Reforms typically take place when the urgency of now is evident in the
midst of a crisis. That is when vested interests are weak, and policy
makers and regulators are no longer complacent. Recently there is a
sense that the financial crisis is abating, and that business is
returning to normal, and a false sense of stability in taking hold,
but it does not imply that the crisis is almost over. The belief that
the world has overcome the crisis is faulty for several reasons.
First, understandably, the guarantees have instilled a false sense of
stability and well being, and financial risks—such as spreads—are no
longer indicative of the condition of the financial system. Second, as
far as one can tell, very few concrete measures address structural
problems. For example, the international policy community has not
demonstrated that it create an orderly global monetary and financial
system. Third, budget deficits and public debt are increasing and
will take an increasing toll on education, health, and welfare
expenditures, and sap social well being. My take is that we have moved
from a raging crisis to a silent, but equally pernicious crisis, with
a weak economic outlook, financial sector fragilities, and strains on
public finances.

Numerous authors have endeavored to identify the causes of the recent
crisis, and proposed various measures to reform the monetary and
financial system. In this context, it is instructive to assess how
much progress we have made in key financial policy priority areas or,
for that matter, along any other public financial policy dimension
that was discussed at the height of the crisis. In the following
section I identify several economic policy challenges in a subjective
order of priority, and assess the progress against the prescriptions
considered.

Global Policy Challenge 1: The global Imbalances. As Martin Wolf has
pointed out in his eloquent articles, global imbalances were at the
core of the excess liquidity that swept the financial markets. The
global imbalances can not and will not go on forever without causing
repeated financial crises. The imbalances have receded temporarily
during the crisis, but structurally they are bound to resume when the
hoped for recovery arrives. Nothing has been done in the policy arena
to prevent global imbalances.

Global Policy Challenge 2: Financial Stability. The limited and half
hearted efforts under the Westphalian principles (of sovereignty of
states and the fundamental right of political self determination;
equality between states; and of non-intervention of one state in the
internal affairs of another state) of the IMF and the FSB are not
suited to meet the challenges of interconnected markets. As Michael
Spence writes (Lessons from the Crisis, Pimco Viewpoints, November
2008), it would be desirable to establish a global commission of top
industry professionals and academics to address the challenge of
measuring and detecting systemic risks and provide the underpinning of
an effective “early warning” system.

Global policy challenge 3: Recapitalization of the banking systems and
removal of toxic assets. The TARP in the US and the recapitalization
effort in the UK have achieved limited objectives. In the US, the
Public-Private Partnership Investment Program (PPIP), introduced by
the US Treasury Department on March 26 2009, was designed to help
banks to rid themselves of loans that hurt their operations. The FDIC
parallel program was the Legacy Loans Program (LLP). Recently, the
FDIC called off LLP and the PPIP is a fading memory. In Continental
Europe, and in particularly in Germany, there is virtual denial re the
severity of the banking problems. Incidentally, one would have hoped
that in parallel with the recap of the banking system, a coherent
process would be developed to manage the inevitable deleveraging
process of the financial system: corporate, banking and households.
In practice, the deleveraging process is exceedingly slow.

Global Policy Challenge 4: Recognition and acceptance of financial
regulation as a benefit and not as a cost of doing business. The US
was expected to lead the world by example to a sounder financial
system. On Wednesday, June 17, 2009 the Obama administration released
the blueprint for reforming financial regulations in the US. As
typical of Secretary Geithner’s previous initiatives, in Joe Nocera’s
words in the New York Times (Talking Business: Geithner’s Plan on Pay
Falls Short June 13, 2009) “But then, as he so often does, he
proceeded to follow these tough words with actual proposals that were
less than inspiring”. I will add to Nocera’s reaction that many of
Secretary Geithner’s initiatives never reach implementation after
their triumphal unveiling, such as the PPIP. The headlines from the
media, such as The Economist (June 18th 2009) point to the obvious
disappointment: "Barack Obama’s plan for regulatory reform is not
bold enough". Other informed analysts, such as Simon Johnson in The
Baseline Scenario (Too Big to Fail, Politically, June 18, 2009) have
joined in the criticism.

The Obama reforms do have some virtues. The reform package belatedly
emulates the Australian reform approach from 10 years ago, or more, in
two respects: consumer protection and systemic stability. The
proposed consumer protection appears to be similar to the Australian
Competition and Consumer Commission - responsible for competition; and
the powers proposed for the Fed appear similar to those of The Reserve
Bank of Australia’s responsibility for overseeing systemic stability
through its influence over monetary conditions and through its
oversight of the payments system. However, as opposed to the
Australian authorities, the Obama plans fails to consolidate the
fragmented Byzantine US supervisory apparatus in an entity similar to
the Australian Prudential Regulation Authority that is responsible
for prudential regulation; Australia as well adopted measures to
ensure competition. In Obama’s plan, the US fragmented supervisory
apparatus, including the benign neglect of insurance and pension
supervision, as well as other aspects such as competition policies are
not addressed.

It is interesting to benchmark the plan with regard to basic reforms
that have been talked about for a while: creating a wall between
commercial banks and investment banks as suggested by Paul Volcker and
the G30; introducing better prudential countercyclical measures;
addressing the derivatives land mines such as instilling a requirement
that investors who buy credit default swaps have provable exposure to
the underlying security that they are insuring and standardizing
derivatives on exchanges with adequate clearance and settlement; and
reforming the short term determinism of compensation structure and
settlement; reforming the short term determinism of compensation
structure. The proposed US reforms are silent on those issues. For
example, under Obama’s plan, however, proprietary trading in
customized derivatives will remain an important part of the financial
landscape. In short, at the end of the day the reforms are basically
cosmetic, and politically motivated to diffuse public outcry over the
excesses.

Global policy challenge 5: Conduct of monetary and fiscal policy. The
Fed, under Chairmen Greenspan and Bernanke, has a long standing
aversion, founded in analytical research, to “leaning against the
wind” in preventing asset bubbles. There has been very little if any
discussion by the Chairman on how the conduct of monetary policy will
be reformed in the aftermath of the bubble.

A recent IMF Staff Position Note (Fiscal Implications of the Global
Economic and Financial Crisis, prepared by Carlo Cottarelli and Staff
of the Fiscal Affairs Department, June 9, 2009) discusses at length
the fiscal implications to the crisis. It is instructive reading and
I will not take more space discussing this issue. The urgent need for
solutions is evident but the policy actions are not in sight.

In short, there is a considerable disconnect between the stern
principles enunciated by policy makers and their actions. Recently
Jacob Frenkel made an astute observation: there are two types of
investors: the ones with short memories, and the others with shorter
memories. To that we need to add two set of policy makers as well.
We are back to business as usual. How disappointing!