VOLUME 2 NUMBER 2 JULY 2014
VOLUME 2 NUMBER 2 JULY 2014
Economic and Political Studies Vol. 2, No. 2, July 2014, 26-45
Global Financial Regulations: An Antidote to Economic Predicament BIN ZHANG * Abstract: Due to the lack of public order in the international financial arena, asset bubbles and resource misallocations persisted over a long period of time and resulted in global financial crisis in 2008. Global financial rules, which can take on a role like that of WTO in the international trade, are urgently needed for global economic recovery. They will balance the pressure of economic restructuring between large and small countries, and push forward some countries’ domestic reforms which may hardly be implemented due to domestic politics. Keywords: global financial regulations, financial crisis, G20
I. Introduction
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N THE AGE OF GLOBALIZATION, price signals in financial markets not only help allocate factors of production across sectors and time horizons within a single country, but also allocate factors across national borders. In 2008, as the most recent global financial crisis unfolded, there were dramatic fluctuations in prices in international financial markets. These fluctuations were a signal of investors’ panic and lack of confidence in the market. Moreover, they suggest that there was the expectation of a redistribution of factors, such as capital, credit, and other production materials, on a global scale. Although the worst of the financial crisis may have now passed, the fundamental problems exposed in the crisis have not been completely resolved and the full impact remains unknown. For instance, the sovereign debt crisis in Europe poses a severe challenge to global economic recovery and the stability of financial markets; the level of the US public debt is unsustainably high and may actually be slowing down the pace of recovery;
* Bin Zhang is from the Institute of World Economics and Politics, Chinese Academy of Social Sciences; e-mail:
[email protected]. The author would like to thank the anonymous reviewers for their helpful comments; the usual disclaimer applies.
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optimism over China’s future is waning given that their export-driven growth model and real estate investments have run into a bottleneck; moreover, investors are increasingly concerned that non-performing loans from local government-backed financing vehicles might undermine China’s banking system. As the IMF pointed out in their World Economic Outlook published in the spring of 2012, global economic recovery is still weak and many economies remain vulnerable to the vicious cycle of financial market volatility and decline in the real economy. This paper aims to discuss the most cost-effective ways to implement financial and currency-related policy adjustments in order to pull the global economy out of the current quagmire. We try to answer the following questions: (1) Why did the financial crisis happen? (2) What impedes a sustainable global recovery? (3) What key policy adjustments are needed to put the global economy back on the path of sustainable growth? Many enlightening studies have been done to address the questions raised above, with scholars particularly focusing on the causes of financial crises. Although it is true that generally scholars are believed to have reached a general consensus on this issue, our research can be distinguished from former studies in two ways. First of all, this paper is completely oriented towards providing policy recommendations, which is not always the case in other studies. For instance, although Rajan (2011) has produced a very comprehensive analysis of the US subprime debt crisis, we cannot deduce from the study the most effective policies to adopt in order to avoid such crises in the future. In contrast, our study aims to provide solutions, which gives our analytical work a much clearer target. Second, this paper examines the issue from a global perspective. We discuss economic recovery on an international scale rather than focusing on a single country. It is our view that, against the backdrop of global economic integration, individual countries’ domestic policies are not sufficient to help the world economy out of recession. From our analysis we draw the following conclusions. First, the absence of necessary rules to regulate global financial markets resulted in an uneven worldwide distribution of factors. These market distortions were left unaddressed and, hence, led to the financial crisis. Despite calls from emerging economies for a fundamental adjustment of the global economic regime, for which a global regulatory framework would need to be built in order to facilitate the adjustment process, the international community not only failed to build a global regulatory regime but also abandoned this option. Instead, blind optimism, opportunism and misguided perceptions
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of growth became the norm. This worsened the imbalance in the global distribution of factors. Therefore, one could argue that the dramatic adjustment seen in the crisis, reflected by the fluctuation of prices in global financial markets, was inevitable. Second, there has been little coordination among countries in terms of leverage, which has significantly undermined the recovery of global economies. A reasonable redistribution of global economic factors would require developed economies to lower their overall debt and leverage levels, while developing economies would need to boost domestic demand and raise leverage. However, deciding on a cost-sharing plan for the countries involved is a major challenge. The US, with the dollar as a major reserve currency, is able to push the cost of deleveraging more easily onto other countries, while the Eurozone is facing a relatively more grim reality. In the several years since the outbreak of the debt crisis, the Eurozone has been engaged in endless negotiations and no plan for a reasonable resolution of the conflict has been found. Third, if we are able to end the current anarchic state of the global financial system, the cost of rebalancing will be much smaller for the global economy. To do so, we need to build a system of international financial regulation, similar to the framework of WTO rules. This will be essential if we want to avoid a Prisoner’s Dilemma situation. There are obvious advantages to building a global regulatory regime that incorporates major state actors and stresses international cooperation. It can find more efficient solutions to the imbalance in the distribution of global factors. Without the regime, it is extremely difficult for any one country to achieve its aims via domestic policy adjustment without coordinating with countries of systemic significance. Only coordinated action can bring the distribution of global factors back to a more reasonable state. In addition, adjustment under the supervision of a regulatory regime is more balanced, meaning that the burden of structural rebalancing on any single country would be lighter. Finally, a set of global financial rules could accelerate domestic reforms in countries where political stalemates have resulted in reform deadlock. The global economy is facing a tough future and structural rebalancing is likely to come hand in hand with depressed economic growth and a rising number of social conflicts. Therefore, external support is very important. The global economy is also facing a critical window of opportunity. The economic governance framework built during this time will determine national and global economic growth prospects for the next few decades.
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II. Crises in the Absence of Regulation Crises have always followed on the heels of economic booms. In the last century, the global economy has swung from prosperity to crisis three times. From the 19th century to the beginning of the 20th century, the world history witnessed the rise of the US, Germany and Japan, which posed challenges against the Britain-dominated global economic governance. Nevertheless, the economic prosperity in this period was followed by the collapse of the gold standard and the Great Depression. In the 1950s and 1960s, the reconstruction of Western Europe and Japan after the Second World War was achieved successfully, which, however, was followed by the fall of the Bretton Woods system and subsequent stagflation in developed economies. In the 1990s, the world saw the rise of emerging economies, which challenged the global economic governance structure dominated by developed countries, but this was followed by the 2008 global financial crisis. It is worth noting that, after the first two crises, the international currency systems that existed at the time both collapsed. However, after the 2008 crisis the dollardominated system remained standing despite the rising tide of voices calling for change. Why does the rise of new economic powers often trigger a global crisis? A general but inconclusive answer is that the phenomenon reflects underlying conflicts between rapid productivity growth in some countries and the established global economic regime, i.e., conflicts occur when the relations of production no longer meet the demands of rising productive forces. Crises are the ultimate embodiment of such conflicts. When developing countries achieve technological progress and efficiency improvements, critical prices in markets, such as interest rates, exchange rates and commodity prices, should systematically adjust to fit the new economic power structure. As a result, factors should redistribute according to the price signals and the power structure would change substantially. However, historical evidence suggests that this brings significant problems, which are difficult to deal with under the established global governance structure. Moreover, these problems are rarely addressed in a timely manner. Due to groups with vested interests in the former price system, there are often attempts to preserve the previous distribution of factors and protect the established power structure. When rising economic forces fail to find a compromise with the established political powers, market prices are distorted
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to the extent that they no longer reflect the underlying power structure. These conflicts then worsen the imbalance in the distribution of global factors and hence lead to financial crises. The rest of the paper will analyze the conflict that underlay the 2008 global financial crisis, which we would characterize as a conflict between improvements in productivity in emerging economies and the absence of a global regulatory regime. 1. The Rise of Emerging-market Economies After a number of attempts, emerging economies, China and India in particular, have found that the crux of their development lies in the opening up and marketization of the industrial sector. On the one hand, market reforms and associated policies have induced more effective corporate governance structures and provided a relatively unbiased competitive environment. While on the other hand, opening up has loosened many technological, capital and market restraints on the industrial sector and promoted growth. In contrast, developed economies are thought to have reached a technological frontier, which means that they are only able to maintain a low but stable growth rate. At the beginning of the 21st century, middle- and lower-income economies overtook developed economies in terms of absolute growth rates. They also managed to unhinge their growth trends from the latter. This can be said to be one of the most successful developments of this kind that we have witnessed since the Second World War. From 2000 to 2010, OECD countries grew at an average rate of 1.77%, while middle- and lower-income economies registered an average growth rate of 5.96%. This represents a margin of 4.19%. In contrast, from 1970 to 1999, the margin was only 0.89%. Of particular note is that emerging economies are ranked top out of the middleand lower-income economies in terms of their growth rates and have an even larger margin over the developed countries. While technological progress and productivity improvements in the industrial sector have accounted for much of the growth in China and India, some countries have benefited from improvements in trade conditions. However, this is mainly because of their dependence on exports of energy for growth. There is an important distinction to make here. In the former case, the countries have seen active improvements in growth; while in the latter case, growth has been contingent on the growth of other economies.
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2. Imbalances in Economic Structure The emerging-market economies that have achieved economic growth based on fast improvements in productivity have significantly changed the demand and supply structure in global markets. In theory, this should have meant that critical prices on financial markets, including interest rates, exchange rates, asset prices and commodity prices, react to the fundamental change and factors are reallocated accordingly. The transition process also mandates that each country should have made substantial adjustments to their investment and consumption behavior as well as to their domestic income distribution. A reasonable response to the rapidly rising productivity of emerging economies would have been a redistribution of capital flows from developed economies to emerging economies. In turn, this would have pushed up the relative prices of assets and the value of the currency, stimulated investment and accelerated income growth, and resulted in an improvement in welfare in emerging economies. Conversely, the currencies of developed economies should have depreciated, asset prices should have fallen and investment and income growth should have slowed, leaving private consumption and welfare to grow at a slower pace. Finally, during the transition process, scarce commodity prices should have surged. However, in this case the reality was inconsistent with what economic theory proposes. The most prominent inconsistency was reflected in the trade imbalances between the US and China as well as the trade imbalances within the Eurozone. For example, the US, because of its lower potential rate of growth, should have seen capital outflow in the form of a trade surplus. Domestic savings in the US should have flowed overseas in search of relatively higher investment returns. However, the US has actually been a net recipient of capital and borrowing from overseas, the funds of which have been used to finance and maintain consumption levels. Whereas, China, with higher growth potential, should have attracted capital inflow in the form of a trade deficit and borrowed from overseas to finance its domestic investment and consumption. In fact, China has experienced net capital outflow and lends its domestic savings to the US. In this way, the international capital flow has run against the general logic of the market. Yet there are possible explanations for this phenomenon. In his research, Lucas (1990) observes the capital outflow from middle- and lower-income countries to developed economies and proposes a number of justifications. For example, it is widely believed that the well-developed financial market
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in the US is able to provide high-quality financial services and help preserve the value of excessive savings. In contrast, the developing economies are disadvantaged in this respect due to being unable to provide premium financial services. This does not mean they cannot create wealth; however, preserving the value of wealth can be problematic. Therefore, capital flows from middle- and lower-income economies to the US, which in turn invests its funds in global markets via its mature financial service industry in search of higher returns. For further clarification, one could use the analogy that the US functions as an investment firm that borrows in large quantities from abroad and then invests overseas to harvest the profit. Economists have suggested that this economic structure suits the comparative advantages of the US, i.e., the US takes advantage of its edge in financial services and borrows heavily from abroad to invest in global markets. This growth model not only raises US productivity and national income, but also has positive spillovers on other countries. However, this model explains neither why the US is a net recipient of capital, nor why capital has been flowing from countries with higher growth rates to those with lower rates. As previously mentioned, the US spends a large proportion of the funds raised abroad on domestic consumption rather than overseas investment. Slightly over half of the US capital account surplus has been reinvested abroad, with the remaining 30% to 40% being used to finance gigantic trade deficits. Even though the return on foreign assets held by the US is much higher than the cost of the country’s foreign liabilities, the large trade deficits still render the US a net borrower with a huge and evergrowing debt level. In short, the US has been borrowing from the savings of other countries to finance huge amounts of spending, which is mostly directed to consumption rather than investment. 3. The Absence of Rules The rise of emerging economies and the role of the US as a global investor should not necessarily lead to an imbalance in factor allocation. Scholarly discussions have approached the problem of structural imbalances from multiple perspectives and come up with a variety of explanations. In this section, we will discuss four influential points of view related to what caused the financial crisis and the underlying structural imbalance. The first is that the US Federal Reserve maintained an excessively low interest rate. The second is that a lack of oversight of the financial system led to the overdevelopment of the financial derivatives market and a serious mispricing
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of risk. Third, there exist substantial price distortions within middle- and lower-income economies, represented by the mispricing of tradable goods relative to non-tradable goods, causing a distortion in the real exchange rate. Fourth, a serious deficiency exists in the international monetary system. Upon further analysis, it is clear that the four points of views mentioned above concern the same underlying problem, i.e., the lack of a set of global rules governing the international financial and monetary system. This has left the mispricing of assets and subsequent distortions unaddressed and, thus, the imbalance in the distribution of factors and the dysfunctional price system has pushed global markets into crisis time after time. The domestic misallocation of factors in the US was a result of the distortion of interest rates and the mispricing of assets. The direct cause of this mispricing was blind optimism and opportunism within the government and private investors. This blindness and opportunism lead to the neglect of economic principles and unchecked investment speculation, respectively. Before the start of the 2008 financial crisis, scholars and policy makers did express concern over the existence of asset bubbles, excessively low saving rates in the private sector, and over-spending and unsustainable current account deficits across the US as a whole. From 2004 to 2007, the global imbalance was the most frequently discussed topic by scholars studying international macroeconomics. However, at the same time optimism over the “new economy” was also prevalent and many scholars even suggested that the global imbalance could be sustainable. Indeed, Alan Greenspan, former Chairman of the US Federal Reserve, expressed his worries about asset bubbles and financial derivatives. However, he concurrently acknowledged the merits of the “new economy” and eventually opted for a lower interest rate policy, which one could consider a reckless choice in light of our discussion. Taylor (2009) criticizes the decision saying that, if the Fed followed the Taylor rule as closely as it had done in the past, then the interest rate should have been higher, which might have limited the damage of the financial crisis. In fact, it was not only the US monetary authority that opted for blind optimism during this time. Policy makers in charge of public finances also chose to reduce taxes and expand the public welfare system, despite facing rising deficits. Moreover, investors continued to buy into the illusion rather than relying on solid economic principles to make their investments. In sum, the situation was allowed to spiral out of control in the absence of effective regulation. In terms of middle- and lower-income countries, market distortions and mispricing were largely caused by the misguided perception that
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the development of the industrial sector was a higher priority than the development of a fair and competitive market. Throughout modern history, every economy that has managed to overtake its competitors has relied heavily on the rise of the industrial sector. The productivity of this sector can be improved over a very short time frame via taking lessons from advanced modes of production and emulating superior managerial skills, making it an ideal powerhouse of growth. However, this overemphasis on industry can create a bias in the economic structure against other sectors. Nevertheless, the development of the industrial sector doesn’t necessarily have to result in trade surpluses and structural imbalance. Actually, it can lower the relative price of industrial goods and provide favorable conditions for the development of the service sector. If the price mechanism is flexible enough, economic factors can then be efficiently redistributed between sectors. This would allow for the enhancement of overall productivity and, therefore, capital would still flow into middle- and lower-income economies. In reality, however, developing economies have put too much weight on the development of the industrial sector. In order to overtake advanced economies as soon as possible, governments have taken measures to induce the flow of resources into the industrial sector to the detriment of fair competition. Such measures include intervention in foreign exchange markets, subsidies on factors of production or even direct price manipulation and a regulatory framework with a bias against other sectors. These types of intervention can paralyze the price mechanism and allow an excessive amount of resources to flow into the industrial sector, especially for the purposes of export and import substitution. Hence, this has generated serious structural imbalances across sectors. In particular, the industrial sector has grown faster than domestic demand, so emerging economies can only rely on capital outflow/trade surplus to release the overcapacity in tradable goods production. This growth model has thus unhinged domestic welfare improvement from economic growth and relies too much on external demand. It is worth noting that this model is especially unsustainable for larger economies as the problem of overcapacity can grow to much larger heights and is much more vulnerable to bottlenecks occurring on the demand side. Moreover, the imbalance between sectors can exacerbate the income distribution problem and weaken domestic demand, creating further imbalance and a higher risk that the economy will deteriorate into crisis. Without an effective regulatory regime, the international financial and monetary system could not successfully restrain the overconsumption in the US and the over-heated development of the industrial sector in emerging-
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market economies. If more cautious oversight had been adopted and a regulatory regime had already been put in place to correct the imbalance of current accounts, interest rates and exchange rates, the crisis could have been avoided or at least contained. However, the anarchic state of the international financial system and the lack of an institutionalized public governance structure failed to address the deepening imbalance in the distribution of global factors. There is a serious discrepancy between the globalization of finance and the absence of an international regulatory regime. The seemingly accidental and unforeseen nature of the financial crisis cannot disguise its actual inevitability.
III. Difficult Economic Recovery in the Absence of a Global Regulatory Framework 1. Methods for Economic Recovery Shortly after the 2008 crisis, the global economy saw a strong recovery propelled by numerous stimulus packages released by multiple governments. However, this did not last long. Since 2010, the public debt problem in developed economies has deteriorated and triggered high levels of volatility in global financial markets. In terms of emerging-market economies, the stimulus plans as well as the global environment of low interest rates and the surging price of commodities have increased inflationary pressure. This has in turn prompted developing countries to implement policies to tame inflation and calm their overheated economies. Overall, these measures have caused a substantial drop in growth rates. Under the circumstances, an effective global redistribution of factors is required to bring supply and demand back on track. Only by doing so can the pressure on financial markets be relieved and economic recovery become sustainable. For developed countries, this means deleveraging, particularly in the public sector. This is the greatest challenge to global economic recovery so far. Before we proceed to the discussion of why this process is certain to be difficult, we should first identify the substance of the deleveraging process. In general, there are three ways to deleveraging in the public sector: first, loose monetary policies, leading to a combination of inflation plus currency depreciation; second, tight fiscal policies; third, bankruptcy followed by debt restructuring. These three methods use different mechanisms to lower the ratio of public debt to revenue and are, therefore, very likely to have different
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impacts on economic growth. Loose monetary policy can lower the debt/revenue ratio in two ways. On the one hand, inflation lowers the cost of public debt in real terms; on the other hand, the reduction in the real interest rate depreciates the currency, which should stimulate growth in investment, public revenue and trade. In their research on debt crises over the last eight centuries, Reinhart and Rogoff (2009) point out that almost every nation state that has encountered a sovereign debt crisis has relied on inflation and currency depreciation to alleviate the pressure of debt repayment. However, there is a limit to the effectiveness of this method. First, there is the risk of hyperinflation, which would cause substantial volatility in domestic prices, and disrupt investment, production and consumption activities. This could in turn lead to a sharp fall in real income, which would actually worsen the debt/income ratio. Second, if distortions in the economic system are prevalent, a reduction in the real interest rate might fail to stimulate investment and income growth. Finally, if you gear monetary policy towards the promotion of inflation, this might trigger a global race to the bottom, which would jeopardize the effectiveness of inflation as a debt reduction strategy. Fiscal tightening has a more direct effect on the public debt/income ratio. However, often there is little space left for fiscal tightening if the debt level is already too high. Fiscal tightening would most likely put downward pressure on aggregate demand in the economy, leading to lower public revenue. Therefore, if the debt ceiling is already high, a significant spending cut would be required, which could drag the economy into recession. In addition, strong fiscal tightening is likely to run into tough political resistance. In a country already in crisis, solely relying on fiscal tightening to aid debt repayment, in the most extreme case, could end in default. While there is no international court that can send a state to prison for defaulting on its debts, in democracies voters have been known to drive out governments that implement large-scale fiscal tightening programs. Since the beginning of the Euro debt crisis, a number of governments have been forced out of power, which shows that in some countries relying too much upon fiscal tightening is simply not feasible. Bankruptcy and debt restructuring, on the other hand, also have immediate effects on lowering the debt level, but they require a considerable amount of negotiating and compromise from creditor countries. Without effective coordination between creditors and debtors, the restructuring process could cause chaos in the credit system and create serious panic, likely leading to a huge negative impact on the real economy. This kind
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of economic meltdown could result in numerous firm bankruptcies and a soaring unemployment rate. In light of this, it is crucial to strike a balance between each of these three methods to reduce unaffordable public debt. However, each country faces different constraints when using the aforementioned policy tools. Moreover, inflation, bankruptcy and debt restructuring all involve conflicts of interest between debtor and creditor countries. Therefore, the US, with the dollar as the major reserve currency, has much more leeway to address its debt problems, while the Eurozone countries are having difficulty utilizing such methods. In fact, many argue that, due to the lack of an international regulatory regime to supervise the global financial and monetary system, the US has actually been able to take considerable advantage of its privileged status in this regard. 2. The Eurozone Crisis Shortly after the 2008 financial crisis, Iceland, Ireland and Greece all ran into serious problems in terms of their public finances. In May 2010, the Greek debt crisis even drove the global markets into a state of panic. In fact, it can be said that Eurozone debt problems have been the most notable disruption to the stability of financial markets. In spite of bailout programs and assistance from the European Union, European Central Bank (ECB), IMF and states outside the Eurozone, the crisis continues. The Eurozone debt crisis has been the strongest headwind against economic recovery in the post-2008 world. Countries haunted by debt problems have a lot in common, with Greece often being taken as a typical example. In general terms, the direct cause of the Greek debt crisis was that public revenues were not keeping up with public spending and, unfortunately, during the financial crisis, this gap just expanded further. The underlying problems, however, are manifold. Two precursors to the crisis are worth noting. First, by joining the Eurozone, there had been a notable reduction in the cost of financing in Greece. Before that, Greek bond yields were substantially higher than those of the core states of the Eurozone. Based on CEIC and the author’s calculation, between 1995 and 1999 the gap between yield rates in Greece and those in Germany was between 2% and 10%. However, the yield rates gradually converged after Greece joined the Eurozone, which significantly reduced the cost of public financing in Greece. Second, the productivity increase in middle- and lowerincome economies and US monetary policy changes jointly brought down
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interest rates and, therefore, further lowered the cost of public financing. However, at the same time the rise of developing countries weakened the competiveness of the Greek economy in international markets and generated significant amounts of structural unemployment. The Greek government took advantage of the low interest rates and relied on the expansion of public debt to mitigate this negative demand shock. Although this action may have kept the welfare system running and sustained economic growth in the short term, in the long run it resulted in huge damage. The deficiency of the regulatory system is one of the crucial reasons for Greece being plunged into a sovereign debt crisis. We have to ask why Greece was able to raise that amount of public funds despite being in such a poor financial position, why investors would still lend to the country, and why no firewall had been built to identify and solve the problem. The Greek case is similar to that of many Eurozone countries; so how can we break this vicious cycle of crises in public finance, markets meltdowns and decline in the real economy? Eurozone countries have not yet worked out an effective plan for deleveraging because, due to their own concerns, creditor and debtor countries have not been able to reach a fundamental compromise. Without a regulatory regime working to support conflict resolution, the two sides have been allowed to fall into a war of attrition, which has repeatedly disrupted financial markets. Let’s again take Greece as an example to illustrate why Eurozone states have been haunted by the crisis. As the region has adopted a single currency, domestic inflation and currency depreciation could not be used to address the debt problem. Moreover, debt restructuring was not sufficient to meet the liquidity and repayment challenges facing Greece. Hence, fiscal austerity was the last resort. However, the Greek government could by no means rely on fiscal tightening to solve the problem when the economy was already in a deep recession. Moreover, a new government was elected in the wake of the crisis, which did not keep the promises made by the former administration. The other side of the problem is with the creditor states, which, in the case of the Eurozone, is predominantly Germany. However, Germany is also in a dilemma. If Germany supports the ECB, relaxes monetary policy and floods the market with Euros, the situation may improve. Nevertheless, this would have a huge and negative impact on Germany. For Germany, the ratio of its trade surplus to GDP has been around 5-7% since 2004. This has helped it accumulate a large amount of foreign assets, most of which it has invested within the Eurozone. Higher inflation rates would mean that Germany would
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suffer from a huge devaluation of its foreign assets. Moreover, if Eurozone monetary policy has been loosened, Germany would become more at risk of inflationary pressure than any other Eurozone country. Indeed, although higher inflation in Germany relative to other states would lead to structural rebalancing in the Eurozone, it would also be difficult to ascertain how much inflation in Germany would be needed for this to happen, given that the debtor states would need to increase inflation as well to solve their debt problems. It would be very hard for Germany to tolerate that much inflation due to its cautious attitude towards loose monetary policy. Therefore, since Greece and Germany cannot reach a fundamental agreement, the essence of the problem has not yet been addressed despite the measures taken to stabilize the financial markets. Each country has its own reason not to cooperate, but the absence of cooperation only makes matters worse, not only for the Eurozone but for the global economy as a whole. The Eurozone needs to loosen its monetary policy, raise taxes, and increase public expenditure in addition to restructuring its debt and reforming its labor markets. All these measures need to be taken simultaneously in order to get out of the current vicious cycle. Unfortunately, the Eurozone cannot reach a consensus, so the cycle of surging debt levels, market panic and economic recession has continued. 3. The Role of the United States and China Compared to the Eurozone, deleveraging in the US has gone rather smoothly. After the financial crisis, the US government adopted strong monetary and fiscal stimulus plans to cushion the vehement deleveraging in the private sector. From the point of view of the US, the policies have been successful in that they have shifted the debt burden to other countries. However, this has also slowed down the domestic restructuring process. The continuation of negative real interest rates has shifted the balance between consumption and investment, prolonging the problem of overconsumption. Therefore, although in the short run these measures have fared well in terms of the stabilization of financial markets and economic growth, they have had one very important consequence: the public financial sector has taken on much larger liabilities. Because of this, the US is facing an unsustainably high level of public debt. In fact, the government’s debt level compared to GDP has reached the highest it has been since the Second World War. More worryingly, it is actually expected to grow faster under the current policy framework. Currently, there
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are two financial instruments that constitute the US government’s public debt. The first is US treasury bonds held by the private sector, which totaled around 62% of GDP in 2010. The second is US federal bonds held by both the private and public sectors (including enterprises run by the government), which surged to about 100% of GDP. The Congressional Budget Office has suggested that if no substantive policy adjustments are made, the ratio of fiscal deficit to GDP will rise over the next 20 years, making unsustainable public finance the top problem for the US economy in the medium to long term. The fallout emanating from the US Federal Reserve’s policies have not only put the US itself in a difficult position, but have also harmed other economies. For example, interest rates on US public debt have been kept at an all-time low. The US government has been able to do this because of the role of the dollar as an international reserve currency and the Federal Reserve’s extremely loose monetary policy, which has left the US plenty of time to address their debt problems. However, this policy is also creating a notable negative spillover effect. The sudden increase in the supply of dollars has pushed up commodity prices, generating intense pressure on the structural adjustment and stability of other economies. For the Eurozone in particular, the surge in commodity prices has added pressure to inflation, preventing the ECB from relying on a more expansionary monetary policy to tackle their own debt problems. Furthermore, the loose monetary policy in the US has caused the value of the dollar to depreciate, enhancing the competitiveness of US exports to the detriment of its major competitors, such as Japan and the Eurozone countries. Finally, this loose monetary policy will eventually trigger inflation and depreciation, lowering the purchasing power of dollar assets held by foreign investors, which to a certain extent amounts to a default on foreign debt for those countries. China also implemented enormous monetary and fiscal stimulus packages during the aftermath of the financial crisis. China’s policy was designed to make up for the demand gap in the industrial sector following the collapse of external demand. The benefit of this policy was that it was able to simultaneously stimulate imports and reduce exports, thus raising China’s leverage and mitigating the negative demand shock caused by the deleveraging process in advanced economies. Indeed, the policy has played an important role in bolstering the global economic recovery after the crisis. However, the growth brought by a stimulus package cannot be sustained. This is because the money was spent on infrastructure investment and follow-up investments in other sectors, whose returns do not usually live up
The data are based on the US Congressional Budget Office Long-term Budget Outlook (2010/6).
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to expectations. Moreover, since the package was largely financed by bank loans, the stimulus investments exposed the banking system to the enormous risk of non-performing loans. As a result, banks have now tightened approval procedures for such projects, further dragging down Chinese economic growth. Moreover, the Chinese growth model currently still relies on external demand. The only way to rebalance supply and demand towards domestic markets is to shift more resources from the industrial sector to the service sector. From a global perspective, less external demand for Chinese exports means more external demand for the exports of advanced economies, which would greatly facilitate the deleveraging process in these countries. However, the focus of economic policies in China is still to protect the interests of industrial corporations and has not been reoriented toward the growth of the service sector. Moreover, current stimulus plans are short-lived and are likely to leave behind them problems of inflation and non-performing loans. If domestic growth falls short, China’s industrial sector will again be facing a huge demand gap. In that scenario, China will have no choice but to turn back to a reliance on external demand, which would create new pressures on the deleveraging process of developed economies. For the past 30 years, the development strategy in China has centered on the industrial sector. According to National Bureau of Statistics of China (NBS), value added of the secondary industry in GDP amounted to 45% in 2012, which is much higher than other economies. Because this strategy has been very successful, this has not only reaffirmed the efficacy of current policies among policy makers but has also produced powerful interest groups who are determined to defend the industry-first policy. Under the circumstances, a structural change driven solely by domestic policy would be extremely difficult; therefore, external regulations and oversight would be a valuable supplement. An external regulatory framework would be able to prevent China from further aggravating its already huge structural imbalance and protect against financial market fluctuations.
IV. Proposals for Establishing a Global Regulatory Regime After the financial crisis, the international community has become aware
The author’s calculation, based on the NBS data which are available at http://data.stats.gov.cn/ workspace/index?a=q&type=global&dbcode=hgnd&m=hgnd&dimension=zb&code=A020105®ion =000000&time=2012,2012.
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of the deficiencies in the current global financial and monetary system and their causal relationship to the crisis (IMF, 2011; Lin and Treichel, 2011). At each subsequent G20 conference, reforming the system has occupied a high priority on the agenda. So far, we have seen progress in domestic reforms on market oversight. The US and the UK, among others, crafted new regulations on financial markets and the Basel III regulatory standards were initiated in 2009. However, at a more macroeconomic level, especially for reforms on an international scale, no major progress has yet been made. When we talk about forming a global regulatory regime, it is important to highlight the role of public goods in the international financial system. Within individual countries, they work as a coercive power regulating financial activities, helping each country to avoid a Prisoner’s Dilemma situation, addressing the imbalance in the distribution of global factors, and forestalling financial crisis. We have witnessed the tragedies caused by the absence of such public goods. However, since the 1990s, crises have occurred on a regular basis, partially because of problems within individual countries. Therefore, it could be argued that if effective external disciplines and international assistance had been in place, then the majority of these crises could have been avoided or at the very least the damage could have been largely contained. Another reason for needing such international regulations is that their external coercive power may work as a device ensuring commitment to domestic reforms. For often complex political reasons, it is very hard to implement many rational financial policies domestically. A global regulatory regime can simplify the matter by buttressing any effective framework for oversight in each country and help improve the efficiency of the distribution of factors and lower risk. WTO rules and regulations are good examples in this regard. In the following section, we lay out our detailed proposal for an international regulatory regime. 1. Implementing a Regulated Floating Exchange Rate Regime in G20 Countries The collapse of the Bretton Woods system, the 2008 financial crisis and the Eurozone debt crisis have all proven that exchange rates are critical for the efficient distribution of factors. However, exchange rates cannot have much effect on their own and an inflexible mechanism to determine exchange rates will even worsen the imbalance in the distribution of factors. A flexible exchange rate is therefore crucial. Nevertheless, there are serious problems with a system of free-floating exchange rates (Engle, 2009). In my opinion, a
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neutral, regulated floating rate system would be the best choice. Under this framework, each country can intervene in the exchange rate market given that the intervention is subject to a global standard. Alternatively, a country could apply to the IMF for an act of intervention carried out on their behalf. This system has a number of advantages: (1) it allows the exchange rate to work as an efficient leveraging mechanism to distribute global factors; (2) it guarantees a fair and competitive market environment; (3) it avoids the harm excessive volatility may have on real economies; and (4) it lowers the demand for the international reserve currency and facilitates a healthy balance of payments for each country. 2. Rebalancing International Payments There should be a ±4% threshold for the current account balance-toGDP ratio. Of course, a reasonable distribution of factors does not always correspond to the current account balance. However, once the ratio surpasses a certain threshold, the risks of market distortion and financial crisis do rise. Because of this, there does need to be a limit on the ratio and the imposition of sanctions if governments allow the ratio to exceed ±4% of GDP. The penalty funds could then be transferred into a pool that can be used for future emergency assistance or as compensation for countries suffering from negative fallout. 3. Regulation with an International Reserve Currency It is critical to ensure that international reserve currencies maintain a stable value. Under the current international monetary system, international reserve currencies are also sovereign currencies. Therefore, countries, whose currencies also act as international reserve currencies, must be aware of this dual function as it is often the case that once conflicts of interest occur, the international currency function is sacrificed for the sake of domestic policy goals. The health and sustainability of a country’s public finances are the foundations for maintaining any international reserve currency’s value at a stable level. Given that, the liabilities of the private sector have been frequently taken over by governments, so there should also be supervision over the private sector in these countries. Although it is extremely difficult to regulate domestic monetary policy, the international regime could encourage a more diverse base of reserve currencies to promote competition.
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In that way, countries with international reserve currencies would have more incentive to adhere to external regulation. 4. Strengthening Oversight of Short-term Capital Flows We cannot deny the positive effect of short-term capital flows on the diversification of risk and the efficient distribution of factors. However, because of the ubiquitous presence of policy arbitrage opportunities, resulting from information asymmetry within financial institutions and principal-agency problems, short-term capital flows have also posed a great threat to the economic stability of many countries. In particular, while developing countries are engaged in rapid marketization, no reform is set in stone and the incremental nature of reforms often produces more arbitrage opportunities. The international regime could consider a variety of measures to solve this problem, including higher transparency of capital flows, taxation of high-frequency trading and capital flows, restraints on currency mismatch in financial institutions, or, in extreme cases, the temporary cessation of short-term capital flows. 5. Establishing a Global Financial Market Stabilization Fund and Lender of Last Resort During the crisis, central banks established numerous currency-swap agreements. These have the potential to develop into a global reserve pool with further bi-lateralization or multi-lateralization. This pool could provide sufficient liquidity in the event of any short-term demand. However, a more important question is who is to take charge of the funds and by what standards would they be maintained and utilized. For this, a consolidated international institution is needed, such as the IMF, BIS, or any new institution founded under the global regulatory regime. 6. Crafting a Conflict Resolution Mechanism We cannot allow debt problems, such as those within the Eurozone, to have such a deleterious effect on global financial markets and real economies. In many cases, the lack of a conflict resolution mechanism has caused a vicious cycle of market fluctuations and economic decline. The longer it takes to solve problems, the more extreme the solutions have to be. Under the current circumstances, parties to a loan should put forward a timetable
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for repayment that clarifies the responsibility assumed by each party and the penalty of default. This would help solve conflicts in a more systematic way.
REFERENCES Engle, Charles. 2009. “Exchange Rate Policy.” Paper prepared for the wrap-up conferences of the BIS Asian research program, “The International Financial Crisis and Policy Challenges in Asia and the Pacific,” in Shanghai. August 6-8. International Monetary Fund (IMF). 2011. “Strengthening the International Monetary System: Taking Stock and Looking Ahead.” Available at http://www.imf.org/external/np/ pp/eng/2011/032311.pdf (accessed: December 10, 2013). Lin, Justin Yifu and Volker Treichel. 2011. “The Unexpected Global Crisis: Researching Its Root Cause.” World Bank Policy Research Working Paper Number 5937. Lucas, Robert. 1990. “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review, 80(2): 92-96. Rajan, Raghuram G. 2011. Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton: Princeton University Press. Reinhart, Carmen M. and Kenneth Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press. Taylor, John B. 2009. Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. Stanford: Hoover Institution Press.
