Everyone is now keenly aware of the imbalances that allowed the financial crisis to develop into a cataclysm. But governments are pursuing the same old policies that brought on the crisis in the first place, because no one has yet succeeded in giving countries incentives to take global financial stability into account when crafting their domestic policies. It’s time for a new approach.
A global macroeconomic imbalance fanned the flames of the crisis. Low interest rates and excess consumption in the U.S. were exacerbated by excess savings in China and other emerging-market economies. The long-term solution is for those emerging economies to boost their own consumption. Right now, however, they’re on track to do the opposite because they’re focusing on short-term domestic benefits and ramping up efforts to boost exports, increase savings and enlarge foreign exchange reserves, which they pour into U.S. government bonds as a safe haven. Meanwhile, they’re expecting U.S. consumption, in the form of a debt-fueled stimulus plan, to pull the global economy out of its slump.
We need a global solution for this collective action problem. The best option is an insurance pool for the Group of 20 largest economies that would reduce incentives for reserve buildups and help focus policy makers’ attention on the international consequences of individual countries’ actions.
Here’s how it would work: The insurance pool would function like a reserve fund, offering participants a short-term credit line they could call upon in the event of a crisis. In exchange for this “coverage,” each country would pay an entry fee of between $10 billion and $25 billion, depending on its economic size. It would then pay an annual premium.
The premium would depend on the level of insurance a country desired, and would average about 1% of the face value of the policy ($1 billion in annual premiums would secure, on average, access to a $100 billion credit line). But around that average level, the premium would also depend on the country’s economic policies. A country that chose to run large budget deficits or accumulate large amounts of debt would pay a higher premium. In this sense the program would be much like car insurance, where owners of expensive cars or risky drivers pay more.
The twist is that countries with policies that drive up global risks also would face higher premiums. A country might decide that it still prefers to accumulate a large stock of its own reserves to protect itself. That country could be charged a higher premium, which would serve as a disincentive for such policies. The premiums would also increase with the persistence and levels of policies that contributed to global risks. A country running large budget deficits or accumulating large stocks of reserves in successive years would pay rising premiums.
Premiums would need to be based on simple rules. For instance, a current account balance (either deficit or surplus) larger than 2% of a country’s GDP could trigger a higher premium, with the premium amount also linked to the dollar amount of the current account balance to take into account country size. This transparent, rules-based mechanism would strengthen moral suasion and force a country to at least partially internalize the effects of its own policies on global risks.
The premiums would be invested in a portfolio of U.S., euro-area and Japanese government bonds. In return, those central banks would be obliged to top up the pool’s lines of credit in the event of a global crisis. This would simply institutionalize swap arrangements of the sort that the Federal Reserve and Bank of Japan recently opened up to provide liquidity to other central banks. A key point is that because this insurance pool would be smaller than the collective reserves it’s intended to replace, it would not contribute to global imbalances the way current reserves often do.
Why would the world’s largest economies sign on to this program? Leaders could make it a condition for membership in the Financial Stability Forum, which has an important role in developing principles for international financial regulation. This would also have the benefit of tying together financial and macroeconomic policies. The Forum could easily administer this insurance program. Economies outside the G-20 could also participate in this insurance pool, although that wouldn’t automatically guarantee Forum membership.
Some have argued that the International Monetary Fund could provide such insurance if only it had more resources. But that’s politically unrealistic. Borrowing from the IMF carries a stigma and remains a toxic proposition for emerging-market politicians. The IMF is also unable to police effectively the macroeconomic policies of major countries. More resources for the IMF will not by itself solve the global macroeconomic imbalance problem.
Unless emerging-market economies are presented with a viable alternative policy, the crisis will push them to accumulate even larger stocks of reserves to stay free of the IMF’s clutches, and inoculate themselves against volatile capital flows and attacks on their currencies. But self-insurance through reserve buildups is costly for emerging markets. Reserves tie up savings, which could otherwise finance domestic investment, in low-yield, industrialized-country government bonds. Moreover, large reserve buildups could sow the seeds for the next crisis.
One thing is clear: It would be a serious mistake for countries to try to get themselves out of this crisis by following the same policies that got them into it. Leaders increasingly speak of the importance of coordinated action. Now they need tools, like a global insurance pool, that will help them put that talk into action.