Making the case for smart governance
Global economic crises tend to reignite discussions of global governance and international cooperation. This is because crises lay bare the shortcomings of existing international rules and institutions. The recent crisis has been no different.
We have seen how weaknesses and failures in banks and capital markets can spread through the international financial system. The same is true for other challenges faced by the world today, whether we are talking about climate change, nuclear weapons proliferation, or health pandemics. What happens anywhere affects everybody – and increasingly so.
So it is pretty clear that the world needs more, not less, international coordination and cooperation. But how to achieve this goal? In a recent article, Martin Wolf of the Financial Times discussed the importance of global public goods and how to provide them: “The states on which humanity depends to provide these goods, from security to management of climate, are unpopular, overstretched and at odds. We need to think about how to manage such a world. It is going to take extraordinary creativity.”
Wolf is right that we need to be creative to make progress. We need smart governance if we want solutions that work for today’s global economy.
In this column, I focus on three related topics:
- The historical relationship crises have with governance reforms and policy coordination;
- The governance reforms and policy coordination responses since the financial crisis of 2008; and
- My reflections on how global economic governance might evolve – how ‘smart governance’ may provide the right balance between flexibility and effectiveness that the world needs to manage globalisation.
A world in transition
The global economy is in transition. Global economic power is shifting from west, to east and south. Emerging and developing economies already make up more than 50% of global GDP (on a PPP basis), and ten years from now this number is expected to increase to 64%.
At the same time, trade and financial linkages have risen spectacularly. Cross-border bank claims grew from $6 trillion to over $30 trillion between 1990 and 2008, and global merchandise exports of goods and services increased from $4 trillion to $20 trillion. While these numbers contracted somewhat in subsequent years due to the global crisis, the growth rates for the past 20 or 30 years are still impressive.
On the production side, global supply chains have become the norm rather than the exception. A typical manufacturing company today relies on inputs from more than 35 different contractors from around the world – for some companies, such as car and aeroplane manufacturers, this number can range in the tens of thousands.
With the sharp increase in interconnectedness and the growing diffusion of economic power, it would have been reasonable to expect a simultaneous transformation and expansion of global governance. In theory, demand for global governance should have increased with rising levels of global integration, in order to manage the rules of the game and reduce negative spillover effects.
In fact, global governance issues were on the backburner in the run-up to the financial crisis. Indeed, against the background of high growth and low output volatility – what has been called the ‘Great Moderation’ – observers even wondered whether global governance was an outdated concept, and institutions such as the IMF, World Bank, and WTO superfluous.
Only in 2008 – when disruption in a relatively small segment of the US financial system morphed into a full-fledged global financial crisis – did it become clear that there had been an undersupply of global governance in previous years.
Crises as opportunity
Five years after the onset of the global financial crisis, economic governance remains at the centre of the policy debate. This is no surprise, given that historically there has been a symbiotic relationship between crises and the evolution of governance.
Granted, governance is often seen as evolving slowly and in an incremental manner, while crises are intrinsically disruptive and revolutionary. However, crises often bring out the shortcomings of existing governance arrangements, and the fear of recurrence can galvanise support for reform.
For example, in the wake of WWI, the League of Nations was created to promote international cooperation and achieve international peace and security, while experiences of hyperinflation in the 1920s motivated efforts to restore the gold standard. Similarly, the Great Depression and WWII triggered much of our current architecture of global governance, including the creation of the United Nations, IMF, World Bank, and the General Agreement on Tariffs and Trade, now the World Trade Organization. The traumatic experience of WWII also provided impetus for political and economic integration in Europe.
In the US, the financial crisis of 1907 paved the way for the creation of the Federal Reserve, while the bitter experience of the Great Depression led to a major overhaul of financial regulation. The Glass-Steagall Act, which separated commercial and investment banking, passed in 1933 and remained in place for more than sixty years. More recently, the regional currency swap arrangements among members of the Association of Southeast Asian Nations – known as the Chiang Mai Initiative – were created in the aftermath of the Asian crisis.
As with past crises, the global financial crisis of 2008 imposed large costs and hardship on affected countries. However, from an economic governance perspective, it has also provided a window of opportunity to advance reforms and strengthen policy coordination.
Did the world let a good crisis go to waste?
A mixed report card
The efforts in governance reform since the crisis can be broadly split into three categories:
- Coordinating macroeconomic policies,
- Fixing global financial regulation, and
- Strengthening regional and global safety nets.
First, macroeconomic policy coordination. Although not perfect, such coordination was particularly strong at the initial stage of the crisis. In October 2008, six major central banks took the unprecedented step of announcing a coordinated cut in policy rates to ease global economic conditions. The Federal Reserve and 14 different monetary authorities established temporary US currency swap arrangements to mitigate dollar shortages in short-term funding markets. The first ever G20 Leaders’ Summit was convened in November 2008, and led to a commitment to coordinated fiscal stimulus and a pledge to restrain from protectionism.
These massive efforts meant that, instead of another Great Depression, we got the Great Recession – which is actually a significant achievement given the possible counterfactuals. However, more recently, the momentum for policy coordination has slowed, as the focus has shifted from preventing a calamity to avoiding future crises and supporting the nascent recovery. Some have argued that while the G20 was good in war, it might not be able to deliver as much in peacetime.
The task is far from over. One challenge will be to continue the dialogue on unwinding unconventional monetary policies and managing potential spillover effects. Another will be to manage our way out of the debt burdens accumulated during the crisis.
Second, global financial regulation. To address the origins of the crisis, G20 members committed to a fundamental overhaul of global financial regulation, with the intention of promoting a more transparent, safe, and resilient global financial system.
Most notably, the Financial Stability Board was created in 2009 with a mandate to develop and promote effective financial regulation. Significant progress has been made in terms of strengthening system-wide oversight, increasing capital and liquidity buffers, promoting the exchange of financial information, and implementing macroprudential policy frameworks. Efforts are also underway to facilitate cross-border resolution.
Yet major challenges remain, such as ending the too-big-to-fail problem, reforming shadow banking, and making derivatives markets safer. In the Eurozone, recent policy actions have helped ease market stress, but more still needs to be done to reverse financial fragmentation and move towards a full banking union.
Third, strengthening regional and global safety nets. To mitigate the impact of the crisis, countries came together to strengthen the global financial safety net, including by trebling the IMF’s resources and increasing the allocation of Special Drawing Rights. The financial architecture of the Eurozone was enhanced through the creation of the European Stability Mechanism and the ECB’s Outright Monetary Transactions framework. In other parts of the world, commitments to regional financing arrangements – such as the Chang Mai Initiative and the Eurasian Economic Community Anti-crisis Fund – were reinforced.
However, progress has been uneven in other areas. For example, in the case of the IMF, the agreement reached in 2010 on important quota and governance reforms that would further increase the voice and representation of emerging market and developing economies has not yet been implemented. While two of three required conditions have been fulfilled, further support is needed to meet the final condition that will allow the reform to take effect.
If we put all this together, the report card on global governance reform since the crisis is somewhat mixed. Policymakers need to seize the opportunity to advance governance reform while memories of the crisis and the sense of urgency remain fresh. There is a real danger that the window of opportunity for addressing some of the most challenging global issues might soon close. How can momentum be regained, and important reforms finalised? To answer this question, it is helpful to look at the different solutions that have evolved for delivering global public goods.
Soft vs. hard policy coordination
In what direction is the system of global policy coordination evolving? To answer this question, it is instructive to differentiate between ‘hard’ and ‘soft’ policy coordination.
Hard policy coordination is typified by quid pro quos in policies with a focus on specific and tangible outcomes. Examples include the two initial G20 Leaders’ Summits that took place in the immediate aftermath of the crisis, and resulted in the coordinated fiscal policy response mentioned above and the creation of the Financial Stability Board.
In contrast, softer forms of coordination are more process-based, without a priori expectations of substantial outcomes or agreements. They are designed to facilitate an ongoing exchange of views and information, such as the regular discussions among central bankers at the Bank for International Settlements.
Soft and hard policy coordination can complement each other. For instance, soft arrangements can keep the policy dialogue alive during quiet times, and provide a framework for harder policy coordination during crises.
Soft vs. hard governance
A parallel argument can be made for governance. Hard governance arrangements require the establishment of legal obligations and independent institutions through treaties. The UN, IMF, World Bank, and the WTO typify such arrangements.
On the positive side, this kind of hard, treaty-based architecture strengthens the credibility of member countries’ commitments, and grants legal enforcement powers to institutions. However, these institutions are relatively slow to establish and adapt, which can be problematic when the global environment or the needs of members change.
Soft governance arrangements – such as the G20 and BRIC country groupings, the Financial Stability Board, or the Financial Action Task Force – have no international legal personality or obligations. As a result, they tend to be more flexible and can often be put in place more quickly. They do not, however, have treaty-based mandates or legal enforcement powers. As a result, they have a more limited ability to enforce commitments, which can pose challenges for their relevance and effectiveness over time.
Finally, there are also private sector solutions to governance challenges. One example is Collective Action Clauses, which allow a supermajority of bondholders to agree to changes in bond repayment terms, with the intention of facilitating smoother debt restructuring. Another example is International Financial Reporting Standards, an independent nonprofit foundation that promotes the harmonisation of global accounting standards.
A mosaic of solutions
In sum, the global economic governance structure of the future may well be a mosaic – or ecosystem – of hard and soft elements that operate in a complementary fashion. In such a system, governance arrangements would be issues- and context-driven, with choices between hard and soft governance arrangements depending on what is the most efficient and practical solution for the specific matter at hand. Making such a system ‘smart’ depends crucially on using hard or soft governance at the right time and for the right issues.
Consider three examples of how hard and soft governance have been combined:
- First, consider trade. Multilateral trade agreements are preferable to regional ones. Since the gains from trade are well recognised, the WTO dispute resolution process has real ‘teeth’, with an ability to impose sanctions on those who violate global trade rules. Increasingly, mega-regional agreements (like US–EU or the Trans-Pacific Partnership) are less about tariffs than about standards and non-tariff barriers. To the extent that they help set global norms that facilitate trade, they bring us closer to more global solutions, and potentially reinforce (or in future become integrated with) the WTO framework.
- Second, consider the balance between hard and soft governance in the euro crisis. Arguably the hard governance came from the IMF and the ECB, and soft governance from the Eurogroup. Europe’s complex governance arrangements worked well in peacetime, but decision-making processes were not well suited to managing crisis.
- Finally, consider financial regulation. As part of its mandatory Financial Sector Assessment Program, the IMF conducts financial stability assessments every five years of jurisdictions that have systemically-important financial sectors. These mandatory assessments are a good example of hard surveillance, where countries are assessed against compliance with clear global standards and stress-tested against national and international spillovers. Every two years after a Financial Sector Assessment Program, the Financial Stability Board does a peer review (a sort of soft governance) of follow-up on the Program’s recommendations, as a complementary way to advance key financial reforms.
However, a flexible and efficient global governance structure may not emerge automatically. For example, when hard global institutions, such as the IMF, the World Bank, and the WTO adapt too slowly to changes in their environment, governance gaps will open up. Softer institutions may step in to fill these gaps, but as substitutes rather than playing a complementary role. This would not be efficient and could result in a weaker global governance system.
The case for IMF governance reform
In the evolving ecosystem of global governance and policy coordination described above, it is essential for the elements of hard governance to stay relevant by adapting to changes in the world economy.
Over the years, the IMF has demonstrated a remarkable ability to adjust its work and operations in response to major changes in the global economy, including the fall of the fixed exchange-rate system in the early 1970s, the debt crisis of the 1980s, and the collapse of the Soviet Union in 1991.
The key reason why the IMF has remained relevant has been a political governance structure that adapts, albeit slowly, to changes in the world economy. The IMF also has an independent staff and a constitution (in the form of the Articles of Agreement) that allows it to adopt a longer-term perspective. The IMF has also managed to internally integrate some elements of hard governance, such as mandatory surveillance, with softer elements – such as voluntary Reports on the Observance of Standards and Codes, or facilitation of standards for sovereign wealth funds. On the softer side, the IMF’s consensus-based decision-making has been effective at ensuring that member countries’ points of view are being heard.
In future, it will be crucial for the IMF’s effectiveness and legitimacy to ensure that its governance structure reflects the relative position of its member countries in the global economy. Approval of the 2010 reforms would be an important step in this direction, although further shifts in quota and voting shares to dynamic economies will also be needed.
To achieve this, some countries will have to accept relative declines in their quota and voting shares. Understandably, this will not be an easy decision, but it will help ensure that the IMF can continue to remain strong and legitimate for the benefit of the entire membership – and the global economy.
While significant efforts to improve global economic governance were made in the initial phase of the crisis, the momentum of reform and policy coordination has slowed recently.
Indeed, while the current system is able to deliver governance and policy coordination when there is a lot to lose – such as in a crisis, it is much less effective in galvanising action when there is potential for mutual gain – such as global economic rebalancing.
One possible explanation is that the global community tends to rally in a time of crisis, when the time horizon is short and immediate costs are high. However, in normal times, gathering momentum for action today may be hard because the cost of inaction lies far in the future.
Some observers point toward plurilateralism and the rise of soft global governance as a threat to the traditional pillars of hard global governance, including the IMF. I am much less pessimistic. I see these two forms of governance as potential complements rather than imperfect substitutes. Soft governance works when innovation is needed but there is time to act, when getting a subset of countries to act is sufficient and ad hoc implementation can work. Hard governance is needed in a crisis, or when global approaches are needed and when consistent enforcement is key.
Returning to Martin Wolf’s call for extraordinary creativity in seeking solutions to the multitude of challenges faced by the world today, I believe we can tackle the issues by being smart about the governance we need, and by making the most of political opportunity when it presents itself. By integrating soft and hard governance more intelligently, better outcomes can be achieved for everyone – small and large countries alike.
Editor’s note: The author is grateful to Andreas Bauer, Sanjaya Panth, Niklas Westelius, Camilla Andersen and Dustin Smith for their help in preparing the speech on which this column is based, and to Olivier Blanchard, Sean Hagan, and Jose Viñals for their thoughtful comments. This column is based on a speech delivered on 5 December 2013 at the University of Oxford, see http://www.imf.org/external/np/speeches/2013/120513.htm