The global financial crisis demonstrated clearly how the flow of money across borders could deepen and widen a financial crisis. A decline in U.S. housing prices led to a re-examination of the safety of financial securities based on them and an implosion in credit markets as financial institutions sought to re-establish their soundness by shedding the securities that were now seen as toxic. These institutions included European banks that had purchased mortgage-backed securities and other collateralized debt obligations. Eventually the emerging markets were brought into the vortex by capital outflows that disrupted their own financial markets. But are we ready to change the rules governing global finance if they impinge on national sovereignty?
Andrew Haldane, chief economist of the Bank of England, spoke last October about the need to manage global finance as a system. He identified four areas that require strengthening: global surveillance, improvements to national debt structures, the establishment of macro-prudential and capital flow management policies, and improved international liquidity assistance. Advances have been made in all these areas since the crisis.
The IMF, for example, has expanded the scope of its surveillance activities to focus more on the spillovers of national policies on other countries and regions. The latest Pilot External Sector Report, for example, examines global imbalances and finds that
“…disorderly external adjustment in some deficit economies remains a risk, particularly in an environment of tightening external financial conditions, and if the policy/institutional environment were to deteriorate or other idiosyncratic shocks materialize. Moreover, country-level risks would have spillovers and carry the potential of becoming systemic, e.g., if a group of EMs (Emerging Markets) with excess deficits were simultaneously affected by negative shocks.”
But is calling attention to possible adverse shocks sufficient? Biagio Bossone and Roberta Marra(see also here) of The Group of Lecce have called for a new commitment by the members of the IMF to be “Global Good Citizens.” This would entail amending the IMF’s Articles of Governance to include ‘global systemic stability’ as a mission of the Fund and its members. This new goal would be defined to include sustainable equilibria in the members’ balance of payments, high levels of domestic employment and income and reasonable price stability, and management of the cross-border transmission of shocks. To achieve these goals, all members would be responsible for implementing external adjustment programs as well as ensuring domestic employment and low inflation, and cooperating with other members to minimize the international transmission of shocks. Moreover, the IMF would be granted the authority to assess whether the policies of its members were consistent with global stability. The Fund could use multilateral consultations to address systemic issues and to call on policymakers to take the cross-national effects of their actions into account.
How good is the IMF’s record on calling out members who have violated existing obligations? Not so good. There were consultations with Sweden and Korea in the 1980s regarding their exchange rates, and discussions in 2006 with China, the U.S., Japan, Saudi Arabia and the Eurozone regarding global imbalances. But the latter were unsuccessful in changing the national policies that led to the imbalances. Large nations traditionally place little weight on the welfare of other countries when formulating policies, and, if pressed, will claim that their actions benefit the global economy.
But it would be short-sighted to dismiss Bossone and Marra’s innovative proposal to expand the responsibilities of national policymakers to include spillovers. Ignoring cross-border effects is at best myopic and possibly self-defeating. Charles Engel of the University of Wisconsin in a survey of research on spillovers concludes that:
“An optimal policy aimed at inflation and employment will increasingly need to take into account the impact of events in other countries, including the effects of foreign monetary policy. It may ultimately be the case that greater stability and growth at home depends on international coordination.”
Financial markets will continue to grow in the emerging markets as well as frontier markets, and financial flows across national borders will continue to rise. These flows may bring benefits but they will also increase financial and economic linkages. Soon the question may be not whether to coordinate, but how and when.