Reshaping the Global Financial System
Presentation at a conference on "Brazil and the London Summit" in São Paulo, Brazil
The immediate problems posed by the crisis will certainly have to be dealt with in London. For example, the politicians will have to make sure that all their number are making the contribution to the fiscal stimulus of which they are capable, they will have to repeat trade pledges and hopefully will create some monitoring machinery, they will need to unlock trade credit for poor countries, and they must increase the resources of the International Monetary Fund (IMF). They may not pay much attention to the most important cure of all, fixing a banking system that is weighed down by the toxic assets that it created, but that is because most of them have given independence to their central bankers and do not want to be seen going back on that decision.
But the severity of the current crisis and a widespread view that it was a consequence (though not widely predicted) of the existing system make it possible to hope also for initiating more fundamental reforms. There is a welcome desire to use the present occasion to make changes to the global financial system designed to prevent future crises from occurring at all, or at least to make them less severe. Since reforms happen only under the spur of a crisis, it would mark a failure of the London summit in the eyes of historians if its outcome should be confined only to stimulating demand.
Perhaps the most important changes concern the system of regulation. Thus I cannot conceive that it would be possible to base the future financial system on a perpetuation of the past system of financial regulation, which was procyclical in its impact, arbitrary in its incidence, and outdated in its concerns. It must be replaced by rules that cover all players with significant collective macroeconomic impact, add macroprudential concerns to the exclusive focus of present regulations on microprudential factors, penalize security or other mismatches, and combat the tendency to regard financial mergers as a solution rather than (as evidenced by the spate of banks that are too big for their home countries to save) a problem. I regard the most important reforms as those that will counter procyclicality and those that will combat large financial institutions. Both can be accomplished by appropriate variations in required capital-asset ratios without entering the quagmire of trying to regulate liquidity.
The second element of a reshaped global financial system will be a revamping of the international financial institutions (IFIs). This is unique among reform proposals in that it could both alleviate the short-run problems facing the global economy and form the basis for long-term reform. My colleague Morris Goldstein has suggested that the changes needed to revamp the international financial institutions could be agreed in London as a "Grand Bargain." This would involve an expansion in the ability and willingness of the IMF to lend on low conditionality where a deficit is not primarily due to national policies, in return for an enhanced role for the IMF in surveilling macroeconomic policies.
The international community would agree to provide plentiful international liquidity through the IMF on no or low-conditionality terms, without the need to run the large and costly trade surpluses that are required to self-insure by earning reserves under present arrangements. This would involve a resumption of special drawing rights (SDR) allocations and the reestablishment of the Conditional Financing Facility (CFF) on the older and more generous terms.1 To make this an attractive prospect to emerging markets and developing countries it would be necessary for them to come to regard the Fund and World Bank as their own institutions, which they have hardly done in the past. The changes this implies have been discussed ad nauseam in recent years: They are essentially changes in governance, involving increasing the relative size of the quotas of Asian emerging markets at the expense of European countries, increasing the representation of emerging markets and developing countries on the boards of the institutions, opening up the leadership selection process to the whole international community, and recruiting from a wider spectrum of talent. To make possible an increase in the generosity of IMF lending, it will be necessary to increase the finances of the IMF. This will involve both resuming SDR allocations and making extra sums available to the Fund. But in return for these increases in both the economic position and the political clout of emerging markets and developing countries, and provided they agree to subject themselves to the same discipline, the industrial countries could expect a surveillance system with teeth. Global imbalances of the size seen in recent years would be neither necessary (because there would no longer be a need to earn increased reserves) nor possible (because countries would not have the right to maintain undervalued exchange rates and would have a duty of taking international conditions into account in determining demand).
I take the view that these are the indispensable reforms. There has also been discussion of an early warning system and an expansion of the Financial Stability Forum (FSF). I tend to be skeptical about the feasibility of designing and implementing an early warning system, partly because I doubt it can be made to work (crises are inherently unpredictable and tend normally to arise out of unique situations), and partly because if it did work there would not be any crises to give early warnings about (countries would take evasive action). What people really mean when they speak of an early warning system is warning countries that on present policies they are heading for trouble. But the IMF already tries to do this through Article IV Reports and World Economic Outlook publications. The main problem is that countries, especially large ones, tend not to take any notice, which is a problem that cannot be cured through multilateral agreements. As for the FSF, it has recently announced that it is planning to expand and welcome emerging markets like Brazil. This particular reform has already happened.
Reforms of the multilateral development banks (like increasing the profile of the Millennium Development Goals or greening their lending practices) are also highly desirable, but less critical from the particular standpoint of revamping the IFIs to avoid future financial crises.
I believe that Brazil would benefit through reforms along the lines sketched above. The advantages stem essentially from a better-functioning world economy, which I see as favoring Brazil (along with most other countries). We now live in an interdependent world, where all sink or swim together.
Achieving a recovery is going to be influenced by the immediate policies agreed at the London summit. Sustaining it will certainly depend upon policy going forward that is green enough to limit climate change, as is to be discussed this afternoon. But sustaining growth will also depend on the avoidance of financial crises, at least of the severity of the current one. I have argued above that this will require both fundamental reform of the system of financial regulation and a revamping of the IFIs. London is the right place to start this process of reform.
1.The G-20 will have to act quickly to expand the CFF, because the IMF appears to have resolved to go in the opposite direction and kill it altogether.