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Putting Finance Back in the Box

Restoring shared prosperity will require re-establishing a link between productivity growth and wages and having economic policy commit to working toward full employment. Moreover, this will have to be accomplished within the additional constraint of environmental sustainability. This is a massive task requiring a range of policies related to labor markets, the international economy, the public sector, the environment, and macroeconomic policy. Given the critical role of finance, such a transition also requires regaining control over finance so that it again serves the real economy, rather than the real economy serving finance.

One part of the challenge is political and concerns campaign finance reform. The political power of finance rests on money, which is why it is so critical to reduce the role of money in politics; absent political reform, finance will be able to distort the democratic process and block necessary economic policy reform. A second part of the challenge is changing corporate behavior. This requires a reform of corporate governance that makes business more accountable, changes incentives that promote current business practice, and recognizes the interests of stakeholders other than shareholders. (See Chapters 15 and 19.)

A third challenge is to regain control over financial markets. Figure 16–5 illustrates a four-part program for putting financial markets back in the box so that they promote shared and more-sustainable forms of prosperity rather than destructive speculation.

Figure 16–5. Putting Finance Back in the Box

The top edge of the box indicates the need to restore a commitment to full employment, abandon a rigid ultra-low inflation target, and recognize that monetary policy can permanently influence the level of economic activity. The left edge of the box concerns the need for tough regulations that impose appropriate capital and liquidity requirements on financial institutions, and also bar banks from engaging in speculative activity using government insured deposits—the so-called Volcker rule.

Regulation also must be enforced, which speaks to the importance of a good government agenda that ensures the integrity and operational efficiency of regulatory agencies. The right edge of the box concerns the need for a financial transactions tax (FTT), which can raise revenue, help shrink the financial sector to more appropriate and healthy proportions, and discourage damaging speculative transactions.

Lastly, the bottom edge of the box advocates that the Federal Reserve institute a system of asset-based reserve requirements (ABRR) that covers the entire financial sector. ABRR require financial firms to hold reserves against different classes of assets, and the regulatory authority sets adjustable reserve requirements on the basis of its concerns with each asset class. By adjusting the reserve requirement on each asset class, the central bank can change the return on that asset class, thereby affecting incentives to invest in the asset class.

The U.S. housing price bubble showed that central banks cannot manage the economy with just interest rate policy targeted on inflation and unemployment. Doing that leaves the economy exposed to financial excess. Interest rate policy therefore must be supplemented by balance sheet controls, which is the role of ABRR.

ABRR provide a new set of policy instruments that can address specific financial market excess by targeting specific asset classes, leaving interest rate policy free to manage the overall macroeconomic situation. ABRR are especially useful for preventing asset price bubbles, as reserve requirements can be increased on overheated asset categories. For instance, a housing price bubble can be targeted surgically by increasing reserve requirements on new mortgages. That makes new mortgages more expensive without raising interest rates and damaging the rest of the economy.

Finally, ABRR can be used to promote socially desirable investments and “green” investments that are needed to address climate change. Loans for such investment projects can be given a negative reserve requirement that can be credited against other reserve requirements, thereby encouraging banks to finance those projects in order to earn the credit. In sum, ABRR provide a comprehensive framework for collaring the financial sector and ensuring that it promotes shared prosperity.

Conclusion: Beyond Orthodox Economics

We live in an age of market worship. Orthodox economics fuels that worship, and it also gives special standing to financial markets, which are represented as the most perfect form of market. Although there is some critique of the functional efficiency and casino aspects of financial markets, this stops far short of a deeper critique of financialization. Consequently, orthodox diagnoses of the financial crisis and policy recommendations stop far short of what is needed to put finance back in the box.

The economic evidence shows the need to make finance serve the real economy, rather than having the real economy serve finance, as is now the case. It can be done. The challenge is to get a hearing for policies that will do so. Meeting that challenge requires getting new economic ideas on the table, which is why the debate about economics and the economy is so important. However, the road to policy change runs through politics. Putting finance back in the box also requires breaking the political power of finance, which is why campaign finance reform, electoral reform, and popular political engagement are equally important.

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