November 12, 2008
It should come as no surprise in a world of globalization that it's not just the good things that move more easily across borders, but the bad things as well. Now, America has exported its downturn to the world.
A global financial crisis requires a global solution. Uncoordinated macro-economic policies, for instance, have contributed to Europe's problems. When the European Central Bank refused to lower interest rates earlier this year, focused as it was on the threat of inflation, while America's did, focused on the impending downturn, it led to a stronger euro. This in turn contributed to Europe's downturn, though it made America's GDP numbers look better for a while. Now, Europe's downturn is ricocheting back on America: Europe's weaknesses are contributing to America's.
The same has happened when it comes to regulation. To too great extent, there has been a race to the bottom in accordance with the myth that deregulation breeds innovation. Instead, the innovation was greatest when it came to getting around the regulations designed to ensure good information and a safe and sound financial system.
Financial markets are supposed to be a means to an end -- a more prosperous and stable economy as a result of good allocation of resources and better management of risk. But instead, financial markets didn't manage risk, they created it. They didn't enable America's families to manage the risk of volatile interest rates, and now millions are losing their homes. Furthermore, they misallocated hundreds of billions of dollar.
The Human Toll
The consequences of these mistakes will run into the trillions -- not just the money that is being spent on the bailouts, but the shortfall between global economic potential growth and actual performance.
Beyond this, of course, is the human toll -- families whose life dreams are destroyed as they lose their homes, their jobs, and their life savings. If we are to maintain global financial liberalization, with financial products moving easily across borders, we must be sure that these products are safe and that the financial institutions who are selling them can stand behind the products they create.
Financial market regulators, at both the national and international level, have failed. To a large extent, Basel II, the new framework of bank regulation, was based on self-regulation, itself an oxymoron. Banks have shown that they are not up to the task of managing their own risk. But even if they had, there is the more fundamental problem of systemic risk.
The current global financial architecture hasn't been working well. But more than that, it is unfair, especially to the developing countries. They will be among the innocent victims of this global crisis that wears the 'made in America' label. Even countries which have done everything right -- those which have managed their economy with far better regulation and better macro-economic prudence than the US -- will suffer as a result of America's mistakes. Worse, the International Monetary Fund has -- at least in the past -- demanded pro-cyclical policies (raising interest rates and taxes, lowering expenditures when an economy goes into a recession), while Europe and America do just the opposite. The result is that capital flees developing countries in times of crisis, reinforcing the vicious cycle.
Flawed Governance Structure
There is mounting evidence that the developing countries may require massive amounts of money, amounts that are beyond the capacity of the IMF. The sources of liquid funds are in Asia and the Middle East. But why should they turn their hard earned money over to an institution with a failed track record; one which pushed the deregulatory policies that have gotten the world into the mess where are in now; one which continues to advocate the asymmetric policies which contribute to global instability; and one whose governance structure is so flawed?
We need a new financial facility to help the developing countries, one whose governance reflects the realities of today. Going forward, this new facility might lead to deeper reforms at the IMF. Such a facility needs to be created quickly, but if experts from the finance ministries and central banks are loaned out to this new institution, it could be up and running in short order.
There are further reforms that need to be undertaken. The dollar-based global reserve system is already fraying -- the dollar has proven not to be a good store of value. But moving to a dollar-euro, or a dollar- euro-yen system could be even more unstable. We need a global reserve system, for a global financial system. Keynes wrote about this at the time of the last big downturn, but the need today is even greater. His hope was that the IMF would create a new global reserve currency. He called his Bancor, much akin to the IMF's SDR (special drawing rights). This is an idea whose time may have finally come.
It is inconceivable that America would have prospered had it left the management of its financial system to the 50 separate states. They have a role, but that of the national government is essential. We now have a global financial system, but we are leaving its management to that of the individual countries. This system simply cannot work.
We will never achieve perfect stability of our financial markets, or of our economy. Markets are not self-correcting. But we can do a lot better. Hopefully, at the summit in Washington, the leaders of Europe and Asia will lead the way, beginning the task of creating the global financial architecture that the world needs if we are to have a stable and prosperous 21st century.
Joseph E. Stiglitz, 65, won the Nobel Prize in economics in 2001 for his contribution to analyses of the relationship between markets and information uncertainties. He is widely cited and writes a popular column for the New Yorker.
