The G20: expect nothing, hope for the best and prepare for the worst

The Group of Twenty (G20) meetings that start on April 2, ought to have started on April 1 instead.  That way, when nothing but hot air emanates from the Docklands venue, at least the organisers of the event will be able to claim it was all an April fool’s joke.

In the unlikely event that the assembled dignitaries get serious and decide to negotiate as if the well-being of mankind hung in the balance – as it does – I have a short agenda to propose.

(1) A true commitment to maintain an open global trading environment

The summit of finance ministers and central bankers from the (G20) in the English town of Horsham on 13-14 March 2009, concluded with a statement that contained the following sentence: “We commit to fight all forms of protectionism and maintain open trade and investment”. Let’s just hope they are more successful that they were for the past year and a half, or even since their mid-November 2008 meeting.

The hypocrisy and mendaciousness of the G20 when it comes to protectionism are breathtaking.  The World Bank published a Report on March 2, 2009, which shows that seventeen of the 19 developing and industrial nations (plus the EU) have introduced restrictive trade practices since pledging (again!) in mid-November to avoid protectionism.

The G20 includes the Group of Seven industrialised countries — Britain, Canada, France, Germany, Italy, Japan and the United States — and 12 developing countries and emerging markets — Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, South Africa, Saudi Arabia, South Korea and Turkey — as well as the European Union. Since the financial crisis started in August 2007, officials in the countries monitored by the World Bank (including but not restricted to the G20 members) have proposed and/or implemented roughly 78 trade measures.  Of these 66 involved trade restrictions and 12 trade liberalising measures; 47 trade-restricting measures were implemented.

Scanning the World Bank study (I did not have access to the raw data), it is clear that all the G7 countries (and the EU) imposed protectionist measures.  So did Argentina, Australia, Brazil, China, India, Indonesia, Russia and South Korea.  There must be two more among the four G20 countries not named in the Report (Mexico, South Africa, Saudi Arabia and Turkey) that did impose trade restrictions — my guess would be Mexico and Turkey.

To avoid screwing up the world economy any further, it is not enough to abstain from actions that violate WTO rules.  Many WTO-compliant actions are deeply protectionist.  The Buy American provisions in the American Recovery and Reinvestment Act of 2009 (Recovery Act) are an example:

“SEC. 1605. USE OF AMERICAN IRON, STEEL, AND MANUFACTURED GOODS. (a) None of the funds appropriated or otherwise made available by this Act may be used for a project for the construction, alteration, maintenance, or repair of a public building or public work unless all of the iron, steel, and manufactured goods used in the project are produced in the United States.”

This is protectionism of the most blatant kind.

Another example of WTO-compliant protectionism is bound tariffs’, which are the maximum tariff rates that WTO members agree to.  These can be high for developing countries. Raising the actual tariff level does not breach any WTO obligations as long as the new higher tariff level does not exceed the bound level.  For instance, India has actual tariff rates for manufactured goods in the 10 percent to 12 percent range, but has bound rates in the 40 percent to 60 percent range.

Another potentially WTO-compliant set of protectionist measures fall in the Anti-Dumping category – used extensively by the advanced industrial countries and by India.

Every country whose banking sector has got into trouble to the extent that financial support actions had to be mounted, underwritten ultimately by the Treasury and the tax payer, has indulged in financial protectionism.  Governments have extracted promises of additional lending from banks suckling at the public teat (the UK and the Netherlands are examples).  It is clear that the expectation is that this lending will be to domestic enterprises and households.  It is therefore not surprising that cross-border leverage in the banking sector is declining much faster than overall leverage.  Much of this financial protectionism is the politically unavoidable consequence of the use of national fiscal resources to bail out banks and shadow banks.  In (2c) below, I propose that to avoid financial protectionism from spreading beyond what we will have to live with because of the absence of supranational fiscal authorities or international fiscal burden sharing rules, permissible restrictions on cross-border banking activity be explicitly regulated with reference to macro-prudential stability criteria.

(2) A true commitment to tackle the fiscal stimulus and macro-prudential financial regulation issues as part of an integrated package

There is no point in the US and UK authorities clamouring for a larger global fiscal stimulus until it is recognised that the global financial system that grew up since about 1980 has collapsed and cannot be patched up, let alone reconstructed to re-capture its 2006 state of glory, with just a light trimming of a few excesses.

There is a huge problem in the US and in the UK particularly caused by the inability/unwillingness of the authorities to recognise that we have to re-think 39 years of financial sector de-regulation.  In the US, Larry Summers and Tim Geithner were major players, during the Clinton Presidency, in creating the financial structures that have now collapsed.  In the UK, distortions and excesses were allowed or even encouraged to develop on an unprecedented scale under the stewardship of Gordon Brown as Chancellor of the Exchequer.  Clearly, these developments had started earlier, under the governments of Margaret Thatcher and John Major, but the cult of light-touch regulation or even no-touch regulation (or self-regulation) reached its most extreme form when Gordon Brown was Chancellor of the Exchequer.

It is unlikely that those who put together the faulty design are the right persons to clean up the mess after the collapse of the system, and to lead the construction of a new banking and financial system, domestically and globally.  The theory that only those who screwed it up can sort it out has no evidence to support it, but continues to exercise a powerful influence.  In the case of Long Term Capital Management, the geniuses who brought the hedge fund to the edge of collapse were allowed to stay on (with an equity stake) to manage down the portfolio, something that could have been done by a handful of ABD graduate students in finance from any top university.  Hank Paulson’s tenure at the US Treasury is widely judged to have been a failure.

It doesn’t really matter at this stage whether it is selective blindness (cognitive capture) or more conventional forms of capture that have made the officials in charge of the rescue of US financial intermediation as ineffective from the perspective of the macroeconomy and as attentive to the wishes and demands of the financial establishment as they have been since the crisis started.  The result is a dysfunctional non-system that continues to enrich a few while failing to serve the many.

Let me suggest the following as a minimal global regulatory reform agenda.

(2a) All systemically important financial institutions and markets will have to be regulated according to the risks they pose to the financial system and the real economy.  The legal form of these institutions is irrelevant.  Failure to pursue the macro-prudential regulation of institutions, markets, trading platforms and other financial infrastructure according to the systemic risk they pose, and according to this risk alone, will result in another round of cross-legal-entity regulatory arbitrage, even within a given national regulatory jurisdiction.

(2b) This regulation has to be done at the global level.  Failure to do so will result in another round of cross-border regulatory arbitrage resulting in the kind of global soft-touch regulation that was at the root of many of the excesses that were allowed to sprout and propagate during the Great Financial Deregulation (1979-2007).

(2c) There has to be an agreement to restrict the scope of systemically important cross-border banking and other financial activity to what can be effectively regulated and supervised, supported with central bank liquidity and bailed out fiscally.

As an example, cross-border bank branches would be ruled out, except in a region like the Euro Area, where there is a supranational central bank, provided there is a single Euro-Area banking supervisor and regulator for cross-border banks and shadow banks, and provided the Euro Area creates either a supranational fiscal authority, a fund or a fiscal burden sharing rule for recapitalising cross-border banks (and the Eurosystem).

There can be cross-border bank subsidiaries, but they would have to be independently capitalised, with independent, dedicated liquidity, managed at arm’s length from the parent and supervised and regulated by the host country.  For centralised management by the parent and partial or full pooling of capital and liquidity of parent and subsidiaries, it is necessary that the parent and each of the subsidiaries (1) be regulated and supervised by the same regulator/supervisor; (2) have access to the lender-of-last-resort-and market-maker-of-last-resort-facilities of the same central bank; and (3) have the same fiscal authority, facility or arrangement as a back-stop source of capital and other financial support.

(2d) There has to be international agreement on restricting the size and scope of financial institutions.  Aggressive enforcement of anti-monopoly policy and the imposition of capital requirements that are increasing in the size of a bank (for given leverage and risk) would be two obvious tools for achieving this.

(2e) Financial innovation (that is, the introduction of new instruments, services, products and institutions) should be regulated the way the FDA regulates pharmaceuticals.  The required testing, evaluations, trials and pilot schemes should be regulated at the global level, to avoid innovation arbitrage.

Economies of scale and scope in banking and shadow banking are limited.  The reasons banks want to be huge and like to be involved in a wide range of financial services, products and activities are (1) the desire to exploit monopoly power; (2) the desire to shelter systemically unimportant but profitable activities under the umbrella of institutional support given to the banks by the state because of their systemically important (narrow banking) activities; and (3) the attractions of exploiting conflict-of-interest situations.

Once these financial regulatory issues are agreed, a global fiscal stimulus, modulated according to (1) national fiscal spare capacity and (2) the national sustainable current account imbalance.

This means no further fiscal stimulus for the US, and preferably a reduction in what has already been announced.  The US political system does not today permit a credible commitment to future tax increases or public spending cuts.  The government deficits of 14 percent of GDP or more that are likely in the US even without any further discretionary stimulus are likely to be more than the markets are willing to tolerate and absorb, except at a much weaker external value of the US dollar and a much higher level of long-term Treasury bond rates.

A country with fiscal credibility can promise virtue in the future in exchange for fiscal laxity now.  That permits it to escape the painful consequences of the paradox of thrift: that an ex-ante desire to increase the national saving rate (say though fiscal tightening or a shift upwards in the private propensity to save) may, at least temporarily, depress economic activity to such an extent that ex-post savings will not rise very much if at all.  For the US, I see no alternative to a painful restoration of external balance through a higher national saving rate.

The UK’s position is not very different.  On current policies, government deficits of more than 10 percent are likely for the next fiscal year.  As with the US, such banana-Republic deficits are likely to spook the market.  As with the US, the pro-cyclical behaviour of fiscal policy during the last boom will have done nothing to get the markets to believe that this time things will be different.

China, Germany and even France, however can do more than they have so far indicated they will do.  So can some other emerging markets, including Brazil.  Only the virtuous can follow Keynesian policies.  If they don’t, they not only are bad global citizens, they will also shoot themselves in the foot.

Like all recessions, the current global recession is proximately an investment-driven recession.  The recovery, when it comes, will be an investment-driven recovery.  Those who point to large increases in private saving rates in the US and some other countries (including the UK) should recognise that household investment includes residential construction, spending on home-improvement and purchases of consumer durables, including cars, white goods, furniture and IT equipment.

Investment can be internally financed, out of retained profits, as well as externally.  When animal spirits re-awaken in the enterprise sector and firms want to invest again, retained profits will, after several years of deep recession, be low or negative.  So external finance – its availability and cost – will be key to a sustained recovery.  This holds even for the recovery of inventory investment and working capital investment.  That is why reconstructing financial intermediation by creating a new banking system and a system of functional capital markets is so central.  There will be no sustained recovery without it.

3. A true commitment to increase the resources of the IMF at least 10-fold and to change its governance to reflect the current distribution of economic power in the world.

The IMF has approximately $250 billion worth of resources.  With what it has already committed in Europe (Iceland, Latvia, Hungary, Ukraine and Romania, with Lithuania about to join the party), there is not enough left in the kitty to provide effective support to a couple of large EMs.  Doubling the resources to $500 billion would be a sad under-reaction to the severity of the crisis.  To be a serious player in the global financial stability game, even if just in the EM and developing countries, the IMF needs an increase in its resources of about $2.25 trillion.  Global capital markets are likely to remain impaired for years to come, not just for developing countries and emerging markets, but also for a large number of supposedly advance industrial countries.  The need from IMF financing is BAAAAACK!

It should be granted that increase through an increase in quotas (a massive new issue of SDRs) rather than through a series of bilateral loans from countries keen to buy influence.  The increase in IMF resources should be accompanied by a revision in voting weights that reflects the current economic realities.  That means a radical reduction in the shares of the European nations (ideally, they should be replaced by a single European Union Executive Director)),

It also means a reduction in the voting weight of the US large enough to deprive it of its veto power in the organisation.  It is clear that the US and the European nations have repeatedly muzzled the IMF when the organisation wanted to sound the alarm about financial in stability in the heartland of financial capitalism.  That should no longer be possible.

Tax havens and regulatory havens

It is likely that the G20 will push further on the issue of tax havens.  This certainly is the time.  The aspect of tax havens that matters is not the tax rates on different sources of income or different kinds of wealth, but bank secrecy – the ability of natural and legal persons to hide assets and income from their domestic tax authorities.   Bank secrecy serves tax avoidance, tax evasion and tax fraud.  It assists tax evaders, tax frauds and other criminals to hide income, be it legitimate income or the proceeds from illegal activity, from the eyes of the authority.  They should be closed down.

The easiest way to achieve this is to make it illegal for any natural or legal person from a non-tax haven country to do business with or enter into transactions with any natural or legal person in a tax haven.  That ought to do it.  Tax haven, again, is defined not with respect to tax rates or tax bases, but with respect to bank secrecy, that is, with respect to the information shared by the country’s financial institutions with foreign tax authorities.  That information sharing should be automatic and comprehensive.

As regards regulatory havens, once common G20 standards for regulatory norms, rules and regulations has been set, countries that violate these standards would be black-listed.  The obvious sanction is non-recognition of contracts drawn up in the regulatory haven jurisdiction and non-recognition of court decisions in these regulatory havens.  That ought to do it.


Moral indignation is no substitute for thought.  Structuring incentives to promote the long-term interests of all the stake holders in listed companies is both important and complicated.

Where possible, the regulator should take into account the impact of internal incentive structures on the risk profile of the organisation when it comes to determine capital adequacy.  Governance, however, is a matter in the first instance for shareholders and boards.  Shareholders have been robbed blind.  Now it is the turn of the tax payers.  Boards have often been complicit or oblivious in these robberies.  Corporate governance reform is obviously overdue.  The insiders (agents), that is the management and employees, have had their day at the expense of the outsiders (principals), that is the shareholders and tax payers.  In new corporate governance legislation, the same person should never combine the obviously conflicted responsibilities of Chairman of the Board and CEO.  The fiduciary duties of the Board to the shareholders and to the other stakeholders would be spelled out clearly.  Civil and criminal law consequences should follow from wilful negligence.

We clearly don’t want to have sectorally differentiated tax policies for bonuses or other forms of remuneration.  Simple rules like taxing all income according to the same schedule, be it labour income, bonuses, interest, dividends or capital gains, would remove some obvious distortions.  Further mitigation is likely to result from more progressive income taxation (including a higher top rate) in a much-changed political climate.

Ceterum censeo Carthaginem esse delendam.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website