The global financial and economic crisis, and how to fix it, has dominated newspaper headlines and public policy discussions this year. The financial turmoil which started with the collapse in the US Sub-prime mortgage market is of a scale not seen since the 1930s. However, recent positive economic data from Asia and Europe have raised hopes of a turnaround in the global economy, and vindicated the robust fiscal stances of many governments who sought to apply countercyclical traction to their economies. The stimulus packages seem to be working – or at least have prevented the situation from becoming even worse – but of course, the immediate stimulus needed will only treat the symptoms of the crisis. Addressing the deeper causes will require a different set of measures, targeting reform at the system of global finance.
Indeed, there now seems to be agreement, and even the adoption of some measures, to reform the global financial architecture. Yet, the actions and proposals to date have been limited to relatively marginal tinkering, for example, increasing the voice of developing countries in the IMF, strengthening banking supervision, or even closing down tax-havens (with no obvious link to the current crisis). In contrast, relatively little public discussion has been devoted to the broader systemic challenges and more fundamental reforms of global finance. Nevertheless, they will be needed, and UNCTAD’s 2009 Trade and Development Report identifies several ideas that could be addressed by policymakers in this regard. Here, I outline, in brief, a few of the Report’s findings; to read more, please visit the UNCTAD website.
Re-regulating global finance
There is growing consensus that the model of deregulated global finance has failed. Based on the mythical belief that the “market knows best”, this model failed to take into account that speculators are subject to herding behaviour, and that markets do not always price risk accurately. And this global crisis is only the latest in a series to painfully demonstrate that markets can fail.
In addition, the light-regulation model underestimated the possibility of regulatory arbitrage, with banks simply shifting risky assets to less regulated non-bank institutions, creating a veritable “shadow banking system”. At its peak, the US shadow banking system held assets of approximately $16 trillion, about $4 trillion more than regulated deposit-taking banks. While the regulation focused on banks, it was the collapse of the shadow banking system which kick-started the crisis.
In response, UNCTAD’s 2009 Trade and Development Report calls for more comprehensive regulation of financial markets, and complex financial instruments in particular. An early task of regulators should be to weed out financial instruments which only increase risk without providing any true social return.
In order to avoid arbitrage, any such regulation should tackle excessive speculative financial activity across all sectors. Establishing national regulations to prevent housing bubbles and the creation of risky financial instruments alone would only intensify speculation in other areas such as stock markets or commodities futures markets, which we witnessed last year. Similarly, regulations should not be exclusive to one region alone. Regulators around the world should communicate and share information, set standards, and avoid “races to the bottom” in financial regulation in attempts to attract investment funds. Nevertheless, it would be a mistake to impose uniform regulatory standards: there is no single regulatory system which is right for all countries.
A multilateral exchange rate system
A further form of speculation that requires a comprehensive response is currency speculation. Over the past two decades, short-sighted domestic policies and an unregulated international financial system attracted financial investors to leverage the short-term opportunities provided by divergent monetary policies in different countries. Under the so-called “carry trade”, billions were borrowed from countries where interest rates were low and invested in countries where interest rates were high, generating large short-term profits for investors and artificially inflating the value of the currencies of the capital-receiving countries. As the financial crisis hit, the highly leveraged exchange-rate “bubble” burst.
The fallout from short-term currency speculation has contributed to sharp collapses in the values of some national currencies as the global economic crisis has intensified. That has made the economic damage of the crisis much more severe for some countries. The Icelandic krona declined by 51% (against the US dollar) in the second half of 2008, for example. Subsequently, a further wave of devaluations reflected the de-leveraging of speculators’ positions and also the shocks hitting the global financial sector at large.
The first step in stemming such destabilizing effects is to remove most of the incentives for short-term speculation in currencies. UNCTAD therefore proposes a new multilateral exchange rate management system that links lead and satellite currencies (either globally or regionally) in a way that would maintain effective real exchange rates at relatively constant levels. Nominal exchange rates would be adjusted to reflect differences in rates of inflation between trading countries. That way, real exchange rates could be kept constant, allowing fair competition between producers from different countries and preventing potentially damaging speculation.
Needless to say, these are only suggestions, which will require further work and refinement. However, we should ensure that such a debate about the broader systemic issues at stake actually takes place, and that this reform does not fall by the wayside. For let us not forget that already after the Asian Crisis of 1997/1998, several reports with ambitious recommendations for much-needed reforms were published. Some of the reforms proposed may have helped to prevent this crisis. Unfortunately, as the world economy recovered, they were largely ignored. Let us not make the same mistake again.
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