It is no help to say ‘if you want to get there, you shouldn’t start from here’. We are where we are. And crises offer opportunities, not only to clever investors, but to reform-minded politicians. Political leaders can seize the day and lead the reforms, with academics providing ideas.
A ‘New Bretton Woods’ is an evocative but misleading shorthand for the task and the opportunities ahead. Even in the medium run, no new institutions should or will emerge, no global macroeconomic structure or exchange rate system will be devised. Nor will a single country be able to impose its vision. That makes the task harder. Real progress on some of the major issues will require a ‘grand bargain’, whose outlines I shall sketch. But there are other areas where all should realise they could be better off even without difficult tradeoffs.
In a crisis, nothing is impossible. We have already seen policy initiatives that were unimaginable only a few months ago. But those who advocate massive state intervention will be disappointed. This is not a crisis of capitalism nor the market economy, unless bad policies make it so.
Don’t get bogged down in details
Expectations for the G20 meeting on 15 November may be excessive. It will not agree on changes to the institutions of global governance, nor will it come up with an ‘n-point plan’ for dealing with the crisis. Its primary objective should be to bolster confidence by convincing the public and market participants that the leaders understand the issues and have a clear process for confronting them with a reasonable timetable. Commentators should not say afterwards, ‘Fine principles, but where are the details?’ The leaders should convince us that this is a mistaken demand, that their demonstration of unity on the principles and the process goes side-by-side with the short-run measures they are already taking. And if, for example, wide-ranging fiscal stimulus is necessary (as I believe it is), governments are learning that already and need not act explicitly in concert.
They face a new configuration: greater interdependence in both trade and finance, higher global risks, more links among global issues, all in a context of huge disruption to international finance. No decoupling, only deleveraging. Some of the problems are not fully understood. It would be unwise to seek agreement now on specific reforms. Rewriting rules should be the job of technocrats, not politicians – if only because the politicians are understandably inclined to find scapegoats, shoot (or guillotine) the speculators, and shut down markets. But political leadership must set out the principles and how officials should proceed in implementing them.
Principles for the agenda
Some of the desirable principles are broad. The leaders must state their consensus that they will not retreat into protectionism nor try to turn back globalisation, and that they are conscious of the dangers of overregulation. They should indicate that they want strategies to exit in due course from the extraordinary degree of new direct government involvement in financial institutions and markets. International financial integration and domestic financial development, going hand in hand, promote economic growth. So they should take a stand against financial repression and repression of finance. They should explicitly recognise the macroeconomic roots of the crisis in global imbalances, rather than just blaming it on unbridled greed. They should acknowledge that the international institutions are unrepresentative and therefore lack legitimacy and that they are poorly coordinated and in some respects ill suited to deal with key problems.
They could be more specific. The agenda should include finding ways to cut the vicious circles that have made the crisis so grave – the interactions among inappropriate accounting practices, opaque derivative markets, credit ratings, and deleveraging. Financial regulation must be better designed, more comprehensive, more harmonised across countries, and indeed more multilateral. It should focus on incentives as well as on rules. Enforcing greater transparency is also a legitimate and important function of regulation. And the major countries, in particular the US and the UK, must recognise the dangers of regulatory competition and arbitrage.
A new regulatory framework should be based on the principle that financial institutions no longer fall into distinct categories – commercial banks, investment banks, insurance companies, hedge funds, and other financial firms all now overlap. And all require at least regulatory oversight, with varying degrees of intrusive regulation. Those with global or regional systemic importance require global regulation that goes beyond national regulatory authorities and incorporates burden-sharing rules to deal with failures. Outsourcing regulation – as, for example, by ‘hard-wiring’ the ratings agencies into the regulatory framework – should be abandoned, eliminating the ‘regulatory license’ that the agencies now have. Self-regulation should be re-examined with considerable scepticism. Often greater transparency will enforce regulation, so regulators should require it, e.g., by bringing over-the-counter derivatives trading (in particular, the CDS market) onto exchanges.
Officials should ask economists and lawyers who specialise in contracts, incentives and mechanism design to put forward proposals for regulating executive compensation, refocusing managers on longer-term performance, and reducing conflicts of interest.
Principles should relate micro to macro, e.g., acknowledging the procyclicality of the Basel II structure (which would not be cured by substituting leverage ratios for capital adequacy ratios). And on the macro side, the leaders should come down against global capital controls but agree that individual countries may reasonably turn to capital account measures in appropriate circumstances (with IMF assistance rather than opposition), while not reversing financial market reforms. They should not seek exchange rate target zones, grids, or reference rates. They should recognise, however, that exchange-rate movements have often been excessive, sometimes abrupt, with frequent prolonged misalignments, so that exchange-rate management is often warranted (in which sterilised intervention can be effective).
The central institutions for implementing these principles are the International Monetary Fund and the Financial Stability Forum. The latter should not be subsumed into the former. The structure and governance of the IMF, its universality, are inappropriate to regulate the international financial system, in which only a small number of countries are important and no financial resources are required. Instead, the FSF should take on many of the multilateral regulatory activities suggested above, with executive authority and a broader membership. It should include all the countries that are now important in the global financial system. The leaders could now state that this is their intention. The FSF should be responsible for the Financial Sector Assessment Programs that the IMF now administers – and they should be mandatory for all countries, even the largest.
Where would that leave the IMF? It cannot be an international lender of last resort, in the strict sense, nor should it be a ratings agency (for sovereigns), nor prescribe ‘equilibrium’ exchange rates. The Fund should conduct surveillance of macroeconomic policies and current accounts, and henceforth perform explicit capital account surveillance as well. One short-run measure to which the leaders should agree is to increase the resources available to the Fund to deal with the crisis-induced needs of many emerging market countries running large current account deficits or facing major capital outflows.
The IMF must be prodded to come up with new ideas and revive some of the old ones. The Fund has manuals on how to restructure distressed banking systems – where are they? What are the Fund’s ideas on the key macro issues? For example, the Fund should be examining the carry trade: why was it so profitable for so long, how did it affect the capital accounts and exchange rates of ‘target’ countries (most of which are now on the IMF rescue list), and how is it related to the foreign exchange swap market? Most importantly, perhaps, the Fund must fully take on the role of ‘relentless truth telling’ that Keynes expected of it.
What about the G7, and indeed the G20 itself? The former is an anachronism and should simply be abandoned. It cannot discuss decoupling and recoupling, global imbalances, exchange-rate adjustment, or the obligations of surplus countries. A smaller group (with the euro zone having a single representative) should deal with global imbalances and the like, and larger, appropriately constituted groups with other issues highlighted above. Most of the relevant players are in the G20, but some in the G20 are not always relevant. In principle, the memberships should be suited to the issues – a kind of variable geometry.
What they must do
But the key to progress on most of these issues lies in the willingness of major countries to accept some basic propositions. Germany must achieve a deeper understanding of the issues at stake, rather than focusing on whether other countries are just trying to get Germany to bail them out. France has played a more constructive role, but it is still inclined to blame ‘neoliberalism’ and press for policies that will surely be unacceptable to the UK and the US. The UK has to accept that its primary objective should not be to protect the City of London, which will not lose its central role in international finance even if there is more multilateral regulation. China must take on the full responsibilities of a country with $2 trillion in international reserves and some of the largest banks in the world. Japan should play a much more active and positive role in these discussions than it has so far. And most importantly, the US must accept that we are long past Bretton Woods, and it cannot maintain sole leadership and veto power in the international financial system.
In the medium run, this could lead to a grand bargain, in which the central players would be the US and China, but with a key role for the EU (in particular, the euro zone). China and other major reserve holders would use their excess reserves to recapitalise the major financial institutions and would change their domestic policies to reduce their excess savings and hence their current account surpluses. The US would stop China-bashing on both trade and exchange rates. The US and EU would agree on bringing China into the FSF and raising its weight in the IMF. The EU would recognise that it would have more influence in the Fund if it would act jointly, so it would concede that as a set of countries it is currently over-represented and that at least the euro zone should have only a single representative. And the US would give up its veto.
So what is feasible for the meeting on November 15? To agree on principles, though not in the full detail set out above and to set up working groups with fixed but different timetables, though ideally coming to detailed conclusions by spring 2009, when the new US administration should be ready to take some major decisions. The working groups should cover the structure of financial regulation, issues in financial regulation, issues in market structure and the transparency of markets and financial instruments, the roles of the IMF and FSF. Governance of the Fund should be left for later, although giving the International Monetary and Financial Committee of the IMF executive powers should be considered now, as should increasing IMF funding for new facilities and rapid action.
We have no time for the doctrine of unripe time – and if there ever was a moment for wide-ranging reform, this is it. But the political leaders must put great effort on selling all this to a fearful and sceptical public.