With all the crises besetting U.S. President Barack Obama following his re-election – the fiscal cliff and Iran’s nuclear program in particular – he is presumably giving little thought now to longer-term issues. But here is one problem that, if left to fester, could undercut his hopes for a healthy economy: the weaknesses of international institutions responsible for fostering global economic and financial stability.
The financial crisis that erupted in 2008 cast profound doubt over the effectiveness of these institutions and their successor bodies, which include the International Monetary Fund, the Financial Stability Board and the Basel Committee on Banking Supervision. Adroit action by them, guided by the Group of 20 major economies, is now required to overcome serious challenges that loom in the wake of the crisis.
The first of these challenges involves re-balancing the global economy to ensure a sustained recovery. Massive trade imbalances must be shrunk, preferably with a well co-ordinated plan. After all, the countries that have run large trade deficits, notably the United States, are obliged to impose significant austerity measures sooner or later. Belt-tightening in deficit countries will endanger global growth unless countries with large trade surpluses, such as Germany and Asia’s export powerhouses, take offsetting action by ramping up demand and importing more goods.
International co-operation is likewise critical for regulating the global financial system. The nations of the world must avoid creating a hodge-podge of new rules, lest banks move operations to the countries with the laxest regulatory regimes. Better international rules regarding banks and shadow banks – or at least well-harmonized broad principles – are vital, as are improved systems to manage crises that spill over from one country to others.
Hasn’t plenty been done already to beef up the institutions that deal with these issues? Yes, the G20 – which supplanted the elitist G7 as the global economy’s steering committee – undertook co-ordinated action in 2009 that helped avert depression. The IMF got lots of extra financial firepower. And the FSB, composed of policy makers and regulators from two dozen countries, was created to take the place of a feebler group called the Financial Stability Forum. (The FSB’s chairman is Canada’s dynamic central bank governor, Mark Carney.)
But serious shortcomings and failings in these institutions are evident from a detailed look at their inner workings (and that of their predecessors) during the period leading up to the crisis. That is the upshot of research I have done, based on interviews with more than 100 policy makers and thousands of pages of confidential documents – memos, e-mails, meeting notes and transcripts – that have never been previously disclosed. This wealth of material points to dispiriting conclusions about the ability of these institutions and the world’s major countries to co-ordinate the policies necessary to generate a balanced, sustainable global recovery and prevent future crises.
The point is not that these institutions caused the crisis; they didn’t. But they have proven inefficient in two critical ways. First, despite their efforts to attain elevated, global perspectives on the workings of modern markets, they can’t accurately tell where and how crises are likely to arise. Second, they don’t have the power, and they often lack the will, to stop countries from pursuing policies that threaten neighbours’ stability or even the entire financial system.
One illuminating example took place in a March 2007 meeting of the Financial Stability Forum, which was created in 1999 to guard against crises like the ones that had stricken Asia. Signs of serious trouble were emerging in the U.S. mortgage market – precisely the type of threat that the FSF was supposed to assess. But the view FSF members got from a U.S. Federal Reserve official was soothing. It was “important to recognize that the market segment affected ... only constitutes 7 to 8 per cent of the overall U.S. mortgage stock,” a confidential summary of the meeting quotes him as telling the group, “and there has been little evidence of spillover into other market segments.”
This sanguine view drew no challenge from others. “Nobody around that table said, ‘This is not believable,’” one former FSF member acknowledged to me. And that, he added, was fairly typical of FSF meetings, where “there was great defensiveness, and excessive politeness.” Only six months later, financial turmoil provided the first early warning of what was to come – and even then, the FSF was way behind the curve. Its worst-case scenario had to be updated the following March, when the crisis had deepened well beyond the FSF’s expectations.
To achieve global economic re-balancing and effective financial regulation, the world needs institutions that are as free as possible from “great defensiveness and excessive politeness.” It needs institutions that can make and issue credible, candid assessments of problems arising in individual countries that may adversely affect others – and preferably these institutions will gain power to enforce judgments. In a world of sovereign nations, that may be an impossible dream. But in a world where capital roams freely, the lack of such institutions leaves the global economy in grave peril. Hopefully the Obama administration will help guide the international community toward an appropriate remedy.