The Basel Committee’s replacement for Basel II. Moving with much greater speed than with its previous accords, the committee approved Basel III in September 2010. The new rules rely heavily, as before, on banks’ own internal risk models, but they set tougher standards for the quantity and quality of capital that banks must maintain to cushion themselves against downturns, as well as new requirements regarding liquidity, a subject that Basel II had failed to address. Basel III also includes an element of macro-prudential policy — “counter-cyclical” provisions aimed at forcing banks to accumulate more capital during boom periods, a financial version of the ancient maxim about the wisdom of storing grain during years of good harvest so that enough is available during lean years. Disappointingly for advocates of macro-prudentiality, however, this element was watered down, so that instead of being mandatory on an international basis, individual governments are allowed to apply it in their own countries as they see fit.
The FSB’s series of actions to buttress the global regulatory infrastructure. These include the intensification of regulation and supervision over “global systemically important financial institutions” (G-SIFIs), of which the FSB designated 29 from among the world’s biggest mega-banks, securities firms and insurance companies. Additional capital requirements will apply to these institutions, above and beyond those imposed on ordinary banks under Basel III; they will also come under closer scrutiny from “colleges of supervisors” in the various countries in which they operate and must draft “living wills” that spell out a plan for their possible demise. The FSB has also mandated requirements for many derivative financial instruments to be traded on organized exchanges with central clearing systems, instead of in private, over-the-counter exchanges between financial institutions. This latter reform is aimed at addressing one of the major problems that undermined confidence during the crisis — worries about whether financial institutions dealing in derivatives could depend on their counterparties to honour the contracts.
The IMF’s new mandate for scrutiny of member countries’ economies and the external effect of their policies. Approved by the executive board on July 18, 2012, this “Integrated Surveillance Decision” replaces the 2007 decision, and it authorizes the Fund to discuss with member countries how their policies may affect the international monetary system. By agreeing to this new decision, the world’s nations have implicitly recognized that their policies may have some impact on the stability of the global economy — and that they have some responsibility for that impact.
Are international institutions now sufficiently robust to manage the main challenges facing the world economy? Do the above measures, taken at the London G20 Summit and after, mean that institutional arrangements are in place to secure the economic rebalancing necessary for healthy global expansion, and the regulatory rules and apparatuses necessary for minimizing the risk of future crises? The evidence presented in this book provides ample grounds for answering in the negative.
No Global Sheriff in Sight
In the introductory chapter, two overarching deficiencies of international economic institutions were posited as the chief reasons for doubting that they can deliver what the world needs of them. The first is the institutions’ inability, despite their lofty global perspectives, to discern where crises are likely to arise; the second is their lack of both power and will to crack down on national economic and financial policies that threaten the global commonweal. A third factor cited as a further reason for concern about the governability of the global economy is the impact the crisis has had on US power, in particular Washington’s capacity to maintain the hegemonic role it previously played in building and guiding international economic institutions.
These inconvenient truths could hardly be starker in much of what we have seen about the inner workings of institutions such as the IMF and FSF.
At the risk of belabouring the point, it should be remembered that neither the FSF, nor the IMF, nor the CGFS — the bodies with chief responsibilities for surveilling the world economy and financial markets — were “blowing the whistle,” even privately, before the outbreak of the crisis. It also bears repeating that once the crisis was underway, the FSF misjudged how bad the situation might get. Even worse, arguably, was the performance of the Basel Committee. Not only were some of its key rules and decisions based on assumptions about bank safety and soundness that proved fallacious, the prescriptions ended up aggravating the crisis in certain respects. Again, the people responsible for these policies are neither stupid nor uncaring. Even after the election of Barack Obama brought ostensibly brilliant and less rigidly pro-market policy makers to power in Washington, the problem of obliviousness to impending disaster remained. Several officials who were centrally involved in the tripling of IMF resources in 2009 told me that they recall no thought being given to the possibility that the funds might be used to bail out euro-zone countries.
As for the power that international institutions can wield on behalf of the global interest, reflecting on the IMF’s efforts to deal with global imbalances helps elucidate how depressing the limitations are. The multilateral consultations showed that corralling governments into acting in the collective good is beyond the ken of international institutions, unless an extraordinary confluence of events occurs. Not only must the public interest of each nation be served, but also the short-term political interests of each government and even the personal priorities of key policy makers. The 2007 decision taught even harsher lessons about the scant heed that countries must pay to institutions like the IMF, and the immunity that sovereign governments generally enjoy from any action, including diplomatic embarrassment, that an institution might use to spur cooperation. The IMF let the United States and Japan off the hook for “fundamental misalignment,” and couldn’t even enforce its decision in the case of the Maldives; then it half-heartedly went after China — abandoning its pursuit when Beijing suddenly loomed as a more potent force on the global scene than before. The FSF, for its part, was no paragon of institutional courage either when it came to calling countries to account, as witnessed by the “great defensiveness and excessive politeness” that (to harken back to the words of one participant), characterized discussions at its March 2007 meeting as well as others.
Regarding the US position in the world, this book will not resolve the heated debate between those who perceive the United States as in inexorable decline and those who deride such theories as excessively gloomy. But the retrospective on the 2007 decision, in particular, offers nuggets of insight. Historians may some day look back on the approval of that decision by the IMF board as the last attempt by the world’s old guard to shape the international system without obtaining Chinese assent. The mess that ensued is a vivid reminder of Washington’s relatively diminished clout and the necessity of enlisting Chinese support for any initiative involving governance of the global economy. It is remarkable to contemplate how, less than a decade earlier, Robert Rubin, Larry Summers and Alan Greenspan were widely depicted (with only modest exaggeration) as the IMF’s puppet masters. No Chinese policy makers show any sign of assuming, or even wanting to assume, the kind of influence that trio held. But for the foreseeable future, the successors of Rubin, Summers and Greenspan will have to consider their counterparts in Beijing as indispensable partners in whatever new directions global economic policy making takes.
For good or ill, the “rules of the game” have fundamentally changed. The United States can no longer exploit international economic institutions for geopolitical and economic advantage to the extent it could in prior decades. Using those institutions to thrust burdens of economic adjustment on others without accepting equivalent burdens, or imposing rules on others without also abiding by them, or expecting institutions to use the American model as the basis for economic “upgrades” — those phenomena are becoming increasingly passé, if not being eliminated altogether. This does not mean that the United States has less of a stake in these institutions; on the contrary, Washington ne
eds them as much as ever, if not more, to create the global conditions that best ensure American prosperity. The clearest illustration concerns macroeconomics. With the federal budget deficit swollen as the result of the financial crisis and its ensuing bailouts, and massive spending cuts and tax increases required in the future to minimize the risk of a debt crisis, the stimulative impact of global rebalancing would provide an ideal and vital offset. The irony is that the necessary multilateral cooperation is more difficult to achieve, because the international monetary system lacks a leader with the strength Washington once had to impose solutions when problems arise.
For all of the reasons just cited, nothing even remotely resembling what George Soros called a “global sheriff” will materialize in the foreseeable future. Soros’s wistful lament for such a sheriff4 was understandable. In an ideal system, this person (or institution, or multiple institutions) would make and enforce rules, informed by superior insight into the workings of global finance, that would keep countries from beggaring their neighbours in any meaningful way or otherwise putting the world economy at serious risk. The sheriff would have the wisdom to avoid intruding into countries’ legitimately domestic affairs, in recognition of the fact that in a world of disparate cultures and national preferences, one size doesn’t fit all, but would have the power to intervene when certain lines are crossed. This power would prevent “racing to the bottom” in financial regulation, unfairly cheapening currencies, allowing unsustainable bubbles that might affect other countries’ financial systems and taking actions during crises that threaten to trigger stampedes among investors and depositors around the world. To stretch the sheriff metaphor a bit, this global authority would be fearless about pointing fingers at lawbreakers, and would not hesitate to call a posse if necessary — that is, mobilize countries to impose sanctions against lawbreakers who refuse to mend their ways. The rules would be drafted and enforced fairly — that is, symmetrically, so that they would apply without regard to whether a country is large or small, rich or poor, surplus or deficit.
4 Andrew Ross Sorkin (2010), “Still Needed: A Sheriff of Finance,” The New York Times, January 25.
In the realm of trade, the WTO comes close to global sheriff status. Its dispute settlement system is widely recognized as one of the few ambitious successes in international governance, and for good reason. When countries accuse each other of violating the agreed-upon rules, independent panels of outside experts weigh the evidence and render judgments, giving aggrieved parties the right to impose sanctions against countries found guilty of rule breaking. The result is impressive respect for, and compliance with, both WTO rules and its tribunals’ decisions. Flawed though the system may be (some of its features are biased in favour of the strong and powerful, and against the weak and small), the fairness and objectivity with which panels are perceived to operate imparts legitimacy to the process that other international institutions can only envy.
Even the FSF, in its early days, assumed some modest pretensions of global “sheriff-hood,” with its “good, bad and ugly” designations (or, as they were more formally known, Group I, Group II and Group III) used to classify offshore financial centres. These categorizations, it will be recalled, were backed by an implicit threat of sanctions; if an “ugly” (Group III) offshore centre failed to change its ways, firms based there could have suffered some loss of access in the markets of FSF members. Since this “good, bad and ugly” approach was deemed suitable for the likes of the Bahamas, why shouldn’t something similar apply to countries with much more important financial systems?
People who have spent whole lifetimes working in international economic and financial policy have expressed devout wishes for such sheriff-like powers to be conferred in the future. Here are a couple of excerpts from the 2011 report of the Palais-Royal Initiative, which was prepared by former IMF Managing Director Michel Camdessus together with Paul Volcker, Andrew Crockett and more than a dozen other luminaries:
There is no unified global governance structure to help ensure that major economic and financial policy decisions made nationally, including exchange rate policies, are mutually consistent and contribute to global stability. In a world so deeply inter-connected, economic outcomes in each country depend significantly on developments and policy decisions made in others. In such a world, there is a strong case for rules and processes to be developed to help ensure global stability.
Strengthened surveillance over [countries’ economies] is therefore required. It should address fiscal, monetary and financial policies of national governments...[It] should contain, in particular, the following key elements: (a) stronger multilateral obligations, backed by clear, objective norms or quantitative benchmarks on economic and financial policies and performance to function as alarm signals with appropriate thresholds, (b) assessment procedures that permit judgment about the causes and implications of any deviation from those policy norms, and (c) consequences, including the possibility of both incentives and sanctions. While all countries should have the same obligations and assessment procedures, particular attention should be directed to countries whose policies have a larger potential impact on the stability of the International Monetary System.5
5 Palais-Royal Initiative (2011), “Reform of the International Monetary System: A Cooperative Approach for the Twenty-First Century,” January, available at: http://global-currencies.org/smi/gb/telechar/news/Rapport_Camdessus.pdf.
Alas, support for such far-reaching institutional arrangements is limited to reports like that of the Palais-Royal Initiative. No amount of hand-wringing is likely to improve the chances for approval by the powers-that-be currently making the rules for the global financial system. But hand-wringing is an appropriate response, especially after considering how international institutions fared since the crisis in addressing global economic issues of major import.
Recovery, Rebalancing: Missions Unaccomplished
“Moderately undervalued” is the IMF’s latest assessment of the Chinese RMB — not “fundamentally misaligned,” nor even “substantially undervalued.” The conclusion that “moderate” is the appropriate word to describe the currency’s undervaluation came in the Fund’s 2012 appraisal of China’s economy,6 and that view was reasonably consistent with independent opinion, given the extent to which Beijing had allowed the RMB to drift upward against the dollar. Even economists at the Peterson Institute for International Economics, who have been among the most outspoken critics of Beijing’s currency policy, were calculating the RMB’s undervaluation at only around three percent in 2012.7 One major reason for this revised assessment was the dramatic shrinkage in China’s current account surplus, which stood at around 2.6 percent of GDP in 2012 compared with the 2007 peak of more than 10 percent of GDP. Meanwhile, the US trade deficit also diminished in recent years, to three percent of GDP, about half the size it had reached in 2006 as a proportion of the nation’s economy.
6 IMF (2012), “People’s Republic of China, 2012 Article IV Consultation,” IMF Country Report No. 12/195, available at: www.imf.org/external/pubs/ft/scr/2012/cr12195.pdf.
7 William R. Cline and John Williamson (2012), “Estimates of Fundamental Equilibrium Exchange Rates,” Peterson Institute for International Economics, Policy Brief 12-14, May, available at: www.piie.com/publications/interstitial.cfm?ResearchID=2126.
In view of those facts, it might appear that there is no longer much basis for concern about the issues that prompted the IMF to undertake the multilateral consultations and the 2007 decision on exchange rates. Such reasoning would be misguided. Those issues are as troublesome now, five years after the crisis, as ever — arguably more so.
A declaration of “mission accomplished” in the shrinkage of global imbalances would be grossly premature. As the Bank of Canada put it in a recent analysis, the decline in imbalances to date “has mainly been the result of cyclical factors.”8 In the case of the United States, the most important reason for the reduction in the trade gap has been the weakness of
the country’s recovery, which has suppressed demand for imports. As for China, its less gargantuan surplus is partly attributable to dampened demand in its main markets of the West, and also to a government-directed spree of spending by industrial firms on plants and equipment, which helped prop up the economy after the crisis and drew in a substantial increase in imports. Much of that investment by firms will eventually translate into new production for export. China still hasn’t rebalanced its economy in fundamental ways toward domestic demand; consumption, though booming, remains stuck at a little more than one-third of GDP.
8 Robert Lavigne and Subrata Sarker (2012-2013), “The G-20 Framework for Strong, Sustainable and Balanced Growth: Macroeconomic Coordination Since the Crisis,” Bank of Canada Review, available at: www.bankofcanada.ca/wp-content/uploads/2013/02/boc-review-winter-12-13-lavigne.pdf.
“The Great Rebalancing,” as Michael Pettis has cogently observed in his book of that title,9 will entail more durable and deep-rooted changes in the economic structures of major countries — unless the rebalancing is to occur in undesirable forms involving more financial turmoil and recessions. Crucially, it will require action in countries with surpluses as well as those with deficits. A rebalancing of Asian economies (not just China’s) toward greater demand from consumers, with less dependence on exports and investment, would improve the chances that the world economy can sustain momentum in coming years, without the fresh setbacks that may arise as the United States navigates a painful but necessary transition toward fiscal responsibility. Even greater urgency for the rebalancing imperative stems from the crises in the euro zone. If the healthier surplus nations of northern Europe do not help boost demand in the crisis-plagued periphery by importing more goods, and the periphery countries try to bring their indebtedness under control by simply slashing spending and raising taxes, a self-reinforcing spiral of recession, falling tax revenue and more austerity will ensue — the result being dimmer prospects for ending the continent’s turbulence. Germany doesn’t appear to have gotten the message; its progress in rebalancing has been slower than China’s, with its surplus declining from 7.5 percent of GDP in 2006 to 6.4 percent in 2012.10
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