The debate over what governments should and should not be doing in finance is more important than ever, says Joseph Mariathasan

What should be the role of governments in financial markets? There is no right answer, and attitudes can vary with the circumstances and with your politics. The US Export-Import Bank, for example, is likely to lose its charter on 30 June, having served the interests of US industry since president Franklin D Roosevelt established the agency in 1934. Whether you regard the EXIM Bank as an extension of crony capitalism that provides corporate welfare for big business, or a worthwhile entity that helped boost US exports by nearly $28bn (€25bn) and supported more than 160,000 domestic jobs last year alone, depends on your ideological stance.

Ajay Shah, an Indian economist and a keen advocate of the benefits of free markets, makes some points in the Indian context that should also resonate in Europe, both at the national and EU level. Shah believes the job of government is to address market failures in areas such as public goods, asymmetric information, market power and externalities.

It is difficult to argue with this, but where there is debate is how much of a focus there should be on welfare programmes, which is the inevitable consequence of universal suffrage. But that leaves a class of issues where the government is doing something that is not grounded in market failure and does not have political importance.

The creation of the US EXIM bank is a clear case in point. As Shah argues, financing and risk-taking in connection with international trade or cross-border investment is the ordinary stuff the financial industry does. The self interest of financial firms will produce these services. There is no case for the government to subsidise exporters – but, even if that were desired, there are more efficient ways to do this rather than subsidised credit, a view that I would also certainly agree with.

Shah characterises the Indian Financial Code as having nine components, and it is interesting to see how these look in a European context. The first is consumer protection. Financial firms, left to themselves, will mistreat consumers. This is the heart of how regulators should think about financial economic policy. Europe seems to have taken this on board with gusto since the problem that many perceive is too much EU legislation along these lines.

Second is micro-prudential regulation. Left to themselves, financial firms will take on too much risk and fail too often, which will hurt unsophisticated consumers and impose externalities upon bystanders. The imposition of Solvency II, Basel II and MIFID, etc, certainly ensures Europe cannot be accused of a failure to try. But the consequences may not have been fully thought through.

Third is what Shah calls resolution. The ordinary bankruptcy process does not work for financial firms, where failure can be disruptive. The government is required in the field of resolution to identify financial firms that are not viable before they are insolvent and gracefully handle the situation in ways that don’t hurt innocent bystanders and protect unsophisticated consumers. Europe is still struggling to find an effective way to put this in place. But the problem is that it will take another crisis to test whether it works.

Fourth is systemic risk regulation. As Shah points out, this is about seeing the woods and not the trees. Financial regulation inevitably induces pro-cyclicality, and we need ways to combat this. We need ways to reduce the probability of systemic crises, and better ways to deal with them when they do come about. The reaction to the global financial crisis by European regulators is a case in point. Imposing draconian capital rules on holding risky assets forces investors into holding excess sovereign debt at a time when QE is forcing bond yields down, giving rise to unprecedented negative yields. Meanwhile, markets such as the European ABS market, which could provide a stimulus to European recovery, are unduly penalised. Europe clearly has not found a holistic approach to this that works.

Fifth, Shah sees India as requiring a public debt management agency that will do investment banking for the government and figure out the right ways to organise the market for government bonds. In the European context, the arguments over the extent of mutual support for government debt lie at the heart of the euro-zone crisis.

Sixth, India has capital controls, and Shah sees the need for the rule of law, and equal treatment of non-residents, in the working of capital controls. In the European context, so far, that is not relevant, but if Greece defaults whilst remaining within the euro-zone, such issues may come to the fore.

Seventh, Shah argues that monetary policy is also a key activity of the state, with an accountable central bank that will safely produce fiat money, through a sound monetary policy process. Whether in the European context, the ECB is doing that through its QE programme is up for debate.

The eighth activity for Shah is the use of finance as a tool for development and redistribution, whilst Shah’s ninth activity is in the legal framework that underlies financial markets, covering contracts, trading and market abuse. These again are well covered in Europe by the plethora of regulations.

With the UK looking to renegotiate its relationship with the EU, whilst Greece at the other end is desperately struggling to stay in, debating what governments should and should not be doing in finance may be essential to finding a workable compromise.

Joseph Mariathasan is a contributing editor at IPE

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