)

Globalization’s Limits: Conflicting National Interests in Trade and Finance (2009)

IT Auditing and Sarbanes-Oxley Compliance (2009)

An Introduction to Derivative Financial Instruments (2008)

Risk Accounting and Risk Management, for Professional Accountants (2008) Risk Management Technology in Financial Services (2007)

Stress Testing for Risk Control Under Basel II (2007)

Strategic Business Planning for Accountants: Methods, Tools, and Case Studies (2007) International Financial Reporting Standards (IFRS): Fair Value and Corporate Governance (2006)

Wealth Management: Private Banking, Investment Decisions and Structured Financial Products (2006)

The Management of Bond Investments and Trading of Debt (2005)

Financial Cycles

Sovereigns, Bankers, and

Stress Tests

Dimitris N Chorafas

Copyright © Dimitris N Chorafas, 2015.

All rights reserved.

First published in 2015 by PALGRAVE MACMILLAN®

in the United States— a division of St Martin’s Press LLC,

175 Fifth Avenue, New York, NY 10010.

Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.

Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

Library of Congress Cataloging-in-Publication Data Chorafas, Dimitris N.

Financial cycles : sovereigns, bankers and stress tests / Dimitris N Chorafas.

pages cm Includes bibliographical references and index.

1 Business cycles 2 Financial crises 3 Finance 4 Monetary policy I Title

HB3722.C463 2014 338.542—dc23 2014037907

A catalogue record of the book is available from the British Library Design by Newgen Knowledge Works (P) Ltd., Chennai, India.

First edition: March 2015

10 9 8 7 6 5 4 3 2 1

Softcover reprint of the hardcover 1st edition 2015 978-1-137-49797-0

ISBN 978-1-349-69816-5 ISBN 978-1-137-49798-7 (eBook) DOI 10.1057/9781137497987

2 Financial Cycles in a Sophisticated Economy 4

4 A Currency Union Is Incompatible with Sovereignty 12

3 Nineteenth-Century Economic Theories Are Unfit

4 Financial Stability and the Sovereign’s Budget 34

5 Are Western Economies on Their Way to Financial Stability? 38

3 Dismantling Globalization by Changing the Rules 43

2 Monopoly Money and the Unfunded Liabilities 47

4 The Transatlantic Trade and Investment Partnership 53

5 IMF and the New Development Bank of BRICS 56

4 Twists of Monetary Policy and of Supervision 69

3 Resolution Regimes 77

1 Property-Owning Democracy versus Debt-Laden

4 A Democracy in Deep Debt Is in Terminal Decline 99

5 “Just Buying Time” Is an Invitation to Disaster 103

1 Overindebted Countries Abandon Their Sovereignty 109

3 Public Debt Affordability Cannot be Taken for Granted 116

4 Vulnerabilities of Borrowers and Lenders:

6 A Lesson Learned from the Fall of Feudalism 127

5 What’s the Sense of Huge Penalties for

6 The Banking Industry Is Still Not Out of the Tunnel 149

8 A Structure of Analysis through Stress Testing 153

1 Structure of Analysis by Means of Stress Testing 153

2 Dry Holes in the Finances of Euroland’s Credit Institutions 156

4 Policies with Stress Tests in the US and Europe 163

5 Risk Analysis and Asset Quality Review 167

6 Exposure at Default and Unexpected Losses 170

2 Risk-Weighted Assets and Helicopter Fines 178

3 Espirito Santo: The Bank That Drove Itself Nuts 182

5 International Accounting Standards: The New Rules on

10 The European Banking Union: An Exercise in Abstraction 195

2 Reservations about the Banking Union and Its Impact 199

3 Banking Union Weaknesses Because of Profligate

4 Political Risks with the Banking Union 206

5 The Crisis of Confidence Is an Expected Risk 210

6 The Cost Is Half a Billion The Benefit Is Uncertain 214

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Figures

8.1 Stress tests help to project real-life worst cases and

10.1 Banking union and supervisory assessment of exposure of

Table

1.1 The five cycles of the Western economy, post–World War II 6

As financial positions expanded, economies became more able to adverse and unexpected developments, many of which took place outside the usually six to seven years of a business cycle Nikolai Kondratieff, a Russian economist, developed the theory of long waves of

vulner-up to 50 years, incorporating in it an extended cycle of innovation and upward thrust, despite the setback of recessions, followed by a longer era

of decline that business cycles classically admit

In the background of the financial cycle lies the fact that, in this

lon-ger run the trend of growth would eventually exhaust itself while ery requires a consolidating period which, compared to the good years, represents depression and retrenchment This pause is necessary before the economy can regain self-confidence; hence, vigor and growth This

recov-is the concept underpinning the Kondratieff cycle Other economrecov-ists, like Arthur Burns, the former chairman of the Federal Reserve, identi-fied the long swings of up to 25 years, when economic growth and capital formation:

First reaches a peak, and

as the long financial cycle is unfolding, its duration is crucially influenced

by what is inside people’s minds: the psychology of investors, consumers, businessmen, and government executives Peoples’ reactions vary:

They could be disappointed and try to preserve the status quo by

M

aggravating the crisis,

Or, they may adjust to the inevitable and accept the more modest

M

prospects imposed by the new economic conditions characterizing the lower part of the cycle

It should not escape attention that in the 50-year cycle are included two successive generations of economists and market players, with plenty

of psychological effects coming into the picture The third generation that follows the 50 years of a financial cycle has practically forgotten the les-sons of the past and is more likely to repeat the same wrong-way moves and mistakes This is also happening, though at lower intensity, with the 25-year cycle

If economists, market players, politicians, and bureaucrats fail to

honor the limits to growth, then the economy is destined to suffer turmoil

and a greater crisis Essentially, the statements of Volcker, Burns, and Kondratieff have been articulating a classic perspective of central bankers that dictates the choice of order and financial stability, hence moderation

of aspirations aimed at rebuilding the economic infrastructure

Written for an academic readership and addressing itself to the new generation of economists, this book concentrates on three areas that have not yet entered the mainstream of economic thinking, but are not far from doing so The one is the impact of the longer-term financial cycle; the second is the beginning of de-globalization as the world enters an era

of iron-clad economic blocks; the third is the new structure of analysis that, to a significant measure, involves stress testing the financial staying power of credit institutions

As far as de-globalization is concerned, after nearly seven decades

of an effort directed toward globalization, the trend has changed as the financial and political world started to split into economic blocs This emerging policy of de-globalization is not a faraway future It is a reality imposed by political authorities that are changing the rules

It is too early to say how far it will go, or whether it will reverse itself

At the beginning of World War I the German kaiser queried what a ter of a million–strong Swiss Army would do if faced with an invasion

quar-by half a million Germans A Swiss militiaman replied, “Shoot twice.”1

De-globalization is that second shooting We shall see the results

The study of an increasingly complex economic and financial ment also requires a new structure of analysis This is still in the making

environ-It is provided by asset quality reviews of the banking industry made by central banks and supervisory authorities, and most particularly by way

of stress tests The need for a rigorous financial analysis is most spread because, like the mountains of debt, uncontrollable risks have become a most corroding malady of our generation

wide-* wide-* wide-*Chapter 1 explains the concept underpinning financial cycles, bringing

to attention the fact that many of the notions behind it are subject to an

ongoing evolution The interest in financial cycles comes from the fact that, by being longer term, they incorporate economic forces at work that are poorly accounted for in classical business cycles The text outlines the reasons why financial cycles are vital particularly in connection with the study of a sophisticated economy, and it provides a snapshot of the most important methods and tools for their analysis.

One of the basic reasons for the examination of the background and foreground forces affecting a financial cycle is to promote financial stabil-ity This is the theme of chapter 2, which outlines current efforts to ensure financial stability, like the institution of a Financial Stability Board, and demonstrates that nineteenth-century economic theories applied by socialist regimes are unfit for today’s problems and are counterproduc-tive One of the focal points brought to the reader’s attention is the con-nection between financial stability and sovereign budgets

The seven decades that have elapsed since the end of World War II have been characterized by economic globalization This process is now being

reversed as de-globalization forces gain the upper ground Practically all

major industrial economies try to change the rules of the game to their advantage Chapter 3 starts with a historical review of reserve curren-cies, which have provided globalization’s common ground; brings atten-tion to socioeconomic problems characterized by unfunded liabilities; explains why globalization is undermined by parochial agreements like the TTIP; and discusses the likely future of the New Development Bank

of BRICS—a competitor to the IMF

Antiglobalization is boosted by the rapid rise of novel economic and financial forces like shadow banking, the uncertain trumpet of cross-border macro-prudential supervision, and the development of regional resolution regimes Chapter 4 examines the impact of such ongoing developments, in parallel with unorthodox policies by central banks that fill their vaults with the toxic waste of profligate government bonds It also brings in perspective the renewed risk from questionable securitiza-tions that, a short seven years ago, pushed the Western economies to the precipice

Chapter 5 concentrates on the economic aftereffects of the rising mountains of public debt It discusses why this practice is undemocratic and unwarranted Eventually all citizens, and most particularly a coun-try’s economically weakest members, are going to pay for it “We must tax the poor, they are the most numerous,” said André Tardieu, a former French socialist prime minister

Returning to the theme of financial stability, discussed in chapter 2, chapter 5 demonstrates that a policy of steady budget deficits is wrong Its existence is a clear sign of a democracy in terminal decline The infective virus of exploding public debt has infiltrated all Western sovereigns Italy

and France are basket cases, Greece went bankrupt, and the United States

is confronted by a guesstimated $300 trillion of unfunded liabilities (How and why are explained in the chapter).

Goldman Sachs said that Italy’s slam amplifies its public debt woes The installation and steady expansion of modern welfare systems have failed to account for their longer-term affordability A way of life built around endowments has required high and expanding levels of income,

as well as a significant degree of confidence about the future But this

is exactly what is collapsing, taking along with it the personal freedoms that, after World War II, characterized Western society

While engaged in accumulating debt, sovereigns have failed to sider whether or not they are able to serve it, and which ways and means they have available to confront their obligations The theme of chapter 6

con-is debt sustainability, starting with the fact that, whether they know it or not, overindebted countries are abandoning their economic sovereignty Public debt affordability is a complex notion that combines “easy solu-tions” with the absence of prudence in managing the country’s wealth Venezuela is taken as a case study of the new financial cycle, with empha-sis on both borrowers’ and lenders’ vulnerabilities

The close connection characterizing many of the activities of eigns and of big banks mandates the need for a close look at the status

sover-of the banking industry Chapter 7 explains what is special with banks, the problems they encounter with past-due loans, the different question-able policies that make a mockery of banking as social service, and the new income sovereigns derive by prosecuting the banks—a practice that started in America and has now spread to Europe

The fact that the banking industry is not out of the long, dark nel it entered in 2008, mandates a close look at its financial health Risk analysis can be promoted by stress testing, provided that such tests are both pragmatic and honest As chapter 8 brings to the reader’s attention, this is not always the case There are prerequisites to stress testing that are not necessarily observed The results of testing for exposure to default are often bent to hide a bad situation Belatedly, both the Federal Reserve and the European Central Bank warn of tougher stress tests We shall see the outcome

tun-Chapter 9 is a continuation of chapter 8 and provides the reader with case studies One of the case studies concentrates on what happens, and what could happen, with loans to governments Another revolves around the interpretation and manipulation of risk-weighted assets A third looks into the reasons for the recent virtual bankruptcy of Banco Espirito Santo, Portugal’s biggest bank by assets A fourth examines the likelihood of interbank contagion The common ground of these case studies is the

search for rigorous accounting standards that can contribute to ency and an effective risk control.

transpar-Banks can fail and the bankruptcy of a big and complex financial group may create havoc in the economy It could even unravel the com-mon currency shared by a number of sovereign states and their banks

In recognition of this fact and in order to avoid its aftereffects, Euroland has worked on systems and procedures of a banking union, the subject

of chapter 10 This European endeavor is far from being perfect, as the harder-working sovereigns seek to protect themselves from undue exploi-tation by the profligates There is as well the question of whether or not

a single supervisory mechanism is the solution for repairing damaged balance sheets and for implementing structural reforms

The message to retain from this book is that to overcome the more narrow limits of the business cycle, we need to go beyond its traditional six to seven years focus and address the longer term This includes the

analysis of economic risks characterizing the financial cycle, as well as the

appreciation of forces underwriting both the cycle’s growth and its decay

An ever- increasing public debt and the behavior of the banking industry are two principal reasons why the structure of analysis that served the previous financial cycle is no more adequate for present-day realities A new methodology is starting to take shape, even if it still has to acquire political legitimacy

* * *

I am indebted to a long list of knowledgeable people and organizations for their contribution to the research that made this book feasible I am also grateful to several experts for constructive criticism during the prepara-tion of the manuscript Dr Heinrich Steinmann and Eva Maria Binder have, as always, made significant contributions

Let me take this opportunity to thank Leila Campoli for suggesting this project, Erin Ivy for seeing it all the way to publication, and Bhavana Nair for the editing work

Valmer and Entlebuch

Financial Cycles

1 The Difference between a Financial Cycle and a Business Cycle

Ancient Egyptian mythology spoke of seven fat cows followed by seven lean ones Unlike other accounts based on hearsay and traditions, this one had an evidence The fat cows represented the good years when the assets

of the king and the citizens increased; the lean cows reflected the misery associated with bad harvest, floods, and the destruction of wealth.The Bible, too, speaks of cycles of decay and renewal, without making

it explicit that they are integral parts of economic life They have been so since the beginning of civilization, predating commerce, banking, and the early financial transactions The invention of money and the struc-ture of institutions specializing in creating and holding virtual assets, gave a new meaning to these cycles of decay and renewal

Over the centuries economic life acquired its own momentum and the creation of excess reserves saw to it that those possessing significant wealth could not remain indifferent to the demand for loans Economic historians developed the theory that this was for the better, because the existence of a capital base could act as lifesaver in lean times Without it, something in the normal regenerative process would have been missing The absence of a force promoting recovery from the business cycle’s bot-tom would have deprived the economy of an upside

The theory of the business cycle established itself on these premises that reflected the switches in the tempo and mood of business activity over a period of six to seven years Typically, though not always, those swings between rich and lean years were influenced by a variety of more

or less objective events that repeated themselves, but there have been as well less-tangible psychological factors

Also, typically, the high time in the business cycle’s pattern has been a period of prosperity that bred confidence and led to revised standards of what is prudent and what is risky Good years led to risk-on policies, while

risk-off policies characterized the lean years In the case of both renewal and decay, the underlying process was self-reinforcing but also contained some seeds of its own demise as:

Natural limits to the trend supporting prosperity were reached,

As financial positions expanded, economies became more vulnerable

to adverse and unexpected developments, many of which went beyond the usual six to seven years boundary of a business cycle In the early 1920s, Nikolai Kondratieff, a Russian economist, developed the theory of

long waves of 50 years or so, incorporating in it an extended cycle of

inno-vation and upward thrust, despite the setback of recessions, and followed

by a longer era of decline than business cycles classically admit

Economic historians suggest that in his theory Kondratieff was enced by the record-breaking global boom from about 1850 to the early 1870s, followed by a couple of decades of lean years and of economic uncertainties Though neither he nor other economists could give a sat-isfactory explanation of this long wave, he did point out that social and economic forces were propping it up.1

influ-Proposed for equities, Elliot’s Grand Super Cycle theory is close to Kondratieff’s long leg cyclical analysis Elliot used statistics from finan-cial assets prices Some economic history books suggest that in an effort parallel to that of Elliot, the Russian economist had also looked into crucial fluctuations in commodities in terms of patterns characterizing financial instruments and their behavior

In the background of these studies, and of theories based on them, lies the fact that the longer cycle of growth eventually exhausts itself followed

by a chute Recovery requires a period of consolidation, which, compared

to the good years, represents depression and retrenchment before the economy can regain self-confidence; hence, vigor and growth The long wave is the concept underpinning the “Kondratieff cycle.” Other econo-mists, like Arthur Burns, the former chairman of the Federal Reserve, too identified long swings of up to 25 years, when economic growth and capital formation:

First reaches a peak, and

economists and market players with plenty of psychological effects ing into the picture The third generation that follows the 50 years of a financial cycle has practically forgotten the decay earlier on in that period and therefore is more likely to repeat the same wrong-way moves and mistakes This also happens, though at a lower intensity, with the 25-year cycle.

com-According to Paul Volcker, the former chairman of the Federal Reserve,

as the long financial cycle is unfolding, its duration is crucially influenced

by what is inside people’s minds: the psychology of investors, consumers, businessmen, and government executives Peoples’ reactions vary:They could be disappointed and try to preserve the status quo by

M

aggravating the crisis,

Or, they may adjust to the inevitable and accept the more modest

M

prospects imposed by the new economic conditions characterizing the lower part of the cycle.2

If economists, market players, politicians, and bureaucrats fail to

honor the limits to growth, then the economy is destined to suffer turmoil

and a greater crisis Essentially, the statements of Volcker, Burns, and Kondratieff have been articulating the classic perspective of central bank-ers that dictates the choice of order and financial stability, hence modera-tion of aspirations aimed at rebuilding the economic infrastructure.Volcker, Burns, and Kondratieff have seen the reasons why attention should be paid to the long wave So did other economists, but the majority kept on working on the shorter-term, hence more limited, business cycle This is attested by statistics

It needs no explaining that to overcome the more narrow limits of the business cycle, we have to go beyond its traditional six to seven years focus and address the longer term, including the building-up and running-off

of economic risks characterizing the long wave of the financial cycle The

impact exercised by the longer term underlying economic forces is much greater than it might seem at first sight, because it means shifting away from debt as the main engine of growth and targeting policies such as:Repairing balance sheets, and

France and Italy have been doing, ensures that the worst continues to worsen as room for policy changes runs out.

In the shorter run accommodative monetary conditions theoretically help in keeping volatility low But they penalize the financially weaker cit-izen, while signaling a strong appetite for risk on the part of the better-off investors Eventually, economies become vulnerable to shifting global conditions as no market is completely insulated from bouts of turbulence

As long as the economy is in doldrums, companies, sovereigns, and banks face severe balance sheet weaknesses largely stemming from over-exposure to risky holding and (in the case of banks) to highly indebted borrowers Debt drags the recovery at all levels Following the aftereffect

of the Great Recession, from 2007 till today, households and industrial firms have tried to reduce their debt but sovereigns and many banks con-tinued accumulating red ink and toxic “assets”—therefore adding to the problem they intended to solve

A visible part of this discrepancy has been the diminished monetary policy effectiveness all the way to the central banks’ puzzle on how to address unexpected disinflation (chapter 3) Central banks also discov-ered that unorthodox measures, like quantitative easing (QE), present unexpected consequences One of the more puzzling is how to siphon an excessive liquidity injected into the financial system out of it,

Without rattling the market, and

difficul-to infinity.3 Instead the economic players, including financial markets and political leaders, should have appreciated the importance of caution as the better way to avoid a long cycle of retreat, failure, and disappointment

2 Financial Cycles in a Sophisticated Economy

The message conveyed by section 1 is that the more complex and more global the economic and financial environment becomes, the less ade-quate is the classical business cycle timeframe A six to seven years perspective is simply not enough for understanding and analyzing the prevailing economic conditions and to elaborate ways and means for influencing their future behavior

Past theories did not fully account for the interaction between debt, input, output, and asset prices as well as the prevailing impedances Yet, these help in explaining why many advanced economies are now char-acterized by poor health To do so, we must explore the roles played by debt, leverage, and risk-taking in driving economic and financial devel-opments, as well as assess where different economies stand in terms of the financial cycle.

The length of time of rise and fall in economic output is not the only factor that distinguishes a financial cycle from a business cycle In con-trast to classical business cycles, financial cycles also include existing interactions between perceptions of value, profits, risks, and constraints that translate into booms and busts Their aftereffects are measured by a combination of:

Credit aggregates, and

High debt levels undermine sustainable economic growth by ing vulnerable the sovereigns, households, and financial institutions at large Alert minds can see this coming but their advice is not heeded

mak-by politicians and mak-by populist economists In an article he published in

the Financial Times Raghuram Rajan, governor of the Reserve Bank of

India and former chief economist at the International Monetary Fund, warned: “Some of our macroeconomists are not recognizing the over-all build-up of risks We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”4

In the same issue of the Financial Times William Rhodes, former senior

executive of Citibank and elder statesman of the banking industry, stated:

“Financial groups are dialing up risk in their search for yield because of the extraordinary amounts of liquidity created by central banks and the prolonged low-rate environment This is often not being done prudently The key causes of past financial crises are being forgotten at many finan-cial institutions.”5

Both quotes essentially point out why the present financial cycle is characterized by financial distress and economic strains Countries hard-est hit by the crisis, a reference that now applies to the majority of Western

nations, find themselves in a debt and risk trap: An attempt to relaunch

the economy by way of very low interest rates through a protracted time period encourages the assumption of:

Even more debt, and

To obtain an analytical insight to these macroeconomic challenges,

it is necessary to account for joint fluctuations among critical variables involving a wider range of factors These are not moving in unison but they correlate Such a broader picture should include supplies, quantities, prices, and debt as a proxy for leverage, as well as credit spreads, risk pre-mia, risk appetite, and default rates

Of particular importance are peaks and lows in the financial cycle that tend to coincide with banking crises and/or periods of financial stress Also booms during which surging asset prices and rapid credit growth reinforce each other, particularly when they are driven by a prolonged and accommodative monetary policy Loose financing conditions feeding into the real economic structure lead to excessive leverage and bubbles in one

or more areas

Financial cycles are often, but not always, synchronized across an economy, while liquidity conditions tend to correlate across markets External capital often plays a critical role in unsustainable credit booms,

Table 1.1 The five cycles of the Western economy, post–World War II

2007–present Age of Deep Indebtedness Economic and Banking Crises a

Note: a This is still in the beginning stages.

including overshooting rates when national currency is used outside its jurisdiction On the other hand, monetary conditions, including exchange rate appreciation or depreciation, can spread indirectly.Rather than damaging themselves with higher levels of liabilities, countries with large public debts and with steady deficits should give priority to balance sheet repair and structural reforms It serves nothing

to blame austerity for their woes Special attention must be paid to new sources of risks that impact upon the financial cycle affecting a sover-eign’s ability to come up from under

Even if the ratios of private sector debt to GDP have slid from their peaks in the recent crisis, these reductions alone cannot turn around the economy They hardly compensate for the huge increase in household and corporate debt during the crisis, and they fall short of what is needed

to give confidence to the market

As for the record low interest rates, while they have allowed the more serious borrowers to service their debt, they have provided no lasting basis

to wipe that debt out In Euroland, for example, in 2013 and 2014, the nomic situation somewhat stabilized but did not significantly improve The end result has been that the debt overhang continues particularly among profligate member states

eco-There have been attempts to justify this failure to be in charge of the economic situation by distorting the facts A good example is provided by

an article in the Financial Times by Philip Stephens that reads as a paid

advertisement of the policies of Matteo Renzi, the Italian premier who tried to jump the gun of ultra-heavy public debt through a variety of gim-micks The Italian socialist is simply forgetting the old adage that lies and gimmicks have short legs

According to Stephens’s article, the argument between Italy’s Matteo Renzi and Germany’s Angela Merkel revolves around whether or not an arrangement that falls short of a textbook monetary union, can be both economically robust and politically sustainable

Germany and other northern EU states focus on robustness

sustainable” solution, whatever that is supposed to mean

Quite incorrectly, indeed against all logic, Stephens says that the two opposing concepts should be seen as self-reinforcing, particularly

in the sense of credibility.6 But credibility is precisely what Renzi’s socialist party (in essence, social-communist party masquerading as

“democratic”) utterly lacks Reduced business confidence and dubious credibility are characteristic of the financial cycle we are in

The Financial Times article goes on further to maintain that Merkel’s

and Renzi’s “common ground” extends to the urgency of structural reforms That’s a hyperbole because structural reforms are an alien con-cept in Italy, France, and other profligates The Italian prospectus begins and ends with a call for “more economic integration in the EU”—including the suggestion that governments should also throw their weight behind opening Europe’s markets through a transatlantic trade and investment partnership This is another red herring (see chapter 3 on TTIP)

What this and similar articles or pronouncements fail to notice is that a sophisticated economy cannot be managed, much less redressed, through words, empty promises, and questionable comparisons Even a prosper-ous economy will not be able to afford words, words, and words for a long time The day of reckoning is always around, as risks accumulate If they are not put under lock and key, exposures that seem to be affordable tend

to become bogeymen

Take Switzerland as an example It is, today, one of the few ous European economies Successive popular referendums have demon-strated the political maturity of the Swiss public that understood that it cannot afford to say “yes” to initiatives that are diametrically opposed to the notion of Switzerland as an attractive business location able to gener-ate jobs and wealth This, in spite of the fact that, promoted by the so-called young socialists

prosper-The amount of regulatory and administrative red tape is on the rise,

ship and the pioneering spirit

Steady vigilance is the answer to economic problems and this is true all the way to the exchange rate of the currency (the Swiss franc) fixed

by the central bank at the rate of 1.20 francs to the euro To uphold that rate, in the first year of the fixing, from autumn 2011 to summer 2012, the Swiss National Bank (SNB) had to buy the counterbalance of about

440 billion Swiss francs in foreign currency to defend its lower limit That policy inflated the SNB’s balance sheet significantly, but the lower limit held

The downside is that the SNB cannot abandon its lower limit for the time being At the moment, sales of its enormous euro, US dollar, and other foreign currency reserves appear near impossible, as such they would push up the franc’s exchange rate If the SNB were to explicitly abandon its lower limit, the way to bet is that there will be an escalation

of the speculators’ effort for franc-euro parity or worse

Exchange rate parity is one of the economic problems transcending the classical business cycle It is also a part of the financial cycle’s under-lying forces—an important issue relating to imports and exports that dearly affects an economy depending on exports for roughly 50 percent of its GDP In addition to foreign exchange policy, sovereigns with a strong currency must watch their fiscal policies influenced by long cycles This implies constraints The Swiss National Bank cannot raise its key rates before the European Central Bank (ECB) does so, or the exchange rate policy will be undone.

3 Sizing Up the Financial Cycle

In developing economies the financial cycle is measured by aggregating movements of real credit, credit-to-gross domestic product, and real house prices Through these metrics economists estimate peaks and troughs, then compare which might have coincided, and under what conditions, with widespread banking crises and other notable events like inflection points For instance, when was a going trend uninterrupted and for how long.Two methods are favorably looked at in studying business cycles as

well as, by extension, financial cycles One of them, known as the

turn-ing point, rests on original work accomplished in the 1940s It identifies

cyclical highs and lows by examining growth rates of a broad range of variables over a span of time, including output, employment, production, consumption, and more The focal points are changes from positive to negative and vice versa

Research at the Bank for International Settlements (BIS) has shown that real credit growth, credit-to-GDP ratios and the evolution of real property prices represent the smallest set of selected variables needed They are used to depict in an adequate way the mutually reinforcing interaction between:

Positive and negative forces,

The alternative approach is based on statistical filters that extract

from a specific time series cyclical fluctuations within a particular cycle such as output This method, too, concentrates on developments in real credit growth, the credit-to-GDP ratio, and the evolution of real property prices Bandpass filters are used with cycles lasting between eight and thirty years Obtained results are combined into a single series by way of

a simple average.7

Nevertheless, contrary to business cycle estimates, which have been supported by many decades of research, observation and the measure-ment of financial cycles is still in its formative years Neither is the mod-eling approach preferred by economists and analysts fixed forever Given the novelty of financial cycle studies, the examination of many variables

is not based on generally accepted blueprints As a result, those in charge have to draw conclusions as they go along using their imagination and initiative What is required of them is to assume:

How a given crisis should be mapped,

watch stops from deteriorating, or, alternatively, there is an uptick

Up to a point, but only up to a point, the behavior of a process subject

to economic decay can be equated to what goes on in fermentation in

chemical engineering This can best be done by employing the pioneering principles originally developed in the nineteenth century by the genius

of Louis Pasteur.8 I know of no work undertaken in this direction, but it holds a promising novel way of analysis, briefly described in section 4

A basic principle of science and technology is that, no matter which specific analytical methodology is chosen, at the end of the day it must

be able to map the conditions prevailing in real life—in this case, the financial cycle While the choice of the right approach is important, the keyword is personal accountability in applying an experimental solution Cookie-cutter approaches often found in connection to a variety of prob-lems are totally unacceptable, because:

The prevailing economic conditions are fluid, and

preceding events is patently false

Figure 1.1 presents the general schema of business cycles and of a financial cycle Among the better-known turning points have been the

first and second oil crisis in the 1970s; Black Monday in 1987; dotcom crash in 2000; Great Recession in 2007; and big bank bankruptcies in

2008 Economists find it convenient to represent the cycle through a soidal, but in reality no two cycles have the same pattern

sinu-Attention to detail is at a premium when emulating real economic life through a graph Some people say that too much attention to detail means one does not have the brains to look at the bigger picture This is not only ridiculous, but also identifies a person unable or unwilling to do an honest day’s work The devil is in the detail Both the big picture and the detail are important

Along with attention to detail comes the need to keep on learning the twists of the economy and the impact of excesses likely to translate into

a heavy public debt burden (chapter 5) Past trials and errors as well as past successes and failures in analytical studies should be examined both individually and in unison Collectively they provide a path of instruc-tion in order to:

Learn how to take a critical view of economic and financial matters

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that superficially might look “well-known,” and

Proceed with technical auditing, avoiding the repetition of past

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errors because of traditional thinking or plain negligence

When confronted by a catastrophe like the virtual bankruptcy of Greece in 2010, rather than hiding the facts and figures those in charge should invite out-of-the box thinkers who are not afraid to express their critical opinion The mission given to these experts should be to warn those in charge not only on the current status but also on the evolution of

the risks on hand given the existing economic and financial conditions within the prevailing cycle where:

Most developed economies are still traversing a trough

a lower potential growth path

Japan is pursuing massive reflationary policy measures, but their

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efficiency is for the time being questionable

Emerging economies in Asia are suffering from widespread

weak-

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ness and downbeat global trade

Plenty of indicators suggest that the most pressing, and significant, problems in the global economy are unsustainable structural issues with regard to fiscal deficits, crumbling economic structures, and obsolete labor laws Most of the Western democracies, including the US, confront the problem that voters want that the benefits they derive from the common purse are greater than what they contribute to it—which is unsustainable

4 A Currency Union Is Incompatible with Sovereignty

A most discouraging fact is that, as important as expense-cutting is, ernments can’t just find ways to rein in expenditures and spoilage A tax overhaul, a value analysis of expense chapters, and the possibility of rais-ing government revenue are correlated Raising taxes is a prospect that most people have castigated but it needs to be on the negotiating table along with major trimming of ballooning sovereign expenses

gov-The prospects for cutting government budgets are not good Even cians who may be bullish on the long-term ability of their country to pay back its debts, are less convinced that a solution will come anytime soon Few appreciate the urgency for fundamental reform, or the fact that this is impos-sible without an election that changes the main players To become effective, this requires a couple of decades—hence a good part of a financial cycle.The idea of legal action against political wrongdoers remains an unfulfilled promise In Hungary, it targeted three former socialist prime ministers for mismanaging the public finances A parliamentary com-mittee investigating the growth of public debt between 2002 and 2010 from 53 percent to 80 percent of GDP, has called for a probe into Peter Medgyessy, Ferenc Gyurcsany, and Gordon Bajnai

The results of the investigation were supposed to be handed to ecutors and the government did not rule out criminal charges All this happened in August 2011 Three years down the line, by August 2014, nothing had taking place in that direction, as politicians tend to protect

pros-one another In addition, crisis management requires guts The outcome

of our actions can be a friend or a foe depending on our attitude

Are we doing the things that need to be done in a timely fashion?

out-the best economists stumble In his book The Shifts and out-the Shocks

Martin Wolf argues that the world economy is stuck in low gear and set on an unsustainable course Demand is weak and, too often, where spending has picked up it is the result of a dangerous new buildup of debt

Nobody would disagree with that diagnosis, but Wolf’s prescription for getting out of the mess is, at best, wanting In his opinion planned financial reforms have only preserved the essence of an inherently frag-ile system while crises, like the euro crisis, remain unresolved Emerging economies that were resilient after 2007 and 2008 are now facing slow growth and debt problems of their own; and much of this is due to the policymakers’ mistakes.9

That’s true, but the message to be retained from The Shifts and the

Shocks is that not only there are no quick fixes but there are also no clear

ideas on what should be done While many people would say that the origins of the current crisis lie in the revolutionary changes in the struc-ture of the global economy and finance in the 1990s and early part of this century, the “way out” of the crisis is still obscure

Deciding on the right course is complex because there exists a clash between the need to apply fiscal discipline and the notion of sovereignty

To make finance safer, Wolf suggests replacing a fractional reserve ing system, which takes in deposits and lends most of them out in longer-term loans, with a system of “narrow banking” where deposits must be backed by government bonds That is preposterous

bank-The Wolf approach might have made sense

thrifty, eager to balance their budgets, and firm about keeping out

of debt

This is by no means what is now happening Indeed it has become quite difficult to say which debt paper is worse: the bonds of virtually bankrupt Western governments or those of banks that have been saved in extremis through a swarm of public money (For a recent case, see that of Banco Espirito Santo in chapter 9).

The starting point is to recognize reality, however unpalatable

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Contradictions must be avoided, and we should appreciate that there is no single script

In an article he published in the Financial Times in connection with

the Scottish vote for independence from Britain, Martin Wolf stated: “The logic of the one-sided fiscal rules is that within a currency union, the cost

of fiscal profligacy by a smaller member may be shifted on the large one But the much larger member cannot shift the cost of its profligacy on to the smaller one Thus Scotland would have an incentive towards profli-gacy that the UK would not A one-sided risk demands one-sided control

A similar logic applies to financial regulation.”10

A few days later, on September 9, 2014, Mark Carney, the governor

of the Bank of England, made a similar statement when he warned that

a currency union between Britain and an independent Scotland would

be incompatible with sovereignty He cited the problems with Euroland, emphasizing that there had to be three successful components for a suc-cessful currency union:

Free movement of goods and services across the different parts of

central bank; and

Elements of shared fiscal arrangements and of other critical

As for the so-called helicopter money, where governments run deficits that are financed by the central bank, that idea is nothing new It hap-

pens all the time and it is part of the problem, not the solution If it were

the solution, then the Western countries would have been rich—which is

precisely the opposite of what currently happens

Deep and persistent economic mismanagement brought us where we are, and this defines the financial cycle in which we landed The euro, Ukraine, and the jihadists offer Western politicians and the general pub-lic a convenient scapegoat Neither of them stands in the way of a swift restructuring of sovereign and bank debts, or of a robust recapitalization

of credit institutions and a radical change in economic policy that has continued to drift for three decades

With better policy choices from the start of the crisis, the Western economies would not have lost their way kicking the can down the street Albert Edwards, a strategist at Société Générale, dubbed the financial

cycle we are in an ice age, predicting that it will extend across the Western

world.12 These two words, ice age, are tough Their merit is that they mit us to know ourselves and (if unchallenged) our future

per-If you know yourself and know your opponent you don’t need to worry about the outcome of 100 battles, said Sun Tzu, the great Chinese states-man and general, 2,500 years ago The economic forces we try to master

for our own good are our opponents But do we appreciate the reasons why the economy does not move? Do we really know ourselves, our strengths,

our weaknesses, and what we can deliver?

5 A Lesson Learned from Fermentation

The art of sound economic and financial management consists in ing not merely at the immediate but also at the longer-term effects of any decision, policy, or action This requires tracing the consequences of the decisions we make, identifying their most likely aftereffects under the best and worst conditions—not merely for the main issue but also for sub-jects connected to it and affected by our decisions now and in the future.Invariably, this involves choices, bringing to mind what Frederick the

look-Great, king of Prussia, wrote in his Instructions to His Generals: Those

generals who have had but little experience attempt to protect every point; while those who are better acquainted with their profession, guard against decisive blows at decisive points, and acquiesce in smaller misfortunates

to avoid greater ones

An integral and important part of a sound economic, or any other, decision is “to see” its aftereffect When we learn to look into the future we begin to appreciate that there is no end to the new world of our vision On the contrary, once the practice of seeing is lost, the meaning of things goes along with it and life drifts to being abstract or plainly meaningless

We can help ourselves in seeing future events through emulation or simulation.13 This allows us to take measures and be in charge of events before they develop into major problems Simulation is a working anal-ogy When processes are found to exist, which might be dissimilar in their physical nature but exhibit similarities in terms of the particular behavior that we study, observations made in one of them help in understanding the other better This is at the heart of science.

Science is a vast edifice, says Robert Oppenheimer, the renowned icist It does not look like following a plan It has developed like a big city There is neither a central room nor unique alleys in which more rooms will be built; still people are busy They explore vast swaths of ground as well as phenomena that appeared earlier on by millennia They examine the complex mechanisms through which life has transformed itself and proliferated They try to penetrate:

phys-The inside track of human thought, and

What is true of physics is also valid of economics and finance—if

economics is a science “In the sciences,” said Louis Pasteur, “there are people who are convinced of something while others have no opinions Conviction presupposes proof; opinions are most frequently based on hypotheses.”15 Pasteur is right Hypotheses are the bricks with which we construct the scientific edifice—or, more precisely, the room in which we will be working

A case in point is fermentation; this is a basic process of nature The

principle underpinning it is simple Whatever lives dies and whatever dies disintegrates In the physical world this happens either through turning into minerals or by means of gasification As far as the econ-omy is concerned, the elements resulting from disintegration enter into the new cycle of life Life, decay, and regeneration are a widely applied

principle and it characterizes man-made systems as well If things worked otherwise, then:

The mass of old, crumbling entities would have covered the face of

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the Earth, and

The law of perpetuity of life will be compromised by a progressive

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exhaustion of the life’s raw materials.16

“Back to minerals” is a fundamental law in the natural world It is, as well, a concept of our culture and of the way in which the economy works Destroying the old to make way for the new is the essence of a free mar-ket Karl Marx thought of it as being one of the nasty characteristics of capitalism But Joseph Schumpeter, an Austrian economist, cast “creative destruction” as the only way to sustained growth

Successful entrepreneurs appreciate that innovation is key to their company’s survival, even if new products and processes endanger estab-lished market habits and sales patterns “Sticking to one’s knitting” means falling prey to competitors On the contrary, a sound strategy entails an orderly transition, switching out from old lines:

Recycling resources, and

prod-is also true of all NATO members Successful economic developments around the world, and especially in Asia, are substantially reducing the share of US GDP, and hence its military spending

Declining relative spending is only a proxy for power, particularly in

a world of cyber warfare and of intensive civil wars (incorrectly named

“the Arab spring”) It also signals a reduced ability for the US and NATO

to engage in many areas at once Events in the Middle East, Asia-Pacific, and the Ukraine form a pattern on which China and Russia capitalize

So do terrorist organizations such as the ISIS The challengers can see that the West is unable to sort out its priorities Hence, it is less likely to respond In the aftermath, they become more willing to exercise their own military skills

6 Economic Vibrions

A different way of looking at the same problem of decay and recycling

is how universal forces work out This helps in revealing the nature of

challenges characterizing this recycling keeping in mind that civilized man has for centuries been investigating three basic questions:

What are the causes of the slow combustion engineered by ferments?

into fertile soil?

From this investigation can we learn some principle of what to do,

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and what to avoid, with society and with the economy?

In the nineteenth century there was no lack of theories in connection with the science of fermentation The more generally accepted theory was that oxygen was the responsible agent Louis Pasteur had a different opin-ion His thesis was that fermentation was the result of the presence and action of a living organism The proofs he provided about ferments:Turned on their head the scientific theories that had till then carried

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the day, and

Established on a solid basis that the real masters of the world, the very

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force of life, is the very small Germs are casting a long shadow.What is true of chemistry and physics may as well be valid about the economy Fermentation’s microscopic organisms, or vibrions, live, move, and multiply without the need of air or pure oxygen Pasteur called them

anaerobes (from the Greek word meaning without air), and reserved the

term aerobes for all other microscopic organisms that, like the bigger

liv-ing matter, cannot exist without oxygen

Fermentation is the result of the action of these microscopic ons Their presence represents only the first phase of the return to the atmosphere and the Earth of what had been living but is in the process

vibri-of changing status The destruction vibri-of animal and vegetal substances through combustion is engineered by means of these germs under the dual principle:

Life is a germ, and

Confronted with the problems of the origin of life, Louis Pasteur said that all hypotheses are open since the truth about it has not been proven But some of the issues connected to life received given answers The life that has departed from dead matter is succeeded by life in other forms,

as transformations take place through fermentation’s slow combustion followed by regeneration

In addition life may exist anywhere, as the great molecular physicist demonstrated by disproving the then prevailing theory of its spontaneous nature Dust exists everywhere and among the dust of dead particles can

be found living particles whose aftereffect was superficially interpreted as being the subject of an unexpected and spontaneous appearance of life.There is no case known today, said Louis Pasteur, that allows one to claim that microscopic living elements came to this world without germs, without parents similar to them Those who pretend so have been in the game of illusions, victims of badly done experiments full of errors—which they were incapable of seeing or avoiding Spontaneous generation is a chimera.This is absolutely true of the economy as well The elements of growth and decay of a financial cycle are everywhere Many are unseen to the naked eye because we are not trained to observe them, identify them, measure them, and trace their life cycle They escape our understanding and therefore we have no control over them, though we do try to contain the observable effect(s) of their action The time, however, has come to

study these economic vibrions.

Let’s try to put Pasteur’s finding in the right economic and financial context In Western countries as the population ages the productive force

is shrinking while educational standards are being depreciated In June

2014, in Switzerland, the minister of the interior said in an interview that 13,000 jobs for apprenticeships waited to be filled The young generation chooses easy subjects for their training, precisely those that society does not need The work ethic turns to minerals (In other Western countries the situation is a great deal worse.)

With interest rates at rock bottom it is tough to find returns The quantity and quality of money do not necessarily correlate Corporate treasurers try to critically evaluate and optimize the various strategic uses

of cash exploring operational alternatives that might be viewed as nomic vibrions, like:

eco-New capital expenditures,

Companies could benefit by taking a more integrated approach in aging their affairs Executives, however, do not feel so confident about the economic outlook Business confidence is a prerequisite to using more of the available cash to invest in factories and staff.

man-In parallel to this, throughout the Western economies the regulated banking industry has gone into hibernation in terms of loans to busi-ness and industry, while the shadow banking system is expanding rapidly and is only lightly regulated (chapter 4) On a wider scale several finan-cial groups are taking risks in an imprudent way, as they feel competi-tive pressures to produce better results The vibrions have infiltrated risk committees that are still not properly equipped to oversee:

Prudential control of exposure, and

The risk of failing to act is underestimated in several ways There is

a widely held opinion that all citizens are on rent and they will do

noth-ing to upsetthe status quo No attention is paid to the fact that debt can balloon up to a point Eventually the bubble bursts The accumulation of vibrions repeat the story of the straw that broke the camel’s back

7 Can the Financial Cycle Be Managed?

Financial cycles can end in a banking crisis, like the one that started

in September 2008 Not only do the effects of major banking crises last longer than any given business cycle, but they are also irregular There also exists evidence that during their first half dozen years financial cycles and their effects can go largely undetected, as they move too slowly

to warn politicians while the policymakers’ attention is taken by term output volatility till the fallout from the financial cycle begins to look devastating

shorter-The perception of unexpected aftereffects takes a couple of years to slip down economic thinking after booms turn to bust Productivity and employment losses may be large and extraordinarily long-lasting Balance sheet recessions levy a much heavier toll than normal recessions, reveal-ing resource misallocations and structural weaknesses that were up to

a point masked by the booms while debt accumulation over successive business cycles continued

In the meantime in the advanced economies public and private debt has reached new highs propelled, among other factors, by the payment

of interest that accumulates particularly at state level Nations find it

difficult to confront their obligations and avoid bogus nonperforming loans For their part, banks accept to have the past-due interest capital-ized Italy is a basket case of this policy In 2013 the cost of the country’s public debt of €2.5 trillion ($3.37 trillion) to the taxpayer has been a cool

€400 billion.17

The lopsided nature of government policies in Western countries, within the ongoing financial cycle, is leading to fermentation and this is accentuated by the fact that since 2009 company cash flows have surged but investment has been low and firms have not handed much to share-holders For instance, at the end of 2013, US corporate cash pools hit a record high of nearly $2 trillion This was 50 percent higher than their level in 2007

The shortcomings of American economic statistics are just as plain Having initially predicted a 1 percent economic slowdown for the first quarter of 2014, this statistic has been radically adjusted downward as the

US economy is experiencing its weakest post-recession recovery of any of the 11 business cycles since World War II

This is a negative result and it is happening in spite of a nearly fivefold increase in the Federal Reserve’s balance sheet over five years, while inter-est rates are down to zero In addition, contrary to the official pronounce-

ments, higher prices are here to stay and they are not being driven by

swelling consumer demand With inelastic demand companies are ply charging more for goods and services in an attempt to:

sim-Offset low sales volumes, and

While few people dispute the fact that sound government finances promote recovery, governments fail to take the right action to fulfill that premise This raises the costs and tests the voting public’s patience The

US recovery, for example, remains slow by historical standards, one of the reasons being that government policies undermine rather than support business confidence through uncertainty about future moves CEOs cite the fiscal outlook as a deterrent to:

The government fails to lead and the Federal Reserve cannot solve the situation single-handed It may keep on printing money by working the presses overtime, but it cannot address fiscal and structural issues criti-cal to healthy recovery These are largely political issues and they are the government’s remit.

In Euroland, the ECB cannot buy sovereign debt indefinitely without triggering capital flight from corporate debt markets and from the euro What the ECB has done, and continues to do without much success, is buy time This bought time, however, has not been used by Euroland’s sovereigns for needed policy reforms that win market confidence

There are many things central banks cannot do because they fall side their authority, but at least they can give advice Mario Draghi, the president of the ECB, has, on several occasions, entered the conten-tious debate on whether Euroland sovereigns should be compelled to take steps like liberalizing labor markets (he is for it), as well as which rules could ensure that recommendations made by Brussels are put into action

out-In Draghi’s opinion the outcome of structural reforms is not only in

a country’s own interest It is also in the interest of the EU as a whole Economists think that, at least indirectly, Draghi has answered demands

by Italy and France for radical ECB action to rescue their economies and

he cannot go further without violating the ECB’s charter He has also turned a blind eye to deficit targets, while the governments in France and Italy are doing little to improve their country’s competitiveness

Failure to take the necessary measures to beef up global ness within the current financial cycle ensures that the most likely out-come the profligate European sovereigns can expect is major trouble The best estimates indicate that in 2014, Euroland output will expand 1 per-cent at best That’s totally unimpressive accounting for the fact that since

competitive-2011 domestic demand has fallen 4 percent

Taxes in Italy and France weigh too heavily on their economies, while moves to rein in public spending are both too timid and too late Faced with high external and domestic public sector debt other southern EU countries, too, are being forced to review their budgets and current accounts, but they prefer the option of riding the coattails of more buoy-ant EU economies to increase their public and private debt

In the aftermath real growth plus inflation remain low, with some

EU member countries heading down the same path as Japan or worse;

“worse” because unlike Japan their debt is held by foreign investors who have lost confidence in their governance and they are tired of hearing about unrealized promises Foreign investors are more likely to pull the plug than domestic ones

Wrong-way, short-term moves by Western sovereigns have carried the day To boost the pace of recovery, central banks started and continued to experiment with ever more unorthodox measures, struggling to rebuild

an elusive confidence in the financial system This is more easily said than done Not only is it a challenging task in itself, but it is also made more difficult by the fact that about 75 percent of the American capital market is in the hands of shadow banking institutions

Critics say that the measures taken by Washington might have made more sense in the downturn of a business cycle, but they were uncon-vincing within the perspective of the financial cycle Other Western gov-ernments and their central banks, as well, took too long to realize that this was a balance sheet recession associated with an outsize bust of the economy:

The debt overhangs have been much larger than in a typical recession,

ruptcy of some banks, and

The room for policy innovations is much more limited, with central

It needs no explaining that under these conditions reestablishing

a sustainable precrisis economic activity poses significant challenges Moving the economy forward, a little at a time, is no longer-term solu-tion Regaining momentum calls for a several years growth rate with the level of output that exceeds the precrisis average

In an environment where, for political reasons, a perceived duct is heavily penalized leaders of financial institutions will not come forward with initiatives Innovation is taking place, more or less, on peripheral issues like social networks and their portable devices, which have little to do with productivity Printed paper, the fiat money, is not backed by real assets and very few people have confidence in it

miscon-All this leads to the unfortunate conclusion that the answer to the question posed by this section’s heading—“Can the Financial Cycle Be

Managed?”—is not a positive one It is not outright negative because some

of the elements that are necessary are available—but they are not being used Neither are governments, particularly Western sovereigns, taking the proverbial long, hard look “Solutions” have descended to the level of petty policies and this is, indeed, quite a pity

Financial Stability

1 Financial Stability Defined

Financial stability is a condition in which the system of intermediaries,

markets, and market infrastructures is capable of withstanding shocks,

as well as major imbalances, without falling apart Financial stability reduces the probability of disruptions in the process of intermediation, particularly the likelihood of disruptions severe enough to impair capital allocation, play havoc with investments or, even worse, lead to a panic.The safeguarding of financial stability requires first identifying and then understanding the main sources of risk, the vulnerabilities behind them, as well as the ranges in variation of exposure Likely sources include mispricing of risk, inefficiencies in the way the capital allocation process operates, financial mismanagement, and, inevitably, lust and greed

To be effectively in control of the economy—and to promote cial stability—risks and vulnerabilities must be steadily monitored and measured and steps taken to keep them within limits This must be a forward-looking operation, keeping in mind that financial stability plays

finan-a mfinan-ajor role in ffinan-acilitfinan-ating further economic progress It promotes orderly development and prevents adverse shocks from having a major disruptive impact Much depends on whether financial stability has been paid the attention it deserves

With globalization of trade and markets, a financial instability can be,

and often is, exported In 2007 and 2008 the American subprimes crisis triggered Euroland’s debt crisis, which has been magnified by the fact that those who created it paid too little heed to what the consequences might be if the common currency project were to fail.1

As both orderly and profligate economies share the common rency, it is getting difficult and more expensive to save the euro While,