IMF: Inclusive capitalism and financial integrity

Christine Lagarde (Managing Director, IMF) gave an insightful speech in May on the topic of economic inclusion and financial integrity. One of the interesting themes highlighted was that inequality is not a trade-off for better economic performance - indeed, IMF research indicates that the right redistributive policies actually lead to better performing economies. Furthermore, Lagarde focusses on the need to ingrain a greater social consciousness in the financial sector, so as to re-engender trust in the system.

Lagarde noted that recently "capitalism has been characterized by 'excess'—in risk-taking, leverage, opacity, complexity, and compensation. It led to massive destruction of value. It has also been associated with high unemployment, rising social tensions, and growing political disillusion – all of this happening in the wake of the Great Recession. One of the main casualties has been trust—in leaders, in institutions, in the free-market system itself. By making capitalism more inclusive, we make capitalism more effective, and possibly more sustainable. But if inclusive capitalism is not an oxymoron, it is not intuitive either, and it is more of a constant quest than a definitive destination."

"The facts are familiar.

• Since 1980, the richest 1 percent increased their share of income in 24 out of 26 countries for which we have data.

• In the US, the share of income taken home by the top one percent more than doubled since the 1980s, returning to where it was on the eve of the Great Depression. In the UK, France, and Germany, the share of private capital in national income is now back to levels last seen almost a century ago.

• The 85 richest people in the world, who could fit into a single London double-decker, control as much wealth as the poorest half of the global population– that is 3.5 billion people."

"Many would argue, however, that we should ultimately care about equality of opportunity, not equality of outcome. The problem is that opportunities are not equal. Money will always buy better-quality education and health care, for example ... Fundamentally, excessive inequality makes capitalism less inclusive. It hinders people from participating fully and developing their potential. Disparity also brings division. The principles of solidarity and reciprocity that bind societies together are more likely to erode in excessively unequal societies. History also teaches us that democracy begins to fray at the edges once political battles separate the haves against the have-nots."

"It is therefore not surprising that IMF research—which looked at 173 countries over the last 50 years—found that more unequal countries tend to have lower and less durable economic growth." (refer to my separate blog IMF: Redistribution, Inequality and Growth)

"We are all familiar with the factors behind the crisis—a financial sector that nearly collapsed because of excess. A sector that, like Icarus, in its hubris flew too close to the sun, and then fell back to earth—taking the global economy down with it.
We can trace the problems to the evolution of the financial sector before the crisis. Financial actors were allowed to take excessive risks, leading to a situation whereby the profits on the upside went to the industry—and the losses on the downside were picked up by the public."

"Some of the greatest problems, still outstanding today, lay with the so-called too-big-to-fail firms. In the decade prior to the crisis, the balance sheets of the world’s largest banks increased by two to four-fold. With rising size came rising risk—in the form of lower capital, less stable funding, greater complexity, and more trading.
This kind of capitalism was more extractive than inclusive. The size and complexity of the megabanks meant that, in some ways, they could hold policymakers to ransom. The implicit subsidy they derived from being too-big-too-fail came from their ability to borrow more cheaply than smaller banks—magnifying risk and undercutting competition."

In addition to financial sector reforms, the Basel III standards and stronger financial supervision, Lagarde argues that "we also need to turn our attention to the culture of financial institutions, and to the individual behavior that lies beneath. Incentives must be aligned with expected behavior and be made transparent".

She notes that "the behavior of the financial sector has not changed fundamentally in a number of dimensions since the crisis. While some changes in behavior are taking place, these are not deep or broad enough. The industry still prizes short-term profit over long-term prudence, today’s bonus over tomorrow’s relationship."

"Some prominent firms have even been mired in scandals that violate the most basic ethical norms—LIBOR and foreign exchange rigging, money laundering, illegal foreclosure.
To restore trust, we need a shift toward greater integrity and accountability. We need a stronger and systematic ethical dimension."

"When we think about finance, surely one of these core virtues is prudence—which is about stewardship, sustainability, and safeguarding the future. Prudence has long been a byword of banking, and yet has been sorely missing in action in recent times".

"Getting back on the right path requires education and leadership that is sustained over many years. It requires alert watchdogs, including from civil society".

"Most importantly of all, it requires investors and financial leaders taking values as seriously as valuation, culture as seriously as capital".

"Ultimately, we need to ingrain a greater social consciousness—one that will seep into the financial world and forever change the way it does business."

Christine Lagarde (Managing Director, International Monetary Fund), Economic Inclusion and Financial Integrity—an Address to the Conference on Inclusive Capitalism, London, May 27, 2014.

Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides, Redistribution, Inequality, and Growth, IMF Staff Discussion Note 14/02, February 2014.