By Richard Portes

Expectations for the G20 meeting on November 15 are excessive. It will not agree on changes to the institutions of global governance, nor will it come up with an ‘n-point plan’ for dealing with the crisis.

Its primary objective should be to bolster confidence, by convincing the public and market participants that the leaders understand the issues and have a clear process for confronting them, with a reasonable timetable.

Commentators should not ask afterwards: “Fine principles, but where are the details?” The leaders should convince us that this is a mistaken demand, that their demonstration of unity on the principles and the process goes side-by-side with the short-run measures they are already taking.

It would be unwise to seek agreement now on specific reforms. Rewriting rules should be the job of technocrats, not politicians, if only because the politicians are understandably inclined to find scapegoats, shoot (or guillotine) the speculators, and shut down markets.

The leaders must state their consensus that they will not retreat into protectionism, nor try to turn back globalisation, and that they are conscious of the dangers of over regulation. They should indicate that they want strategies to exit in due course from the extraordinary degree of new direct government involvement in financial institutions and markets.

They should take a stand against financial repression and repression of finance. They should explicitly recognize the macroeconomic roots of the crisis in global imbalances. They should acknowledge that the international institutions are unrepresentative and therefore lack legitimacy.

They could be more specific. The agenda should include finding ways to cut the vicious circles that have made the crisis so grave, the interaction among inappropriate accounting practices, opaque derivative markets, credit ratings, and deleveraging.

Financial regulation must be better designed, more comprehensive, better harmonized across countries, and more multilateral. It should focus on incentives as well as on rules. And countries, in particular the US and the UK, must recognise the dangers of regulatory competition and arbitrage.

Financial institutions no longer fall into distinct categories; commercial banks, investment banks, insurance companies, hedge funds and other financial firms now overlap. All require at least regulatory oversight, with varying degrees of intrusive regulation. Those with global or regional systemic importance require global regulation that goes beyond national regulatory authorities and incorporates burden-sharing rules to deal with failures.

Outsourcing regulation, as, for example, by ‘hard-wiring’ the ratings agencies into the regulatory framework, should be abandoned. Self-regulation should be re-examined with considerable scepticism. Regulators should require greater transparency, e.g., by bringing over-the-counter derivatives trading (in particular, the credit default swap market) onto exchanges.

Officials should ask economists and lawyers who specialise in contracts, incentives and mechanism design to put forward proposals for regulating executive compensation, refocusing managers on longer-term performance, and reducing conflicts of interest.

The leaders should come down against global capital controls but agree that individual countries may reasonably turn to capital account measures in appropriate circumstances, with International Monetary Fund assistance rather than opposition. They should not seek exchange rate target zones, grids, or reference rates. They should recognise, however, that exchange rate movements have often been excessive, sometimes abrupt, with frequent prolonged misalignments, so that that  exchange-rate management is often warranted.

The central institutions for implementing these principles are the IMF and the Financial Stability Forum. The latter should not be subsumed in the former. The structure and governance of the IMF are inappropriate to regulation of the international financial system, in which only a small number of countries are important and no financial resources are required.

Instead, the FSF should take on many of the multilateral regulatory activities suggested above, with executive authority and a broader membership. It should include all the countries that are now important in the global financial system. The leaders could now state that this is their intention. The FSF should take responsibility for the Financial Sector Assessment Programs from the IMF - and they should be mandatory for all countries, even the largest.

The IMF cannot be an international lender of last resort; nor should it be a ratings agency (for sovereigns), nor prescribe ‘equilibrium’ exchange rates. The Fund should conduct surveillance of macroeconomic policies, current accounts, and henceforth explicit capital account surveillance as well. One short-run measure that the leaders should agree is to increase the resources available to the Fund to deal with the crisis-induced needs of many emerging market countries running large current account deficits or facing major capital outflows.

They should prod the IMF to come up with new ideas and revive some of the old ones. The Fund has manuals on how to restructure distressed banking systems: where are they? What are the Fund’s ideas on the key macro issues? For example, the IMF should be examining the carry trade: why was it so profitable for so long, how did it affect the capital accounts and exchange rates of ‘target’ countries (most of which are now on the IMF rescue list), how is it related to the foreign exchange swap market? The Fund must fully take on the role of ‘relentless truth telling’ that Keynes expected of it.

The G7 is an anachronism and should be abandoned. A smaller group (with the eurozone having a single representative) should deal with global imbalances and the like, and larger groups with other issues highlighted above. Most of the relevant players are in the G20, but some in the G20 are not always relevant. In principle, the memberships should be suited to the issues - a kind of variable geometry.

The key to progress lies in the willingness of leading countries to accept some basic propositions. Germany must grasp the broader issues at stake, rather than focus on whether other countries are just trying to get Germany to bail them out.

France has played a more constructive role, but it is still inclined to blame ‘neo-liberalism’ and press for policies unacceptable to the UK and the US.

The UK must recognise that its primary objective should not be to protect the City of London, which will not lose its central role in international finance even with more multilateral regulation.

China must assume the responsibilities of a country with $2,000bn in international reserves and some of the world’s largest banks.

Japan should play a much more active role in these discussions than it has so far. And the US must accept that it cannot maintain sole leadership and veto power in the international financial system.

This should lead to a grand bargain, featuring the US and China. China and other big reserve holders would use their excess reserves to recapitalise the major financial institutions and would change their domestic policies to reduce their excess savings. The US would stop China-bashing on both trade and exchange rates. The US and European Union would agree on bringing China into the FSF and raising its weight in the IMF. The EU would concede that it is over-represented in the IMF and World Bank and that at least the eurozone should have only a single representative. And the US would give up its veto.

What is feasible for the meeting on November 15? To agree on principles, though not in the full detail set out above; and to establish working groups with fixed timetables, all ideally coming to detailed conclusions by spring 2009, when the new US administration should be ready for decisions.

Working groups should cover the structure of financial regulation, issues in financial regulation, issues in market structure and the transparency of markets and financial instruments, the roles of the IMF and FSF. Governance of the Fund should be left for later. However, giving the International Monetary and Financial Committee, the IMF’s governing body, executive powers should be considered now, as should increasing IMF funding for new facilities and rapid action.

Most importantly, the political leaders must put great effort into selling all this to a fearful and sceptical public.

Richard Portes is professor of economics at London Business School and president of the Centre for Economic Policy Research

Tags: New Bretton Woods

November 11, 2008 2:53pm in China, Eurozone, Keynesianism | Comment