“The recurrent economic crises...we have suffered…since the beginning of this century, are the inevitable symptoms of the titanic clash between modern industrialism and technology on the one side and the outdated…political system of the sovereign nation states on the other side…The extraordinary evolution of science and technology and the ever-growing yearning of the masses for more consumer goods and luxuries, require production facilities and sales organisations covering increasingly wider areas of the world…but we insist that the economy, which is no longer a national but a world economy…should be developed within the outdated political framework of the sovereign nation-state structure…”
These words, which sound so much on the mark today, were in fact written in 1968 by Siegmund Warburg, banker and prophet of globalisation.1 Yet even today, the inherent reluctance of nations to surrender macroeconomic and financial policy decisions to internationally agreed rules remains a critical weakness in the world economy.
Long before the 2007 crisis breakout, monetary and fiscal policy in the leading economies had become mutually inconsistent. The combination of unchecked international liquidity creation and uneven national saving patterns worldwide fuelled growing external imbalances, leading to extreme risk-taking in financial markets. These factors eventually led to irresponsible credit growth and asset bubbles in financial and housing markets, as well as to the build-up of significant vulnerabilities within most advanced financial markets and institutions.
Today, two years after the outbreak of the gravest economic and financial crisis in eight decades, the world economy continues to be affected by great instability and deep uncertainty. The root causes of the crisis have been left unaddressed, international imbalances remain formidable, and the perverse incentives triggered by incoherent policies, nationally and internationally could lead to new and severe shocks. International cooperation, while initially successful in avoiding the precipice, has largely returned to palpable inconclusiveness. It is clear that world leaders are nowhere close to accepting the lessons their forefathers learned in the 1940s. That is; a stable and dynamic world economy needs a strong multilateral framework that provides legitimate and effective institutions where nations can discuss and deliberate on policy issues and rules by which all nations should abide. Instead, as the just-concluded G20 summit and the period leading up to it have revealed, cooperative inventions are met with a hostile response. (See the recent Vox summary here).
Reforming the international monetary system
So, what sort of system does our global economy need? First, the international monetary system needs major structural reforms if the world economy is to recover balance and to realign distorted incentives. No adequate adjustment mechanism exists to ensure that the external imbalances can be re-absorbed without exacerbating deflationary tendencies. The system provides no incentives for either large creditors or debtors (such as the US) to adjust. While the burden of adjustment falls upon the deficit countries (except if these are reserve-issuers), surplus countries feel neither the responsibility nor the pressure to adjust. One overlooked argument is that surpluses are the mirror image of deficits: if there is an element of irresponsibility from countries running protracted deficits, there is an act of free riding from those that accumulate surpluses thanks to those who overspend.
The current international reserve system is equally deficient. Countries fearing erratic exchange-rate fluctuations and capital flows consistently run current-account surpluses to accumulate reserves. Yet, while this may be individually rational, it turns out to be globally detrimental when pursued systematically by many countries at the same time. It contributes to growing imbalances and global deflationary biases (unless some countries behave “irresponsibly” and take up the slack in demand)
A three-step solution
A radical solution would be to reform the system in three sequential steps. The first step would be for countries to agree on introducing a mechanism of symmetric external adjustment, whereby the responsibility to adjust structural imbalances would fall upon both deficit and surplus countries alike. Surplus countries would be required to invigorate domestic demand, thus re-injecting stimuli into the global economy, while deficit countries would reduce their absorption. The symmetric adjustment rule should also be designed to encourage surplus countries to use their surpluses to finance investments abroad in countries where they are most needed. As a result, the correction of the external imbalances would operate not just through the contraction of imports, but as well through the expansion of exports and investment. The adjustment cost for deficit countries would be contained, and its negative impact on global demand and growth
As adjustment proceeds and exchange rates settle around values consistent with more balanced external positions, countries should establish an exchange-rate target zones arrangement, whereby major currencies would be allowed to float within bands around central parities that would now be in line with economic fundamentals. The arrangement would help stabilise market expectations, and act as an international coordination device for domestic macroeconomic policymaking. In the event that countries disagree on adjustment burden sharing, the exchange-rate zone targets could be revised through negotiations. In any case, countries would be called on to cooperate and to search for compromise solutions. International policy coordination to maintain the exchange rate arrangement and to affect the required policies should take place within the IMF, as discussed below.
Finally, the use of the Special Drawing Right as a reserve asset should be promoted and the IMF Articles of Agreement should be amended to allow for a flexible mechanism of injection and withdrawals of Special Drawing Rights, which would help manage global liquidity.2 Promoting the use of the Special Drawing Right would complement the other envisaged reforms in strengthening the overall discipline on macroeconomic policymaking. It would reduce the incentives for countries to run external surpluses, and would limit the degrees of freedom enjoyed by reserve-issuing countries in governing their monetary policy, thus containing their international spillover effects. At the same time, it would help countries pursue internal and external balance, keeping the economy on a non-inflationary/non-deflationary growth path.
Setting the right international institutions
A further requirement for our global economy is a forum is needed where nations can legitimately determine the necessary reforms to the international monetary and financial system, and where they can coordinate policy action effectively. Reforms and policy decisions that potentially impinge on the life of all peoples in all nations should not be carried out within exclusive country groupings, where the countries sitting at the table have no obligation to represent the views and the interests of those that do not. With all its limitations and the need for a substantial revision of its representation system, the IMF remains the only politically legitimate and technically adequate institution for international monetary and financial cooperation.
A reformed International Monetary and Financial Committee of the IMF could serve as the universal forum where ministers and governors from member countries coordinate national policies. While requiring major changes, the Committee is endowed with a governance structure that gives voice to its member countries in a way that has remained unequalled by any “G” group so far convened. The Committee should be where international policy coordination took place to maintain the exchange-rate arrangement and to effect the needed external adjustments.
In its deliberation process, the Committee should be technically supported by the IMF. Redesigning its role should be accompanied by a bold reform of the IMF’s Executive Board, which should be empowered to ensure that the institution achieves the highest quality in terms of strong competence, broad vision, and unquestionable impartiality in the way it performs economic and financial surveillance and delivers assistance to its members. This requires deep changes in the way the Executive Board is structured and organised. Detailed proposals for reforming IMF and global financial governance have been elaborated by the Group of Lecce.
The world economy is still plagued by formidable disequilibria. Addressing these requires resolute action on the side of our leaders. More than that, it requires that world leaders do as their forefathers did some sixty-five years ago when the world was emerging from the chasm of war, and seize the opportunity presented by the recent crisis to overhaul the way in which our global place is governed.
Our global place needs a strong and genuinely multilateral governance framework, providing for rules by which all nations should feel obliged to abide in the interest of their peoples. It should be a place where nations feel they should consider the impact of their policy decisions on one another, and where national policies with potentially systemic consequences are agreed on internationally before they are acted on.
In other words, our global economy needs much better global governance.
The Editors, “Vox views on issues at the Seoul summit”, VoxEU.org, 12 November.
Joshi, V and R Skidelsky, “Keynes, global imbalances, and international monetary reform, today”, in S Claessens, S Evenett, and B Hoekman (eds.), Rebalancing the Global Economy: A Primer for Policymaking, A VoxEU.org Publication.
1 This passage is cited in Niall Ferguson’s High Financier: The Lives and Time of Siegmund Warburg, The Penguin Press, p. 231.