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September 10, 2009
Globalization has produced unprecedented levels of both economic growth and economic risk. Financial markets have become more open, which allows firms and governments to invest more freely. But as global finance grows bigger, it has also grown more complex. Faster-flowing capital has become more volatile, and economic risk has become harder to track. Domestic regulators struggle to keep up with evolving financial practices, many of which they do not fully understand. To make matters worse, most national governments have refused to cede regulatory authority to a global system. Accordingly, international oversight of global markets has been limited, resulting in an explosion of banking crises, with more than 120 erupting between 1970 and 2007.
The economic crisis that began in 2008 has underlined two major weaknesses with the current architecture of international finance. First, there are simply too many institutions and mechanisms, often with overlapping mandates but limited power. Second, despite this machinery of cooperation, getting agreement on key issues often proves impossible, given the frequent disagreements among states over both the nature of the problem and the basic features of multilateral responses. Creating a more effective regime to govern international finance will require national governments—including emerging powers like China and India—to cooperate in updating, rationalizing, and consolidating existing institutions; to forge multilateral consensus on both the diagnosis of the problem and the course of treatment; and to delegate greater supervisory and regulatory authority to international institutions; and to enhance coordination of national policies to achieve goals set at the international level.
For twenty-five years, globalization produced unprecedented levels of both economic growth and economic risk. Financial markets became more open, which allowed firms and governments to invest more freely. But as global finance grew bigger, it also grew more complex. Faster-flowing capital became more volatile, and economic risk became harder to track. Domestic regulators struggled to keep up with evolving financial practices, many of which they did not fully understand. To make matters worse, most national governments have refused to cede regulatory authority to a global system. Accordingly, international oversight of global markets was limited. International cooperation was based on a patchwork of often ad hoc arrangements with limited scope and coercive power. One result was an explosion of systemic banking crises, with more than 120 (PDF) taking place between 1970 and 2007. By the spring of 2008, policymakers who were disheartened by the severe impact of these crises began expressing anxiety about the lack of effective regulation of the global financial system, which former U.S. Treasury Secretary Lawrence Summers said had generated “over one major crisis every three years.”
Indeed, the entire system was shaken in 2008, when a financial crisis plunged the world into a devastating recession. Since 2008, bail-outs have stabilized many of the world’s markets, but the crisis still illustrates the need for a more comprehensive regulatory system for global finance. As it now stands, the international financial regime has two main weaknesses. First, there are too many institutions and mechanisms—often with overlapping mandates but limited power. Second, despite this machinery of cooperation, getting agreement on key issues often proves impossible. States regularly disagree on fundamental issues, including the sources and solutions for global financial problems. The United States resists regulation even at a national level, Europeans cannot agree on a European regulator, and Asians are developing regional alternatives because they do not trust global institutions.
Many officials and commentators have invoked the vision of a new Bretton Woods, looking back to the conference that created a financial and monetary system after World War II and ushered in a period of strong and fairly stable growth, at least in the advanced industrial economies Some call for a single financial global regulator (PDF), possibly modeled after the World Trade Organization (WTO). Others join UK Prime Minister Gordon Brown in envisioning a “new financial architecture for the global age.” Any such agreement will require reaching consensus among not just the core Group of Seven (G7) advanced democracies but also among the emerging economic heavyweights of the Group of Twenty (G20)—China, Brazil, India, South Africa, and Saudi Arabia, among others. Drafting rules that can tame volatility yet preserve finance’s creative growth in a way that twenty heads of state can accept will be a daunting task, one made more difficult by the absence of consensus among the G20 regarding the causes of the current crisis, let alone the appropriate remedies. Even those pledges that have been drafted and agreed upon (such as the G20’s pledge to sweeping regulatory reforms for greater financial supervision and liquidity buffers) have not been uniformly adopted, and continue to present challenges at the domestic front.
Overall assessment: An increasingly inadequate and anachronistic system
In 1944, world leaders gathered in Bretton Woods, New Hampshire, to craft a global financial regime based on fixed (but, in principle, adjustable) exchange rates. They hoped the regime would provide the financial stability needed to recover from the Great Depression and World War II. But by the 1970s, the postwar setup had become untenable. A key principle of international economics is that countries cannot simultaneously have national policy autonomy, free capital movement, and fixed exchange rates. But surplus countries refused to allow their currencies to appreciate and the United States decided it would rather unhinge the dollar from the gold standard than sacrifice its macroeconomic autonomy. In 1971, the United States allowed the fixed-exchange-rate system to collapse, ushering in a new era of floating exchange rates. This new regime produced tangible benefits, allowing the major economies to combine national policy autonomy with open capital markets. (Emerging economies that valued stability could still peg their currencies to a major currency, though doing so often required large foreign-exchange reserves).
Meanwhile, floating exchange rates stimulated the development of capital markets, opening new opportunities for countries—rich and poor alike—to run large external deficits. In the 1970s, major international banks financed deficits in less-developed countries by recycling petrodollars. In the 1980s, surpluses in Germany and Japan financed the U.S. trade deficit—which rose to the then-high level of 3 percent of U.S. Gross Domestic Product (GDP). In the early 1990s, a wave of enthusiasm about prospects for emerging economies allowed many of them to access global markets for the first time in a decade, and was followed by an interest in U.S. technology companies that financed an expansion of the U.S. deficit. More recently, large surpluses in emerging Asian economies financed a substantial deficit in the United States and a growing deficit in many European countries.
Even in the heyday of globalization, crises periodically interrupted the expansion of global finance, forcing the international community to develop mechanisms that could prevent or mitigate them. The International Monetary Fund (IMF), in particular, evolved into an institution that supplied emergency financing to troubled economies that faced a sudden reversal in capital flows. But crisis response was often ad hoc, and the will to make major changes often dissipated once a crisis had passed. Countries resisted shifting too much power—especially regulatory power—to global institutions like the IMF. Regulation remained fundamentally national, though occasionally states coordinated their national regulations to avoid a race to the bottom. One such initiative was the Basel Committee on Banking Supervision, created by the Group of Ten (G10) to stabilize national financial systems in response to the changing global environment. More often than not, however, advanced economies could not agree on the right response to crises. Some believed that international institutions needed more firepower to help tame global markets. Others worried that provisions for crisis insurance would reduce incentives for investors and countries to avoid crises themselves. Emerging economies, for their part, often trusted in national self-help, building up large reserves, and in some cases limiting capital flows, rather than relying on global institutions.
Aside from its inability to prevent financial crises, the global financial regime has also failed to adjust to tectonic shifts in the international distribution of economic power, particularly the rise of China, India, and other emerging-market economies (EMEs). The governance structures and voting weights in international financial institutions continue to give disproportionate weight to economically smaller countries. The Netherlands and Belgium, for example, have voting shares close to those of China, despite large differences in their global economic weights. IMF shareholders have committed to reexamining the current voting arrangements by the next quota review in 2011—and the Obama administration has tentatively supported readjustment—but the European Union remains skeptical. A similar discussion surrounds World Bank reform, whereby emerging economies want greater representation and advanced economies fear ceding power. The situation, however, is more hopeful when it comes to less formal institutions of economic coordination. In particular, the emergence of the G20 at the Washington summit of November 2008—followed by G20 meetings in London and Pittsburgh in April and September 2009—ranks among the most important breakthroughs in global economic governance in the past two decades.
Coordinating macroeconomic policies and exchange rates: A weak system since 1973
One major shortcoming of the global financial architecture is the lack of any robust mechanism to allow the world’s economies to coordinate their macroeconomic policies, including exchange rates. This gap has become acute in recent years, encouraging massive structural imbalances between surplus and deficit countries, and leading some to question the future of the dollar as the main global reserve currency. And while the global financial crisis has encouraged ad hoc efforts, these have not been institutionalized in an international regime.
Under the Bretton Woods system, the dollar’s value was linked to gold, and other currencies were pegged to the dollar. But when Bretton Woods ended in 1973, no mechanism of multilateral coordination emerged to replace it. After the end of Bretton Woods, Europeans became alarmed by the volatility of exchange rates and created the euro as a common European currency. Emerging economies, meanwhile, rarely allowed their currencies to float freely, which triggered several crises in the 1990s. More recently, the unprecedented buildup of foreign-exchange reserves by emerging economies led some economists to declare the emergence of a new Bretton Woods system—or Bretton Woods 2—marked by unilateral pegs to the dollar. The currency gap has become particularly acute in recent years, encouraging massive structural imbalances between surplus and deficit countries. The United States consistently ran a current account deficit of $700 billion or more, while Asian commodity exporters racked up large surpluses. The current account surplus of China alone rose from $20.5 billion in 2000 to more than $400 billion in 2009.
Because national policy choices continued to spill over to other economies—even in a world of largely floating exchange rates—policymakers and commentators alike called for more coordinated macroeconomic policies. International organizations, such as the IMF, the Organisation for Economic Cooperation and Development, and the Bank for International Settlements (BIS), sought to meet this need by providing financial guidelines for governments and promoting greater coordination. Less formal institutions, like the Group of Thirty, sprang up. But national imperatives usually trumped global cooperation efforts, and particularly when times were good.
Only the latest financial crisis was able to prompt new and extraordinary levels of cooperation among the central banks of the world’s leading economies. In October 2008, for example, the Federal Reserve, Bank of England, European Central Bank, and People’s Bank of China implemented a round of coordinated interest-rate cuts. The Federal Reserve gave European banks unprecedented access to U.S. dollars to buttress them in case of a bank run. Most major economies also tried to enhance global demand by loosening fiscal policy.
But cooperation in these ad hoc interventions has been difficult to sustain. Countries like Germany have resisted U.S. calls for a larger, coordinated policy response to the crisis. China remains reluctant to discuss its exchange-rate regime in international forums. The United States believes that policy changes in the major creditor countries (such as an appreciation of the Chinese yuan) can address the world’s imbalances without a fundamental change in the exchange-rate system. Meanwhile, emerging countries like China advocate broader changes in the system, including a shift away from dollar reserves. Although the latest financial crisis encouraged ad hoc efforts to remedy the imbalances, the efforts have not been institutionalized in any new international regime.
Monitoring and regulating financial standards and financial activity: A persistent Achilles’ heel
Another major weakness of the global financial system is the lack of a coherent regime of rules for monitoring, regulating, and standardizing financial activities. The current system is an uneven patchwork of regulatory efforts and entities, sometimes with overlapping mandates and jurisdictions. Creating a more coherent regime is necessary for increasing transparency in the markets, preventing diversion of resources, and tracking potentially excessive risks. A more coherent system would also make it easier to spot rotten players (or practices) and quarantine them before they infect the entire system.
But before any such regime gets built, participants must agree that they want to limit excessive risk-taking in the first place—a difficult precondition to set. One school of thought holds that regulations give investors false comfort and thus leads them to pay too little attention to the risks of lending to a regulated institution. Others argue that regulation introduces distortions that lead to bad investment decisions.
Financial policymakers first realized the need for more transparency and accountability in the mid-1970s. The first international banking crisis of the postwar era prompted the creation of the Basel Committee on Banking Supervision, which was charged with coordinating national banking supervisory policy. In the 1980s, the debt crisis revealed that many large international banks did not have the capital to absorb an outright default on their loans, leading to almost a decade of rescheduling—or revising repayment timeframes—to give the banks time to build up their capital. In an effort to avoid such crises in the future, the Basel Committee adopted common standards for evaluating risk-weighted capital. After the Asian financial crisis, similar attention shifted to improving the quality of bank supervision in emerging economies. In 1997, the Basel Committee released its Core Principles for Effective Banking Supervision (PDF) and the IMF, in conjunction with the World Bank, began to systematically assess supervision in its macroeconomic health checks through the Financial Sector Assessment Program.
Several similar arrangements emerged in the securities, insurance, corporate governance, accounting, and auditing sectors. In addition, the Joint Forum of Financial Conglomerates and the Financial Stability Board promote overall coordination and cooperation by regularly bringing together overseers of the global financial system. The OECD and the World Bank have also pitched in, leading international discussions on corporate governance standards, insolvency, and bankruptcy.
But global regulatory entities have four obvious flaws. First, financial consolidation has not been matched by regulatory consolidation. Second, regulation remains fundamentally national, and external verification and assessment mechanisms are weak. Virtually no organization has the power to enforce their standards, rules, and guidelines—or to sanction countries that fail to live up to global standards. Third, reaching agreement on global standards has been difficult. Some countries, like the United States, remain reluctant to incorporate new standards they consider inferior to existing national legislation. Some other countries fear that strengthening global standards will force them to eliminate practices they hoped would give their financial sector a competitive edge. Finally, important new financial players have fallen through the cracks of such intricate bureaucratic tissue. Central banks, finance ministries, and bank regulators, for example, were surprised to discover the extent to which new actors in the shadow financial sector—which consists of unregulated special-investment vehicles and broker-dealers—had taken on the risks associated with risky mortgages.
Managing financial crises: Ample space for improvement
Under the current global financial regime, the world has found itself vulnerable to severe financial crises but unable to manage them successfully. The IMF, ostensibly the premier fire-fighter in such circumstances, has often under-performed. And in the absence of a single authority, states have created their own dizzying array of bilateral and multilateral arrangements to help cushion against financial crises.
Excessive volatility in financial flows has become a hallmark of the global economy. In some cases, countries suddenly lose access to market financing and find that they can no longer finance substantial deficits. Likewise, short-term financing for financial institutions can dry up equally quickly—be they special-investment vehicles that have to roll over short-term asset-backed commercial paper, U.S. broker-dealers that rely on the repo market to obtain financing from money market funds, or European banks that rely on the wholesale market. And financial contagion affects weak and strong investments alike. Losses in one portion of a portfolio may prompt a leveraged institution to sell other assets, pushing the price of healthy assets down. Once investors begin confusing sound investments with unsound ones, financial institutions can lose confidence in one another.
The IMF is the key institution for managing financial crises. In the face of a domestic financial crisis, a domestic lender of last resort usually supplies (in theory unlimited) financing to financial institutions facing liquidity trouble. Similarly, the IMF took on some of the functions of lender of last resort when currency crises swept the developing world in the 1990s. It even created two new emergency credit facilities, the Supplemental Reserve Facility of 1997 and the Contingent Credit Lines of 1999, to facilitate more financing more quickly than under its traditional lending facilities.
But the IMF continues to attract sharp criticism and doubt. The IMF issues its loans with a variety of conditions, which often impose painful fiscal rigor on crisis-battered societies. Many in the developing world see the IMF as an agent of the Washington Consensus, which consists of policy prescriptions originally designed in the United States. Others question the discretionary nature of its intervention because it lacks clear standards for determining how much financing countries should receive. Some economists even argue that the existence of the IMF prompts governments and investors to pursue reckless policies because they know they can receive IMF loans if their investments fall through. Finally, critics question the fundamental efficacy of the IMF because, unlike domestic lenders of last resort, the IMF’s lending capacity has always been limited. As one expert notes, “Neither the IMF nor the BIS nor any other international organization has the authority to create and extinguish reserve money.”
Concerns with the IMF prompted a slew of new bilateral, regional, and multilateral institutions—including the Brady Bonds and the Chiang Mai Initiative—all aiming to supply a troubled country with the foreign exchange it needs in a crisis. In 2008, the Fed provided an unlimited supply of dollars to European central banks through reciprocal swap lines, so that the banks could act as dollar-lenders of last resort to the banks they regulated. At their peak, the Fed’s swap lines topped $600 billion, which exceeded what the IMF could ever have made available. The Fed also signaled that it would provide $20 billion to four emerging economies: Singapore, Korea, Mexico, and Brazil.
But efforts to manage crises without the IMF never fully succeeded because they have their own drawbacks. For example, expectations that debt will be restructured or rescheduled can prompt investors to pull out quickly at the first hint of trouble. Likewise, efforts to better restructure sovereign bonds would still not stop domestic or cross-border bank runs. The IMF therefore continued to play an important role in the latest crisis, providing traditional conditional loans to Iceland (its first loan to a developed country since the 1970s), as well as to Hungary, Ukraine, Pakistan, Latvia, and Romania. The IMF even created a new facility (without any conditions) for countries judged to already have relatively sound policies. Mexico, Colombia, and Poland all quickly obtained the new flexible credit line.
To quell fears that this wave of lending would exhaust the IMF’s resources, the United States proposed expanding the New Arrangements to Borrow to provide the IMF with up to $500 billion in supplementary financing. The IMF’s members also authorized a Special Drawing Rights allocation, which expanded the IMF’s global pool of reserves by giving each member additional reserves in proportion to their contribution to the IMF. Recent developments have increased IMF resources to $1 trillion.
Supporting Development: Some progress, but still starving for aid
*Editor’s Note: Analysis of development finance will be examined in greater detail in an upcoming installment of the Monitor on Development.
A final shortcoming of the current global architecture is the disproportionate effect financial crises have on low- and middle-income countries. Poor countries are notoriously vulnerable to negative spillover effects that culminate in rampant poverty, mass unemployment, and food shortages. Over the years, multilateral development agencies and the IMF have refashioned their policies to more effectively support financial sector stability and growth, and to encourage financial activity through incentive programs. However, the situation in developing countries remains dire.
Multilateral efforts to address the needs of the developing world extend back to 1945, when the architects of the Bretton Woods system created the World Bank to support postwar reconstruction. Many capital controls were dismantled, and private capital markets emerged as an alternative source of long-term financing. But countries with rudimentary financial and banking infrastructure or unstable governments still struggled to attract private investment on any but the most onerous terms. Concerns that development failure might spill into neighboring economies created a demand for multilateral development support. The World Bank increasingly focused on helping the world’s poorest economies, and in 1960, it set up its International Development Association, or so-called soft loan window.
Today, the World Bank continues to make loans to middle-income countries with access (in good times) to private markets. These loans are priced commercially so they provide the World Bank with a profit, part of which is used to subsidize concessional assistance to poorer countries. In addition to being a financial intermediary, the World Bank has become a knowledge intermediary: it disseminates lessons and experience by maintaining programs in dozens of countries. Regional development banks have sprung up with similar objectives.
In recent years, the developing world gained yet another source of financing: government-backed firms from the Middle East and Asia, particularly China. Such investment, together with renewed private investment in mines and oil fields when commodity prices soared, pushed investments and loans to Africa from $11 billion in 2000 to $53 billion in 2007. Such investors offered governments an opportunity to sidestep the transparency requirements, performance monitoring, and governance rules attached to loans from development banks or Western ministries.
The financial crisis of 2008 left poor countries in particularly desperate need of funds to counter a slump in foreign direct investment, remittances, and rising commodity prices. Thankfully, industrialized countries have stepped up to the challenge. In the past year, the OECD reported an increase of net ODA to approximately $120 billion—the highest ever recorded. Nonetheless, fulfilling commitments outlined at the 2005 World Summit remains critical to ensuring durable economic development. In many cases, domestic policies in low- and middle-income countries need to become more countercyclical and targeted to address systemic vulnerabilities in financial markets. And development banks and the IMF will inevitably play a critical role in spurring economic growth and extending liquidity as the crisis continues to play out.
Major weakness in the international financial system:
Some people blame the crisis on global sources. When he was a governor on the Federal Reserve Board, Ben Bernanke argued that the U.S. deficit reflected high savings rates in emerging countries, which pushed down interest rates, pushed up home prices, and induced more borrowing in the United States. The United States could not have sustained large external deficits had other countries not run large surpluses. Nor could the United States have received such massive foreign financing had foreign governments not built up their own reserves.
But the United States has been a champion of free markets, the architect of the Bretton Woods system, and home to one of the world’s leading financial capitals. Despite evolving from the world’s leading lender to the world’s largest borrower, the United States has been the major promoter of a liberalized global financial system. In the aftermath of the global financial crisis, many therefore see the United States as the major culprit of the crisis.
To be sure, the rise in the U.S. fiscal deficit, especially from 2002 to 2004, contributed to the rise in the U.S. external deficit. And Wall Street clearly helped fuel the rise in home prices—and the subsequent bust—by engaging in risky behavior, including securitizing so-called innovative mortgages, failing to document income, ignoring the need to insist on a down payment, and making ever-bigger bets with more borrowed money. The complexities of the securitization process and the opaqueness of major financial intermediaries made it difficult to discern which institutions were most vulnerable to falling housing prices. As it became clearer that securitization had not dispersed risk away from the financial system, banks lost confidence in each other, and after Lehman Brothers failed, money-market funds stopped lending to most financial institutions. Without access to credit, banks stopped lending, causing a credit crunch. The dollar, surprisingly, rallied during the crisis as investors flocked to the safety of the Treasury market.
The United States was not the only country that experienced a housing boom, but the size and importance of the U.S. markets meant that the collapse of important U.S. institutions sent shock waves around the world. After Lehman Brothers collapsed, credit to emerging economies dried up. Countries that previously thought they had enough reserves to weather any crisis found themselves under pressure and some turned to the IMF. In fact, so many countries found themselves in need of help that the IMF’s available funds began to look too small.
The collapse of previously reputable financial institutions tarnished the reputation of the United States. Chinese Premier Wen Jiabao blamed Wall Street’s “blind pursuit of profit” for undermining the global economy, and French President Nicolas Sarkozy called on the United States to overhaul its financial system. Russian Prime Minister Vladimir Putin even called for an end to overreliance on the “dangerous” dollar. Low U.S. interest rates didn’t make U.S. financial assets particularly attractive once the panic subsided and the size of the U.S. fiscal deficit raised concerns about the U.S. commitment to fiscal sustainability. Many countries that criticize the dollar still peg their currencies to it, but the size of the Treasury’s borrowing leaves the United States vulnerable to long-term interest-rate increases. A global loss of confidence in the U.S. dollar and U.S. Treasury bonds could make it harder for Washington to borrow the cash it needs to jump-start its economy.
As U.S. households cut back, U.S. imports are falling, bringing the U.S. trade deficit down even as the fiscal deficit increases. But there are concerns that the world might end up relying too heavily on the U.S. stimulus to jumpstart global demand, leading to a reemergence of some of the imbalances that characterized the pre-crisis world. Influential Financial Times columnist Martin Wolf warns that excessive borrowing by U.S. and European households might be replaced by excessive borrowing by U.S. and European governments. Yet Wolf and others also recognized that restraining the scale of the stimulus could limit the speed and scale of the recovery. Balancing the short-term needs to support demand with the long-term needs for economic adjustment thus remains a challenge.
In response, the Obama administration has urged more rigorous global financial regulation, pushed for a broad, global fiscal stimulus so the United States is not the sole engine of global demand, called for a dramatic expansion of the IMF, and encouraged China to allow its currency to appreciate. These and other issues have sparked ongoing debate in the United States over several fundamental policy choices.
Does global finance need sweeping regulation?
Yes: Paul Volcker, a former Federal Reserve chairman and Obama White House special economic adviser, says the current crisis shows that the international financial system is in dire need of tighter regulation. A recent report (PDF) by the G30, a private gathering of some of the most experienced and knowledgeable financial and economic experts from the private and public sectors, called for increased oversight for all major financial institutions whose failure would be disastrous for the global system. Volcker, who served as the report’s lead author, went as far as recommending that regulators keep banks small “so that any failure won't have systematic importance.” The G30 report focused on drawing a roadmap for a regulatory shake-up in the United States. In contrast, the work of the Financial Stability Forum—now the Financial Stability Board produced a blueprint (PDF) for global reform. Proposed reforms include: 1) giving the Federal Reserve a role as a systemic risk regulator, with the task of protecting the system by gathering information about the major financial institutions; 2) banning, or at least regulating, credit default swaps, which are a type of unregulated credit derivative whose associated risk is often difficult to calculate; 3) nationalizing and breaking up troubled banks so that the government can more easily clean their books of their bad assets; and 4) changing the way bankers are paid to reduce incentives to take large risks.
No: Few question the need for reform, but some caution against going too far. Excessive restrictions and government mingling might slow economic recovery by suffocating creative market dynamism. If the government’s hand reaches too deep, politicians and policymakers may be tempted to use regulations to pursue their own agendas, creating dangerous distortions in resource allocation. In sum, these critics argue that today’s painful recession should not make us forget the remarkable results of the past twenty-five years. Stifling financial innovation would be even more costly than the current crisis.
Others argue that instead of regulating too-big-to-fail institutions, the system needs to be made safe for failure—allowing markets rather than regulators to discipline financial institutions. Still others worry that reforms may concentrate too much power in the hands of a few regulators, such as the Federal Reserve, without eliminating the risk of regulatory capture. Moreover, adding new mandates to existing institutions could draw energy and attention away from traditional duties. These voices consequently favor limiting the Fed’s regulatory responsibilities.
Should regulation come through a new global architecture?
Yes: Despite calls from analysts like Richard Cooper, who argued as early as 1984 that global financial markets could not last in the long term, proponents have only now begun to rally support for a truly global financial governance regime. European leaders have been particularly vocal, with European Central Bank President Jean-Claude Trichet urging increased vigilance and a three-pronged approach based on “macroeconomic discipline, monetary discipline, [and] market discipline.” The deep impact of the 2008 financial crisis has persuaded some economists and policymakers to favor a comprehensive financial architecture that looks not only at banks and coordinating macroeconomic policies, but also at the shadow financial market, including enhanced regulation and transparency of investment banks and derivatives. Other analysts have added to the plea by pointing out that the current financial system is too big to be rescued by one national government, and needs a more robust governance body to offer viable rescue packages.
No: Critics of a new Bretton Woods approach believe that the ills of global finance can in large part be cured at home. National policies, they argue, will do more to address the key problem of excessive bank leverage than new global rules. “The fix that rightly commands widest support,” Sebastian Mallaby writes, “is moving the swap contract between financial institutions onto centralized exchanges so that the collapse of one large player does not threaten others.” This reform, he noted, would require only a minimum of financial coordination. Looking at the aftermath of the Asian financial crisis, The Economist argues that huge foreign reserves, flexible exchange rates, and stronger banking systems proved more powerful than international initiatives in spurring economic recovery. Others, such as former Treasury Secretary Henry Paulson, believe that new, intrusive international rules will not only be useless, but also damaging, because they will inevitably rely on a one-size-fits-all approach. And a final group argues that, regardless of whether a theoretical global system would work, it will never see the light of day because countries will simply refuse to turn over real power to international regulators.
Should there be more support for global rebalancing?
Yes: Many analysts agree that a root cause of the current financial crisis has been the global imbalances that have been accruing since the 1990s. Supporters of global rebalancing efforts feel that larger structural changes need to occur to bring these imbalances in check. The U.S. consumer can no longer serve as the engine of world growth. Surplus countries, particularly China and Germany, need to save less and stimulate domestic demand. Better social safety nets in China would decrease the need for high savings rates. The United States must save more—which, in fact, it is already doing—and increase the role of exports in its economy. The corrections in 2009 are fragile and have relied on large fiscal stimuli that are unsustainable in the long run.
No: Critics contend that a global correction is already under way. The 2008 financial crisis has driven global demand lower, contributing to a decline in the U.S. trade deficit, higher savings rate among U.S. households, and a correction in the U.S. exchange rate. Moreover, if countries were to pursue coordinated policies to tackle global imbalances, the question of who would be tasked with spearheading these efforts remains unanswered. The G20 has not adequately addressed the concerns at the London Summit, choosing instead to focus on expanding IMF resources. Some also believe that the informal institution may also be too big to prescribe consensus-based global rebalancing policies. A smaller grouping—such as a G4, representing the European Union, United States, China, and Japan—might be most practical, although agreements would still have to be reached on measures and how to implement them.
Does the world need a new global reserve currency?
Yes: Many countries—particularly creditors like China that hold vast dollar reserves—believe that there is too much reliance on the dollar. Proponents argue that the existing dollar reserve system is slowly eroding as countries with large dollar reserves witness diminishing real values in their U.S. bond holdings without any control over the dollar’s volatility. Overreliance on a few currencies makes the financial systems less stable and increases the likelihood of inflation. An international reserve currency with a stable value would promote economic stability. Russia and China have both proposed using the IMF’s special drawing rights (SDRs) as the new global currency.
No: According to the United States, national reserve currencies and the absence of a global reserve currency are not the problem. The problem is that some countries want to maintain undervalued exchange rates to support their export sectors. This leads to a buildup of foreign exchange reserves and contributes to global imbalances. The problem thus lies not with the reserve currency, but with policy choices.
International Financial Institutions Reform
In the spring of 2008, the IMF committed to a long-awaited quota reform plan that rebalanced representation of member states in an effort to enhance institutional legitimacy. The reform consisted of agreements on a new quota formula, quota increases based on the new formula, and a commitment to reassess quota shares every five years. Despite signing on to the reform process, some countries—notably from the European Union—have been dragging their feet to slow the rebalancing process.
With the onset of the financial crisis, calls for a profound change in the institutional makeup of the IMF reemerged—this time supported by the Group of Twenty (G20)—an expanded informal grouping of economic heavyweights. At the IMF-World Bank Annual Meetings on October 6, 2009, IMF Managing Director Dominique Strauss-Kahn urged member states to pass legislation related to the 2008 quota and voice reform and supported a G20 proposal to redistribute “at least 5 percent” quota shares to underrepresented countries.
Group of 20
On April 2, 2009, leaders of the twenty major economies delineated a plan to recover from the global financial crisis. The London Summit Communiqué (PDF) generated praise from major economies and developing countries—as well as regional bodies and international organizations—for its commitment to reshaping the global economy. Prime Minister Gordon Brown praised the summit for creating “a new world order” and President Obama called it a “turning point.” The leaders pledged to restore confidence in the global economy by restoring lending, strengthening financial regulations, promoting global trade, and reforming global financial institutions. On the latter specifically, leaders committed to make an additional $1.1 trillion in resources available to international financial institutions such as the IMF, World Bank, and other multilateral development banks (MDBs), including a $750 billion expansion of the IMF’s resources and an additional $100 billion for MDBs to increase their lending capacity.
After the excitement of the April 2009 London Summit, leaders convened later in the month for the World Bank and the IMF spring meeting in Washington, DC. This was the first opportunity for the global community to clarify how to raise the funds promised at the London summit, particularly the $500 billion for the IMF—the single largest portion of the $1.1 trillion commitment. Leaders reaffirmed their pledge to boost IMF resources, committing to $250 billion in agreements.
On September 25, 2009, G20 leaders met again in Pittsburgh, where they agreed to elevate the G20 as the “premier forum for our international economic cooperation,” relegating the Group of Seven/Group of Eight (G7/G8) from its role as the top forum on global economic issues. The meeting resulted in a renewed commitment to reforming international financial institutions, including a quota shift of 5 percent at the IMF by early 2011 and the inclusion of emerging economies in the Financial Stability Board (FSB). The heads of state also agreed to strengthen the international financial regulatory system and to launch a new Framework for Strong, Sustainable, and Balanced Growth, which promotes a cooperative policy framework for sustainable global growth.
The Global Financial Crisis and U.S. Leadership
By early 2009, mounting job losses, thinning corporate profits, contraction in industrial production, and adjustments in the housing market had left the U.S. economy in the midst of its worst recession since the Great Depression. In response, the new Obama administration put forth The American Recovery and Reinvestment Act of 2009 (PDF), enacted by Congress on February 17, 2009. The plan provided the U.S. economy with roughly $800 billion of fiscal stimulus targeted at helping low-income and middle-class Americans. In broad strokes, the plan consists of federal tax relief, expanded social welfare provisions, and increased domestic spending for infrastructure. The stimulus package, however, faced opposition from conservative critics in Congress, as well as liberal economists like Paul Krugman who called for a larger handout of up to a trillion dollars.
In an effort to provide relief to the beleaguered banking sector and to revitalize credit flows, Treasury Secretary Timothy Geithner introduced the Financial Stability Plan (PDF) on February 10, 2009. The plan consisted of four components: first, stress tests for banks that determined which institutions needed support; second, a public-private investment fund that provided government capital to assist private markets; third, a trillion dollar commitment to bolster a consumer and business lending initiative; and, last, the launch of a comprehensive housing program. On May 7, 2009, the Federal Reserve released the results of the stress tests, indicating that nineteen institutions would need approximately $75 billion in additional capital.
At the international level, the turmoil of the financial crisis and its widening impact on poorer countries led the UN General Assembly to set up a Commission of Experts on Reforms of the International Monetary and Financial System to assess the severity of the financial crisis and propose recommendations. The commission, headed by Nobel Laureate and Former IMF Chief Economist Joseph Stiglitz, produced a preliminary set of recommendations in early 2009 highlighting strategies for immediate measures and suggestions on a slew of issues, including global institutional reform, financial market regulation, and debt relief programs. The commission has been recognized as an unbiased authority of specialists with a deep understanding of the interrelated issues in global finance and economics. Notable recommendations thus far include the creation of a global economic council to address the integrated economic system in a more comprehensive way, which the commission believes could “provide a democratically representative alternative to the Group of 20.” The report also calls for stricter regulations and enforcement mechanisms for complex financial instruments and credit rating agencies, which have been questioned for their inability to determine adequate risk profiles of certain financial assets.
The global economic meltdown has triggered a variety of operational and normative challenges in both finance and economics. The need to find effective strategies that both solve today’s financial crisis and enable a speedy recovery from the economic downturn is putting pressure on the United States and other major economies. While strengthening multilateral mechanisms remains the foundation for responding to the challenges of financial crises, gravity must also be placed on enforcing coordination of domestic policies, particularly among the top twenty industrialized nations.
In the near term, the United States and its partners should pursue the following initiatives as part of its response-and-recovery tactic:
Meet G20 commitments
At the London summit, the G20 countries pledged to ramp up the IMF’s lending capacity. Thus far, more than $400 billion of the $500 billion promised by member countries has been pledged to the IMF in tangible agreements. The Obama administration has pledged to contribute up to $100 billion toward the IMF’s New Arrangement to Borrow Fund, with legislation authorizing the U.S. contribution to come from part of its war-funding legislation. Congress has approved the expansions to the IMF, though the scurried efforts to reach consensus raised concerns about the capacity of the United States to supply such a large amount during a domestic economic upheaval. Some have noted that delivering on the $100 billion pledge is essential if U.S. leadership is to be espoused in an increasingly integrated global economy. Additionally, the G20 commitment to financial regulatory reforms that tackle widespread gaps in capital markets supervision remains piecemeal.
Enhance the IMF’s monitoring and surveillance capabilities
The current economic crisis has reaffirmed the need to enhance the IMF’s role as a global provider of oversight and surveillance. The institution’s inability to foresee the devastating effects of the U.S. credit crunch has heightened the call for resources dedicated to a more robust early warning system that can adequately assess complex economic linkages and evaluate the risk for spillover effects. Experts have suggested (PDF) that a strengthened and globally representative program would benefit from timely and analytical macroeconomic reviews, better policy coordination, and more commitment to acting on warnings. The United States and the international community at large must wholeheartedly commit to such a framework.
Coordinate fiscal stimulus
The contraction in the global economy, the continuing deterioration in the EU and U.S. housing markets, and the drying up of credit lines are forcing leaders to rethink strategies to spur economic activity. The Obama administration has enacted an aggressive stimulus package and, similarly, other G20 countries have been shaping stimulus packages to mitigate the ensuing risks from the financial crisis. Numerous policymakers, however, have voiced concerns over independently crafted measures that cater to country-specific needs without much regard to the global economy. The need for global coordination of fiscal stimulus was raised by the chief economist of the World Bank, Justin Yifu Lin, who indicated at the annual Davos meeting in 2009 that fiscal stimuli would not work unless coordinated globally. The IMF has echoed this plea by adding that the stimuli will have to be sustained in 2010.
Encourage and implement IMF governance reform
The architecture of the IMF is considered outdated and reminiscent of the global distribution of power in 1944. The IMF has taken the first step to modifying its governance structure by increasing the quota of fifty-four countries in April 2008. Since then momentum on quota reform has been slow. In March 2009, a commission headed by South Africa Finance Minister Trevor Manuel released a report (PDF) consisting of sweeping governance reforms to enhance the IMF’s credibility as a relevant institution grappling with today’s economic realities. Recommendations include initiating a review that would allow greater representation for emerging economies by realigning quotas based on current economic weights. The United States and its partners need to formally endorse this report and the steps needed to implement the structural revisions it outlines.
Beyond the aforementioned near-term steps, the United States should consider another set of important proposals:
Improve regulatory standards to mitigate financial risks
Experts and policymakers have placed much of the blame for the current financial crisis on weak regulatory standards and inadequate supervision of sophisticated financial activities. Although progress has been made, particularly in the developing world, to strengthen financial systems, the complexity and integrated nature of modern finance poses new sets of challenges for regulation and supervision. The newly formed Financial Stability Board, formerly the Financial Stability Forum, provides enhanced monitoring of potential vulnerabilities, including, for the first time, hedge fund activities. Financial Stability Board recommendations remain advisory, however, and have no legally binding enforcement mechanism. This makes the need for financial regulation at the country level indispensable to global financial stability. Given the need to monitor numerous facets of capital markets, including credit rating agencies, over-the-counter derivatives trading, and the use of financial leverage, the proposals by some academics to empower the central bank to act as the primary authority for oversight and regulatory jurisdiction may be a sensible place to begin. Policymakers must, however, be careful to implement sound regulations without discouraging the risk-taking needed for the economy to grow.
Foster good housekeeping policies
Unsound domestic policies have contributed to both the onset and the spread of the current global crisis. To mitigate future crises, prudent domestic regulations and macroeconomic policies are in order. These would entail managing exchange rates and balance-of-payments to reflect stable economic fundamentals, as well as ensuring a transparent and sensible banking system. For emerging economies, such discipline can be encouraged by providing rewards, including more favorable lending terms by the IMF (a recommendation which was also offered by CFR’s independent Task Force on Safeguarding Prosperity in a Global Financial System in the aftermath of the Asian financial crisis).
Finance the developing world
The economic recession that followed the global financial crisis has had a serious effect on developing countries. Export demand collapsed, commodity prices fell (though they have subsequently rebounded), and the flow of both remittances and private capital shrank. The World Bank estimates that 130 to 155 million people have fallen into extreme poverty. Tackling the crisis should ideally involve policy prescriptions that respond to the needs of this very group—the poor in the developing world. Thus, in addition to commitments to the IMF, the United States and its industrialized partners should commit to multilateral financing for development banks and reject protectionist measures in international trade.
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