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Article Excerpt
We are in a crisis which has two faces: a severe disruption of the financial industry and a stark recession. How do we get out of this situation? For the long run, we need a reliable institutional arrangement that will prevent getting into a similar financial distress again. In the short run, we have to move out of the present recession.
It has long been a tradition of Germany's Freiburg school that a market economy--Americans speak of capitalism--needs rules. A prime example is a rule system guaranteeing competition against endogenous market tendencies to form monopolies, if these tendencies remain uncontrolled.
Institutional arrangements, including norms of behavior, laws, and other rules draw from negative historical human experience, mostly historical disasters. Some came into existence after the Thirty Years War ending in 1648 and after other wars and internal turmoil. Rules evolve in order to prevent human hardship and misery. Without rules, life would indeed be "solitary, poor, nasty, brutish, and short," in the words of philosopher Thomas Hobbes.
On a global scale, rules refer to the institutional arrangements among states. In specific areas and to a certain extent, sovereign states cede sovereignty. This leads to the establishment of a multilateral rule system, binding sovereign states and their citizens. In the economic sphere, we have accumulated experience with the institutional set-up that affects all aspects of the international division of labor, mostly in the World Trade Organization. We now are in the process of finding new rules for global environmental scarcity.
After our negative experience with the recent financial crisis, what are the essential elements of a rule system for financial stability? Here are some crucial aspects.
Inflation and hyperinflation can be avoided by an adequate institutional arrangement for the central bank and by an adequate monetary policy. A basic rule is that public budget deficits must not be financed by printing money. The independence of the central bank is of utmost importance. The position of the central bank must be strong enough to resist political pressure for an easy money policy and for simply financing the public budget.
In order to develop rules for the soundness of the financial system, one needs to look at the functions that the financial system has...
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