Crisis summit a chance for genuine reform
By Hossein Askari and Noureddine Krichene
President George W Bush is scheduled to host an economic summit of global
leaders in Washington on November 15. Without careful preparation and
commitment, the meeting could do more harm than good.
For months we have recommended a global approach towards what is after all a
global financial crisis. While we are encouraged that the summit may mark the
beginning of a more thoughtful and comprehensive approach to the problem, we
caution against just another international meeting and photo opportunity for
global leaders.
The participants at next week's meeting will be the heads of state
from the Group of Twenty (G-20), countries representing about two-thirds of the
world's population and about 70% of global economic output [1]. G-20 meetings
are also normally attended by president of the European Union, the European
Central Bank, the managing director of the International Monetary Fund (IMF)
and the president of the World Bank. It is expected that this gathering will be
the first in a series of international meetings designed to address global
financial meltdown and financial reform.
Why do we need a global summit when the US, European countries and Japan are in
such disarray and have not solved their own domestic financial problems? What
should this, and the global meetings that follow, address? How should the world
go about resolving the problems that we face today and what structure and
procedures should be put in place to avoid future problems?
With globalization, no country is an island. While we readily accept this
truism in the area of trade in goods and in the movement of people across
borders, it is also evident in the area of finance. Capital - to buy real
estate, shares, bonds and ownership in companies, to build new companies, to
lend to foreigners and much more - moves across borders. Thus if there is an
equity or a fixed income asset meltdown in one country, other countries are
affected as they may own these securities or might have lent to these
countries.
If countries live beyond their means (that is, run current account deficits),
they have to borrow from other countries, something that the US has done for a
number of years. If exchange rates move significantly, the fortunes of
international investors are affected; and the kind of exchange rate (fixed
versus floating) affects capital flows and the transmission of economic shocks
across borders. While the areas of international financial interdependence are
much more than this, the point is that finance is global.
Put differently, while we could be enjoying stable financial conditions,
adverse developments and instability in another country could impart losses on
us and destabilize our financial conditions. The sources of the transmission of
instability across borders are many and we are witnessing them today - losses
on securities held in other countries, dramatic movements in exchange rates,
diffusion of "financial fear" and panic, failure of financial institutions,
large cross-border capital flows, plunging economic activity.
A country's effort to stabilize its financial system can be aided or thwarted
by conditions in the rest of the world. In other words, simultaneous,
comprehensive and coordinated policies in the world increase the likelihood of
calming financial markets and restoring economic prosperity. Thus to restore
financial stability in any country, domestic, as well as international,
policies and reform are called for.
To calm financial markets and lay the foundations of sustained economic growth
and prosperity, world leaders should avoid the temptation of adopting a quick
fix but should instead adopt a comprehensive approach to address all the
fundamental financial issues facing the world. In no particular order of
importance, world leaders should commit their countries to examining, analyzing
and negotiating agreements that address a number of problem areas.
First, how should the international payments system be changed and modified? At
the Bretton Woods conference towards the end of World War II, global financial
leaders adopted an international payments system with fixed exchange rates
under a gold exchange system.
In 1971, after years of US benign neglect by ignoring discipline in its
macroeconomic policies and running balance of payments deficits (resulting in
exploding dollar holdings in the rest of the world), the system collapsed. In
1973, the world embraced the collapsed international payments system that had
evolved - a hodgepodge, principally with most countries adopting floating
exchange rates (with government intervention) and no discipline in
macroeconomic policies; and ironically no discipline whatsoever on the part of
the major economies, economies that had the major impact on other countries
(US, Europe and Japan) as they had no need of IMF financing.
The system of exchange rates and macroeconomic discipline (including monetary
discipline) and coordination across countries, a fundamental pillar for a
stable global financial system, has been missing.
Second, and an integral part of the above, there is a need to define the
structure and operation of central banks. Admittedly, the US Congressional
debate regarding the causes of the present financial crisis has concluded that
negative real interest rates set off phenomenal speculation in asset and
commodity markets. Monetary policy matters a lot. It would seem that central
banks should be subjected to extra-constitutional laws that would set
publicized targets on money supply and credit, establish a predictable monetary
framework, and eradicate monetary uncertainties arising from interest rate
policy.
Under a fiat money standard, there is no anchor to money policy except via
strict control of monetary aggregates. Hence, the primary function of central
banks should be stable money aggregates, financial regulation, and not overall
economic management. There is a need for a global accord on this issue as the
fallout of central bank policies permeate across borders. Without regulating
central banks, there will be no financial stability.
Third, and closely related to the first two above, there is an urgent need for
a global financial regulatory agency. The United States seems at last to have
acknowledged the obvious. The US needs a single financial regulatory agency to
regulate all (be they state or federally chartered) financial institutions:
commercial banks, investment banks, hedge funds, savings and loans
institutions, credit unions, mortgage companies, and insurance companies. Such
a regulatory agency should have authority over every function of these
institutions and be empowered to issue federal guarantees for depositors.
The reason why every country needs a single financial regulatory agency is that
no single category of financial institution is an island; they impact each
other as we have seen in the recent global financial turmoil. Similarly, no
country's financial system is immune to cross-border developments. There is a
desperate need for a single global regulatory agency (including accounting and
reporting standards) with supervisory and enforcement powers.
Fourth, we need a surveillance of macroeconomic policies. Economic policies
affect financial stability and financial stability affects economic
performance. It is that simple.
Fifth, we need to develop the appropriate institutions and institutional
structures to handle these elements of reform. Where do the Bank for
International Settlements, IMF, and the World Bank fit into this new global
financial infrastructure? How should these institutions be reformed and
restructured? The Financial Times has floated the idea of a world central bank
that oversees central banks. How does this idea relate to similar proposals by
John Maynard Keynes in 1943 and many other leading economists?
Sixth, what is the best (and quickest) approach to ameliorating the ongoing
financial crisis? While this may be the preoccupation of politicians, it should
not be the only topic of discussion by the heads of state.
Unquestionably, the haphazard approach to the financial crisis since August
2007 has wiped out equity assets, precipitated the downfall of large financial
institutions, and caused economic recession. Historical records of major
financial crisis in the 19th and 20th centuries indicated that these crises
were absorbed through bankruptcies of highly leveraged and speculative
institutions, private recapitalization, free and rapid price adjustments, and
sounder and safer resumption of credit. There was no public bailout and no
anti-market mechanism.
A blanket and hurried approach such as the TARP, unlimited bailouts, and
massive recapitalization could turn out to be highly costly, super
inflationary, and disruptive to the real economy. Forcing negative real
interest rates and indiscriminate resumption of credit in a highly impaired
banking system, through unlimited liquidity injections, will endanger the
soundness of banks and undermine recovery. Government opposition to market
adjustment of asset prices, which have become misaligned with economic
fundamentals because of speculation, can only worsen and prolong the financial
crisis. Forcing distortions in relative prices could be too costly in lost
output and cannot be sustained without a huge budgetary cost.
Choosing the inflationary course out of the crisis can only ruin the real
economy and make the crisis unmanageable. While deposits have to be secured,
ailing financial institutions have to be treated on a case-by-case basis and
over a long time span. Interest rates have to be freed. Housing prices have to
be allowed to adjust to incomes, construction costs, and normal profit rates.
Credit policy cannot be free for all. Banks should be allowed to assess risks
and lend on safer basis. If they are forced to lend indiscriminately, they will
incur more losses that will endanger their safety.
While the above is not an exhaustive list of the issues we face, they are the
major issues to be addressed in November. How should world leaders go about
this monumental task? Heads of state should not address any issue in detail.
Instead they should embrace the major issues to be addressed and the modalities
for addressing them. They should also commit to a series of future meetings to
monitor progress.
The appropriate modalities for addressing these issues are extensive. We will
stress those that we think critical.
The heads of state should list and support the major category of issues to be
addressed (in our opinion the six points above).
They should appoint an executive committee to oversee the program of reform and
this committee should also act as an operational committee to monitor problems
and shocks and take corrective measures on a real time basis. This committee
should in turn appoint separate committees to tackle each of the critical
issues that are supported by the heads of state.
The heads of state should agree on a timeline for the initial recommendations
from the executive committee on each of the critical issues listed above and
for future deliberations of the heads of state.
The heads of state should agree on a mechanism to involve countries that are
not represented on the G-20; this is a global problem requiring a global
solution, which means that all countries should participate and have a
meaningful input, if not, the global approach will fail.
In the end, while the quality of the comprehensive technical decisions and
their global adoption is the key to success, world leaders must also impart
confidence and trust to the international financial system. Their mutual
cooperation and willingness to be all-inclusive may be as important as their
substantive achievements in building trust and confidence in our international
and domestic financial structure.
In a world teetering on the edge of financial collapse and the deepest
recession since the Great Depression, a failed meeting will do unimaginable
harm to the global financial and economic system. Preparation for the November
15 meetings is the key. The Bush Administration should take note and prepare.
Note
1. G-20 countries: Argentina, Australia, Brazil, Canada, China, France,
Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South
Africa, South Korea, Turkey, the United Kingdom the United States, the European
Union.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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