1. The ‘New Economics’ and Policies for Financial Stability Philip Arestis University of Cambridge University of the Basque Country Malcolm Sawyer University of Leeds

2. Presentation 1. Introduction 2. Theoretical Background 3. Economic Policies 4. Summary and Conclusions

3. Presentation 1. Introduction 2. Theoretical Background 3. Economic Policies 4. Summary and Conclusions

4. Introduction The purpose of this contribution is to discuss economic policies that could potentially replace the ones that helped to produce the ‘Great Recession’; We emphasize a neglected notion of economic policy, namely financial stability; Clearly, macroeconomic policy formulation is heavily conditioned by the underlying theoretical framework that should underpin it; We, thus, begin with a brief summary of the essential elements of such a theoretical framework.

5. Presentation 1. Introduction 2. Theoretical Background 3. Economic Policies 4. Summary and Conclusions

6. The overall focus of macroeconomic analysis should be: sustainable and equitable economic development and growth; The objective of economic policy should be: full employment of the labour force; Achieving such objective requires the maintenance of a high levels of aggregate demand and sufficient productive capacity. Theoretical Background

7. The general background to the theoretical framework is of a monetary production economy in which finance and credit play a significant role; It relates to an economy which has degrees of instability in the sense of being subject to the ups and downs of the business cycle and prone to crisis; It accounts for distributional effects, which are always important and highlighted recently in view of inequality being a root cause of the ‘Great Recession’.

8. Presentation 1. Introduction 2. Theoretical Background 3. Economic Policies 4. Summary and Conclusions

9. Economic Policies The objectives of economic policy: Full employment of the available labour supply; Inflation rate consistent with output growth rather than an inflation rate target; Financial stability;

10. Economic Policies The instruments of economic policy to achieve these objectives are: Fiscal policy is paramount both in the short run and in the long-run; In the short run, variations in the fiscal stance can be used in conjunction with automatic stabilisers to offset fluctuations in economic activity;

11. Economic Policies In the long run, the general fiscal stance should be set to underpin the desired level of output and employment; Interest rate policy should be set so that the real rate of interest is as low as possible, but in line with the trend rate of growth; This of course may be constrained by world levels of interest rates;

12. Economic Policies Evidence suggests that under fiscal and monetary policy coordination fiscal multipliers are higher than when no policy coordination prevails (even bigger than the Keynesian ones); Clearly under such policy coordination Central Bank Independence should be abolished; Such coordination is possible so long as the fiscal and monetary authorities have a common objective, for example maximization of social welfare;

13. Economic Policies Exchange rate policy is also important. Changes in the exchange rate affect the domestic economy primarily in terms of the level of demand and inflation; Intervention by the central bank in the foreign exchange market with the specific aim to stabilise the exchange rate is important in this respect;

14. Economic Policies Industrial and regional policies are required to ensure that supply constraints are not present; Public expenditure, particularly investment, can also be structured to ease supply constraints; There is often a mismatch between available productive capacity and the labour force and its geographical distribution; higher levels of employment require more productive capacity, and regional policies; There is the need to develop policies to tackle inflation when it reaches high levels; Such approach involves the development of an incomes policy to maintain low inflation.

15. Economic Policies Most important, though, the operation of the central bank should ultimately be directed towards financial stability and this objective of financial stability should be placed as the most significant one for the Central Bank; This requires the development of alternative policy instruments alongside the downgrading of interest rate policy and of any notion of inflation targeting; Financial stability should entail two types of toolkits, both under the banner of the policy makers avoiding rules and employing judgement and thus discretion;

16. Economic Policies The macroprudential toolkit should account for the failures of the system: low levels of liquid assets; inadequate levels of capital with which to absorb losses; too big a financial sector; too leveraged with high risks to the taxpayer and the economy; Thus, macroprudential financial instruments should be able to control the size, leverage, fragility and risk of the financial system; Microprudential instruments relate to the structure and regulation of individual banks;

17. Economic Policies Two relevant proposals have been put forward: the US President’s proposal, initially known as the Volcker Rule, which eventually became the Dodd- Frank Act of 2010; and the Basel III proposal. We begin with the first; The rule contains a number of important constituent elements; the ones relevant to this contribution are as below; Eliminate proprietary investments (namely to prohibit banks that take insured deposits from running their own trading operations) and also ownership of hedge funds by banks; in the final Act this was modified to the banks being allowed to hold proprietary investments of 3 percent of their core capital;

18. Economic Policies Size matters: no financial firm should be allowed to become ‘too big to fail’; End of taxpayer bailouts: the legislation grants government the power to wind down failing institutions, not just banks, if they threaten the financial system; a new ‘orderly liquidation’ authority is equipped with the power to seize a failing ‘systemically important’ institution; Credit rating agencies: this is another important aspect of the Dodd-Frank Act, which is the introduction of a new Office of Credit Ratings to supervise credit rating agencies; ‘Shadow banking’ and non-bank financial services companies are also to be regulated;

19. Economic Policies The ‘Basel III package’ is concerned with bank capital and liquidity standards. It requires banks to hold equity requirements to 7 percent of the risk-weighted assets (RWA); liquidity standards include a liquidity coverage ratio, which is a ratio of high quality liquid assets to net cash outflows over a 30-day horizon; The new ruling will be phased in from January 2013 with full implementation planned to be achieved only by January 2019. This is actually a victory for the banks, especially the small banks in Germany, in view of their undercapitalization;

20. Economic Policies A problem is that unlike the US Dodd-Frank Act, which provided relevant regulations in the case of banks migrating to the ‘shadow banking’ sector and to the lightly supervised non-bank financial services companies, Basle III does not contain such provision; A further problem concerns the definition of the capital ratio, which is defined in relation to risk- weighted assets, not total assets; An implication of this is that toxic leverage is highly probable: when the RWA is a small proportion of total assets, the exposure of the banking sector to risk would be very high indeed;

21. Economic Policies Clearly, then, Basel III has not managed very well in correcting the mechanism through which the main cause of the ‘great recession’ emerged; it should not, then, be surprising if another similar crisis were to take place; All in all, neither the Dodd-Frank Act, which initially intended to separate banks, nor the Basel III proposals, have managed to sort out financial stability; It remains unresolved and elusive; and yet it is of vital importance.

22. Presentation 1. Introduction 2. Theoretical Background 3. Economic Policies 4. Summary and Conclusions

23. Summary and Conclusions The alternative perspective advanced here can be summarised as: Use coordinated fiscal and monetary policy in the short term and in the long term to address demand issues; Employ regional and industrial policies to create the required capacity; Develop incomes policy to maintain low inflation if necessary;

24. Summary and Conclusions Central bank intervention in the foreign exchange market is necessary to control the exchange rate; Central bank role should be financial stability. All policies discussed should include ‘green’ elements.