After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat.  More importantly, policy makers in emerging markets took some serious measures.  Some countries abandoned exchange rate targets and began to float.   Many accumulated high levels of foreign exchange reserves.  Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment.   Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock.  A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.

When the Global Financial Crisis hit ten years later, it was bad news for everyone, except that it was good news for econometricians:  we could observe which countries got hit badly by this common external shock in 2008-09 and which did not, and could try to draw inferences about which strategies helped countries withstand the shock better than others.  The NBER is holding a public symposium in Washington on September 22.   The topic of the 3^rd and final session is: What ex ante policies can help reduce vulnerability to future shocks?

     Three papers that were presented at the earlier NBER conference in Bretton Woods (the culmination of a project on the Global Financial Crisis  sponsored by the Sloan Foundation) fall naturally into this category:

• International Reserves and the Global Financial Crisis, Kathryn Dominguez (University of Michigan), Yuko Hashimoto (IMF), and Takatoshi Ito (University of Tokyo);
• Managing Capital Inflows: The Role of Controls and Prudential Policies,  Jonathan Ostry, Atish Ghosh, Marcos Chamon, and Mahvash Qureshi (all of the IMF);
• International Financial Crises and the IMF: What the Historical Record Shows, Bergljot Barkbu (IMF), Barry Eichengreen (UC, Berkeley), and Ashoka Mody (IMF). 

To simplify a bit, Dominguez and co-authors study whether holding high levels of reserves helped countries do better in the Global Financial Crisis;  Ostry and co-authors study whether capital controls and bank regulation helped; and Barkbu, Eichengreen and Mody consider possible new mechanisms to improve the risk structure of capital inflows and to smooth adjustment to shocks, such as sovereign CoCos (Contingent Convertible bonds) and indexing of debt.

     The question that Dominguez, Hashimoto, and Ito address in International Reserves and the Global Financial Crisis, had been actively debated in the years before 2008.   Some economists thought that China, especially, but other emerging market countries as well, were holding far more foreign exchange reserves than they needed to withstand shocks.  Larry Summers (2006) was one prominent example; I must admit that his argument sounded sensible to me at the time.  When the global financial crisis hit, it was possible to test the proposition.   Some of the early studies found that reserve holdings did not seem to help countries withstand the crisis better.  Blanchard, Faruqee and Klyuev (2009) was one.   A series of papers by Andy Rose and Mark Spiegel (2009a, b) also found no significant effect.   But others found an important effect.    One of the technical contributions of the paper by Dominguez and co-authors is to subtract estimates of interest income and valuation changes from officially report levels of reserves in order to get at the actively managed component.  Their single most important finding is that real GDP growth recovery after the global financial crisis was stronger for countries that had accumulated large reserve holdings before the crisis.

This is the same thing I had found in a study with George Saravelos (NBER WP no.16047, 2010) .   Out of dozens of potential early warning indicators, foreign exchange reserves are the indicator that had been most often identified as significant by eighty pre-2008 studies conducted on earlier data.  We found that reserves are also the indicator that was the strongest predictor of which countries got into trouble in 2008-09. A particularly useful indicator is the ratio of reserves to short-term debt (Guidotti, 2003).   We found that the second most consistently important early warning indicator was overvaluation of the currency by criteria like PPP.   Also important in the recent crisis were measures of national saving.

Why did the Dominguez paper and my paper find that reserves had a significant effect, and others did not?    My guess is that it has to do with different definitions.  In particular, we define the crisis period as late 2008 and early 2009, whereas the earlier papers I mentioned ended in 2008.

     In Managing Capital Inflows: The Role of Controls and Prudential Policies, Ostry, Ghosh, Chamon, and Qureshi do something very important.  Too many discussions lump financial regulations together (speaking indiscriminately of Tobin taxes, Chile-style or Brazil-style controls on short-term capital inflows, Venezuela’s  controls on outflows, etc., even though these are completely different things).  Chamon and co-authors develop three new country indices: one for financial-sector capital controls, one for prudential regulation of foreign exchange transactions in the domestic banking sector, and one for domestic prudential policies.  This helps avoid exacerbating what is often a sterile oversimplified debate.  For example, even if one is ideologically opposed to capital controls, or has been persuaded by research such as Kristin Forbes (2007) that the famous Chile controls caused undesirable distortions, it is hard to be opposed to prudential banking regulations, especially in light of the origins of the 2008 crisis.   Chamon and co-authors find that capital controls and FX-related prudential measures can both help shift the composition of lending, away from FX-denominated bank loans and toward equity and FDI components of capital inflows.   Previous researchers have found that shifts of this sort in the composition of inflow, as opposed to reductions in the level of inflows per se, reduce the probability of a crisis. (Frankel and Rose, 1996, among many others.)   Probably the most important finding by Chamon et al is a reasonably strong statistical association between pre-crisis prudential and capital control policy and resilience to the sudden stop.   Countries in the upper quarter of restrictiveness of FX-related prudential measures do better in a crisis than those in the bottom quarter, by a whopping margin of 2 ½ - 3 ½ % percentage points of growth.  An important lesson for countries facing large inflows today.

     One of the co-authors of International Financial Crises and the IMF: What the Historical Record Shows, Barry Eichengreen, is not just the pre-eminent economic historian of this field but also supplied a lot of the intellectual force behind the adoption of Collective Action Clauses after the preceding round of emerging market crises (e.g., Eichengreen, 2003; and Eichengreen and Mody, 2004).  Thus it is well worth listening to what they have to say about further ideas for structuring capital flows ex ante in such a way as to avoid messy and costly restructuring ex post.

Barkbu, Mody, and Eichengreen explore how to automate the restructuring decision.  Automating the process has key advantages: it preserves the integrity of the contract (which avoids the uncertainties involved in triggering CDS); it is predictable; and it can be priced.   It can also avoid the need for what otherwise might be a lengthy process of renegotiation between debtors and creditors during which time economic activity falls and everyone suffers.  To this end, they discuss the idea of adding to future government bond issues so-called sovereign cocos, contractual provisions that automatically lengthen maturities or reduce interest and amortization payments when a pre-specified debt/GDP ratio is reached.  

There are also other ways of improving risk sharing and avoiding the need for costly restructuring negotiations.  An idea that is older but that I think merits more of a try-out than it has received — applicable for countries that export oil, minerals or agricultural commodities — is to index the debt to the world price of the export commodity.  Also in this category is the basic movement away from dollar-denominated debt and toward domestic-denominated debt, equity and FDI .  It seems to me that countries that heeded such lesson of the 1990s (including many emerging markets in Asia and Latin America) came through the GFC relatively well, whereas those that did not (Eastern Europe), did not.   

References

Barkbu, Bergljot, Barry Eichengreen, and Ashoka Mody, International Financial Crises and the IMF: What the Historical Record Shows, NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Berkmen, Pelin, Gaston Gelos, Robert Rennhack, and James P Walsh (2009), “The Global Financial Crisis: Explaining Cross-Country Differences in the Output Impact“, IMF Working Paper 09/280.
Blanchard, Olivier, Hamid Faruqee, and Vladimir Klyuev (2009), “Did Foreign Reserves Help Weather the Crisis“, IMF Survey Magazine, October.
Chamon, Marcos, Atish Ghosh, Jonathan Ostry, and Mahvash Qureshi, Managing Capital Inflows: The Role of Controls and Prudential Policies,   NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Dominguez, Kathryn, Yuko Hashimoto, and Takatoshi Ito, International Reserves and the Global Financial Crisis, , NBER Conference on The Global Financial Crisis, Bretton Woods, NH, June 2011, organized by C.Engel, K.Forbes, and J.Frankel.
Eichengreen, Barry, 2003, “Restructuring Sovereign Debt,” The Journal of Economic Perspectives, Volume 17, Number 4, 1 November , 75-98.
Eichengreen, Barry and Ashoka Mody. 2004, “Do Collective Action Clauses Raise Borrowing Costs?,” Economic Journal, v114 (495,April), 247-264.   NBER WP 7458.
Forbes, Kristin, “One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms,” Journal of International Economics,  71, Issue 2, April 2007, Pages 294-323
Frankel, Jeffrey and George Saravelos (2010), “Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis,” NBER WP 16047, June.
Frankel, Jeffrey, and Andrew Rose (1996) “Currency Crashes in Emerging Markets,” Journal of International Economics 41, no. 3/4, 351-66.
Guidotti, Pablo (2003), in J Antonio Gonzalez, V.Corbo, A.Krueger, and A.Tornell, (eds.), Latin American Macroeconomic Reforms: The Second Stage, University of Chicago Press.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2009), “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, 99(2):480-486.
Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor (2010), “Financial Stability, the Trilemma, and International Reserves“, American Economic Journal: Macroeconomics.
Rose, Andrew and Mark Spiegel (2009a), “The Causes and Consequences of the 2008 Crisis: Early Warning,” Global Journal of Economics. NBER Working Paper 15357.
Rose, Andrew, and Mark Spiegel (2009b), “The Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review.
Summers, Lawrence, 2006,  “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” March 24.

The members of the G-20 are meeting in Washington on November 15 to discuss reform of the global financial system.  The first thing to say about the calls for a “new Bretton Woods” is that they overreach, in the sense that it is very unlikely that any changes in the structure of the international monetary or financial system will or should, at this point in history, come out of multilateral discussions that are big enough to merit comparison with the first Bretton Woods. Certainly we are not talking about fixing exchange rates, as the 1944 meeting did.

Detour for an anecdote.  In mid-1998, when the crisis that originated in Southeast Asia had reached its one-year anniversary without abating, President Bill Clinton decided to give two important speeches.   He wanted to call for a new Bretton Woods.   His economic advisers (including both at Treasury and in the White House) advised him against this, on the grounds that one should not call for something as portentous as a new Bretton Woods when one was not likely to have proposals substantive enough to merit the name.   Soon after the (successful) speeches, British PM Tony Blair called for a new Bretton Woods.    Clinton asked his advisers, “How come Blair got to call for a new Bretton Woods when you wouldn’t let me do it?”    Our answer was along the lines, “Blair’s Treasury Secretary, Gordon Brown, doe s not necessarily have his interests aligned with his boss, in the way that Bob Rubin does.   So Brown had less incentive to stop Blair from saying something foolish.”   The big irony of the story is that Brown today is himself leading the move for a “new Bretton Woods.”

Even though the effort is virtually certain to fall short of a true “Bretton Woods 2,” it is worth taking the opportunity to consider what changes – whether more ambitious or less — might be made at the multilateral level to improve the functioning of the system.

Changes in government policy at the national level have already been radical in many countries, compared to anything that would have been imagined a short time ago:
• central banks’ extension of credit to institutions and under terms not contemplated in the past,
• governments’ buying up bad assets and recapitalizing, taking over,, or otherwise transforming troubled banks and financial institutions),
• agencies guaranteeing deposits (without limit) and money market funds, and so on.

Some of these steps can be done at the purely domestic level (US takeover of Fannie Mae and Freddie Mac); others require cooperation between a small number of countries (rescue of Fortis by Benelux countries); but others arguably require multilateral agreement, and thus are candidates for a modest “Bretton Woods.”

•  The International Monetary Fund has been given the task of outlining what a new Bretton Woods would look like – appropriate since the IMF is one of the original Bretton Woods institutions (along with the World Bank).
      o An Early Warning system is almost certain to be high on its list. But it already developed early warning indicators, after the East Asia crisis of 1997-98, and they haven’t been much help.
      o Now that the financial crisis is spreading to small economies like Iceland, transition economies in easternmost Europe, and poor countries like Pakistan, the IMF country rescue programs will get back in the saddle.
           This time around, however, the Fund has more competition (including from the ECB, the Gulf countries, China, and Sovereign Wealth Funds), and partly for that reason will probably demand less conditionality from the borrowing countries.    Also the Fund will have to turn to newly-wealthy countries like China to help finance  new facilities and programs.
              • Bill Rhodes has proposed that the Fund facilitate expansion of currency swap arrangements, to allow emerging markets to have the same access that has been made available to developing countries.
              • Michael Bordo and Harold James have suggested that the Fund could manage reserve assets of the new surplus countries; but it is not clear why the latter should want it to.
          The Contingent Credit Lines (CCL) – which were launched by the IMF with some fanfare in the aftermath of the 1997-98 East Asian crisis but were never attractive enough to attract a single client country — are back now, in the form of  new Short-Term Lending Facility.  The idea has always been that countries that have followed blameless policy (or as far as we can come to that in the real world), as judged by pre-crisis criteria, should be able to borrow large amounts from the Fund very quickly when faced with global contagion, without the usual conditionality.    Brazil and Korea look like two countries that had done most things right in recent years (flexible exchange rates, high level of reserves…) and have nevertheless since September seen international investors disappear.    The IMF has responded appropriately, with CCL-type loans that are multiples of country quotas.  
          Only a small number of countries qualify for having followed “blameless policy.”  Morris Goldstein suggests that the larger class of countries that have now been hit by forces beyond their control — the US-originating financial crisis — be helped by a revival of a long-ago IMF loan window, the Compensatory Financing Facility.
• The problem is that the money that the IMF is now able to offer is not only small relative to global capital markets (the IMF has long been used to that circumstance), but also small relative to the countries’ own reserves or to the no-condition funds that the Federal Reserve has now offered them through swap lines.   To expand such facilities, the IMF needs more funding.  Where will it come from?  Sovereign Wealth Funds and central banks in East Asia and Gulf countries.   But that in turn requires giving these countries much greater political representation than they currently have in the Fund.
              o There has been a loose one-year campaign to suggest guidelines for the operations of Sovereign Wealth Funds themselves, to “regulate” them.  But benefits of the SWFs may be more widely appreciated now than a year ago, in the context of the current crisis.   
              o The IMF, just as all the multilateral economic institutions, has moved far too slowly to give added representation to the newly important developing countries such as China, Brazil, Korea, India and Mexico – representation at least in proportion to their economic role, to say nothing of population.
                  A big part of the problem is that larger quotas and voting shares for these countries would have to come to a substantial extent out of Europe’s share.
                  In a fair world, Europe would also give up its stranglehold on the Managing Directorship (especially after the performance of the recent incumbents, who have appeared less interested in their jobs than in domestic politics back in their home countries or in putting new meaning into the phrase “foreign affairs”).  The same goes for the U.S with respect to the World Bank presidency.

•  The G-8 has been increasingly handicapped in recent years by virtue of its obsolete membership.
      o The G-7 still retains some relevance, in its role as self-appointed steering committee for world governance. After all, this financial crisis did not start in the developing countries, as it did those of 1982, 1997 and 2001.
     o But the G-7 cannot discuss the spread of the crisis to developing countries without Korea, Brazil, Turkey, India and Mexico at the table.  It cannot discuss central topics such as global current account imbalances, or the need for exchange rate adjustments, or coordinated global fiscal expansion, or requests that surplus countries fund rescue programs,  without China and Saudi Arabia at the table.     Thus it is appropriate that the G-20 is the group that has been invited to to the November 15 summit in Washington to discuss the new Bretton Woods.   
     o  Coordinated fiscal expansion is the most likely substantive macroeconomic policy outcome of the G-20 meeting.
      
• A probable substantive structural outcome from talk of the need for a bold new multilateral initiative is that there could be a “Basel III” to replace the “Basel II” agreement.
      o It would make capital requirements on banks countercyclical, rather than what has turned out to be procyclical, i.e., destabilizing, under Basel II. (Ironically economists at the BIS in Basel probably deserve credit for being the observers, in addition to Charles Goodhart, who most accurately warned of the procyclicality before the crisis.)
      o A Basel III could also replace the option of self-regulation of banks (under which they could choose their own Value At Risk models) with external regulation.    Dan Tarullo, who could have a  major role on the Obama team, offers some ideas .
      o The highly capable chairman of the Financial Stabilty Forum, Mario Draghi, assures us that already this year substantial progress has been made in such important areas as reducing conflict of interest on the part of credit-rating agencies.
      o International guidelines for guaranteeing deposits (possibly reinstating a ceiling, such as $100,000, after the crisis has passed) should perhaps be coordinated, to avoid flight of the sort that Ireland’s European partners experienced.

• Other possibilities:
      o A more ambitious reform would be to try to agree on guidelines to extend prudential regulation from international banks to non-bank financial institutions, since the latter were such a serious part of the problem in 2008 that many either failed or were bailed out, against all expectations.
      o More radically, regulation of this sort not just agreed multilaterally but carried out multilaterally, rather than at the national level, by the BIS (which now includes major emerging market countries) or a new agency.
      o The IMF, Financial Stability Forum, and other institutions will vie to lead the effort.
      o Other proposals, many of which could be attempted at the national level, but would optimally be coordinated internationally:
           A securities transactions tax, harmonized internationally, to raise revenue in a way that satisfies the public’s understandable feeling that the financial sector, which created this financial crisis, should not benefit from the solution.
           Executive compensation reform (especially in the financial sector).   Options-based bonuses have not been implemented in the incentive-compatible way that the corporate finance theorists anticipate  d, and have instead encouraged inordinate risk-taking.  One possible solution is to discourage compensation by options, in favor of restricted stock.    Another is to regulate corporate governance so as to insure that the CEO’s buddies don’t comprise the committee that determines his or her compensation.
         Regulation of the “originate to distribute” model of mortgage lending. Mortgage-Backed Securities were a useful innovation, but were carried too far.  The banks or mortgage brokers that originate a mortgage loan should be required to reattain a certain slice of each one (some have suggested 1/5), before selling the rest on, so that they have an incentive to monitor the creditworthiness of the borrower.  
           Regulation of Collateralized Debt Obligations.   Perhaps it is enough to raise capital requirement on the holders.  Perhaps something more drastic is required. 
           Regulation of certain derivatives, particularly Credit Default Swaps.  Perhaps it would be enough to standardize CDSs and set up a central clearing house, as many observers have suggested.
           But there is a danger that derivatives regulation could do more harm than good, e.g., a ban on futures markets or short-selling.
  o At the other end of the spectrum, one should consider the possibility that doing nothing might in the end be better than undertaking fundamental reforms in the international financial system, if the latter were driven by clumsy politics.

[To anyone wishing to post a comment:  I recommend you go to the RGE version of this post.]