How to see past the complexities of the financial regulatory mess
Andrew Sheng says knowing what doesn't work is a start; seeing beyond the complexities is next
As we move into the long hot summer, it's time to reflect on whether we are on the slow road to global recovery or another lurch into recession. In late May, the US Federal Reserve's warning of "tapering" quantitative easing caused financial markets to react violently. We also saw social turmoil in Turkey, Brazil and Egypt, the inter-bank shock in China and a reversal of capital flows to emerging markets.
The reality is quite sobering. Among the advanced countries, the US, Japan and Germany have positive but anaemic growth. After Abenomics, Japan is feeling more confident, with the stock market rising more than 35 per cent, but the latest industrial production and inflation figures are still negative.
The euro zone is still in shock. The major economies like France and Italy are in negative territory, whereas unemployment remains high at 12.2 per cent.
Global stock markets have been a forward predictor of how economies are going to perform. The US and German markets are up, but emerging economies' markets have been savaged.
This suggests that the financial markets are predicting slower growth in the emerging markets, which explains why the Institute of International Finance forecast a slowdown in net capital flows to emerging markets to 2015.
Indicators of a slowdown in China have hit commodity prices. The Economist commodity dollar index has declined by 8.7 per cent year on year, while gold prices, the supposed hedge against inflation, have declined by 22.8 per cent.
There is gradual awareness that central banks may be able to affect the risk-free interest rate in their domestic economy, but they may no longer be able to influence the upward movement of risk spreads. In other words, despite the large bout of quantitative printing, the market is beginning to price in risks more realistically.
Bond prices for the safe haven countries, particularly the US and Germany, have remained low, but risk spreads for sovereign debt in all the other countries, especially emerging markets and periphery European economies, have all widened again.
What does that tell us about quantitative easing?
At the June Bank for International Settlements annual meeting - a gathering of central bankers - its annual report warned in uncharacteristically blunt language that central banks may have gone beyond their borrowed time. On their own, they cannot repair balance sheets of households and financial institutions. Central banks should realistically expect that monetary policy cannot solve these problems on its own.
Sitting at the conference trying to figure out the complex euro zone crisis, we asked whether it is a complex question with a simple solution, or whether we have to use complex solutions to fix complex questions.
For example, the financial crisis is being solved by complex regulations. When I complained that no one seems able to understand them, I was told I was being simplistic.
German Chancellor Angela Merkel has the simple explanation for the euro-zone crisis: 7 per cent of world population, one-quarter of world output, and half of the world's social expenditure. This was fiscally unsustainable. The diagnosis was that the euro zone required more banking, fiscal and political union, in that order. But the latter two are much more difficult to achieve.
So, the euro technocrats are busily writing more and more rules on financial regulation and directives, centralising banking supervision away from national regulators. The basic idea is that countries with trade deficits would not go into deficit if the bank regulators were to tighten up on national bank credit. But if the Greek bank regulator cannot control Greek bank lending, what makes you think the euro-zone regulator in Brussels can?
The late Steve Jobs had the best insight into the issue of complexity versus simplicity: "When you start looking at a problem, and it seems really simple, you don't really understand the complexity of the problem. Then you get into the problem, and you see that it's really complicated, and you come up with all these convoluted solutions.
"That's sort of the middle, and that's where most people stop, and the solutions tend to work for a while. But the really great person will keep on going and find the key, the underlying principle of the problem. And come up with a beautiful, elegant solution that works."
His product, the iPhone, is simple to use, but the software and hardware processes are very complex. We don't need to know how the system works, but it does.
The financial markets are sending out a lot of complex and confusing noise, but the smart guys are trying to read the signal - what is the noise telling us?
Basically, the markets will go where central bankers are signalling - whether to tighten or to continue loosening. But the markets and social events are beyond the control of central bankers. That's where it's both simple and complex.
Andrew Sheng is president of the Fung Global Institute