The Elusive Search for Global Financial Rules

Lorenzo Bini Smaghi, a Member of the Executive Board of the European Central Bank.

BRUSSELS – If the financial crisis is global, it is said, then the solution must be global : an international financial system that works better. And, because the Bretton Woods institutions (BWIs) – the World Bank and the International Monetary Fund – form the center of the international financial system, they must be included in the solution.

An enhanced international financial system must pursue two main lines of action. The first is to broaden the scope of international cooperation. At the moment, the Financial Stability Board, whose members include the G-20 countries, mainly pursues initiatives in this field.

A second line of action is to strengthen the international institutions’ soft powers to aim for more consistent economic policies, especially by systemically important economies. This would directly involve the Bretton Woods institutions, notably the IMF. A strengthening of the IMF was agreed after the Asian crisis in the 1990’s, and the G-7 summit in Cologne in 1999 mandated the Fund to play a strong surveillance role to ensure greater transparency and encourage early adjustment by countries with unsustainable balance-of-payments positions.

But, over the last decade, the expectations raised by this mandate have not been met. Some emerging economies did not let their currencies float but, instead, continued to peg them at undervalued exchange rates in order to promote their exports and build up reserves as a form of insurance in case of crisis.

Moreover, the IMF has not succeeded in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions. Nor have advanced economies, particularly the United States, taken IMF advice fully into consideration. The accumulation of large surpluses, especially in emerging Asian economies and oil-exporting countries, enabled the US to finance its current-account deficit. It also lowered long-term interest rates in the US and made monetary conditions there more expansionary.

Emerging economies, following the advanced countries, also attached less importance to Fund surveillance, especially as their accumulation of external assets made them less dependent on IMF financing and advice. For example, the Fund has been unable to complete a surveillance program with China for three years. All this occurred against the background of emerging-market economies’ claims that their relatively low representation in the BWIs denied the IMF legitimacy.

In recent months, the Fund played an important role in resolving the crisis, in particular by assessing the gravity of the situation and providing countries with external finance. But, if we are to create an international monetary system in which crises are the exception, the Fund must play a greater preventive role.

There seems to be a sense of denial in several countries that large external imbalances were a cause of the crisis. These imbalances ultimately reflected the accumulation of excessive international liquidity by countries like the US, stemming from excessive savings by countries like China. This spurred an unsustainable consumption boom, as well as unwarranted risk-taking by consumers and financial institutions, which contributed to the large distortions and bubbles in global financial markets that were the preconditions for the current crisis.

The risk now is that the forces favoring earlier and effective adjustment of imbalances have been weakened. Indeed, few today are calling for the IMF to play a stronger role in preventing the accumulation of excessive external imbalances and in fostering more disciplined domestic policies.

An example of this is the way the IMF’s Decision on Bilateral Surveillance over Members’ Policies, aimed at identifying fundamental exchange-rate misalignments, was modified to allow greater discretion in surveillance, especially over exchange rates. This might look like a tactical choice, but I doubt that it will result in a stronger hand for the IMF.

Emerging and developing countries are demanding a stronger voice in the IMF, but they also seem to be suggesting that they would like it to be less intrusive and less able to impose conditionality – while simultaneously providing more and cheaper financing. This might be appropriate in times of systemic crisis, but it is not sustainable in normal times. Indeed, some thought should be given to an exit strategy from cheap and unconditional IMF financing.

Instead, most IMF shareholders seem to favor making the organization’s financing easier. Enhancing the role of its Special Drawing Rights (SDRs), or supplementing the dollar with another world reserve currency, would help facilitate the financing needs of both deficit and surplus countries. For deficit countries, borrowing from international institutions outside the markets would be easier, giving the issuer of such currency some form of international lender-of-last-resort function. For surplus countries that want to accumulate reserves, it would reduce exchange-rate risk.

But, if financing were to become easier, it would be unclear how both creditors and debtors would perceive the risk of excessive imbalances. The real danger is that adjustment would take place even later, with imbalances left to accumulate for a longer period of time. Under these circumstances, crises could be even greater, and the adjustments harsher – as occurred under the last world currency, the gold standard.

A viable international financial system requires a mechanism to keep imbalances in check. An essential element of such a mechanism is to give the IMF a prominent role in two areas: strong and effective surveillance in order to prevent crises, and responsible lending to countries in need, but with appropriate limits and conditionality.

We don’t need to reinvent the wheel; we just need to follow up on the commitments made ten years ago. Dealing with the short-run challenges of the current crisis should not distract us from the objective of preventing future meltdowns.

Project Syndicate

Post-Crisis World Institute