It’s official: the big boys (and big girls) are coming to town. The White House has announced that the heads of state of the G-20 countries will meet in Washington on November 15 for a financial summit. In some circles this is being billed as “Bretton Woods II”—a historic opportunity to rewrite the rules of the international financial architecture, spurred by the most serious global financial crisis since the Great Depression. Others see it less charitably, as look-busy grandstanding, with bad timing, inadequate preparation, and pie-in-the-sky ambitions.
The truth lies somewhere in-between. The outcome will depend on the answers to three questions. First, can the leaders stay focused on the financial and economic problems that motivated this summit meeting? Second, can they supplement their recent policy initiatives (a coordinated cut in interest rates, large-scale bank recapitalization, public-sector guarantees of bank liabilities, and provision of almost unlimited liquidity support) with further measures to combat the global recession and financial contagion and bolster confidence? Third, can they follow a likely declaration of broad principles of regulatory reform with concrete and detailed policy commitments and with a monitoring mechanism to ensure that those commitments are met in a timely manner?
To help guide the summit participants, I am outlining below a 10-point economic recovery plan and a 10-point plan for future financial regulatory reform.
According to the White House, the summit participants will “review progress being made,” work for “a common understanding of its causes,” and “agree on a common set of principles for reform of the regulatory and institutional regimes for the world’s financial sectors.” This is a reasonable agenda. What counts is what the leaders do with it.
The leaders should focus less on what they already have accomplished and more on what still needs to be done about the threat of a global recession in 2009, the spread of the crisis to developing countries, and the worldwide loss of confidence.
A global recession is defined by the International Monetary Fund (IMF) as a growth rate of world real GDP of 3 percent or less. Judging from recently revised projections, such an outcome is now a real possibility. The industrial economies (with a weight of roughly half in the total) are unlikely to grow at all next year, and the emerging and developing world may see its growth rate slip to 5 percent or even lower. Simultaneously, the earlier view that the emerging and developing countries could “decouple” from this crisis can now be discarded as they grapple with a quintuple whammy: slower growth in exports, rapidly falling commodity prices, a jump in investor risk aversion, an unwinding of the global carry trade, and a fall in private capital inflows.
Last week the emerging-market bond spread hit 900 basis points above US Treasuries for the first time since October 2002. The index for emerging market equities has fallen more than 50 percent from its pre-crisis level, and more than a half dozen developing countries face balance-of-payments problems and banking/currency crises forcing them into requests for IMF stabilization programs. Meanwhile, sharp falls in global equity markets—along with continuing (albeit improved) high spreads in money and credit markets—point to the task still ahead in calming the anxieties of investors and counterparties.
What then to do? The G-20 leaders should pursue the following ten step recovery program:
- Their central banks should undertake a further coordinated cut in interest rates of 50-100 basis points in all G-20 countries where growth and inflation concerns permit it.
- Fiscal policy expansion of 1-2 percent of GDP should be implemented in all G-20 countries where such a temporary stimulus would not generate adverse currency and external financing pressures.
- All G-20 members should continue to monitor closely the capital adequacy and lending behavior of their systemically-important financial institutions and be prepared to intervene forcefully—with appropriate protections for taxpayers—if the flow of credit to the nonfinancial sector is seriously disrupted.
- The large industrial countries should establish or increase swap lines to the emerging economies that need reserve-currency liquidity, while the emerging economies should refrain (until the crisis is over) from any large-scale shifts in their management of international reserves.
- The IMF should revive its compensatory finance facility and contingency finance facility to provide quick-disbursing loans to emerging and developing countries with acute but temporary balance of payments problems. Use of these facilities should be linked either to a temporary fall in export earnings (that is largely beyond their control) or to an abrupt fall in private capital inflows (that is not a result of underlying policy inadequacies).
- The World Bank should redouble its efforts to cushion the effects of this crisis on the most vulnerable, while also holding G-7 members to their Gleneagles commitment of 2005 to increase development assistance.
- Reserve-currency members of the G-20 should agree to cooperate closely, including the possibility of coordinated intervention, in cases of disorderly exchange markets.
- G-20 members should commit themselves to refraining from any protectionist trade measures and should agree to consult with other ministers before introducing further public-sector guarantees that could have unfavorable competitive effects on the financial firms of other countries.
- Any G-20 members who operate or are establishing sovereign wealth funds should agree to abide by the Santiago Principles governing investment standards that were recently agreed for such funds.
- In G-20 economies where housing prices threaten to overshoot their equilibrium on the down side, and where home foreclosures rates are at historic highs, the authorities should step up actions to reduce foreclosure rates.
Turning from crisis management to crisis prevention, staying focused means concentrating on a workable set of financial regulatory reforms that address the major regulatory failings and gaps revealed in this crisis. On October 7 at a luncheon speech at the Peterson Institute for International Economics on addressing the financial crisis, I presented a ten-plank program for financial regulatory reform. In summary they are:
- Establishing a prompt-corrective-action and orderly closure rule for systemically important financial institutions—whether they are banks or nonbanks.
- Creating an international, quantitative liquidity requirement for banks, along with private-sector pooling arrangements for liquidity.
- Reworking the Basel II bank capital regime—in favor of higher minimum capital ratios, making the regime countercyclical, adding a simple leverage ratio alongside the risk-weighted assets measure, and temporarily dropping the use of banks’ internal models and external credit ratings to calculate risk weights.
- Improving coordination between the monetary and regulatory authorities during the build-up of asset-price bubbles so that both of them don’t simultaneously say that “pricking asset-price bubbles is not my job.”
- Establishing clearing houses in the OTC derivative markets to reduce systemic risk.
- Reducing conflict of interest in the major credit rating agencies by restricting their activities to the ratings business.
- Improving incentives in the securitization process.
- Making Wall Street compensation an integral part of risk management by giving firms an incentive to implement sensible deferred compensation plans.
- Streamlining the financial regulatory structure by moving to objective-based regulation.
- Reforming the housing finance industry.
If the G-20 leaders agree on broad principles for regulatory reform in their (initial) summit meeting on November 15, these principles ought to serve only as a short-term way station toward the adoption of more specific policy reforms like those summarized above (and like some others recommended by the Financial Stability Forum). After all, one of the reasons why we find ourselves in this crisis is that financial regulation has been based too heavily on principles that were not specific enough or binding enough to constrain excessive risk-taking. The summit should also indicate that once more specific regulatory measures are in place, the IMF and the World Bank, working in concert with national regulatory authorities, will be asked to monitor and report on countries’ compliance with these new measures. Such a step would be an extension of the work that these two institutions already do in reporting on the observance of various other standards and codes.
Staying focused also means absorbing the key lessons of the crisis and not being tied rigidly to pre-crisis reform positions. What the crisis has revealed is that whether a financial institution calls itself a commercial bank, an investment bank, an insurance company, a money-market mutual fund, or a hedge fund, these categories are not what ultimately determine eligibility for a government rescue. Instead, it’s whether an institution is “systemically important”—a designation reflecting a combination of its size, leverage, and interconnections to financial markets. Accordingly, it is more appropriate to call for the regulation of all systemically-important financial institutions than to call for regulation of any one class of institutions.
Similarly, the crisis has not been kind to the view that self regulation will suffice for the operation of OTC derivative markets, or that risk weights in the Basel bank capital regime can confidently be based either on banks’ internal models or on external credit ratings, or that a further set of principles on liquidity risk management will provide sufficient incentive for banks to end their undue economizing on owned, truly liquid assets.
Staying focused also means imposing limits on the summit’s agenda. Given the short amount of time before the meeting and the demands of other more pressing priorities, this is not the occasion to pursue a reform of the global exchange rate system, or to press for a global financial regulator, or to try to pull a rabbit out of the hat on the stalemated Doha Round, or to realistically expect to fashion new identities for both the IMF and the World Bank. Some modest improvements can be made in some of these areas, including a stronger early warning role for the Fund and perhaps a partial early harvest of some the tentative agreements made in the Doha negotiations. But the main show has to be crisis management and crisis prevention.
In sum, one could make a good case that it would have been preferable to delay holding a G-20 financial summit until early next year when a new US administration would be in place and when there would probably be greater agreement on what caused this crisis, how to get out of it, and how to prevent the next one. But since the die has been cast for November 15, the leaders must make the best of it. My “ten-plus-ten” plan would be a good place to start. Given what’s at stake, the big boys need to deliver.