Rethinking the international financial system?

Rethinking the international financial system?

Many people are now calling for fundamental reforms of the financial systems, internationally. This includes international banking and finance, to reform of international financial institutions such as the World Bank and IMF.

Part of the reform suggestions also include giving more voice and power to poor countries, who typically have little say in how the global economy is shaped.

Traditionally powerful countries have resisted these calls—that have been voiced for decades, not just during this crisis. This crisis however has seen even powerful countries contemplate changes that would be more favorable to emerging nations. Whether these changes can happen is hard to predict.

Reforming international banking and finance?
Leaders of the Bank of England have also called for fundamental international banking reform. Bank of England deputy governor Sir John Gieve said the “fundamental rethink” meant increasing capital and liquidity requirements at institutions with “strong restraints on the build up of risk.”

Some of the ideas considered are quite significant, such as increasing the reserves banks must have. (Fractional reserve banking often allows banks to have small reserves against which loans can then be made out for larger amounts as usually most people do not withdraw their cash deposits at the same time. This works well in good times, but can then lead to a crisis through encouraging more loans which get riskier as competition increases; a moral hazard in reverse.)

The Bank of England’s governor, Mervyn King, even went as far as saying a “little more boredom” would not be a bad thing for the industry. This too is significant as it suggests restraint for an industry that otherwise is a strong proponent of financial market liberalization and supportive of very rapid growth. The recognition here appears to be that maybe slower but more stable long term growth is better and sustainable in the long run rather than short bursts of high growth followed by disruptive bursts, some of which can be very violent as the current crisis is showing.

Joseph Stiglitz argues that failures in financial markets have come about because of poorly designed incentive structures, inadequate competition, and inadequate transparency. Part of this is because larger institutions have been resistant to changes that would actually create more healthy competition, something Adam Smith had long noted in his Wealth of Nations, often regarded as the Bible of capitalism. Better regulation is required to reign in the financial markets and bring back trust in the system. In a short but very powerful article he concludes,

Part of the problem has been our regulatory structures. If government appoints as regulators those who do not believe in regulation, one is not likely to get strong enforcement. We have to design robust regulatory systems, where gaps in enforcement are transparent. Relatively simple regulatory systems may be easier to implement and more robust, and more resistant to regulatory capture.

Well-designed regulations may protect us in the short run and encourage real innovation in the long. Much of our financial market’s creativity was directed to circumventing regulations and taxes. Accounting was so creative that no one, not even the banks, knew their financial position. Meanwhile, the financial system [has] resisted many of the innovations that would have increased the efficiency of our economy. By reducing the scope for these socially unproductive innovations, we can divert creative activity in more productive directions.

The agenda for regulatory reform is large. It will not be completed overnight. But we will not begin to restore confidence in our financial markets until and unless we begin serious reform.

— Joseph Stiglitz, A crisis of confidence, The Guardian, October 22, 2008

Professor of economics at Cambridge, Ha-Joon Chang adds some additional thoughts when commenting on Jeffery Sach’s suggestions such as the Tobin Tax and changing emissions trading towards a more straight forward carbon tax. Chang said a lot more could be entertained, including the following:

The introduction of a country bankruptcy code that will enable orderly sovereign debt restructuring.
Not just expanding the capital adequacy requirement, but also making it counter-cyclical, rather than pro-cyclical as it currently is (i.e. making credit a bit harder to get during good times).
Stricter regulations of tax havens and private equity funds, which have greatly contributed to increasing opacity in the financial market.
Credit rating agencies play a critical role in today’s financial system and given the damages they have inflicted by blessing all those toxic assets, these agencies need to be much more heavily regulated or even replaced by an international public body.
Chang also voices concern about IMF reforms, questioning whether trade liberalization for poor countries is always good. (He has been one of the more vocal critics of that idea and argues that rich countries developed using more protectionist policies and moved to free trade once they were industrialized, but that they now say poor countries should liberalize straight away, either because of historical amnesia or because they want to “kick away the ladder” they climbed to achieve industrialization. The Institute for Economic Democracy has also suggested this for many years too, and is worth looking at for more depth on the political aspects of economic dominance over the centuries.)