11 Mar 2009
The G20 London Summit on 2 April comes at a perilous time for the international economy - advanced, emerging market and poor countries alike. Private consumption and investment, output, employment and trade are falling sharply worldwide. Poverty is rising, the middle classes are threatened, and the wealthy and retirees find their assets shrinking dramatically. In most developed countries, new waves of bank rescue packages follow the previous, unsuccessful ones. Conservative central bankers take on risky assets, their balance sheets and prospective losses swell. Some warn of deflation, others worry that fiscal and monetary stimuli will bring back inflation. Even countries that have accumulated high levels of foreign exchange reserves are concerned by capital outflows, while those without queue at the IMF. The problems are global; the solutions must be cooperative and coherent across countries.
Those preparing for the summit know well the fundamental issues on which the G20 leaders should agree. In the short run, they must revive financial intermediation and create an international macroeconomic environment that will support stabilisation efforts, while putting up a united front against protectionism. For the medium and long run, they must restructure financial regulation so as to reduce the likelihood and magnitude of future financial crises. As the crisis deepens, the political pressure and the temptations for each country to free ride increase, and the need for coordination becomes more evident. Hence the importance of the Summit; a consensus on clear and consistent policy guidelines could itself go far to reassure markets that political leaders are regaining control of the deteriorating situation.
But the detailed outlines of desirable policy packages have not been well understood. Here economic analysis has much to offer. It can help to eliminate policy options that are appealing yet inefficient or unnecessarily costly to taxpayers; identify the most effective solutions, so these can anchor the discussions and make it easier to reach agreement; and facilitate estimating the costs and benefits of each policy proposal.
Facing the unprecedented challenges, academics have responded (1). And the policy community has recognised that researchers have potentially useful new approaches to the new problems. Much of the underlying research is not in fact new, and if not a consensus, there is substantial common ground among academic economists on both the micro and macro issues. We know a lot about banking crises, debt deflation, unconventional monetary policies, market failures, regulation and incentives.
Much of that knowledge and the policy implications are set out in a new ebook, Macroeconomic Stability and Financial Regulation: Key Issues for the G20, published by CEPR (2).
Initial versions of the papers were discussed at a seminar with G20 Deputies and private sector representatives hosted by HM Treasury and the Bank of England on 31 January 2009. Highlighted here are some of the policy proposals emerging from the book, each of which is justified with detailed analysis.
Global imbalances and capital flows
Address global imbalances by creating credible insurance mechanisms for countries that forego reserve accumulation and stimulate domestic expansion, along three possible lines: more central bank swap lines; ‘reserve pooling'; and a major expansion of IMF resources, together with IMF emphasis on a large, flexible, fast-disbursing facility that would come with little or no conditionality to countries that are adversely affected by global shocks.
Accelerate the development of financial systems in emerging markets, in particular local currency bond markets and foreign currency hedging instruments. Promote regional cooperation in the design of common institutional standards for financial market development and work to lift barriers to cross-border asset trade within regions.
Challenges for macroeconomic policy in the crisis
Use macroeconomic policy to meet any threat of deflation promptly, before it takes hold, with a zero interest rate policy (ZIRP) and quantitative easing. Establishing an inflation target may help to avoid expectations of deflation.
A global ZIRP would raise a particular problem: not all countries can benefit from the stimulus of exchange-rate depreciation. A country with large trade surpluses and positive GDP growth should refrain from intervention to prevent appreciation, which would be a beggar-thy-neighbour policy.
Design fiscal stimuli cooperatively, so that they internalise the effective demand externalities of the stimulus while reflecting each country's 'fiscal spare capacity'.
Mitigate procyclicality by adjusting the Basel II capital requirements using a simple multiplier that depends on the deviation of the rate of growth of GDP from its long-term average.
Create a centralised clearing counterparty for CDS trades without further delay. Consider requiring that CDS be exchange-traded and consider prohibiting naked CDS (those that do not insure a holder of the underlying asset).
Sever the link between credit rating agencies (CRAs) and issuers, so that a CRA's rating cannot be influenced by the prospect of future business with the issuer. Prohibit indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services.
Consider eliminating the 'hard wiring' of the CRAs in the regulatory system - less rather than more regulation here.
Force greater disclosure of information about the underlying pool of securities for structured instruments.
Controlling financial institutions
Establish a harmonised bankruptcy regime for banks, based on US-style 'prompt corrective action', giving an independent, well-staffed supervisor strong powers to limit the freedom of bank managers (and possibly remove them) and shareholders (and possibly expropriate them) before the bank is technically insolvent.
Consider the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities.
While these are for the most part either ‘micro' or ‘macro' proposals, the editors stress above all the short-run policy imperative. Here micro and macro are deeply complementary. Neither monetary nor fiscal policies will work unless and until the blockages in the supply of credit are resolved. Financial intermediation and the structure supporting it must be restored to near-normal conditions to stop the accelerating decline.
Richard Portes (email@example.com) is a Professor of Economics at London Business School and President, Centre for Economic Policy Research.
(1) For an extensive range of academic contributions, see recent ebook Baldwin and Evenett (eds), "The collapse of global trade, murky protectionism, and the crisis: Recommendations for the G20", and the two books collecting Vox columns on the crisis: The First Global Financial Crisis of the 21st Century and The First Global Financial Crisis of the 21st Century II, both edited by Andrew Felton and Carmen Reinhart and published by VoxEU.org, July 2008 and February 2009. VoxEU.org has published two other relevant ebooks, both edited by Richard Baldwin and Barry Eichengreen: What G20 Leaders Must Do to Stabilise our Economy and Fix the Financial System, November 2008; and Rescuing our Jobs and Savings: What G7/8 Leaders Can Do to Solve the Global Credit Crisis, October 2008.
(2) The authors are Marco Becht, Markus Brunnermeier, Willem Buiter, Mathias Dewatripont, Xavier Freixas, Stefan Gerlach, Hendrik Hakenes, Takatoshi Ito, Philip Lane, Marco Pagano, Richard Portes, Rafael Repullo, Jean-Charles Rochet, Jesús Saurina, Isabel Schnabel, Carlos Trucharte and Paolo Volpin.