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Symposium 2014

Proposal - Some Thoughts on the Shape of the New Global Financial Architecture

The Challenge

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions ...

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions on the credit market, regulation is still highly fragmented among different national supervisory authorities. To maintain systemic stability and prevent contagion, more is required than merely ensuring the orderly operation of individual financial institutions. Different regulators—including monetary authorities—must cooperate in order to achieve better, but not necessarily more, regulation. Better regulation should aim at identifying overleveraging and emerging vulnerabilities, ensuring the adequate pricing of risk, and promoting better incentives for prudent behavior. In pursuing these targets, regulation will require changes to institutional structures, the content of rules, and especially the structures of supervisory agencies.

  1. The challenge is to identify potential sources of vulnerability and undertake appropriate remedial measures in order to further reduce and possibly eliminate the potential of the next major financial crisis.
  2. For any individual country, it is important to maintain macroeconomic and financial discipline (given the swiftness with which markets respond to economic and financial developments). However, strong economic fundamentals, while necessary, are not sufficient conditions for the prevention of such crisis. This is because, as was pointed out by Jeffrey Sachs and Joseph Stiglitz, the cause of the 1997/1998 financial crisis was instability in the international financial markets due to inappropriate financial liberalization, including allowing hedge funds to take big bets on a coordinated basis, with the Western international banks allowing them to leverage as much as 20 times the capital.
  3. We need to create a system of global finance that allows a more balanced world economy. It is neither desirable nor sustainable for global macroeconomic balance to be achieved by recycling huge savings surpluses of fast emerging economies into excess consumption of the world’s richest consumers. Even now, fast growing developing countries with underdeveloped financial systems are exporting savings to the developed world for packaging and re-exporting to them (i.e. developing countries) in the form of financial products.
  4. Therefore, an important task ahead for all of us, both in developed and developing countries, is to work together to create a system of global finance that allows a more balanced world economy, with some of the excess savings being channeled to finance infrastructure projects in developing countries, so that these countries can move up to the take-off stage of economic development. The most important ingredient of development for developing countries is infrastructure. Such a move will be positive for all countries, rich and poor, as infrastructure development will boost world GDP and consumption.
  5. If we do not have balanced global financial flows, we would continue to face periodic financial crises, occurring with growing intensity and alarming frequency, requiring the helping hands of governments to throw in life jackets to the invisible hands of the market. Perhaps the appropriate description for the Anglo-American type of capitalism is life jacket capitalism. The invisible hand of the market that Adam Smith referred to so admiringly can be seen every time there is a crisis, waving for help like a drowning man. The hands become invisible again during good times.
  6. Where is the likely source of the next major financial crisis? One such source is the continuing international financial liberalization – free and rapid mobility of short-term capital (hot money) result in developing countries becoming vulnerable to financial speculation.
  7. The increasing importance of the financial sector and particularly the fast increase in derivative trading (which caused the 2008 crisis) is continuing much the same as before. The premise of Greenspan’s remark in 2002 (although proven false) is still held by the bankers and many Western leaders as gospel truth. This is what Greenspan said:-
    “The use of a growing array of derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial institutions. As a result, not only individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial systems as a whole have become more stable.”
  8. Greenspan was proven wrong in 2008. His whole intellectual edifice collapsed but the lesson on the danger of uncontrolled derivative trading has yet to be learned and could haunt us one more time.
  9. Recent research by economists from the IMF and academia offers some new insights about income inequality, with important implications to future financial crises. Research findings have now shown that greater inequality (of wealth and income) and higher debt could make future crises more likely. Briefly, the theory is that rising inequality and stagnant incomes in the lower income groups lead workers to borrow to maintain their consumption growth. As these households become increasingly indebted, they continue to borrow more to maintain their consumption. This increases the leverage, and eventually a shock to the economy leads to a financial crisis. This theory holds for both the 1920’s stock market crash and the 2008 Great Recession.
  10. We need to create a stable regime of exchange rates. At present, developing countries are exposed if major currencies (USD, Euro, Yen) fluctuate violently. Developing countries should also understand the risk of over reliance of corporations on foreign loans, which can be withdrawn at short-call and subject to currency risk.
  11. Unfortunately, despite the recent crises, there is very little focus on preventive measures regarding how to avoid a crisis. The focus appears to be on how to limit the fall out after the crisis has occurred. There is yet no institutional recognition of policy implications that financial globalization has fundamentally exacerbated the problems of pro-cyclical crises. There is also very little, if any, attention to the role played by financial institutions and policies in creditor countries in triggering financial crisis.
  12. Interestingly, most discussions on preventing crisis circle around greater transparency and information, although there is no evidence whatsoever that greater transparency will prevent crisis. There is also the hypocrisy if transparency is required of Governments but not from the hedge funds. When a crisis occurs, the rescue packages by IMF and others focus on bailing out creditors rather than stabilizing the economy.

    Possible measures to avoid next global financial crisis
  13. The following are some possible ways to mitigate the occurrence of a major financial crisis in the years ahead:-
    1. Reduce the importance of the financial sector in the GDP of a country. The role of banks and financial institutions is to facilitate trade and development. The financial sector has now become a major sector on its own, with little reference to its role as facilitators of real growth. The funding from financial institutions must be for productive real economy, not for speculation.
    2. The multilateral rules of financial policy should recognize the right of countries to enforce capital control for reasons of both financial sovereignty and prevention of financial crisis. Developing countries need to think seriously their participation in trade and investment agreements that constrains their ability to protect themselves from and respond to financial crisis. The proposed TPPA is a case in point. It will not allow capital controls to be imposed by a participating country.
    3. There is a need to review seriously a mechanism to tax short-term capital flows, often referred to as the Tobin tax.
    4. There is a need to reduce the role of the US dollar as the reserve currency. As it is, this role enables the United States to live beyond its means, thereby triggering futures crises.
  14. Given that a consensus at the international level may not be that easily forthcoming in the near future, reforming the financial architecture at the regional levels should also be considered. The reason a solution at the international level may be difficult has to do with politics. The fact that the Great Recession of 2008 has so far not resulted in a rethink of the need for a new financial architecture shows the lack of political courage, mainly on the part of the United States and Europe, where the banking lobby is strong, and where many investment banks have acquired the status of “too big to fail.”

 

Conclusion

Not taking action to prevent the next global financial meltdown is not an option. Leaders in all parts of the world are operating in a bewildering new environment in which little is certain, the tempo is quicker and the dynamics are more complex. The next financial crisis can hit us from anywhere.

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