About three months ago, the editors of Finance and Development (an IMF publication) asked me to reflect on the lessons the effort to reform the international financial architecture in the 1990s holds for today’s effort to reform the global financial system. Then, as now, there was a real desire to create a system that was less prone to major crises -- though the financial crises of the late 1990s were concentrated in the emerging economies, not the US and Europe.
One of my conclusions was that summits rarely are the venue for the key decisions that end up defining the character of the world’s financial system. Many of the decisions that ended up mattering the most were fundamentally national decisions. Other key decisions were made in the heat of an acute crisis -- not in a conference room hashing out communique language.
The US decision to provide Mexico with a large loan to avoid default in 1995, for example, had a bigger impact on the global regime for responding to acute financial crises in emerging economies than any subsequent communique. The US decision ended up spurring the IMF (with US support) to offer a large loan first to Mexico and then to other emerging economies. Lots of time was spent talking about the need to return to a world of smaller rescue loans, but it never really happened. A new norm had been established. The conditions that the IMF -- with the support of the US and the rest of the G-7 -- attached to their initial loans to cash-strapped Asian economies in 1997 had an equally profound, though different, impact: even if the IMF was willing to lend more than in the past, no emerging economy wanted to be subject to the IMF’s conditions if there was a realistic alternative.
The global exchange rate system of the past decade was defined by China’s decision to stick to its dollar peg. That fundamentally was a national decision -- though one that had profound consequences for the system. If China hadn’t followed the dollar down from 2002 to 2005, China’s current account surplus wouldn’t have grown as large as it did, China’s reserves wouldn’t be as large as they are and China’s economy wouldn’t be as dependent on exports as it is.
The system of global financial regulation was defined by a deep reluctance by key nations to regulate financial institutions too tightly -- an unwillingness, incidentally, that was shared by both the US and Europe. Markets were trusted more than regulators, and no one wanted to lose financial business to a rival financial center. Alas, the financial system ended up extending ever-more credit against ever-higher real estate values without a corresponding increase in the capital needed to absorb downside risks.
When economic and financial historians look back at the current crisis, I would bet that they will also focus on key national decisions. My list would include:
The United States’ decisions not to support Lehman -- and the United States’ decision a few days later that it had no choice but to bailout AIG. The aftershocks of Lehman’s failure demonstrated that many institutions really were too big to fail and needed to be regulated accordingly; the bailout of AIG illustrated that a broad set of institutions could be source of systemic risk. That made a change in US regulation inevitable. And since individual countries bailout (and regulate) the major global financial institutions, a change in US regulation is in some sense a change in global regulation.
The US decision to provide an unlimited supply of dollars to Europe’s central banks so they could act as lenders of last resort -- and then to extend (somewhat more limited) swap facilities to the currencies of four emerging market economies effectively transformed the Fed into a global lender of last resort. At least for those institutions needing dollars based in countries whose currencies was considered acceptable collateral.
China’s decision to remain pegged to the dollar. So long as China’s dollar peg remains in place, the current crisis is likely to produce more profound changes in national financial regulation than in the international monetary system.*
China’s decision to shift its reserves from Agencies -- and likely other somewhat risky assets -- to Treasuries may prove to be equally consequential. The total size of China’s US portfolio probably hasn’t increased all that much over the last six months. But the shift toward Treasuries has made the scale of China’s US portfolio a lot more visible, both inside China and in the US. The risk of large losses in the Agency markets certainly seems to have alerted China’s leaders to the risks of holdings a large portfolio of reserves -- though it isn’t yet clear whether the shift in China’ rhetoric augers a real shift in policy.
The US decision to adopt a large fiscal stimulus clearly ranks up there -- as does Germany’s reluctance to encourage Europe to follow suit.
Nor have all the key decisions been made by national governments acting alone. The countries of the world collectively decided that they were willing to lend a number of Eastern European countries ten times their IMF quota, or over 10% of the crisis’ countries GDP. That made it clear that the IMF’s stated lending norms weren’t the IMF’s real lending norms, something that IMF formally acknowledged a few weeks ago when it raised its "access" limits.
This though isn’t though an argument against summits. Summits are often a useful spur to national decision-making. Few countries want to appear to be pushed to take a major decision by international pressure. At the same time, a desire to ward off international pressure can be a spur to domestic decision-making. The deadline created by an approaching summit can concentrate the mind.
China announced a large fiscal stimulus last fall primarily because its own economy was slowing. But the fact that China knew it would face pressure to support domestic demand globally at a series of global summits also likely pushed China’s domestic decision-making process along. The Obama Administration’s proposed regulatory reforms respond to a real domestic need. But they also provide President Obama with a positive agenda to push globally.
Moreover, the London summit also looks poised to do more than just highlight existing areas of agreement (formulations like "we agree to what is necessary ... can mask disagreement over what is necessary") and bless existing national decisions. Above all, the leaders look set to expand the IMF’s resources significantly. That is a real change. A few years back the Bush Administration’s policy was to starve the IMF of resources. Now the US is looking to the IMF to avoid a deep crisis in Europe’s backyard. Simon Johnson has this right:
"The IMF currently has about $250bn to lend; this is not enough to really make a difference in a world of trillion dollar problems. The Europeans proposed to raise this to $500bn, which seems still low - particularly as it’s mostly European countries that have a pressing need to borrow; you guessed it, the Germans don’t want to put up more. The Obama Administration is pushing for closer to $1trn in total IMF funding and, after a lot of hard work, seem likely to get close to this target. In essence, this is a clever way to force the Europeans to help themselves. "
The IMF is also trying to change the way it lends. It has a new facility that allows countries to borrow large sums (theoretically unlimited sums) for long periods of time (three to five years) with any conditions when the loan is made. Not every country qualifies of course. Most Eastern European countries, for example, wouldn’t make the cut. But the new facility does seem to be a real effort to make the IMF’s pooled of shared reserves a viable alternative to high levels of national reserves. And Mexico is interested, in a big way.
Martin Wolf is right to argue that this summit has to be evaluated against the demands created by a very sharp global downturn. The OECD is now forecasting a global contraction of close to 3%. I certainly had hoped that the world’s large surplus countries would do more to support a recovery in global demand -- and in Germany’s case, to facilitate a needed adjustment among the countries of the European Union.
But as a veteran of almost ten years of debate over the scale and scope of IMF lending, I am amazed by the set of changes that seem poised to happen. Here is one benchmark: the reworking of the IMF’s lending facilities goes well beyond anything that Nouriel Roubini and I proposed back in 2004.** Maybe that is more evidence that Dr. Roubini and I were too timid in our recommendations then than that the world’s leaders are acting boldly now. But it is evidence that the realm of the possible has changed.
Read my article for Finance and Development. And let me know what you think of the argument.
*Of course, a world where China is pegging to appreciating dollar will differ from a world where China pegs to a depreciating dollar. But it also isn’t a world where China’s currency floats against the other major currencies.
** Most of the Roubini/ Setser recommendations are in chapter 9