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.]