Nov 13th 2008
From The Economist print edition
On November 15th world leaders are due to sit around a table in Washington, DC, to fix finance. They have their work cut out
Illustration by Bill Butcher
THE leaders arriving in Washington, DC, for this weekend’s economic summit are being presumptuous. If they want what they are calling Bretton Woods 2 to live up to the original, which took place in New Hampshire overshadowed by war and the Depression, it will have to establish a new economic order for the capitalist world. In 1944 that meant creating the IMF, the World Bank and a body to oversee world trade. Imagine Hank Paulson, America’s treasury secretary, as John Maynard Keynes; or picture Gordon Brown, Britain’s prime minister, as Winston Churchill (as Mr Brown himself secretly may), and you get a sense of the task ahead.
The Bretton Woodsmen of 2008 are grabbing the credit before they have earned it—rather as all those subprime householders did. More than two years of gruelling technical work laid the ground for the wartime conference of officials and finance ministers (prime ministers and presidents had other things to deal with). By contrast, the leaders gathering this weekend from the G20, a mix of industrial and emerging countries, plus the European Union, have cobbled together an agenda in a few frenetic weeks. They will doubtless produce no shortage of promises. Just what these are worth will depend on sweat and summits yet to come.
The summit is sure to stir up a debate about the institutions that oversee the international economy. By convening the G20 rather than the closed, rich club of the G7, the old order has in effect acknowledged that the rest of the world has become too important to bar from the room. But what new order should take its place? Answering that question has been a parlour game for economists since long before the crisis. By encouraging them to dust off their pet ideas, the summit will at the very least create a bull market in new schemes for global economic governance.
Because everyone agrees that something big needs fixing and that the world expects action, calling the summit Bretton Woods 2 could yet come to be seen as a rallying cry for reform. And yet there are lots of reasons to see it as vainglory. The agenda is vague and sprawling. With so many of the world’s political leaders sitting around the table, it will be hard to escape platitudes and hypocrisy. There may be disagreements—especially where sovereignty or competitiveness is threatened. And most of all, the recent international financial collaboration is fraught with in-fighting and complexity.
At first sight, this summit seems no different. For instance, consider how Mr Brown and Nicolas Sarkozy, the president of France, have vied to claim paternity of the summit for their own domestic reasons. Mr Sarkozy sees a chance to show he is a man of action, and he will find it easier to force through domestic reform if he can show he is not in thrall to all that Anglo-Saxon free-market ideology.
Mr Brown has been calling for a global summit for weeks, emboldened by international acclaim for his plan to rescue Britain’s banking system. The prime minister is keen to show that the crisis is one of those worldwide messes that—honestly—has nothing to do with the past 11 years of Labour government. And he wants to play the lead in Washington so as to protect the free-market City of London from the Gallic machinations of Mr Sarkozy.
From despair, hope
But there is more to the summit than politics. Perhaps inevitably, the run-up to the summit has produced dozens of different proposals. Broadly, they fall into three areas. First and most urgent is the need to limit the crisis, which is even now spiralling from the rich world to emerging economies. Second is financial regulation: its flaws have been laid bare, and the summiteers will want to put it right. Third is global macroeconomics. The G20 needs to find ways to correct the imbalances—Asian saving and Western spending—that lay behind the boom.
Pervasive economic gloom is the best reason for hoping that something important will come of this weekend’s meeting. After savaging the financial markets, the credit crisis has broken loose into the real economy. This month the IMF lowered its forecast for global growth next year by 0.8 percentage points, to 2.2%. The rich world is already in recession. Unemployment, foreclosures and corporate bankruptcies are rising. Emerging economies have also been ensnared, as investors from richer countries retreat to their home markets. The fund cut its forecast for their growth rate by a percentage point, to 5.1%.
Such pain demands an ambitious policy response. On November 6th Kevin Warsh, a governor of the Federal Reserve, put it in dramatic terms: “We are witnessing a fundamental reassessment of the value of every asset everywhere in the world,” he said. “The establishment of a new financial architecture, thus, is the essential policy response to the greatest economic challenge of our time.”
The easy bit will be to harness that sense of urgency to produce concerted interest-rate cuts and government spending. Already, several countries are talking about a co-ordinated fiscal stimulus to help offset a collapse of private-sector demand. China set the standard on November 9th, with a huge spending plan worth 4 trillion yuan (nearly $600 billion), or about 15% of GDP (see article). Not everyone can muster such resources, but other countries, including America and Britain, are preparing to act too. Germany, which has promised a piffling €12 billion ($15 billion), may be shamed into spending more. With concerted action, countries will find that each national stimulus buys more confidence than it would do alone.
Many commentators also want to build confidence by increasing the spending power of the IMF. If a large emerging market, such as Poland or Turkey, were to need help, says Willem Buiter, an economist at the London School of Economics, its present resources of $250 billion “would be gone before you can say ‘special drawing rights’.” Although some European delegates want to strengthen the IMF, the Americans are resisting: the summit may produce nothing more than a pledge to find the money if the fund needs it.
In financial regulation, some changes ought to be easy to agree on—such as ensuring that banks stop holding assets off their balance-sheets and put capital aside against possible failures in a wider range of securities. The summit is also likely to try to bring order to the market for credit-default swaps, which trade the risk that borrowers will not honour bonds, by concluding that, within 120 days, the business should be routed through clearing houses rather than settled privately by investors.
That is progress, to be sure. But it is small potatoes next to the summiteers’ ambitions. And little else will be easy, even if the leaders can issue a declaration that sets out their common principles and a schedule of negotiations for further reform. To see why, leave behind the first Bretton Woods conference for the more recent history of international financial regulation.
No end of squabbles
Illustration by Bill Butcher
The difficulty with cross-border rules in finance is explained by Barry Eichengreen, a professor at the University of California, Berkeley, and one of 20 economists from around the world who have written an “e-book”* that describes what this weekend’s summit should do.
On the one hand, finance is every country’s business. This crisis has shown that what happens deep inside one national financial system can wreck another halfway across the world. In the United States subprime lending was a relatively small bit of the mortgage market—itself just a part of America’s financial markets. And yet the cascade of failing credit and risk aversion that began there, partly as a result of inadequate supervision, has spread not just to the overstretched banking systems of Europe, but also now to untroubled banks in emerging markets.
On the other hand, nation-states jealously guard the right to oversee their own banks. This is not just out of principle, or a desire to see that the regulations suit their own financial institutions—although most regulators would think these alone to be sufficient reason. It is also because, when a crisis comes, the nation-state foots the bill for a bail-out. In addition, Wendy Dobson, of the University of Toronto, notes that regulators need intimate local knowledge of their charges and their own financial structures if they are to have a hope of prevailing—and even then, as the world has seen, the odds are against them.
The tug between national and supranational regulation has gradually led to an ad hoc arrangement for the international banking system. In the 1980s America and Britain grew worried about the expansion of Japanese banks, which by 1988 accounted for nine of the world’s ten largest by assets, up from one at the start of the decade. What bothered the West was that Japanese regulators allowed their banks to count shareholdings as core capital. Cheap capital fed their growth. And it was indeed reckless, as the subsequent collapse of the Japanese stockmarket showed.
Under the auspices of the Bank for International Settlements (BIS), a central bankers’ central bank in Basel, in Switzerland, the big economies agreed to set common standards for what counted as capital and how much a bank should hold in order to qualify as safe. Their negotiations were partly about rules to make the global financial system more resilient. But they were also, in effect, about a trade dispute, over what the West saw as a subsidy to Japan’s banks. This ambiguity between the common good and national interests complicates all financial negotiations—including any that will follow the G20 summit.
Andrew Gracie, who worked on regulatory design at the Bank of England and founded Crisis Management Analytics, which advises central banks on financial stability, points out that right from the start regulators looked at systemic risk one bank at a time. The assumption was that if each institution was safe, then the system as a whole would be too. Similarly, when banks had many subsidiaries, regulators short of money and time tended to worry only about their own piece of the jigsaw.
This “micro-prudential” philosophy was always questionable. Now it looks absurd. Banks tend to own similar assets. In a crisis the capital of the entire industry tends to fall, which means that the instability of one bank can undermine the standing of the next. Hence the talk about a new “macro-prudential” sort of regulation that seeks to take account of the whole system’s vulnerabilities, as well as the health of individual banks, by, say, adjusting capital charges over the economic cycle.
The strengths of the original Basel standards (Basel 1) lay in being reasonably simple to negotiate and administer. But therein lay their weaknesses also. Banks soon started to favour business that was profitable (ie, risky) but which, under Basel 1’s crude definitions, escaped the appropriate capital charges. As the banks adapted to Basel 1, so the rules became less useful.
That gave rise to the effort to create Basel 2, which began in the late 1990s. This sought to strike a different balance, by asking banks to be more sophisticated in assessing the riskiness of their assets and thus their capital requirements. But sophistication came at a high cost. A recent book† by Daniel Tarullo, a professor of law at Georgetown University who is fancied for a senior economic post under Barack Obama, describes how the negotiations dragged on for years as governments jostled for a deal that would give their own banks some advantage. Mr Tarullo observes that the banks would accept all sorts of arbitrary provisions as long as the end result was to reduce the amount of capital they had to put aside.
Faults and lessons
Basel 2 is a flawed agreement. Although it is not yet in force, it already needs updating. Its chief failing is its reliance on rating agencies and the banks’ own models of the risks that they are carrying—an idea that has been discredited by the way banks have been caught out. In addition, the accord did not allow for the evaporation of liquidity that prevented the banks from financing their businesses. It is hardly reassuring that the minimum capital that rescued banks are aiming for today is far above the minimum set by Basel 2.
The story of bank-capital standards contains important lessons for the leaders gathering at the G20. The talks dragged on because their objectives were unclear, the subject matter was complex, negotiators were fighting for the upper hand and there was little sense of urgency. Even if all that can be put right, the schedule of work has expanded. Supervision may need to extend beyond banks, to any financial institution whose failure could threaten financial stability, which might include some large hedge funds and non-bank financial companies such as GE. The capital-standards regime also needs to become more macro-prudential. Regulators need to be able to put more trust in banks’ risk models and rating agencies and supplement them with simple rules about the level of borrowing. Mr Tarullo suggests that banks should issue new securities to serve as gauges of investors’ faith in them.
There are two difficulties in all this. The first is that it will take time and, as urgency fades and the negotiators drown in complexity, national interest may gain at the expense of collective safety. The second is that original dilemma: international rules require enforcement, but nation-states demand sovereignty. Dominique Strauss-Kahn, head of the IMF, wants an inspectorate. Mr Eichengreen has proposed a World Financial Organisation, with disciplinary panels. The EU wants “colleges” of national regulators for each bank and an IMF to give warning of crises. The summit looks most likely to back the EU idea—but it ought to be more ambitious. The system will work only if governments heed outside warnings. But just look at how they browbeat the IMF into giving favourable assessments of their economies.
Although this summit looks likely to dwell on financial regulation, it cannot ignore the macroeconomics that preoccupied the original Bretton Woods conference all those years ago. As Martin Wolf, a columnist at the Financial Times, explains in a new book‡, the boom was fuelled by the imbalances that grew out of the Asian financial crisis in 1997.
Illustration by Bill Butcher
Countries that had grown used to incoming foreign capital suffered terribly when it suddenly flowed back out again. To protect themselves in future, they started to run current-account surpluses and to amass foreign-exchange reserves. Spendthrift America and Britain were happy to help Asia save, even if that meant running the corresponding deficits.
Surpluses are all very well, but they cannot continue to accumulate for ever. Perversely, if they unwind violently, they will create instability. Much of the cheap money recycled from the saving countries found its way into housing and other assets in the West. It was too much to hope that it would flow back out of those assets in an orderly way.
The conflict between sovereignty and safety here is even less easy to disentangle than it is in financial regulation. Clearly, no country would agree to live by a rule that it should balance its current account. Raghuram Rajan, a professor at the University of Chicago and a former chief economist at the IMF, points out that current-account surpluses and deficits can indeed help countries cope with shocks and finance investment. At the same time, no international organisation like the IMF could plausibly have the independence or the resources to make a credible promise to back all the economies suffering from capital flight in a crisis.
This conundrum leads straight back to a souped-up IMF—still too small to save the world, admittedly, but bigger than today’s, and backed by swap lines from the three large regional central banks, the Fed, the European Central Bank and eventually the People’s Bank of China. For that to work and for the IMF’s help to lose some of its stigma, rich countries will have to admit more emerging economies to the fund’s board. Cue yet more difficult negotiations.
There are two ways of thinking about this weekend’s summit in Washington. To be charitable, look on and wonder at the sheer ambition of taking on so many hard, important questions. A severe financial crisis may be the only time when the technicalities wallowing near the bottom of policymakers’ agendas receive the attention they deserve. But there is a more cynical interpretation. Perhaps the summiteers will bask in the headlines and then, out of the glare of the television lights, set about something disappointingly modest.