The Way Forward for Global Financial Policy

Kenneth Rogoff
Kenneth Rogoff
Kenneth Rogoff Thomas D. Cabot Professor of Public Policy and Professor of Economics - Harvard University, Former Brookings Expert

April 13, 2007

Financial globalization is exploding. Yet, as the world’s leading finance ministers and central bankers convene in Washington this month for the semi-annual International Monetary Fund board meetings, policy paralysis continues. There is simply no agreement on how to address glaring problems such as America’s increasingly fragile trade deficit, or financial dysfunction in a number of emerging markets.

This paralysis has three layers. First, rich countries are deeply reluctant to embrace any collective plan that might impinge on their own domestic policy maneuvers. The United States is the worst offender. US Treasury secretaries have always loved to lecture their foreign colleagues on America’s economic perfection, and why every country should seek to emulate it. Never mind that this logic is now in danger of unraveling along with the US housing market; Treasury Secretary Hank Paulson will stick to it. But the fact that the US looks set to borrow almost $900 billion this year from the rest of the world is hardly a sign of US strength and foreign weakness.

It is difficult to summarize the cacophony of European voices so succinctly. The French are deeply ambivalent about globalization, as if it were yet another invading force. The British have nearly the opposite perspective. Nevertheless, Europeans generally agree that their societies produce the best lifestyles, even if their economies are less efficient than America’s in a Darwinian sense. Thus, European finance ministers, too, will not be keen to admit any need for major policy changes to deal with risks from financial globalization.

The Japanese typically try to keep quiet. As huge winners from globalization, they want to avoid criticism of their trade and financial policies, which arguably remain considerably more protectionist than those of their rich-country counterparts. And they certainly don’t want to be pressed to apologize for holding hostage over $800 billion in foreign currency reserves, acquired to resist yen appreciation.

Developing countries are also at fault. Too many policymakers still believe that externally imposed opening to international capital flows was the main culprit behind the financial crises of the 1990’s — a view that unfortunately is lent some intellectual respectability by a small number of left-leaning academics.

Never mind that most of the crises could have been avoided, or late least substantially mitigated, if governments had let their currencies float against the dollar, rather than adopting rigid exchange-rate pegs. Instead, the bogeyman of financial globalization is used as an excuse for continuing to coddle inefficient and monopolistic domestic financial systems. The inability of backward domestic financial systems to allocate investment efficiently is a big factor pushing funds out of poor countries and into the US.

Last but not least, the IMF, as the multilateral agency charged with maintaining global financial stability, ought to be providing more leadership. Indeed, it is probably the only player with the universal political and intellectual legitimacy to find a way forward on collective action to address financial globalization.

Unfortunately, the IMF is paralyzed by the need to confront some internal governance problems, the biggest of which is the lack of a sensible way to recalculate the voting shares of countries as their relative influence in the global economy evolves. In particular, a radical increase in the weight of Asia’s vote is urgently needed.

What, then, should ministers do when they gather in Washington? First, there is the long-standing litany of policy responses needed to deal with the global trade imbalances. These include greater fiscal discipline in the US, greater reliance on domestic demand in both Europe and Asia, and more flexible exchange rates in Asia.

But it is time to go further and begin to lobby aggressively for faster financial liberalization in the developing world. True, most studies suggest that developing countries ought to precede any sharp opening to international financial markets by liberalizing trade. Stable macroeconomic policies also need to be in place, while fixed exchange rates are to be avoided.

Many developing countries, however, are well on their way to achieving these preconditions. Ironically, bad memories of the IMF’s first, premature attempt to promote long-term capital market liberalization remain an obstacle today. The IMF’s attempt to enshrine capital market liberalization in its charter, coming as it did in the middle of the 1990’s Asian financial crisis, was a public relations disaster. But it is now time to revisit the idea, at least in a modified and more nuanced form. Weak financial systems in emerging markets are a major obstacle to balanced development. They are also a big factor behind the global trade imbalances.

Pushing for greater capital market liberalization after the debacle of the 1990’s will be controversial. But the core of the idea was right then, and it is right now. In the absence of better mechanisms for capital allocation, global growth in this century will slow down a lot sooner than it should. Policymakers cannot hide from that reality forever.

View the original article on the Project Syndicate web site.