Much attention has focused on how to reform financial regulation in light of the most recent crisis (see, for instance, Acharya 2011 on this site). But these reforms alone are unlikely to eliminate all of the risks associated with large global capital flows. Broader reform of the international monetary and financial system is essential. While the international community has taken a few steps towards reforming other aspects of the international monetary and financial system (such as the launch of an enhanced policy coordination approach under the G20 Framework for Strong, Sustainable and Balanced Growth, and the introduction of the IMF’s financial safety nets), there are doubts about whether these actions will be effective enough. We argue that additional reforms need to be considered.
This lack of progress likely reflects a lack of agreement on the underlying problems associated with today’s international monetary and financial system. It is those underlying problems – which allow excessive current-account imbalances to build up and/or which impede the smooth adjustment of the system to any unwinding in those imbalances – which should be tackled. In a recent Bank of England Financial Stability Paper together with Michelle Wright (Bush et al. 2011), we provide a framework for thinking about those underlying imperfections and suggest reforms to tackle them. It is, of course, difficult to identify the imperfections precisely, and many of them are inter-related. But this exercise is important in order to focus on the key areas where reforms should be targeted. It may, however, be impossible to make sufficient headway in reducing these frictions, so a more fundamental overhaul of the international monetary and financial system – in which a rules-based system would prevail – may be necessary.
We identify three objectives for a well-functioning international monetary and financial system:
- Internal balance.
- Allocative efficiency.
- Financial stability.
Overall, the evidence suggests that today’s system has performed relatively poorly against all three of them. While inflation, and inflation volatility, have fallen in both advanced and emerging economies (a positive from the perspective of the internal balance objective), per capita GDP growth has, at the same time, been slower and more volatile than in the Bretton Woods System, for example.
The pattern of “uphill” capital flows, where capital flows from emerging-market economies (EMEs) to advanced economies, suggests also that today’s international monetary and financial system is not meeting its objective of allocative efficiency, with capital not necessarily flowing to its most productive use. But the key failure – as evidenced by the extraordinary severity of the 2007-9 global financial crisis – has been the system’s inability to achieve financial stability and to minimise the incidence of disruptive sudden changes in global capital flows. The reappearance of episodes of global financial instability has coincided with a rapid increase in international capital mobility (see Figure 1). And we find that the incidence of banking and currency crises has been higher in the current international monetary and financial system than in any previous regime, with the incidence of sovereign default second only to the interwar period. In the most recent period, there is also some suggestive evidence that countries that have experienced the largest current-account reversals have also seen the most pronounced slowdowns in output growth (Figure 2).
That said, today’s system has proven durable and has not yet experienced a crisis that has led to the current framework being abandoned. But the 2007-9 crisis and current developments in the Eurozone pose important questions about the failings of the current arrangements.
Figure 1. Capital mobility and the incidence of banking crises
Sources: Obstfeld and Taylor (2003), Reinhart and Rogoff (2008) and Bank calculations.
Notes: (a) A judgemental index on the extent of capital mobility constructed by Obstfeld and Taylor (2003).
Figure 2. Current-account reversals and output growth, 2007-10(a)
Sources: IMF World Economic Outlook (April 2011) and Bank calculations.
Notes: (a) Current-account reversal is defined as the change in the current-account balance from 2007 to 2010. Only advanced economies and EMEs are included.
We suggest that the key frictions that the international monetary and financial system needs to resolve can be grouped into four categories:
- Missing markets.
- International institutional frictions.
- Imperfect information, particularly in financial markets.
- Nominal rigidities.
Generally speaking, the first two frictions (missing markets and international institutional frictions) have encouraged the build-up of risky imbalances, in particular by ‘pushing’ capital away from its most productive use. At the same time, imperfect information has played an important complementary role, ‘pulling’ capital towards less productive uses, for example because investors were unaware of the risks that they were taking on. We identify missing financial markets in EMEs as a key factor behind their desire to accumulate excessive precautionary reserves as a form of self-insurance. This is both because missing financial markets make EMEs more vulnerable to sudden reversals in capital flows, and because these EMEs are less able to obtain insurance against such sudden reversals and so are left with little option but to self-insure. The international institutional friction we identify relates to the WTO rules which restrict the use of direct production subsidies. This restriction arguably encourages countries that wish to pursue an export-led growth strategy to undervalue their exchange rates as an alternative policy tool (Rodrik 2009), leading to a further pushing of capital uphill and thus contributing to the build-up of risky imbalances.
But the missing markets and imperfect information frictions have, in conjunction with the fourth friction (nominal rigidities), also played a large role in increasing the costs of the eventual adjustment to these imbalances. Imperfect information, for example, encourages the likelihood of herding behaviour and contagion, which can amplify changes in exchange rates and capital flows, exacerbating the impact of a shock and meaning that the output cost is much larger than it might otherwise be. Nominal rigidities mean that the smooth adjustment to global imbalances through relative price adjustments is either too small, or too slow. In today’s international monetary and financial system, these nominal rigidities are exacerbated by the prevalence of fixed or managed exchange-rate regimes in EMEs, with around one fifth of the world (in terms of global GDP in PPP terms) having some form of fixed or pegged exchange-rate arrangement with the dollar (IMF 2010).
So what reforms should be implemented? Measures that countries could implement themselves include greater flexibility in nominal exchange rates, reforms to make national balance sheets more resilient, and measures to improve financial market participants’ understanding of the risks on countries’ balance sheets. We advocate actions in all of these areas. One option to make national balance sheets more resilient is for countries to issue GDP-linked bonds. These bonds pay a return that varies with the behaviour of GDP – investors share some of the risk with the issuer, receiving a lower payout in bad times, and vice versa. Such proposals have been advocated by Shiller (1993), among others. These reforms would help to smooth the adjustment of the international monetary and financial system once imbalances have emerged. And to the extent that they reduce capital structure mismatches, they could encourage countries to accumulate fewer precautionary reserves, thus also helping to reduce the build-up of those imbalances.
Policy initiatives that require some degree of international cooperation to be effective include improvements to global financial safety nets, where we advocate the IMF detailing its assessment of a country’s eligibility for its Flexible Credit Line and Precautionary Liquidity Line in its Article IV reports; international initiatives to close data gaps; coordination on financial regulatory reform; and possibly revisiting the application of WTO rules.
But we also recognise that it may prove impossible to make sufficient headway in reducing these frictions. In this case, consideration should be given to a more fundamental overhaul of the international monetary and financial system in which a rules-based system would prevail, to force countries to internalise the externalities that result from their policies. The G20 Framework should be able to achieve this. Indeed, leaders stated this as their objective back in September 2009:
“Our Framework for Strong, Sustainable and Balanced Growth is a compact that commits us to work together to assess how our policies fit together, to evaluate whether they are collectively consistent with more sustainable and balanced growth, and to act as necessary to meet our common objectives" (G20 2009).
But its peer-based review process has not yet proved itself. We set out a vision for a rules-based system, in which – as suggested by economic theory – Pigouvian taxes are used to deal with the externalities from countries’ policies.
How would this work at the current juncture? With demand set to be deficient at the global level, countries with current-account deficits would be allowed to tax current inflows from countries with whom they run bilateral current-account deficits. As demand shifted from surplus to deficit countries, countries with current-account surpluses would have three choices. They could:
- Adjust domestic policies to boost domestic demand.
- Do nothing.
- Choose to try to counteract the tax by subsidising their exports to countries with whom they run bilateral current-account surpluses, leading to a transfer to deficit countries.
In all three cases, the sanctions would remain in place until global conditions were deemed to have returned to normal. And in all three cases, deficit countries should find it easier to maintain sufficient demand without running such a high risk of a painful external adjustment. This mechanism would effectively mimic the role of exchange-rate realignment (rotating demand towards deficit countries and away from surplus countries, who are better placed to offset any fall in their output), or would work by transferring resources to deficit countries which could then be spent. This system would discourage excessive imbalances rather than limiting gross trade, which is important given the international monetary and financial system’s role in facilitating trade.
Clearly, the big risk with this kind of framework is that it leads to a generalised increase in trade protectionism. But it is expected that countries would realise the high costs for all countries that this would entail, and therefore refrain from pursuing such a strategy. Furthermore, the risks of a trade war absent a reform proposal such as this should not be ignored. At a minimum, a debate on these issues is required.
Authors note: The views expressed in this column are those of the authors.
Acharya, Viral (2011), “The Vickers report: Ringfencing is a good idea, but no panacea – risk weights are crucial”, Vox Talks, VoxEU.org, 23 September.
Bush, O, K Farrant, and M Wright (2011), “Reform of the International Monetary and Financial System”, Bank of England Financial Stability Paper No. 13.
G20 (2009), “Leaders’ statement – the Pittsburgh summit, September 24-25 2009”, available at www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf.
International Monetary Fund (2010b), Annual Report on Exchange Arrangements and Exchange Restrictions.
Rodrik, D (2009), “Growth after the Crisis”, mimeo.
Shiller, R (1993), Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks, Clarendon Press, Oxford.