World Economy After The Global Crisis, The: A New Economic Order For The 21st Century

A New Economic Order for the 21st Century

Barry Eichengreen, Bokyeong Park

• Publisher: WSPC
• Year: 2012
• Print ISBN: 9789814383035
• eBook ISBN: 9789814452205
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

List of contributors

The global credit crisis of 2008–2009 was the most serious shock to the world economy in fully 80 years. It was for the world as a whole what the Asian crisis of 1997–1998 was for emerging markets: a profoundly alarming wake-up call. By laying bare the fragility of global markets, it raised troubling questions about the operation of our deeply integrated world economy. It cast doubt on the efficacy of the dominant mode of light-touch financial regulation and more generally on the efficacy of the prevailing commitment to economic and financial liberalization. It challenged the managerial capacity of inherited institutions of global governance. And it augured a changing of the guard, pointing to the possibility that the economies that had been the leaders in the “global growth stakes” in the past might no longer be the leaders in the future.

What the crisis means for reform, however, is still unclear. This book brings together leading scholars and policy analysts to describe and weigh the options. Successive chapters assess options for the global financial system, the global trading system, the international monetary system, and the Group of 20 and global governance. A final set of chapters contemplates the policy challenges for emerging markets and the advanced economies in the wake of the financial crisis.

Contents:

• Introduction
• Financial Reform after the Crisis
• Did WTO Rules Restrain Protectionism During the Recent Systemic Crisis?
• The International Monetary System after the Financial Crisis
• The Group of 20: Trials of Global Governance in Times of Crisis
• Emerging Markets in the Aftermath of the Global Financial Crisis
• Challenges for Emerging Asia
• Long-Term Challenges for the Advanced Economies: Reducing Government Debt

Readership: Students and researchers in the fields of international economics, macroeconomics, finance and development.

CHAPTER  1

Introduction

Barry Eichengreen and Bokyeong Park

The global credit crisis of 2008–2009 was the most serious shock to the world economy in 80 years. It was for the world what the Asian crisis of 1997–1998 had been for emerging markets: a profoundly alarming wakeup call. By laying bare the fragility of global markets, it raised troubling questions about the operation of the 21^st century world economy. It cast doubt on the efficacy of light-touch financial regulation and, more generally, on the prevailing commitment to economic and financial liberalization. It challenged the managerial capacity of institutions of global governance. It augured a changing of the guard, pointing to the possibility that the economies that had been leaders in the global growth stakes in the past would no longer be leaders in the future.

Given that the 2008–2009 crisis was first and foremost a financial crisis, it is appropriate that analysis should start in Chapter 2  with Nicolas V´eron’s assessment of the causes of recent financial problems and the successes and failures of post-crisis financial reform. The mainstream narrative emphasizes impetuous deregulation in advance of the crisis and a swing back to re-regulation in its wake. V´eron offers a more nuanced view: he argues that the traditional separation of macroeconomic and financial policies — the “Tinbergen principle” of assigning monetary policy to the maintenance of price stability and regulatory policy to financial stability — is part of what caused the crisis, and that the development of a synthesis, which flies under the flag of “macroprudential” or “macrofinancial” policy, points the way to a solution.

But the devil is in the details. How exactly macroeconomic and financial policies should be harmonized to ensure financial stability without undermining the efforts of the monetary-policy authorities to hit their price-stability target remains to be determined. The question of how to regulate and, in the worst case, resolve large cross-border financial firms has barely been touched. The international coordination of financial reform has been inadequate; with different countries and regions adopting different approaches, there is the danger of conflicts leading to fragmentation of the global financial space — in other words, there is a risk that the fruits of financial globalization, such as they are, will be lost. Finally, and most importantly, the implications of new regulations and procedures for economic growth remain imperfectly understood.

Another striking aspect of the crisis was the abrupt collapse of international trade, which declined even more than the production of goods and services. Why the impact on trade was so dramatic continues to be debated. There was the collapse of the demand for consumer durables, which bulk large in international transactions. There were disruptions to the supply of trade credit. There was the growing importance, by the standards of the past, of far-reaching and often fragile international supply chains.

Then there was the protectionist response, described by Simon Evenett in Chapter 3. A few governments responded to the crisis and recession with overtly protectionist policies, but more important, Evenett’s data suggest, was “murky protectionism” defined to include not simply import tariffs, quotas and export taxes but also subsidies, bailouts, preferential public procurement practices, and other policy supports only indirectly related to trade. The good news, such as it is, is that only 11 nations implemented discriminatory measures covering more than a quarter of the possible product categories. This is in contrast to the Great Depression, when many countries imposed barriers on imports across the board.

Multilateral disciplines, notably those to which governments commit when becoming members of the World Trade Organization (WTO), are widely cited as preventing countries from resorting to a protectionist response. Evenett questions this contention. While no country violated its tariff bindings at the WTO, governments in fact resorted to a variety of other discriminatory measures that were not, in practice, covered by WTO disciplines. Evenett suggests that other factors, such as the opposition of multinational firms to measures that augured disruptions to trade, were a more important source of restraint in practice. Still, if WTO disciplines are not as effective as typically assumed, then the multilateral trading system may not be as robust as the conventional wisdom would have it. Evenett concludes by warning that prudent policy makers should prepare for this possibility.

The global crisis also deepened disenchantment with the structure and operation of the international monetary system. It was already a commonplace that a system in which the US dollar enjoyed the “exorbitant privilege” of providing the vast majority of global foreign exchange reserves was dangerously prone to imbalances. The crisis then highlighted these risks. Official foreign purchases of US treasury and agency securities, by central banks and governments seeking to accumulate reserves, rendered US treasury rates lower than they would have been otherwise and thereby contributed to Federal Reserve Chairman Greenspan’s famous bond-market “conundrum.” Low treasury rates encouraged investors, stretching for yield, to move into riskier instruments. This fueled the housing boom and the securitization market, permitting the US to crawl further out on an unstable financial limb. Then, in the ultimate injustice, the dollar actually strengthened when the crisis struck, as foreign central banks and governments desperate for liquidity scrambled into dollar-denominated assets.

While this much is clear, less obvious is how to remake the system to avoid such problems in the future. In Chapter 4, Barry Eichengreen sketches likely future trajectories for international monetary arrangements. He is dismissive of far-reaching reforms ranging from a regime based on Special Drawing Rights on the one hand to restoration of a gold-based system on the other. But he is equally skeptical about the viability of a dollar-centric monetary system like that of the recent past. The remaining option being a system organized around several national currencies — not just the dollar but also the euro and the Chinese renminbi — the question then becomes how to ease the transition to such a system and to smooth its operation when it arrives. Eichengreen concludes that reforms of national policies, of multinational institutions like the International Monetary Fund (IMF) and of regional arrangements all will be needed in order to achieve this.

Among the notable long-term consequences of the crisis has been the emergence of the Group of Twenty (G20) as the de facto steering committee for the world economy, displacing earlier advanced-country-centered groupings, notably the Group of Seven/Eight (G7/8). When with the collapse of private demand it became necessary to organize a coordinated fiscal response, it was clear that a group in which emerging markets like China were not represented would not do. The emergence of the G20, which better reflects the composition of the 21^st century world economy, was one concrete consequence of the crisis. In a structural sense, it was also perhaps policy makers’ most important achievement.

But, institutionally, the G20 remains a work in progress. As Ignazio Angeloni explains in Chapter 5, it has no permanent staff or written constitution. It has no global mandate; why it includes the countries it does reflects the particular historical process out of which it emerged. The details of how the G20 will work with multilateral organizations such as the IMF and Financial Stability Board when additional problems arise remain to be determined.

Angeloni argues that the G20 would be strengthened by measures to enhance its legitimacy; its membership could be harmonized, for example, with that of the Executive Board of the IMF. More could be done to ensure continuity as the chairmanship rotates from one country to another, by inter alia establishing a multi-year work program and a permanent steering committee and secretariat. Most of all, the G20 requires a shared vision of what needs to be done to stabilize and strengthen the functioning of the world economy. At the time of writing, consensus on the important issues of substance — such as reform of the international monetary system, of which Eichengreen writes in Chapter 4 and which putatively dominated the work program of the G20 in 2011 — is notable by its absence.

As the growing prominence of the G20 reveals, another consequence of the crisis has been to enhance the weight of emerging markets in the global economy. Their economies held up best in the face of the shock, and they continue to grow robustly. Eswar Prasad in Chapter 6 marshals a number of indicators showing just how fast the emerging markets of East Asia, South Asia, Latin America and Africa have grown and how importantly they now figure in the world economy.

At the same time, as Prasad explains, these countries face serious challenges in the post-crisis environment. Stagnation in the advanced countries is a challenge for their traditional strategy of export-led growth. Very different economic conditions in emerging and advanced-country regions imply different monetary and financial policies, in turn producing large and disruptive capital flows. As emerging markets as a group become large relative to the world economy, their policies become even more important determinants of global economic outcomes. Hence, the governments of what are still relatively poor economies will have to acknowledge and act on the fact that they have effectively become stewards of the world economy.

Where Prasad considers emerging markets, broadly defined, Bokyeong Park and Junill Kim in Chapter 7 focus more closely on the challenges facing the emerging markets of East Asia in particular. The global crisis of 2008–2009 and, more recently, financial turmoil in Europe had relatively little impact on East Asia’s fast-growing economies. To be sure, the region saw an abrupt decline in exports in 2009, but the substitution of domestic demand in the form of government spending and, in the Chinese case, bank lending to the construction sector helped keep growth going in the face of this external-sector weakness. Asian countries had limited exposure to the subprime market in the US, and they had accumulated ample reserves which they could now deploy to keep imports flowing. Aside from a few cases like South Korea, where banks had substantial offshore foreign currency exposures, the temporary shortage of dollar liquidity had little impact on their financial markets. The emerging markets of East Asia, it was increasingly asserted, had successfully decoupled from the advanced-country world.

Park and Kim ask in their chapter whether this will remain the case going forward. As global liquidity strains rose again in the latter part of 2011, a number of East Asian currencies weakened substantially, highlighting the region’s continuing dependence on external financial conditions. International reserves, having risen steadily, reversed direction as central banks intervened to support their exchange rates. China, having ramped up bank lending in 2009 and encouraged local governments to borrow, now has less capacity to respond to additional shocks, given heavier debts and the prospect of nonperforming loans going forward. The inflation associated with previous policies of stimulus is, increasingly, a problem. All this heightens the urgency of rebalancing from foreign to domestic demand as a way of reducing the vulnerability of East Asia’s emerging markets to external shocks. This in turn makes it disturbing that most of the region’s economies, and above all China, have not moved faster to develop their financial markets, strengthen the domestic safety net, and permit the exchange rate to strengthen faster and fluctuate more freely.

But if the challenges that emerging markets will face in the new postcrisis environment will be formidable, they pale in comparison with those that will confront the advanced economies. The advanced economies as a group emerged from the crisis with large budget deficits and heavy debts. Winding down those deficits without derailing recovery and damaging the prospects for growth will not be easy. Deleveraging by households raises doubts about whether consumer demand will be able to substitute for public demand as fiscal consolidation proceeds. All this takes place against a gloomy demographic backdrop that implies rising old-age dependency ratios, heavy pension obligations and health-care costs, and a declining share of the population participating in the labor force.

Joseph Gagnon and Marc Hinterschweiger take up these issues in Chapter 8. They frame their analysis around a number of distinctions. In the short run, there is the distinction between the countries of Southern Europe that face severe immediate fiscal challenges and other advanced countries that still enjoy low interest rates. In the medium term, there is the distinction between countries with more and less favorable demographic outlooks, which in turn point to different prospects for the growth of health-care and pension costs. But, notwithstanding these differences, medium-term fiscal challenges are daunting across the advanced-country world. Under any plausible projection of the evolution of macroeconomic variables, current policies are not sustainable. Difficult decisions are unavoidable.

Gagnon and Hinterschweiger acknowledge the existence of major uncertainties clouding the forecast. Prominent among them are the likely future cost of health-care technology and the scope for delivering health services more efficiently. Also uncertain are the appetite of investors for government bonds and the future path of interest rates. Finally, there is uncertainty about the pace of growth in the advanced economies — about whether that capacity has been permanently impaired by the financial crisis and about whether technical change has been slowed by a “Great Stagnation.” But even under optimistic assumptions, current policies, if maintained will result in the explosive growth of public debt and, sooner or later, fiscal crises.

The authors chart a number of paths along which debt-to-GDP ratios stabilize at sustainable levels and crises are averted. The requisite adjustments are straightforward in economic terms: they involve a combination of reduced discretionary spending, increases in current revenues, and reductions in the growth of health-care and pension costs. But timing is everything; Gagnon and Hinterschweiger show that adjustment costs are substantially lower when that adjustment is initiated early than if it is delayed. And the politics, unquestionably, are fraught.

The global financial crisis has cast a long shadow. It has profoundly affected advanced economies, emerging markets and the balance between them. The implications for international trade, the monetary and financial system, and global governance are far reaching. Drawing out those implications and beginning to comprehend what they mean for the future is the task we take up, collectively, in this volume.

CHAPTER 2

Financial Reform after the Crisis

Nicolas Véron

1 Introduction

Financial reform has been a core dimension of the initial global policy response to the financial turmoil of 2007–2008. At the first G20 summit of heads of state and government in November 2008, more than four-fifths of the action points in the final declaration were about financial regulation (Rottier and Véron, 2010b). Obviously, the crisis is not over at the time of writing, and the cycle of financial reform it triggered is very far from complete. But it can be said confidently that the crisis has been transformational for financial regulatory policy, at least in the US and Europe.¹

One of the key lessons of the crisis is the close interdependence between the detailed features of financial systems and macroeconomic outcomes. Thus, the tight separation of financial and macroeconomic issues, which is entrenched both in academia and in the policymaking community, needs to be overcome. Initiatives to better analyze “macrofinancial” linkages and to conduct “macroprudential” policy have mushroomed since the start of the crisis, although they generally fall short of a fully joined-up framework. From this perspective, the focus of this chapter is financial regulation in an old-fashioned sense, understood as a cluster of interrelated policies designed to ensure the proper functioning and integrity of financial systems. This scope includes public regulation and supervision of bank capital, leverage, liquidity, and risk management; control of moral hazard and financial industry incentives; protection of the customers of financial services; and regulation of capital markets. Other reform areas such as capital-flow controls, prevention of money laundering, and taxation of financial activities can overlap with this agenda, but are not considered here part of it in a strict sense.

The general impetus of financial reform as a reaction to the crisis, in the US and Europe, has been toward more regulation, or re-regulation. This is admittedly too simplistic a generalization: this policy area is multidimensional and cannot be reduced to a simple choice between less or more regulation. Nevertheless, there was a clear turning point in 2008 with the renewed realization that financial systems, including banking systems, could not be left to their own devices, both because of the large potential economic cost of financial crises and because public expenditure is often a key component of their resolution. This age-old wisdom was neglected in the preceding decade in both the US and Europe, for different reasons, more than in the rest of the world, including Australia, Canada, Japan, and emerging economies.

Financial regulation is a complex thicket of highly technical policy challenges, often subject to the use of mutually incomprehensible jargons even as they are mutually interrelated. The devil is generally in the details, and elegant quantitative modeling of policy trade-offs is rarely available. Analytical frameworks tend to be similarly fragmented across different academic silos, including economics, financial research, accounting, political science, and sociology. From an economic research perspective, this is a less mature field than other policy areas such as fiscal, trade or labor policies. Hopefully, the crisis itself will result in new avenues for research, the results of which might start to become available in a few years’ time.

The first section of this chapter examines the dynamics of financial reform as they have unfolded since the start of the crisis. The second and last sections look at the forthcoming challenges and future prospects.

2 The Dynamics of Financial Reform

Systemic financial crises frequently result in major financial regulatory initiatives. The US is a typical example: the key historical milestones of US financial regulation before the current crisis were the creation of the First Bank of the US in 1791, as a consequence of the states’ difficulties repaying the debt from the War of Independence; the creation of the Second Bank of the US in 1816 in the wake of the inflation and financial difficulties associated with the war of 1812; the Legal Tender Act of 1862 and National Banking Acts of 1863 and 1864 to deal with the challenges of financing the Civil War; the Federal Reserve Act of 1913 in the aftermath of the banking crisis of 1907; the New Deal legislation, particularly the Securities Act of 1933, the Banking (Glass–Steagall) Act of 1933, and the Securities Exchange Act of 1934 after the Wall Street crash of 1929 and the banking panic of early 1933; the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 as a reaction to the Savings and Loan crisis; and the Sarbanes–Oxley Act of 2002 after the Enron collapse and a string of other financial reporting scandals. Similarly, in Japan much of the current financial policy framework was introduced in the late 1990s and early 2000s following the financial turbulence that accompanied the country’s “lost decade.”

In the European Union (EU), a distinct driver of financial reform in the two decades preceding the crisis was the effort to create a single market for financial services, particularly after the introduction of the euro in 1999. Landmark corresponding pieces of legislation include the 1989 Second Banking Directive, which encouraged the creation of cross-border branches; the 1993 Investment Services Directive, which established a single “passport” regime for investment banking operations ...

Table of contents

• Cover Page
• Title Page
• Front
• Title Page1
• Copyright
• Acknowledgments
• Contents
• Contributors
• Chapter 1. Introduction
• Chapter 2. Financial Reform after the Crisis
• Chapter 3. Did WTO Rules Restrain Protectionism During the Recent Systemic Crisis?
• Chapter 4. The International Monetary System after the Financial Crisis
• Chapter 5. The Group of 20: Trials of Global Governance in Times of Crisis
• Chapter 6. Emerging Markets in the Aftermath of the Global Financial Crisis
• Chapter 7. Challenges for Emerging Asia
• Chapter 8. Long-Term Challenges for the Advanced Economies: Reducing Government Debt
• Index