A new economic paradigm is essential for development

Speaking at a UN policy dialogue with international financial and trade institutions, former Dominican Republic President Leonel Fernandez stressed that regulation should be undertaken “globally, transparently and rapidly” to put finance at the service of innovation and development.

by Kanaga Raja

GENEVA: To ensure that prosperity can be shared all over the world, it is necessary to move towards a new economic paradigm, one that requires a proper regulation of financial activities in order to make it an essential tool for development.

This was the main conclusion of Leonel Fernandez, former President of the Dominican Republic, in a keynote address during the High-Level Segment of the United Nations Economic and Social Council (ECOSOC) which took place here on 1-4 July.

In his address at a high-level policy dialogue with the international financial and trade institutions on current developments in the world economy on 2 July, Fernandez stressed that this new economic paradigm “must prevent new episodes of high price volatility in commodities markets due to speculation; it must prevent loss of competitiveness caused by abnormal capital inflows and it must prevent the manipulation of benchmarks to restore the credibility of the financial system.”

“Non-transparent profit-seeking financial transactions are detrimental to development. Innovative financing instruments are necessary to enable adequate innovation policies, secure long-term economic growth and foster sustainable development worldwide,” he said. “I think we can all agree this is the world we want.”

Also participating in the policy dialogue were Wu Hongbo, UN Under-Secretary-General for Economic and Social Affairs (the moderator); Pascal Lamy, Director-General of the World Trade Organization (WTO); Supachai Panitchpakdi, Secretary-General of the UN Conference on Trade and Development (UNCTAD); Zhu Min, Deputy Managing Director of the International Monetary Fund (IMF); and Mahmoud Mohieldin, the World Bank Group President’s Special Envoy on the Millennium Development Goals (MDGs) and Financial Development.

Huge cost

In his address, Fernandez said that the Great Recession has had an unprecedented cost for the global economy. According to a report published by the US Government Accountability Office in February, the 2008 financial crisis cost the US economy more than $22 trillion. The agency stated that the toll of the financial crisis on economic output may be as much as $13 trillion, an entire year’s gross domestic product. Paper wealth lost by US homeowners totalled $9.1 billion. Consumption dropped much more severely than in any other recent economic meltdown.

Other sources, he said, indicate that developing and developed nations have seen 20 million jobs disappear since the beginning of the 2008 financial crisis. Various nations have reached double-digit unemployment rates. Spain, specifically, has 26% of its working population without a job. Youth unemployment now exceeds 30% in Greece, Spain, Italy and Portugal. It is greater than 15% in two-thirds of advanced economies.

Furthermore, said Fernandez, the crisis had large spillovers in the developing world. In a resolution of the 65th General Assembly of the United Nations, dedicated to the follow-up of the outcome of the UN Millennium Summit, it is clearly stated that “the financial and economic crisis ... has reversed development gains in many developing countries and threatens to seriously undermine the achievement of the Millennium Development Goals.”

Today, he noted, a total of 178 million children under five have difficulties growing as a result of lack of food, and the number of people who have become malnourished has climbed to at least 1 billion.

“Due to the global economic downturn, 53 million more people will fall into extreme poverty. In rural areas, more than 19% of the population from poor countries does not have access to clean water, nearly five times more than in urban areas, and the target of 75% coverage of access to sanitarian facilities will not be met in 2015.”

He underlined that the total cost of the crisis may even be larger if “we take into account the impact it has had on innovation, which is the main engine for economic growth”. Innovation, he said, plays a major role in increasing productivity and is “the key driver to improve our human condition”.

“Progress made in healthcare, for example, raised our living standards: the pacemaker (1958), artificial heart transplants (1963), MRI (1971), biomedicine, nanotechnologies used in surgery, HIV treatments, all changed our lives. Thanks to those breakthroughs, life expectancy in the world increased by more than 15 years on average in the second half of the 20th century.”

“New technologies of communication completely changed the way we work, move and relate to each other. From the microprocessor (1946) to Facebook (2007), miniaturization technologies, satellite communications, mobile devices, cloud computing and artificial intelligence, have all transformed our habits, made the world smaller, and promoted dialogue among cultures,” he added.

However, four years after the housing bubble burst, the number of patent applications in most countries is yet to recover to its pre-crisis trend. Investments in research and development (R&D) by businesses were highly affected. In Japan and the UK, for instance, they dropped respectively by 12% and 5% between 2007 and 2009.

“In other words, the crisis disrupted the innovation process,” Fernandez said, citing some factors to explain this damage on both the demand side and the supply side.

Furthermore, austerity programmes implemented in the US and Europe due to the surge of public debts were not favourable to large investments in R&D. In the eurozone, for instance, public spending in R&D significantly decreased after 2009.

He also noted that the credit crunch led to the fragility of the banking sector and made it difficult for businesses, especially small businesses, to find financial support for their activities and innovative projects. Total corporate loans fell 8% in Spain, 4% in Ireland and an average 2.7% in the eurozone this year, the biggest drop in two years, according to Morgan Stanley.

Deregulation drive

The former Dominican Republic President posed the question: “How did all this happen and what can we learn from it?”

“The great progress we have experienced in the last decades has been accompanied by a change in economic thinking, led by market liberalization in the 70s and total market deregulation since the 80s. It was indeed assumed that markets were more efficient when self-regulated.”

In the US, Fernandez said, President Nixon began the first liberalization reforms in 1971, in the transport sector for railroads and trucks. The sector was then fully deregulated under the Carter administration, which supported the Airline Deregulation Act (1978), the Staggers Rail Act (1980) and the Motor Carrier Act in 1980. The process then was pursued in telecommunications, energy and finance by the Reagan administration, while Margaret Thatcher launched the deregulation of the UK financial sector in 1986, giving rise to the City as a major global financial centre.

But self-regulated markets induce a “winners take all” effect, Fernandez emphasized, which leads to strong inequalities. “We observe indeed that inequalities surged worldwide since the 80s.”

“It is however striking to see how deregulation became almost a dogma, supported by all international agencies, with several economic studies showing the benefits of deregulation on labour, productivity and growth.”

In 2005, assessing the global deregulation process, the IMF conceded that the reforms caused social unrest and political upheavals. But rather than questioning the underlying logic, it concluded that “reforms are most effective if executed in a coordinated fashion”.

“The financial sector followed naturally these liberalization and deregulation trends,” Fernandez said, pointing out that the Gramm-Leach-Bliley Act voted in 1999 by the US Congress removed the constraints set by the Glass-Steagall Act in 1933. Banks were now allowed to own both commercial banking firms and securitized firms.

One year later, the Commodity Futures Modernization Act completely deregulated the use of over-the-counter derivatives. In less than 10 years, the gross market value of global over-the-counter derivatives multiplied by 10.

During this period, new financial tools were designed and commercialized. The first SWAP was introduced in 1981, and Collateralized Mortgage Obligations (CMO) were invented in 1982 to package mortgages and sell fractions of them as financial assets. The first Credit Default Swaps (CDS) appeared in 1994 to provide insurance schemes against the default of a loan, but with one specificity: anyone could purchase a CDS, even buyers who did not hold the loan instrument.

“The theory suggests that such financial innovations do improve market efficiency, and contribute to reducing asymmetries of information. But then a question arises: what to do when financial products become a source of profit by themselves and for themselves?”

Noting that the financial sector absorbed more than a third of the total corporate profits in the US since the 1990s, Fernandez asked: “Is such a financialization of the economy compatible with the idea that finance should only be an intermediary in the production process and at the service of innovation?”

“There is in fact a strong paradox in this rapid expansion of the financial sector. Taking advantage of the progress made in communication tools, markets made an extensive use of digital technologies to develop new trading techniques.” High-frequency trading is the best-known example. But there are others: direct access trading is a technology that allows stock traders to interact directly with stock exchanges, avoiding brokers; tick-size variations can automatically change the way prices are adjusted for each individual stock. Dark pools of liquidity enable a set of investors to trade anonymously large blocks of securities, on a separate network, hidden to other investors.

“These new tools, combined with unregulated and profit-seeking financial contracts eventually amplified the burst of the housing bubble, and transmitted this shock all over the world. In other words, the unregulated finance grew thanks to innovations, but then severely damaged innovative structures, and destroyed human capital.”

Fernandez cited a report from the US Senate Permanent Subcommittee on Investigations that sustained that a trading operation was found that ignored limits on risk taking, hid losses, dodged oversight and misinformed the public. It is called “synthetic credit derivatives portfolio”. “Really, few people know what it means, but it created a loss of over $6 billion.”

Mobilizing finance for innovation

He stressed that finance is meant to allocate resources for the real economy and should only act as an intermediary, at the service of innovation and therefore of development, adding that there is a strong need to mobilize financial resources “to overcome the challenges we are facing and will face in the future”.

In this context, he highlighted that in the health sector, HIV, malaria, genetic diseases and cancer are today urgent priorities, and innovations in healthcare can result in more convenient, more efficient and less expensive treatments. “New drugs, diagnostic methods, drug delivery systems, and medical devices, will offer the hope of better treatment and care that should be less costly, disruptive, and painful.”

The depletion of energy resources also calls for urgent transition patterns in all countries. Deep-water windmills are still under development; smart grids might enable flexible and efficient distribution of electricity; environment-friendly exploitation techniques of shale gas could also be promising. The financial sector should be dedicated to developing new products to finance these long-term projects around the globe.

Fostering the formation of human capital also needs important resources. Education and life-long training are indispensable to allow all continents to integrate into the digital economy and contribute to innovative projects. They are necessary to overcome the challenges of long-term unemployment.

In every country, a culture of innovation should be taught at school, and a whole new generation should be given the tools to successfully address health, energy, water supply and agricultural challenges.

“To channel those financial resources, it is necessary to introduce appropriate regulation at the global level. Currently, only national responses are provided to curb the financial sector.”

Fernandez noted that the Dodd-Frank Act in the United States was voted in July 2010 and is still under implementation. It represents nearly 400 new rules and mandates. Three years later, a total of 279 Dodd-Frank rule-making requirement deadlines have passed. Of these, 175 have been missed and only 104 have been met with finalized rules.

“This gives some insights on the complexity of the regulation process, and the resistance of certain sectors within the financial industry to be regulated,” he said, adding that in Europe, many discussions are underway to design and implement an appropriate regulatory framework of the banking sector.

A process of regulation is thus just starting. However, the monitoring of financial activities will need a much broader action plan than isolated national or regional regulations.

“Recent scandals, such as the Libor manipulation, show that the opacity of financial activities [makes] regulation a challenge that should be undertaken globally, transparently, and rapidly, since some Mortgage Backed Securities are already back in the financial markets,” he stressed.

Some guidelines for such reforms have already been proposed. For instance, as a response to the manipulation of financial benchmarks, the International Organization of Securities Commissions (IOSCO) proposed a framework that should be applied to assess the risks of these financial instruments.

“In a word, it is of utmost importance that conflicts of interest be avoided thanks to full transparency in market operations.”

Innovation gap

Finally, said Fernandez, all must be done to enable developing countries to participate in the knowledge-based innovation economy. As of today, a dramatic innovation gap exists between developed and developing countries. More specifically, high-income countries produce 20 times more patents than middle-income economies.

“The great majority of developing countries are parties to international treaties regarding patents. Even though patent laws are normally designed to foster innovation by protecting innovators, it has become difficult for middle-income countries to overcome the obstacles and legal difficulties of current Intellectual Property Rules.”

Indeed, patents are definitely necessary to protect huge investments in R&D. But mechanisms to share technological progress and to reduce this innovation gap should be proposed.

Fernandez said that it is therefore important to consider whether the current system of intellectual property rights and practices is adequate to encourage innovation, guarantee technological transfer and promote knowledge sharing. He cited the Organization for Economic Cooperation and Development (OECD) as recognizing that “in certain cases the abuse of the control with which IPR [intellectual property right] owners are endowed could hamper competition, fair use and the diffusion of technology”.

In conclusion, he said that the Millennium Development Goals have been a fabulous instrument to focus attention of the international community on poverty reduction. Three out of the eight Millennium Development targets – on poverty, slums and water – have been met ahead of the 2015 deadline. But the crisis has significantly slowed the progress on the other targets.

Today, he added, the United Nations has set up a task force on the post-2015 development agenda. Interestingly, he noted, the first report published by this task force underlined that “an essentially unregulated financial system” was a threat to development policies. (SUNS7620)                                         

Third World Economics, Issue No. 549, 16-31 Jul 2013, pp2-4