11 November 2008

Financial crisis: Europe's leaders can seize this opportunity to fill the leadership gap

Even were President Bush not a lame duck, it is hard to see how he would have much credibility. This is not only a crisis that wears the "made in America" label, it is a result of the deregulatory philosophy and economic policies that he has pursued for eight years. But the absence of leadership from the US gives others an opportunity to step in to fill the gap.

France and the UK have recognised this as a new "Bretton Woods moment." This is their chance to push not only for the new regulations needed to restore confidence now and prevent this kind of global financial crisis from happening again, but also for a new global financial order. These reforms are necessary if we are to make financial market globalisation work, or at least work much better than it has been.

Clearly, we need a new, strong, global regulatory system. Wall Street tell us that light regulation encourages innovation but the financial innovation that we have seen in recent years has mostly been directed at regulatory, accounting, and tax arbitrage, figuring out ways to deceive investors about the true value of the company, or to get around regulations designed to ensure that banks act in a prudent way.

Instruments were created that were so complex that not even their creators knew their full implications. They didn't help manage risk; they created risk. Meanwhile, financial markets didn't engage in the kind of innovation that would have enabled our economy to manage the risks which it faces better. They didn't create products that would help ordinary Americans stay in their home in the face of changes in interest rates or other economic circumstances.

In Europe, they have resisted innovations, like the Danish mortgage bonds which have proven so successful in that country for more than two hundred years. They resisted innovations, like GDP bonds, which help countries and investors handle the risks associated with economic volatility. When I was in the Council of Economic Advisers, I pushed for inflation indexed bonds, of the kind that Britain has long had.

Many on Wall Street opposed it - they were worried that these bonds would not be traded over and over again, but instead people would hold them to retirement. They were more worried about their commissions than the well-being and security ofpensioners. (America eventually did issue the bonds, over that opposition.)

Good regulation will encourage good innovation - creative energy might be devoted to addressing society's needs, rather than to figuring out how to exploit loopholes, or taking advantage of ill-informed borrowers. Regulatory harmonisation would be helpful to all market participants, and institutions from countries who don't comply with basic standards should be treated as pariahs Good financial institutions should not be allowed to deal with them.

Regulation begins with transparency and disclosure, but goes much further. The complaint about banks' compensation schemes is not just the level of pay, but the form, designed to encourage short sighted behaviour that was excessively risky, that encouraged bad accounting - putting too much off the balance sheet, to drive up reported profits, stock prices, and hence the value of stock options.

Conflicts of interest have been pervasive - from rating agencies paid by those whose products they rate, to mortgage companies that owned their own appraisal companies. Commercial banks and pension funds, entrusted to care conservatively with assets of others, should not be allowed to gamble with other people's money.

But that is what they have been doing, and taxpayers are now being asked to pick up the tab. These institutions need to be ring-fenced, not allowed either to gamble (which means that derivatives can only be purchased when they can be explicitly related to reducing a specific risk exposure) or to be exposed to risks from those that do. They should, for instance, not be allowed to lend extensively to unregulated non-transparent hedge funds.

There will need to be deeper reforms in the global financial system, of the kind suggested three quarters of a century ago by John Maynard Keynes. The dollar-based reserve system is inherently unstable, and is already fraying. But a euro-dollar, or a euro-dollar-yen system is likely to be even more unstable. We need a global reserve currency, based on a market basket of currencies, to reflect the multi-polar world of today. Such a system would help prevent a recurrence of the dangerously large deficit the US has had for the last 25 years. The global financial system is unbalanced in other ways and if we don't restore the balance we will have continued global financial instability.

Currently, emerging markets are hostages to the vagaries of the markets. But when the market decides they are too risky, money flows out and, more often than not, they call in the IMF which makes them cut spending, reduce deficits and raise interest rates.

These policies make the resulting downturn worse. No wonder then that developing countries are viewed as risky; it is a self-fulfilling prophecy. That is why, strange as it seems, money is leaving developing countries, that didn't cause the current problems, and going to the US, which did. It is an unjust world, and Europe's leaders should do what they can to correct the situation.

That means dealing with the IMF and the World Bank. It is at times like these that we recognise the importance of such multilateral institutions. But the IMF did nothing to prevent the crisis, and may not even have the resources necessary to help the poorest countries.

But given its flawed governance and its lack of credibility, why should those with pools of liquid capital, in Asia or the Middle East, provide more funding to the IMF, rather than work directly together with the developing countries? It is clear that reforms in governance are imperative, but in the past, such reforms have been too little, too late.

Ten years ago, at the time of the Asian financial crisis, there was much discussion of the necessity of reform to the global financial architecture. Little - too little, it is now evident - was done. It is imperative that we not just respond adequately to the current crisis, but that we begin the process of the long run reforms that will be necessary if we are to have for a more stable and more prosperous global economy.

This is a Bretton Woods moment. I hope Europe's leaders seize the moment. Much will depend on it.

Joseph Stiglitz, Noble laureate in economics and former chair of the US Council of Economic Advisers in the Clinton Whitehouse.

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