The Impact of the Global Financial Crisis on the Development Agenda
Presentation to the World Bank Executive Directors
© Peterson Institute for International Economics
The list of questions for discussion suggested by Justin Lin strikes me as covering the right topics, so I propose to adhere closely to these and resist the temptation to repeat what I have said previously about the Washington Consensus. I shall, however, omit discussion of social protection, where I know that my copanelist, Ravi Kanbur, has a strong comparative advantage that he has just displayed to you.
1. Has the crisis, including the willingness to resort to nationalization, inter alia, of banks, suggested the need for a more active role for the state than was previously accepted? Is there a difference between the answers for advanced and developing countries?
Neither I personally nor the generality of Washington ever believed that the state had no role in economic policy. What was true was that we argued that the best role was limited to those areas where a clear rationale could be developed: where there were important external effects that needed to be reflected in the decisions made (where externalities needed to be internalized), where competition was threatened by market developments, or (in the view of some of us) where income distribution could be made less unequal without threatening severe disincentive effects. The crisis has showed that in addition to these classic cases for state action there can arise Keynesian situations in which a state with a concern for its populace is driven to exceptional actions dictated by immediate needs. Unless it can be shown that such situations can be equally effectively addressed without state action, one needs to add these situations to those that can justify state intervention in the economy.
Postwar history suggests that such situations are exceptional. It is now 64 years since the end of the Second World War, of which only the last two years have exhibited the symptoms that Keynes feared would provide the norm rather than the exception. If this pattern is maintained in the future, it will be feasible to reverse the nationalizations that have occurred in response to the crisis within a few years. There is a world of difference between accepting temporary nationalization as the least bad action in an abnormal situation and its embrace as a routine part of economic policy.
I would not regard advanced versus developing countries as the right basis on which to draw a distinction on this issue, although I can conceive that one might want to make a case for state action in an economy that lacked a vibrant private sector. But nowadays many developing countries-largely those that are frequently described as emerging markets-have private sectors at least as vibrant as those in advanced economies. It is in countries in the early stages of the growth process that still lack a vibrant private sector where state sponsorship of enterprises may play a positive role (to judge by the past experiences of several of the emerging markets).
2. Has the crisis suggested the need to rethink our advocacy of an export-led development strategy?
The crisis has indeed suggested that the existence of a large export component of aggregate demand creates a vulnerability to severe recession in the outside world. Note that it is not a surplus per se that creates this vulnerability but a high ratio of exports to GDP, so it is not a reply to this concern to argue (as I do) that export-led growth was equally prevalent in the current account deficit countries of East Asia prior to 1997 as in China in recent years.
We need to accept that there is a trade-off. Export-led growth (with or without a current account surplus) implies striving to raise the ratio of exports to GDP, which adds to the vulnerability to a world recession. On the other hand, it has the advantage, which we have been preaching ad nauseam, of minimizing the danger of domestically generated macroeconomic crises while the world is prospering. (I regard the case for export-led growth as largely macroeconomic, rather than dependent on some special microeconomic virtue of export production, although I also accept that a decision to confront the balance of payments constraint by pushing exports has the virtue of generating competition throughout the economy.) The disadvantage can be largely met by the policy of carrying a relatively large volume of reserves, which is further discussed below. Accordingly it still seems to me to be wise to pursue a policy of export-led development.
3. Is it still prudent to rely on capital inflows as an important source of development finance? Or is there a case for capital controls to help insulate economies from external shocks?
With due respect I submit that we have learned nothing new in this respect from this crisis. Even though the Washington Consensus was sometimes interpreted as calling for free capital flows, the originator of this term has always been unambiguous in arguing that it is folly to rely on external debt, especially short-term debt and debt denominated in the creditor's currency, to finance development. (For documentation of this see the paper circulated by my copanelist.) If a country borrows equity capital it at least has the advantages of sharing the risks with investors and of being reasonably confident that investment will rise, while allowing free inflow of portfolio equity avoids the practice of privileging multinationals, which occurs if only foreign direct investment (FDI) is liberalized. But borrowing debt exposes a country to all the risks that were demonstrated so vividly in East Asia in 1997. It is best avoided. And avoidance without the burden of loss-making financial intermediation implies capital controls, though for the reasons sketched I would restrict these to debt and not equity.
4. What are the lessons for the strengthening of financial regulation? Is there a case for breaking up financial conglomerates that are "too big to fail"?
One of the notable but little-remarked features of this crisis is that both regulated and unregulated institutions failed, with no obvious tendency for failures to concentrate in one category rather than the other. Accordingly I doubt whether a "strengthening" of regulation is the right remedy. It seems to me rather that the need is to improve regulation, by adopting appropriate principles. These have been illuminated by much of the discussion provoked by the crisis:
- A first principle is to insist that the issuer of a loan retains a significant part of the risk of it turning bad, so as to provide an incentive for the issuer to ensure that the loan is prudent. It would not be difficult to legislate this, by requiring that a certain percentage (10 percent? 20 percent?) of the principal remain on the issuer's book.
- A second principle, which seemed to have been widely agreed a while ago, envisaged penalizing derivatives that retained the over-the-counter (OTC) feature rather than being traded on an exchange, where their value is guaranteed by the exchange so that they are far less risky to the holder. OTC derivatives could be penalized if all derivative contracts required backing by capital and the required capital-asset ratio (CAR) were higher for OTC contracts.
- A third principle that has been widely endorsed envisages making CARs countercyclical, in contrast to the way that the system operated in practice in the past. A way of achieving this would be to introduce a macroprudential CAR (to be determined by the central bank of the host country), with a bank's final CAR being the multiple of the macroprudential figure and the microprudential figure based as now on the home country's requirement. The macroprudential figure might be small under circumstances of recession such as those currently prevailing, but would rise to well above unity under boom circumstances like those prior to 2007. This would give the central bank two instruments with which to pursue its two targets of macroeconomic and financial stability.
- Another principle suggested by the experience of this crisis would be to penalize mismatches in the maturities of assets and liabilities. Variations in the CAR would again be a suitable instrument.
- I certainly take the view that financial conglomerates that are judged "too big to fail" (and the crisis has certainly demonstrated that the expression describes reality) impose a cost on society and are subsidized by the taxpayer. Both efficiency and justice would be served by their being required to sustain a higher CAR. I would, however, much prefer to see them being penalized in this way rather than forced to downsize their activities to a specified level.
- It has been persuasively argued that the crisis has been intensified by the large volume of credit default swaps in existence. At the same time it is clear that these instruments can perform a real social function in allowing different risks to be carried by different parties. It has been urged that the way to avoid credit default swaps being used as purely speculative instruments is to require that those buying them hold a real asset whose value they are seeking to protect.
In conjunction with intellectual acceptance of the idea by the central bank that its responsibilities include combating speculative booms, a reformulation of regulation along these lines would in my view give the world a sporting chance of avoiding future financial crises.
5. Given that many countries are likely to seek high reserves as insurance, how should international monetary arrangements evolve and what are the implications for the future role of the dollar?
I agree that many countries, especially developing countries, are likely to (indeed, I hope they will) seek to hold high reserves as insurance in the future, although this may be offset to some extent by acceptance that the reserves of some countries are now higher than could conceivably be needed. The implication is straightforward. If the dollar remains the dominant reserve asset, specifically if the growth in reserves continues to consist principally of dollars, then reserve objectives can be satisfied only if global imbalances persist. A new (but different) crisis will eventuate within a decade, this time caused by an unacceptable level of indebtedness of the United States.
Given that the world has already invented Special Drawing Rights (SDRs), and given that the G-20 decided to recommend to the International Monetary Fund (IMF) that SDRs be issued on a large scale, the solution is equally clear. The world needs large regular SDR allocations, on a scale that will satisfy reserve-accumulation objectives. The only obstacle to issuance on the necessary scale consists of attachment to the familiar. Historically developing countries have been among the worst offenders in their unwillingness to embrace the unfamiliar, although the recent speeches of the governor of the People's Bank of China give grounds to hope that this is changing. There would be strong advantages to developing countries in future SDR issues, which would channel a part of the seigniorage benefits of reserve creation to the developing countries.
6. Does the crisis have implications for the future role of the international financial institutions?
Most certainly it does. The IMF's traditional business has been revived, so there is now general recognition that if the IMF did not exist we would have to invent it. As just discussed, avoidance of a new crisis emerging within the next few years is dependent upon large-scale issuance of SDRs. (On the negative side, the IMF has recently abandoned its attempt to become an effective force in the business of multilateral surveillance.)
Similarly, the ability of middle-income countries to borrow from the multilateral development banks (MDBs) even when world circumstances are adverse shows that these institutions retain a role that is broader than their undisputed claim to service low-income countries. The willingness to innovate, e.g., by lending intended to replace lost access to the banks to finance trade credit, likewise makes the MDBs extremely valuable to the middle-income countries during the present crisis. These roles are likely to go back into cold storage if and when the present crisis recedes. But it is clearly of some importance for the world to retain these institutions as insurance against a repetition of global crisis.