At the recently completed CIGI ’12 Conference, Five Years After the Fall, I had the pleasure of chairing a session on Global Financial Regulation and International Governance of Global Capital Flows. Part of the remit of that session was, “The … session will focus on attaining a suitable international regulatory framework for successful global financial integration. Such a framework would reduce the risk of future crises and ensure financing for the investment and innovation that will drive growth going forward.”
As part of the agenda I was asked to prepare a background study which will eventually be published by CIGI. The highlights of that paper are summarized below. In addition to the recommendation made in the background paper there are several other interesting proposals put forward by the other panelists and it is worthwhile considering these and the audience’s reactions to the ideas put forward. You can watch the webcast on the CIGI website.
The Global Financial Crisis (GFC) was a crisis that originated in advanced economies but eventually spread beyond that group to affect most emerging markets. Despite convincing research which finds that financial crises are more costly in terms of lost output, and recovery can typically take almost a decade, Five Years After the Fall decision-makers seemingly continue to believe that the severity of any crisis led downturn can be divorced from its source. Instead of limiting the extent to which the financial sector is prone to crises, policy makers have opted to socialize the downside risks of a future financial crisis. Moreover, in some parts of the world, the consequence of the build-up of government debt has led to a more intertwined relationship between banks and sovereigns.
It is unclear whether global factors or a confluence of domestic factors explains how the world economy has unfolded since late 2007. Many economists have a more prosaic explanation for the events since 2007. The crisis was a systemic event and its proximate cause is a failure of the banking system in a financial system that was too highly levered. One of the fallouts of the crisis was that the clear demarcation lines between fiscal and monetary policies, normally the sine qua non of a sound macroeconomic policy regime, began to blur. Indeed, as 2012 ends, it is tempting to view some central banks as picking-up the fiscal slack created by the withdrawal of conventional fiscal stimuli. The consequences of central banks ‘not sticking to their knitting are, as yet, unknown but must be part of the discussion concerning the future of international financial regulation.
The Problem: Cooperation if Necessary, but not Necessarily Cooperation
The choice of exchange rate regimes is greatly influenced by fears of the consequences of unfettered capital movements but there is little persuasive evidence that capital account liberalization is harmful to an economy. The IMF has given its blessing to some forms of ‘prudential’ capital controls as a device that internalizes the inherent instability, that spills over into the rest of the world, created by individual economies facing a financial crisis. Even if this kind of thinking were sufficient to promote more cooperative behaviour it remains unclear what prevents economies from excess reliance on capital controls as an excuse for defending domestic policies that may become increasingly distorted as a result. Moreover, if a series of bad policies by governments is responsible for most financial crises then it is doubtful that they can be trusted to implement effective forms of prudential controls on capital movements.
Clearly, searching for a set of policies that will encourage meaningful cooperation is necessary. Complicating matters still further is that we may well be going through an era when there is no economy, institution, or central bank that can ‘call the tune,’ as the Bank of England once did several decades ago and, until lately, did the U.S. Federal Reserve. While the rise of China is seen as promising a realignment of sorts in the global economic environment, even optimists believe there are significant economic and financial risks if the U.S. shares the global stage with China.
There is too little appreciation that earlier international monetary systems required cooperation precisely because exchange rate systems, whether of the gold standard or Bretton Woods varieties, rendered economies dependent on collaboration between the participants. Therefore, if the aim of policy makers is to make the exchange rate flexible, allow each economy to individually decide what is ‘sound’ in macroeconomic terms while also recognizing that domestic considerations may well trump global needs when it comes to regulating capital flows, then another mechanism has to be found to create the incentives to cooperate on reforms of the international financial system. At the moment then it is looking a lot like the inter-war era when, as the influential report published in 1944 by Ragnar Nurkse concluded, “The piecemeal and haphazard manner of international monetary cooperation sowed the seeds of subsequent disintegration” (Nurkse, 1944. International Currency Experience. Geneva: League of Nations, p. 117).
The background paper argues that credibility and trust in any new international regulatory framework must, first, begin at home with a determination for fiscal and monetary policies to work in harmony. This includes cooperation, bur not necessarily coordination, of regulatory and supervisory functions to ensure that macro-prudential policies effectively complement domestic monetary policy and provide an additional tool to implement a sound macroeconomic framework that will soften the blow from the next financial crisis. Nevertheless, it is necessary to ask how much cross-country variation can be tolerated if it assumed that it is either impractical or undesirable to expect a ‘one-size-fits-all’ international monetary regime. The fear seems to be that policy makers cannot be seen to disagree on the governance of an international monetary system. Disagreement in the economic outlook, when combined with sufficient transparency, can be beneficial (e.g., see Siklos (2013), “Sources of Disagreement in Inflation Forecasts: An International Empirical Investigation" Journal of International Economics (forthcoming)). The same principle can surely be extended to devising a stable international financial system.
Where Do We Go From Here?
- Systemically, and politically important, nations ought to demonstrate some leadership by agreeing on a range of acceptable regulatory frameworks and demonstrate, in a transparent manner and at regular intervals, how each is capable of operating with a minimum of spillovers that might threaten financial system stability.
- Transparency, by its nature, is more likely to be achieved the simpler the framework and when there is formal recognition that there are ‘unknown unknowns’ that require, from time to time, an economy to step out of an international policy strategy in place but not without due allowance and accountability for the spillover costs that may be created under the circumstances. This is best achieved by allowing each member country to issue a ‘directive’ to the international community when it is incapable or unwilling to follow the range of standards set by the international community.
- Just as sovereign nations have devoted decades to finding the right macroeconomic strategy to deliver stable prices, a growing economy and financial stability, there has not been much thought given since the end of World War II to what a coherent global macroeconomic and financial regulatory strategy might look like. If there are unintended consequences from these choices, establishing a range of acceptable domestic policies and an understanding of how the resulting spillovers operate may then help the next time economic shocks, particularly of the financial variety, are transmitted globally.
- Policy makers should reconsider the status of the Financial Stability Board. In terms of global finance the group is more representative than its G20 cousin.
- International cooperation ought to recognize that a single set of acceptable standards is unlikely and unreasonable. The potential for a mutually assured destructive financial crisis of the Great Depression variety ought to be sufficient to concentrate minds on open and cooperative behavior in regulating global financial markets. Financial stability and how it interacts with other elements of sound macroeconomic policies, to borrow the words of Winston Churchill, remains “…a riddle, wrapped in a mystery, inside an enigma.”