Reforming Global Economic Governance

An Unsettled Order

Carlo Monticelli

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781351109253
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The architecture of global economic and financial governance has undergone a deep and pervasive reform in the last ten years, radically transforming international institutions and groups, such as the International Monetary Fund, the G7, and the G20. This book investigates the new, unsettled order which is now prevailing, driven by the change in the balance of power between advanced economies and key emerging market economies.

Bringing together multiple strands of analysis, traditionally kept separate, Reforming Global Economic Governance: An Unsettled Order particularly explores the role of Europe within this changing world. The book documents and examines a broad range of events, building on methods from economics and other disciplines, as well as on the insights from the author's personal involvement. This innovative approach allows the reader to ascertain the defining features of the reform: the increasing fragmentation of governance; the interconnectedness of its different elements; and the strong concern for inclusiveness. Furthermore, it presents analyses highlighting the controversial nature of the new order which underpins the current policy debate on international economic relations, including the resurgence of nationalism and trade conflicts. Through these explorations, this engaging book has direct relevance for the future prospects of international economic affairs.

Offering a comprehensive view of these issues, this accessible text will appeal to scholars, insiders, and the general reader. Its detailed and thorough analyses will also be of great use to those studying economics, international political economy, and international relations.

1

Unsettling the Balance of Power

“I come from a culture that says that, if a business does not make it, it has to fail. Now, people I trust, including Secretary Paulson here, have explained to me that for banks things are different. If banks fail, they can cause harm, serious harm, to many hard-working people who have done nothing to deserve that”. These are the words that President Bush uttered on 11 October 2008 to a surprised audience of ministers, central bank governors, and senior international officials. The words of President Bush marked the beginning of a new phase in global economic governance. Not because of their content – after all, the awareness they expressed came too late to avert the decision to let Lehman Brothers go, something that had already pushed the global financial system to the brink of collapse. Rather, the historical significance of the words lay in the venue at which they were pronounced: a G20 meeting, the first one ever to be attended by a leader.

That particular G20 meeting of finance ministers and central bank governors was hurriedly convened to seek the involvement of a wider group of countries in the extraordinary line of action that had been decided on the previous day by the G7, the advanced economies’ club at the centre of global economic governance. In the most drastic international effort ever made to stem financial panic, the G7 had basically committed to provide a State guarantee to all short-term liabilities of the financial sector towards other financial intermediaries. This was an extreme response to the mounting risk of a generalized bank run and to the freeze of the basic flow that underpins all modern economic activity: the day-to-day short-term lending between financial intermediaries that was paralysed by the widespread terror that any bank could suddenly go bust, just like Lehman had.

The incipient implosion of the financial system had originated in its very core – Wall Street – but it was not confined to it. It was global. It was as global as the network of financial relations that, for volume and interconnectedness, had long transcended the capabilities of control and emergency remedy by national authorities. The collapse risked dragging the entire world with it, causing “harm, serious harm, to many hard-working people” well beyond the US and the other advanced economies. The notion that a global crisis could no longer be credibly addressed by the traditional economic powers within the established framework of international governance was catalysed, with a sense of urgency, into a need for action. To stand a chance of success, the policy response required the endorsement – indeed, the active participation in ways yet to be defined – of the emerging powers, in particular China, whose persistently colossal trade surplus epitomized the perilous disequilibria besetting the world economy.

The severity of the situation precipitated the need for the involvement of new powers in the emergency action plan that had just been conceived. Reflections on the most effective way to organize their engagement and negotiations on the set of invited countries were a luxury that could not be afforded in that moment. They were replaced by a brief, informal meeting of G7 finance ministers with the US president, arranged on the spot. There, it was determined that use would be made of the presence in Washington of ministers and governors for the ritual jamboree of the International Monetary Fund (IMF) and the World Bank’s Annual Meetings and that advantage would be taken of an existing network, the Group of Twenty, which had been established some ten years before. In his capacity as holder of the G20 rotating chair, the Brazilian finance minister Guido Mantega – who would years later gain popularity for his outspoken castigation of “currency wars” – expediently summoned an extraordinary meeting of the G20 ministers and governors, within a few hours’ notice and with a one-item-only agenda.

Last minute emergency meetings to cope with a crisis had been called countless times. This one had a very different background with respect to the responsibility for the crisis and the perceived need for a joint policy response. G7 countries could not play the role of benevolent firefighters, wisely dispensing resources and advice, when in fact they had been the arsonists. And they were the ones, in particular the US, which most compellingly felt that a common G20 position was necessary to dazzle the public so as to restore orderly market conditions. The new economic powers had plenty of reasons to accommodate this request, spanning from the direct benefits of a (hopefully) more effective action to cope with the emergency, to the political gains of being (and being recognized as) part of the solution rather than the problem, as they had so many times in the past. But some coaxing and admission of responsibility by advanced economies had to be part of the deal. The US obliged, and, unannounced and unexpected, their president participated in part of the G20 meeting.

President Bush did not apologize for the mistakes in US financial regulation and supervision that had been the detonating cause of the dangerous mess world markets were in. Yet, to those who were present at the meeting, like this author, his body language could hardly conceal the humbling uneasiness of having the US on trial by the public opinion of the world, his disbelief that the troubles with subprime mortgages were not a minor glitch but the symptom of much deeper problems, and his consternation that sticking to common-sense principles could have such devastating consequences. Bush nodded gravely when listening to the coarse voice of his Treasury Secretary, who was marshalling the consensus for the G20 to endorse a communiqué¹ in which the G20 “stressed their resolve to work together to overcome the financial turmoil” and committed to “remain[ing] engaged and in close contact”.

These words reflected the agreement in principle to a common, cooperative attitude that had to be filled with operational and political content. The follow-up to this understanding was rapid and momentous, as befitted the worst financial crisis in eighty years. Just two days later, G20 capitals were notified of the US intention to convene a G20 meeting in Washington within a few weeks – a meeting with a formidable innovation in format, purposefully meant to signal the importance attributed to the involvement of a wider group of countries. For the first time, the reunion was to be at the leader level² with finance ministers as part of the delegation, while central bank governors – habitual participants in G20 meetings – were not invited to attend.

This discontinuity in the G20 process was significant for both the enhanced deliberating power of the Group and the upsurge in its symbolic status vis-à-vis the insiders of the international community as well as the public at large. It was the first application, concrete and meaningful, of the slogan that would be tirelessly repeated in the coming years in all sorts of circumstances, relevant and inappropriate: “the crisis is global and requires a global solution”. Yet, the choice of the leader-level format for the G20 signified the beginning of the profound change in global economic governance which is the subject of this book.

As is often the case, the crisis was not by itself the main cause of the change. Rather, it acted as a potent catalyst, accelerating the transformation in the international decision-making process on economic and financial issues, and the related institutional modifications that, in some form or another, would have occurred regardless to reflect the new power balance in the world economy. No doubt the new powers, China in particular, were quick to seize the opportunity. They deliberately leveraged the stronger negotiating influence granted to them by the crisis to make the change faster and more pronounced. However, the economic and political reasons underpinning the need for a deep reform in the governance of the world economic and financial system had been there for a long time.

The reasons for reforming global governance were profound and compelling. To start with, the prevailing framework for international interaction in economic and financial policies was inadequate because of its conspicuous inefficacy and litigiousness, as manifestly confirmed by the outburst of the crisis. Even more importantly, relative weights in the world economy had undergone drastic transformations that had eroded not only the effectiveness but also the legitimacy of a system unwilling or unable to adapt at the required pace.

The circumstances and reasons behind the emergence of the G20 as the premier forum of international economic cooperation and the potential lynchpin of new economic governance, unsettling the international power balance, are the focus of this chapter. The outburst of the crisis and its causes, meanwhile, are the starting point of its analysis.

Many failures led to the crisis

Like many times in the past, the crisis was preceded by time-honoured excesses: unreasonable inflation of asset prices, inordinate borrowing, and overinvestment. Once again, warnings had been wisely propounded – irrational exuberance³ was the catch phrase – and blatantly ignored, creating the conditions for a disorderly adjustment. On that score, this time was not different, as documented in one of the most thorough and convincing post-mortems of the crisis.⁴

What was different was the depth and propagation of the crisis, both of which were flagrantly unpredicted. At the G20 deputies meeting of August 2008 – just a few days before the bankruptcy of Lehman Brothers – the Federal Reserve representative earnestly belittled the significance of the fall in the US stock market and housing prices as physiological corrections that the US financial system could easily withstand. Subprime mortgages, it was repeatedly stressed, were a negligible proportion of the mortgage market, let alone of the entire financial sector. Was this defensive eagerness meant to assuage other countries’ apprehension? Maybe. But no other delegation seriously challenged the US delegates’ reassuring interpretation, nor pointed out the severity of the imbalances in the US financial sector and the global economy.

The moment of reckoning came a few days later, sweeping away all benign diagnoses and brutally uncovering that the troubles in the US financial system were much more acute than hoped or envisaged. Their parallel to the financial crisis that initiated the Great Depression immediately gripped the public imagination. The collapse in US stock market prices and industrial production after Lehman’s default was faster and deeper than the downfall that started with the ill-famed Black Monday of 28 October 1929.⁵

Indeed, the comparison with the previous financial crisis of similar magnitude would remain a constant in the narrative of the policy response, at the national and international levels. In particular, explicit emphasis was placed on the need to avoid economic disruptions precipitating the kind of political turmoil that had led to World War II. This narrative is a powerful and admittedly self-congratulatory discourse: several policy mistakes that caused the Great Depression were not repeated, and the post-crisis rebound in global activity came sooner (not to mention the fact that political tragedies have so far been avoided). And yet, it involves several fallacies that have been unwittingly ignored or deliberately exploited.⁶

Historical comparisons aside, where did the fragility in the system come from? How was it possible for the US economy to move so rapidly from an unprecedented series of mild business cycles, spanning a quarter of a century – the “great moderation”⁷ that some central bankers attributed to their own independence and wisdom – to an incipient collapse? “Why did nobody notice that the crisis was coming?”, as the Queen of England famously asked at a reception at the London School of Economics.⁸

Analyses of the causes of the crisis abound, and they all converge on attributing the central, detonating role to the excesses of finance – excesses that were old in their core motivation of greed and speculative mania. Opinions differ on the importance of the motives underlying the malfunction of finance and its disruptive implications for economic activity, in particular with regard to macroeconomic factors. Yet, ultimately, it is pointless to embrace a single interpretation, as views tend to be complementary rather than alternative. Indeed, the crisis has many deep-rooted origins with widespread responsibilities. Several remarkable failures prevented the operation of safeguard mechanisms that could, and should, have prevented the outbreak of the crisis by spurring (or forcing) gradual preventive corrections.

First, markets failed. Market discipline and self-regulation in the financial sector proved grossly ineffective in guaranteeing the stability of the system. The outburst of the crisis blatantly disproved the view that market participants know better than public authorities when it comes to assessing the risks they take. Rather than increasing efficiency in the allocation of resources, financial innovation was geared towards taking advantage of regulatory loopholes and generating short-term profits, creating perverse incentives that undermined the integrity of the financial sector.

The best-known example is that of toxic assets, by now becoming iconic. These assets were created by repackaging, in a technically sophisticated way, loans of poor quality, which nonetheless received the safest (triple-A) evaluation from credit rating agencies.⁹ When the underlying loans were not repaid, the allegedly safe assets turned out to be worthless, effectively “poisoning” the balance sheets of the banks who had bought them. Even more fundamentally, the balancing checks that the (in principle independent) risk assessment function should have provided in each financial firm turned out to be unreliable – unreliable in a systemic way which involved basically every financial player. The mechanism of market discipline signalling and punishing excessive risk taking either did not work or worked too late to be of any help.

Part of the reason for this failure was that some of the instruments were so complex that not even their inventors, let alone the banks’ management or the regulators, could actually evaluate the risk they entailed. Even more importantly, risk assessment firmly hinged on the principle that variations in asset prices and their correlations had to be in line with past experience. This hypothesis was blatantly violated during crisis times, when panic and herd behaviour led to sharper price movements than past experience could possibly suggest. Resulting losses were far greater than estimated even in the most adverse scenarios and often larger than the capital available to cover them.

These (and other) ingrained flaws became evident during the crisis. Together with the exorbitant compensations to bankers, they fanned...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of figures
• List of abbreviations
• Acknowledgements
• Introduction and overview
• 1. Unsettling the balance of power
• 2. Success and failures of the G20
• 3. The reform of the International Monetary Fund
• 4. Multilateral Development Banks in fashion again
• 5. Re-regulating finance
• 6. Europe and global governance
• References
• Index