The Orthogonality of Leadership and Crisis

or·tho·go·nal (ôr-thog-uh-nl)

Adj. 1. irrelevant - having no bearing on or connection with the subject at issue; "an irrelevant comment"; "irrelevant allegations."

misregulation (mis-reg-yuh-ley-shuhn)

Noun. 1. wrong or imperfect regulations. 2. a process of deliberately wrong or imperfect regulation for personal gain.

The U.S. does not have a monopoly on leadership failure. In a recent editorial in the New York Times and Herald Tribune, Paul Krugman states the obvious.

...the people who should be steering us away from that abyss are out to lunch.
A leadership vacuum, NYTimes, 3 Oct 2008

The economic crisis in the U.S. is deep and real, and requires leadership to match. The mismatch between leadership needs and the crew in charge is frightening. At the same time, a similar drama is unfolding on the other side of the Atlantic. In some ways, it offers more potential to go wrong in many more frightening ways than in the U.S., as it is exposing historical fractures linked to the most base tribal instincts of the European leadership class. This is one reason why the open letter from academic economists posted on VoxEU to European policy makers needs to be taken seriously.

This is a once-in-a-lifetime crisis. Trust among financial institutions is disappearing; fear may spread. Last week’s US experience showed that saving one bank at a time won’t work. A systemic response is needed and in Europe this means an EU-led initiative to recapitalize the banking sector. Unless European leaders immediately unite to address this crisis before it spirals out of control, they may find themselves fighting over how best to salvage the aftermath...
Open Letter to European leaders on Europe’s banking crisis: A call to action .

How bad is the crisis in Europe? In a recent posting, I noted that the the European and Asian exposure to the toxic financial sludge floating around global financial markets is probably at least as bad as in the U.S. However, while the U.S. has set aside an initial $700 billion, and the pundits are admitting that more will be required, the only coordinated (meaning European) response so far has been the early renewal of existing European Central Bank credits for €32 billion, and the breaking up of an emerging cross-border banking system back into national sub-units. (In the Fortis bailout out, for example: the government intervention is breaking up the cross-border group along national lines, including the interest in ABN AMRO it bought in a consortium with Royal Bank of Scotland and Banco Santander.) The Irish step to guarantee deposits was also discriminatory (beggar-thy-neighbor) in implementation. The exposure of European banks to bad debt may be as bad as in the U.S. In my view, the relaxed approach to shielding investors from information they might not like (misleading them) is at the core of the problem. Indeed, the editorials and blogs pointing to the "failures of deregulation and market capitalism" miss the point. This crisis is the consequence of globally mixing bad math, misinformation, and good-old-boy politics with financial misregulation.

At one level, the issue is the global nature of the unfolding banking crisis. Recent news includes the nationalization of Fortis Bank by the Dutch government (including the retail banking business of ABN-AMRO), the collapse of the rescue package for Hypo Real Estate this weekend, and increased agitation in Europe as beggar-thy neighbor national solutions are emerging for what is really a Continental problem. In Ireland, for example, the decision of Ireland to provide a 100% guarantee to the deposits of Irish banks is causing a shift in deposits from non-Irish banks, obviously helping Irish banks but at the expense of other (e.g. British) banks operating in the same market but without guarantees.

At another level, this crisis is also a test for Europe. Following an announcement this weekend by European leaders that they would follow a more coordinated approach,

"Germany's Chancellor Angela Merkel insisted states would mainly act individually..."

This position has been backed by the head of the ECB, who has sided with Merkel. In response, like Ireland, Greece has also now guaranteed deposits.

Sigh.... Merkel's reactive undermining of a joint solution should be an alarm bell. Europe has been pushing deeper integration, including cross-border integration of its locally fragmented financial sectors. This is a good thing and a political necessity given history. It reflects hard work and real costs by the post-War generation. However, notwithstanding the pro-German reaction of the ECB, with the benefits of more integrated markets comes a responsibility for a more integrated approach to regulation and crisis management. A piecemeal approach to the current crisis will inevitably be beggar-thy-neighbor. There needs to be an integrated approach at a European level. Failure by European leaders to find a European solution risks setting back decades of European economic and political integration and efforts to exorcize Europe's tribal demons. Without a coordinated and aggressive attack on this crisis of confidence, it may get much much worse. Once European leadership is locked into national solutions, economic borders will grow wider and the slide back go tribal rivalry may begin yet again. The time to sort out responsibility (presumably the ECB is worried over wrong incentives and moral hazard) is after the crisis has been weathered.

Europeans deserve better from their leaders (and their Central Bankers) than a narrow local focus. They need to demand wider vision. A narrow, nationalist approach will not fix this problem, and will carry long term costs. It is important that national leaders in Europe act responsible and talk about positive, European approaches to the problem. Nationalist rhetoric may be appealing and easy. It is also irresponsible and reprehensible, especially given the shared burden of European history.

Quoting the letter again:

The problem is not a lack of understanding of how to stop financial crises. The problem is a lack of political will.

ADDENDUM:
There is a good discussion of the European exposure by Daniel Gross and Stefano Micossi on RGE Monitor: "Crisis Management Tools for the Euro Area." There is also some emerging realization that Europe's schadenfreude at the "American" crisis was premature. This crisis does not prove the "superiority of the general European banking model." Indeed a number of European state-owned banks have been caught in the same mess. As I have noted earlier, European banks have been staging mini-crisis for a while now (look up BAWAG scandal in google). Also see: "Europe Beginning to Realize Its Lenders Share in the Blame."

References:

[1] Open Letter to European leaders on Europe’s banking crisis: A call to action, VoxEU, October 2008.
http://www.voxeu.org/index.php?q=node/1729

[2] Paul Krugman,"A leadership vacuum," NYTimes 3 October 2008.
http://www.iht.com/articles/2008/10/03/opinion/edkrugman.php

[3] Joseph Francois, "Three Card Monty on the streets of New York, or "If this crisis is so different, why is it so familiar?" The Random Economist, 2 October 2008.
http://www.intereconomics.com/blogs/jff/2008/10/three-card-monty-on-streets-of-new-york.html

[4] Reuters, "Dutch media split over Fortis nationalization," 4 October 2008.
http://www.reuters.com/article/gc06/idUSTRE49314H20081004

[5] RTE News, "German bank on verge of collapse," 5 October 2008.
http://www.rte.ie/news/2008/1005/economy.html

[6] AFP, "Europe fights financial storm as bank deal collapses," 5 October 2008.
http://afp.google.com/article/ALeqM5hcWdSreh2tNafF5YVZbb2Te-Eivg

[7] Reuters, "EU rescue fund rejected as U.S. bailout advances," 3 October 2008.
http://www.reuters.com/article/bankingFinancial/idUSL252209520081003

[8] Daniel Gross and Stefano Micossi, Crisis Management Tools for the Euro Area, RGE Monitor, 2 Ocrtober 2008. http://www.rgemonitor.com/globalmacro-monitor/253833/crisis_management_tools_for_the_euro_area

[9] Craig Whitlock and Edward Cody, "Europe Beginning to Realize Its Lenders Share in the Blame," Washington Post, 1 October 2008. http://www.washingtonpost.com/wp-dyn/content/article/2008/10/01/AR2008100103406.html