Reforming the international financial system

Fundamental weaknesses in the international financial system played a key role in the current global economic crisis. Financial deregulation and lifting of capital controls in most countries had supported greater global financial integration during the 1990s and 2000s. It also facilitated the move of financial innovation into the area of new, complex derivatives and the increased distancing of financial instruments from more tangible and productive assets. This fed a rapid expansion of short-term capital movements. Financial markets also became increasingly interwoven with insurance, commodity and real estate markets through complex instruments that could be easily transacted internationally. In large part, this process of “financialization” expanded beyond the control of regulators. In addition to fostering an illusion of asset diversification, the system promoted excessive risktaking and asset inflation bubbles which stimulated what proved to be an unsustainable pattern of global economic growth. Unregulated financial expansion also fed pro-cyclical capital flow volatility and speculation in commodity markets. The latter played some role in the fuel and food crises.

The central function of a financial system is to intermediate efficiently between savers and investors and to provide reliable and adequate long-term financing for investment. Financial growth of the past decades clearly lost track of that function. The rate of (productive) investment stagnated in most parts of the world, despite the explosive growth in finance (figure O.5). Greater capital mobility has given developing countries greater access to financial resources, but it has also made macroeconomic policy management more challenging because of the volatile and boom-bust nature of financial flows in deregulated markets.

In today’s world of increased economic and political interdependence, achieving a broad-based, rapid and sustained growth in employment and incomes involves even more complex policy challenges than those of the past. The multilateral arrangements designed at Bretton Woods did not include a global regime for capital movements, as capital mobility was expected to be limited. However, even after the breakdown of those arrangements, and despite the surge in private capital flows, no such regime emerged. Clearly, a renewed Bretton Woods system will be needed to help both developed and developing countries mitigate the damaging effects of volatile capital flows and commodity prices.

Strengthening international financial cooperation

A number of options are available for creating a more stable financial system and a better environment for sustainable growth. Some are being addressed as part of the responses to the 2008-2009 global crisis, but probably all will need to be adopted, and simultaneously, to bring about the desired outcome.

First, improved international financial regulation is needed to stem excessive risk-taking and capital flow volatility, including through appropriate capital controls and macro-prudential regulatory reforms imposing counter-cyclical biases in rules for reserve requirements and loan-loss provisioning.

Second, strengthened international tax coordination and lifting of bank secrecy are needed for comprehensive financial regulatory and supervisory reforms so as to ensure that oversight extends to offshore banking centres which currently are unregulated and operate as tax havens.

Third, as new systems of regulation are being elaborated, there is a need for a fundamental revision of existing mechanisms of compensatory financing designed to cope with external shocks. Such revisions should ensure more adequate availability of and easier access to international liquidity, especially for developing countries, by modifying the terms of access to such resources along the lines of recent reforms of IMF credit facilities but with a further easing of access, especially for low-income countries, through alignment with national development strategies and new aid modalities, as proposed above.

Fourth, multilateral surveillance will need to be revised so as to include within its purview all possible international spillovers of national economic policies. Surveillance for crisis prevention and safeguarding of global financial stability remains a key responsibility of IMF, which has centred its efforts on external stability and exchange-rate assessment. It did not prove effective in preventing the recent global crisis, in part because the existing mechanism did not differentiate among countries in terms of their influence on systemic stability—that is to say, surveillance was not more rigorous for countries issuing major reserve currencies. Such differentiation should be an essential part of surveillance; but, more importantly, perhaps it should be embedded in a strengthened and institutionalized mechanism for coordinating macroeconomic policies internationally. As the crisis has made clear, such a mechanism is needed in order to moderate swings in the global business cycle and address the problem of global financial imbalances. The promise of the Group of Twenty (G-20) to establish a framework for generating strong, sustainable and balanced world economic growth should be fleshed out and operationalized urgently. However, as sustainable rebalancing of the world economy will take many years, the implementation of such a framework cannot be left to informal consultations at the level of the G-20: it will require proper institutionalization within the multilateral system and establishment of enforcement mechanisms to make policy coordination effective and accountable.

Fifth, a new global reserve system could be created, one that no longer relies on the United States dollar as the single major reserve currency. The dollar has proved not to be a stable store of value, which is a requisite for a stable reserve currency. Nonetheless, motivated in part by needs for self-insurance against volatility in commodity markets and capital flows, many developing countries accumulated vast amounts of such reserves during the 2000s. Hence, a new system needs to be developed. That system should allow for better pooling of reserves at the regional and international levels; it must not be based on a single currency or even multiple national currencies but, instead, should permit the emission of international liquidity (such as SDRs) to create a more stable global financial system. Such emissions of international liquidity could also underpin the financing of investment in long-term sustainable development, as suggested above.

Reforming governance of the international financial architecture

None of these reforms will work effectively, however, if the democratic deficit undermining the credibility of the Bretton Woods institutions is not repaired. The governance structure of IMF and the World Bank must be reformed so as to more adequately reflect changes in the weights of actors in the world economy, and to be more responsive to current and future challenges, thereby strengthening the legitimacy and effectiveness of these institutions. It is important not only to rebalance voting power in these institutions but to fundamentally restructure their functions and to equip them with the resources necessary to enable them to effectively safeguard global financial stability, coordinate macroeconomic policies and provide adequate long-term development financing.

A new multilateral agency would need to be created to enforce the rules to be established for better and more comprehensive international financial regulation and supervision. Existing institutions, such as the Basel Committee on Banking Supervision and the Financial Stability Board, are too limited in terms of the scope of their functions and instruments and they lack sufficient representation. The new multilateral financial authority would also need to ensure coherence between the global financial regulatory framework and multilateral trade rules.

Is fair and sustainable globalization feasible?

The present set of institutions and rules for managing the world economy were established more than 60 years ago together with the founding of the United Nations and the creation of IMF, the World Bank and the General Agreement on Tariffs and Trade (GATT). Since then, the world has changed beyond recognition, while, in contrast, institutions for global governance have changed little or have adapted slowly. National economies have become ever more closely integrated through trade, investment, finance, international migration, and the technological revolutions in transport and communications.

It is clear that development outcomes in the twenty-first century will be shaped, to a large extent, by the international context. It is also clear that the inequities, both in formal terms and in practice, in the ground rules operating throughout the world economy is unduly restricting the policy space essential for promoting development. This year’s World Economic and Social Survey argues that there is a need to eliminate inconsistencies in multilateral rules-setting related to different spheres and to international versus national objectives. This can be achieved through progress in achieving the following key actions:

• Empowering national authorities to deploy a much broader range of development policies than those implemented in the last two decades through reform of aid mechanisms, international trade disciplines and financial regulations

• Significantly expanding the access of developing countries to technology so as to render it comparable with the access provided to the international trade in goods

• Establishing just, predictable and comparable regulatory regimes to facilitate the international movement of both labour and capital

• Institutionalizing counter-cyclical macroeconomic coordination through reforms in surveillance mechanisms and the global payments and reserve system

• Achieving effective coordination in financial regulation and tax cooperation, which will require abandoning the self-defeating State competition over foreign investment flows that has gone on for years

• Averting the threat of climate change through globally coordinated action, which will require adjustments, through the aid, trade and financial architectures, in rules-setting and priority-setting so as to make them coherent with global sustainable development objectives

Retooling the rules of the game for a fair and sustainable global development is necessary, but not sufficient. It is also about the players. Providing developing countries having weaker initial conditions with more time, resources and policy space for becoming full participants is not to be regarded as an act of charity or goodwill on the part of the powerful but as an imperative for realizing the shared goal of expanding international commerce. The principle of common-but-differentiated rights and obligations defined as a function of level of development will need to be applied in practice and embedded within a system of clear rules.

Reshaping rules is easier said than done. Players will need to agree on the common global sustainable development goals to be pursued and will need to be convinced that cooperation will provide net benefits for all—benefits serving present and future generations. However, within any scheme of international cooperation, net benefits may be perceived as not being equal for all; and any expected unevenness in outcomes may impede the reaching of effective global solutions. Because of differences in living standards, and therefore in capacity to pay, some countries will be expected to shoulder larger shares of the total costs of providing global public goods, which may reduce their incentive to cooperate in providing them. Hence, with respect to establishing multilateral agreements, the proposed pattern of burden-sharing is as important as the extent of the benefits to be conferred by the public goods.

The international community must face a key fact, namely, that the pattern of uneven development brought about by globalization so far has been sustainable neither economically nor environmentally, nor has it been feasible politically. As this time around, developing countries are much more significant and much better integrated into the world economy, the global crisis has profounder implications and more serious consequences for development.

W hile the present crisis only highlights the ever-present risks associated with the deeper integration of national economies into the world economy, the issue concerns not so much a retreat from globalization, although in quantitative terms the current crisis is forcing such a trend, as a feasible reshaping of the globalization process. The proposed means of retooling the existing aid, trade and financial architectures aim at overcoming present shortcomings. It is equally important to overcome institutional shortcomings in current decision-making in the key organizations of global economic governance, such as IMF and the World Bank, and to eliminate inequities in respect of the access to participation in other organizations, such as the World Trade Organization.

There is a need to strengthen the global coordination of economic decisionmaking so as to minimize the number of cases where rules dealing with trade, aid, debt, finance, migration, environmental sustainability and other development issues come into conflict. At present, there is no international agency dealing systematically with questions of coherence and consistency in multilateral rules-setting. Although in 1995, it was proposed that a reformed United Nations Economic and Social Council exercise this directive role, the proposal received only modest support at the time.

The global crisis has provided painful evidence of the weaknesses of the present system. The issues of climate change and demographic changes demand even greater coherence among the spheres of global governance and between decision-making processes at the global and national levels. Whatever its shape, the foundation to be established for international coordination based on shared principles and transparent mechanisms is more urgently needed than ever.