The G20 meeting has come and gone. The group of 20 representatives was established in 1999 and represents 85 per cent or more of the economy, 80 per cent of trade and 66 per cent of the population of the whole world. From 2008, it has met at heads-of-government level to deal with the economic crisis caused initially by the deficiencies in the United States of America’s banking system that spread like a virus across the globe. The latest summit in Toronto was divided between the contrasting positions of the Europeans, who wanted to press ahead with stringent economic measures to reduce fiscal deficits, and the US, which urged that there should be no let-up in the stimulus packages that encouraged growth, promoted trade and reduced unemployment. Despite the preponderance of the G20 in the global landscape, it is only a consensus-building forum and not a body that can act quickly or ensure compliance. So this was again a case of prescribing remedies globally while action was to be taken locally. There is globalization of finance, but there is no globalization of regulation, and in the areas that have free flows of trade and capital and a common currency like the Eurozone, the choice of policy instruments available at the national level is almost zero. This leaves governments with a seriously difficult task of managing sudden flights of capital.
The economic meltdown has brought renewed attention to the role of governments in preventing such crises and managing them when they do occur. Since the 1980s, mainstream thinking has veered towards de-emphasizing the role of the government and the public sector in direct economic activity to create greater space for markets through deregulation and the pursuit of profit. Faith in this ideology rests on the ability of markets to self-adjust and reap the benefits of financial liberalization. Hence foreign trade was liberalized and restrictions on cross-border financial flows were removed.
But the recession from 2007 onwards has exposed the inability of governments to contain and manage the crisis, with growth turning negative in large parts of the world, along with the loss of jobs, savings and houses. While rescue packages were put in place with some speed in the US and elsewhere, the revival of the economy remains fragile. The question is: was the recession an inevitable part of the market-led growth process or can it be managed with a better defined role for the public sector?
It is clear that the turmoil could be attributed to certain factors. The opening of borders to trade, capital flows and financial services exposed many countries to vulnerability. For example, the huge export surpluses of China resulted in a sharp increase of short-term flows of capital. Driven by electronic technology, any crisis now spreads and magnifies more rapidly. The abolition in 1999 of the Glass-Steagall Act in the US, that had been formulated after the Great Depression to prohibit commercial banks from acting as investment banks or owning firms dealing in securities, encouraged banks to play the markets for profit. Added to this was a bonus-earning culture that tempted bankers into short-term speculation. The valuation of underlying assets, like houses under mortgage and sub-prime loans (loans given with inadequate collateral), bundled into hybrid instruments with names like credit default swaps and collateral debt obligations could not be valued in any transparent manner, least of all by oligopolistic credit rating agencies such as Standard and Poor’s, Moody’s, and Fitch. Soon these came to be known as ‘junk bonds’.
Regulatory operations were weak, uncoordinated, lacking in power. They relied too much on the companies’ own assessments, leading to unwarranted risk-taking in open defiance of regulatory regimes. Hedge funds were obscure, not regulated, and became major financial players, while banks became ‘too big to fail’. There was an unholy alliance between bankers, property developers, and political parties that deliberately obfuscated the real state of toxic assets. The International Monetary Fund, the apex body intended to warn of systemic risks, was conspicuous by its silence. Its governing structure being weighted towards the industrialized West, it was unable to help its main shareholders when their regulatory mechanisms were captured by the very institutions that fuelled the crisis.
At the Toronto meeting, Manmohan Singh stood tall between the US and Eurozone positions. He is on strong ground in seeking balance, since there is evidence that countries that have relied more on governmental direction have managed to contain the crisis better. Among these countries would rank China, India, Brazil and Canada. China’s accumulation of huge foreign exchange reserves and a large public sector enabled it to effect a significant stimulus by way of investment in infrastructure and subsidies to consumers. Brazil’s high reserve requirements, with the Banco do Brasil leading the way, were able to step in to prevent bank failures and replace the credit from abroad which had dried up. Canada limited the extent of leveraging and adopted a cautious approach towards easing the regulatory framework. India was prudent in having a significant State-owned commercial banking sector that enabled the Reserve Bank of India to stabilize the situation quickly.
The non-bank financial companies, such as insurance, pension funds and mutual funds, were regulated, the use of innovations like derivatives was moderated and non-core activity by banks was restricted or banned. The pay, entry and exit bonuses of bank officials, even in the private sector, were scrutinized and subject to guidelines. Singh was also right to recall that countries with big governments, with concentration of economic and political power in a few hands and agencies, run the risk of a loss of freedom and innovation, and poor service delivery, since monopoly suppliers of goods and services are purveyors of indifferent quality and high costs. So what is needed is competition and decentralization of power.
Countries whose currencies form part of the international reserves, like the dollar, yen and euro, have an advantage in funding stimulus packages whereas other countries have to earn these currencies through exports. There may be a case here for a global unit like the Special Drawing Rights that could be allocated to countries under a formula that gives weight to the gross domestic product and trade volume. As to who should bear the burden of the rescue packages, it is natural that some have looked to the banking system to take responsibility and fund some of the costs of intervention. But other countries have opposed any levy on banks to create a sinking fund and, though this proposal has been deferred, it is not likely to gain traction. Similarly, a revival of the Tobin Tax on capital flows to reduce volatility in short-term capital flows may not find favour.
Yet the assumption that the world can press the pause and reset buttons is misplaced. Germany will not accept a situation where it is repeatedly asked to subsidize the rest of the Eurozone. Reflecting the popular backlash against Wall Street, the US Congress is on the point of finalizing the biggest financial regulation reform since the Depression. While there is traditional Republican opposition to any controls, achieved by raising the bogey of socialism, under the compromises necessary in any US legislation there will be higher capital requirements for banks, a limit of three per cent of capital imposed on the banks’ ability to make risky speculative bets on hedge or private equity funds, and a consumer financial protection bureau set up to prevent sharp practices by credit card companies and mortgage lenders.
Wall Street will nevertheless breathe a sigh of relief: the initial proposals would have limited the size and leverage of banks, the three per cent limit is a dilution of the original limit, and a five-year transition for banks to meet the new capital rules has been agreed upon, with banks having less than $15 billion in assets being exempt altogether. Speculation on interest rates and currency exchange rates are exempt from the ban on credit default swaps, which Warren Buffett called “financial weapons of mass destruction”; banks will henceforth have to deflect to separate affiliated companies to protect themselves from potential losses. While this legislation represents the second major success for Barack Obama after healthcare reform, it remains doubtful whether the actions taken by the G20 and the US will insulate the world from financial meltdowns in the future. Public anger may seethe at Western bankers who inflicted such widespread distress, especially on the most vulnerable, but the persons who are resolving the crisis are the same ones that failed to anticipate it. Until a root and branch reform of the financial system is undertaken, the next crisis will not be long in coming.