"To Do List" for the Politicians.

It is important to note that this inflation will only repair the problem in the short run, as the illness will remain.  Furthermore it would be tragic to not repair the long term problems while this inflation happens, as otherwise no government will have any ability to return to flat inflation as it will lack credibility to do this. 

Sovereign Debt:

In essence a very tough measure should be put in place, ideally almost outlawing sovereigns from running deficits.  This should carry criminal responsibility for people who break these laws, almost to ensure that they cannot be easily replaced at the later date in order to win the new elections.

Lack of deficit will also mean lack of trade deficit, as the basic Econ 100 student will remember the twin deficit issue.

Terms of Trade:

Recognizing that we are living in the increasingly global society it is essential to understand that to live in the global society there must be either:

A.     Free Exchange Rate mechanism

B.     Protectionism

In many ways the policies of countries that are deliberately weakening their currencies are not in the line with the responsible global policy, as they lead to destabilizations of not only the countries with the overvalued currencies, but ultimately also in the countries with the undervalued currencies – see China now, which in essence being a manufacturing hub of the world is capable of simply collapsing as its structure of the economy is so much export and manufacturing orientated.

Likewise from the point of view of the developed countries it is essential to accept and even manage people’s expectations that the current situation where the income difference between United States and China is that of 10 fold is simply not realistic and it will need to be corrected, as people in China just like people in US have ten fingers each, hence why should they receive less pay for the same work that is being done?  If people in US do not accept this than they will have to implement Protectionist measures, though even these measures will not work in the long run – and are also likely to backfire down the line as few would argue that in the long run protectionism promotes growth (though it can in the short run).

Financial Sector:

In our view there is a structural problem with the setup of the financial industry, though we are very much open to debate on this topic, and we are learning a lot from many of our scientists and colleagues here.  Our view can change as like others we are learning, but our current approach is:

1.     All the mortgages must be linked to the expected income rental of the property, rather than the price of the property which is based on the price of other properties on the street.  This created the US and UK bubbles, while interestingly in Germany where mortgages would only be given in relation to the income stream, there was no real estate bubble

2.     Definite end to any form of accrual accounting. If there are assets that do not have market valuations due to their illiquidity, than there has to be an independent method of establishing these prices (and while this is easier said than done,  I do not believe that society is not able to set this up).  Current situation where the Greek debt is valued at 100% on the books of the French and German banks, when it is trading at 50% in the bond market is a gross manipulation of any logic, and while today regretfully it must happen to protect the current status quo, in the “new post inflation setup”  this should be never allowed to happen again.

3.     Change of accounting from emphasis on large corporate auditors like Arthur Andersen, to responsibility being taken by both the company and the individual.  It should not be Mr. Arthur Andersen who sings the audits but specific group of people who take specific legal and even criminal responsibility for what they are doing.  In many ways the modern audit companies have became the tools to legitimize the illegalities, and this has to change if we are to remain to tolerate corporate, stock markets, bonds and other forms of “collective” financing products.  If this cannot happen, than we might as well return to the financial markets from the 16th and 17th centuries, where everything was in essence private, but not collectively private – i.e. max 50 shareholders in a one company, max 50 bondholders, etc.  Simple method actually.

4.     Financial sector:  this is the most controversial one, and very difficult to change, meaning that nationalization of all the banks is very much on the cards if we are to start the system from the right model

a.     Stop of all Deposit Guarantee Schemes.  These are by definition stupid, create moral hazard where depositors do not really care about what banks they put the money to, and just care about the politicians and bureaucrats who award them a banking license

b.     The level of all deposits should be REGULATED and set at the level of inflation.  This means, that every financing institution will be paying the same amount of money for its deposits, i.e. they will not engage in what we are observing now which is a Deposit War, which will just as bad as the Asset Interest war that we have observed in the 2000 – 2007 leading to effectively borrowing rates being at 0.50% credit spread (like my house for instance)

c.      Requirements for banks to be very transparent about their investment policies, and maximum return on equity capped at say 20%, with the rest in essence being very highly taxed – what will stop any economic desire by the banks to obtain unnaturally high levels of return at the potential risk of the depositors

d.     Capital adequacy ratio at the level of say 30%, and certainly exceeding the rate set in point c).  Here we do forecast that this could be linked to the nature of the investment portfolio.

e.     VERY IMPORTANTLY:  REGULATED add-on spreads to various loans, standardized across the asset types… i.e.…  2% running tax on every mortgage, 5% on corporate loan, 10% on personal loan (these are examples only… but these will aim to stimulate and discourage specific sections of the asset classes)

f.      Emergence of powerful investment funds, which in essence will replace banks and will be free to do what they want, though any returns on these should be highly taxed to generally disincentives people from any speculation activities.  Let’s accept that taxing in the society happens anyway, so why not tax activities such as speculation, and tax less people’s employment tax?  Surely it will be more economically and socially correct to incentivise people to work than to use capital to speculate, or even accumulate it without directly investing it into the economy (look at Sweden for example of taxation on not used capital).

5.     On the Government Sector:

a.     Proper supervision.  It is tragic today that vast majority of Ministers of Finance or Central Bankers have no idea about practical finance, and are almost exclusively a group of academics.  To give you a practical comparison:  an academics in these roles are like scientists who perform medical operation.   Number of politicians are aware that there needs to be a much greater emphasis on the “committees of experts” , and these experts must be proper financiers and not the representatives of academia who cannot differentiate between LIBOR set in advance and LIBOR set in arrears (I am sure that derivatives bankers and traders understood this, but if you the reader have not – you do not know finance).   Naturally these people will need to be properly paid, but I always found it very strange that a person with the power of the Chairman of the FED should not be paid more than the guy running Goldman Sachs.  You simply cannot save on the top “managers” like this, or on the salary of the President of your country / City, as otherwise you will get the people that are worth their money.

b.     Reward whistle-blowing.   Recently following the announcement of USD2bn losses by one trader at UBS , we suggested that bank CEOs should reward traders who come forward with the identified loopholes.  This creates the auto-corrective mechanisms and helps to avoid huge one off loses.  In similar ways in the macro world it will be difficult to establish the financial world that is perfect, as things change.  Reward identification of loopholes  (such as Hybrid Capital which started to exist in 2000s or emergence of highly complex investment products such as synthetic CDO squared, which frankly are great, but are totally not needed for common use and someone should have put a stop on this).

Other Elements:

There are also many other policies that could be done such as increasing of pension age, changing of the way healthcare works, and even very extreme measures such as opening of stock markets for only on one day a week (can someone tell me the economic reason why stock markets have to be open daily?).  There are also supply side policies such as promoting the knowledge economy (today it was announced that South Korea by 2015 will teach its students on the online curriculum, impressive bearing in mind that South Korean students are already the world leaders in IT literacy).  All of these policies are theoretically at least very positive and good, but from our point of view they are not essential to make the system work, where as this paper focuses solely on the measures that need to be corrected as they alone have the potential to destabilize the system.