INTERNATIONAL
Why global rules to prevent another crisis are so elusive
Autumn 2009
We had most of the tools to prevent the financial crisis, says ECB board member Lorenzo Bini Smaghi, and the awful truth is that they were agreed upon 10 years ago but were not used appropriately
Commentary:
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The leitmotif of recent months has been “if the crisis is global, the solution must also be global”, and that global solution consists of creating an international financial system that works better. And because the Bretton Woods institutions (BWI) – the World Bank and the IMF – are at the centre of the international financial system, they should by definition be part of the solution. There seems to be broad consensus on this point, but it’s not very clear what it means in practice.
The global financial crisis showed that the international financial system did not function properly. There are at least two reasons for this; first, that both the national and international regulation and supervision of markets and institutions were not up to the challenge posed by the steady growth in financial innovation and integration. Second, that not enough pressure was put on those countries that were conducting unsustainable economic policies, and this in turn led to the build-up of national and international imbalances. The combination of these two factors fuelled the systemic instability which triggered the global crisis.
A proper international financial system should be able to introduce corrective actions, either directly or through the national authorities in charge of regulatory and supervisory powers. And it should also be able to implement appropriate macroeconomic polices. But international institutions cannot force national authorities to change their policies, and certainly cannot oblige them to take greater account of external developments in their domestic decision-making. In other words, international institutions only have the ‘soft powers’ of persuasion, while the national authorities have the ‘hard powers’ of enforcement.
Although the BWI have for many years had some soft powers in the field of macroeconomic and structural policies, there is no institution formally in charge of international coordination that can exert the sort of pressure needed to bring about changes in national regulatory and supervisory policies. There are fora like the Financial Stability Board where the national authorities exchange views and try to coordinate actions, and the Basel Committee which aims to harmonise regulations, but there is no surveillance mechanism to check if the national supervisory authorities are also taking into account the broader international context.
An enhanced international financial system would need to follow two main lines of action. The first would be to broaden the scope of international cooperation. At the moment, initiatives in this field are mainly being pursued by the Financial Stability Board, whose membership now includes the G20 countries. A second line of action would be to strengthen the international institutions’ soft powers to aim for more consistent economic policies, especially by the systemically important economies. This would directly involve the Bretton Woods institutions, notably the International Monetary Fund. A strengthening of the IMF had in fact been agreed after the Asian crisis in the 1990s, and the G7 summit in Cologne in 1999 mandated the IMF to play a strong surveillance role with a view to ensuring greater transparency and encouraging early adjustment by countries with unsustainable balance of payments positions.
This was subsequently endorsed by the G20, but over the last decade the expectations raised by this mandate have not been met, for several reasons. First, a number of emerging market economies have not let their currencies float freely and against the advice of the IMF have continued to peg their exchange rates at undervalued rates. They have not only had a fear of floating but they have also wanted to promote their exports and build up their reserves as a form of self-insurance in case of crisis. In turn, the accumulation of large surpluses, especially in emerging Asian economies and in oil-exporting countries, made possible the financing of the U.S. current account deficit. It has also influenced monetary conditions in the U.S., lowering long-term interest rates and making monetary conditions more expansionary than would otherwise have been the case.
The second reason is that the IMF has not succeeded in convincing countries to pursue macroeconomic policies that are consistent with sustainable current account positions. Nor have advanced economies, the U.S. in particular, taken the IMF’s advice fully into consideration in their decision-making. Emerging economies, partly following the practice of the advanced countries, have also attached less importance to IMF surveillance. At the same time, their accumulation of external assets made them less dependent on IMF funding and advice. A good example of this is that the IMF has not been able to complete an Art. IV surveillance programme with China for three years. All this has occurred against the background of emerging market economies’ claims that the IMF lacks legitimacy because of their own relatively low representation in the BWIs.
What conclusions might be drawn then from the experience of the last ten years and from the current crisis? One is that the IMF’s recommendations were wrong, and should be abandoned. An alternative conclusion is that they were right but have not been appropriately implemented, in which case they should be further strengthened. I myself tend to side with the latter view; this crisis offers an opportunity to reinforce the role of the IMF at the heart of the international financial system.
In recent months the Fund has played an important role in resolving the crisis, in particular in assessing the gravity of the situation and in providing countries with external finance. But if we are striving to create an international monetary system in which crises are the exception, the Fund has to play a greater preventive role. In this respect, the discussions that have taken place in most international fora since the start of the crisis have not been encouraging. There is even a risk that the way in which this crisis is being tackled could weaken the Fund’s preventive tools, at least with respect to macroeconomic policies.
Looking more closely on the problem, there seems to be a sense of denial in several countries that the large external imbalances accumulated over the past decade have been a cause of the crisis. It was striking that the G20 communiqué after the London meeting in March contained no reference to external imbalances. The IMF itself seems now to favour the view that the roots of this crisis are not so much to be found in its members’ policies or in external imbalances but in insufficient regulation and supervision, and in the improper behaviour of market participants.
This is quite a change of attitude, and it might absolve not only those countries that recorded large deficits or surpluses but also the IMF itself for not having pressed them to do so. But there is a wide range of literature that includes IMF publications up until 2007 that shows how global savings-investment imbalances played a fundamental role that must not be neglected. These imbalances ultimately reflected the accumulation of excessive international liquidity by countries like the United States, and of excessive savings by countries like China, and stemmed from a reduction in the cost of capital and interest rates, in particular in the U.S. This spurred an unsustainable consumption boom as well as excessive risk-taking by consumers as well as financial institutions. These imbalances contributed to the large financial distortions and bubbles in global financial markets that were the preconditions for the present crisis.
The risk is that the forces favouring earlier and more effective adjustment of imbalances, that might thus help to avoid the next financial crisis, have been weakened. In the current discussion on reform of the international financial system, not many voices are calling for the IMF to play a stronger role in preventing the accumulation of excessive external imbalances and in fostering more disciplined domestic policies. An example of this is the way the IMF’s Decision on Bilateral Surveillance over Members’ Policies, aimed at identifying fundamental exchange rate misalignments, has been modified to allow greater discretion in surveillance, especially over exchange rates. This might look like a tactical choice, but I doubt that it will result in a stronger hand being given to the IMF.
While emerging and developing countries are requesting a stronger voice in the IMF, they also seem to be suggesting that they would like this institution to be less intrusive and less able to impose conditionality, while at the same time providing more and cheaper financing. Advanced economies have been tacitly supporting this position, even though they have inundated the IMF with funds that are available with very little conditionality or none at all. This might be appropriate in times of systemic crisis but cannot be sustainable in normal times. Some thought should also be given to a strategy to exit from cheap and unconditional IMF financing.
Overall, most of the IMF’s shareholders seem to favour making the organisation’s financing easier. Enhancing the role of its Special Drawing Rights, the SDR, or of supplementing the dollar with another world reserve currency, would help to facilitate the financing needs of both deficit and surplus countries. For deficit countries, this would make it easier to borrow from international institutions outside the markets, giving the issuer of such currency some form of international lender-of-last-resort function. For surplus countries that want to accumulate reserves, it would reduce the exchange rate risk. If financing were to get easier, it would not be clear how the risk of excessive imbalances would be perceived by both creditors and debtors. The real risk is that the adjustment would take place even later, while imbalances would be left to accumulate for a longer period of time. Under these circumstances the crisis could be even greater, and the ex post adjustment even harsher. That was the experience of the last world currency, the gold standard.
In sum, a viable international financial system needs a mechanism that can keep imbalances in check. An essential element of such a mechanism would be to give the IMF a prominent role in two areas; strong and effective surveillance in crisis prevention and responsible lending to countries in need, but with appropriate limits and conditionality. This was the prevailing consensus after the previous financial crisis, but the corresponding action was never taken. We don’t need to reinvent the wheel, just to follow up on the commitments made less than ten years ago. Dealing with the short-run challenges of the current crisis should not distract us from the overwhelming objective of preventing future crises. The Bretton Woods institutions should be given a major role to achieve this goal, as was agreed a decade ago.