The Triple Comeback—The Impact of the Financial Crisis on Global Economic GovernanceBy Dominique Strauss-Kahn, Managing Director, International Monetary Fund
Geneva, December 8, 2010
As prepared for delivery
Today I would like to talk about how the financial crisis is changing global economic governance.
In the wake of a devastating global conflict, the countries of the world came together to create durable postwar institutions to secure the peace and promote economic cooperation. For a time, these institutions delivered. Then, in the 1980s, the idea took hold that we knew how to manage developed economies. A simple doctrine gradually emerged, comprising a few common-sense rules (fiscal and monetary) underpinned by the idea that markets were infallible. This was the heyday of deregulation, at least in the advanced economies. The others—the emerging and poor countries—would gradually embrace what appeared to be sound management, and, in the meantime, the IMF would advise rules that seemed to benefit them. This was the doctrine referred to as the “Washington Consensus.”
But the world has changed significantly. Rapid growth in emerging and developing economies has redefined the balance of economic power. The global financial crisis has swept away so much of the old economic order. Today, the effects of the crisis are far from over. The situation in Europe remains troubling, and the future is more uncertain than ever. But without waiting for calm to be restored, we need to start rebuilding these governance structures. It’s time for a triple comeback.
First, the comeback of global economic governance
In a sense, the global financial crisis can be traced to bad governance.
The landscape is familiar. The global growth model turned out to be unbalanced and unsustainable. It relied too much on excess borrowing by some countries, made possible by excess saving by others. Many countries also saw large increases in inequality that tugged at the social fabric. In the United States, for example, inequality on the eve of the crisis was back where it was just prior to 1929. The global financial crisis has shattered the illusion of stability. Almost overnight, the Great Moderation turned into the Great Recession.
The onset of the crisis was clearly linked to insufficient financial regulation and supervision. Buoyed by a boundless optimism about rising asset prices and economic fortunes, financial institutions took unprecedented risks. They engaged in complicated financial engineering that both magnified and disguised risk. Regulators and supervisors were often less attentive than they should have been. In many cases, they had bought into a culture of deregulation and a belief that financial markets could police themselves effectively. This is the bad news.
The good news is that global governance has been renewed by the crisis. Led by the G20, countries came together to face common challenges with common solutions focusing on the global common good. We saw this in monetary policy, with coordinated interest rate cuts, with swap lines between the Fed and many other central banks, and the decision to adopt unconventional monetary policy measures. We also saw this in fiscal policy, where countries with fiscal space delivered a 2 percent of GDP global fiscal stimulus, as the IMF had advised.
Thus we have so far avoided a second Great Depression, a threat that was on many minds after the fall of Lehman Brothers. This exemplary cooperation will go down in history as the first time that governments representing billions of men and women were able to work together to tackle a global danger.
The crisis also prompted financial sector reform. Aware of the errors that caused the crisis, the FSB, together with the IMF and other institutions, is leading this agenda. The recent Basel III accord on banking regulation is a major step in the right direction and should deliver a significant qualitative and quantitative improvement in bank capital. The next step is to deal with the regulation of non-bank financial institutions, which played such an important role in the crisis.
However, I believe that we are not moving fast enough in this area. Reforming banking sector regulation was both urgent and necessary. But regulation is only one pillar. The two other pillars are supervision and crisis resolution. Supervision may be even more important than regulation. You can have the best rules, but with inadequate compliance, disaster is just around the corner. In the subprime meltdown, it was not so much regulation as supervision that failed. And the Greek and Irish experiences revealed the need for crisis resolution tools. But very little has been done in these two areas. The delay in strengthening supervision and creating effective crisis resolution mechanisms could well lead to the next crisis.
Despite these problems, we did see a powerful move towards better economic governance in the wake of the crisis. The government’s role in shoring up weak private demand and in restoring financial sector stability attests to this. And it is at the global level that this new governance has emerged.
Second is the comeback of the IMF to the center of global governance
From Davos (January 2008) to London (April 2009): from warning to response. In January 2008, the IMF issued a warning. Our forecasts at the time predicted a much larger drop in growth than many then anticipated. No doubt this was because the IMF is the only institution liable to focus on the interaction between the financial sector and the real sector—standing at the corner of Main Street and Wall Street. The Fund admittedly did not predict the crisis. But it was the first to gauge its gravity. The IMF therefore called for budgetary support to sustain faltering private demand—this was the famous stimulus. Everyone was surprised to see the IMF, previously so liberal, become “Keynesian”.
At the April 2008 Spring Meetings, we shifted from warning to alarm. Not only was it necessary to prop up demand, it was also essential to cover banking system losses—not to bail out bankers, but because the collapse of the banking system would ignite another Great Depression. “A trillion dollars in losses” was the press headline. Subsequent events would show that this was in fact an underestimate. But what was most striking at the G7, which was meeting at the time, was the refusal to face reality. With one voice, the G7 finance ministers criticized the Fund, claiming we were too pessimistic, and that growth would hold. We know our economies better than you do, was their refrain.
The first global response to the crisis occurred in early October 2008, during the Fund’s Annual Meetings, a month after the fall of Lehman Brothers. At this stage, everybody realized that government intervention was necessary, and stimulus was being put in place wherever possible, from Europe to China, from the United States to Brazil. Also, wherever banking systems were affected (primarily in the US and in Europe), restructuring plans were being drawn up and the necessary financing provided.
The second response came from G20 leaders—in April 2009, in London. It was no longer enough to support growth and repair the banking system—countries in difficulty had to be helped. The IMF’s resources were tripled and the Fund was authorized to issue $250 billion in SDRs, to be distributed proportionately among all members based on their quota. In addition, because of the firm resolve of the G20 Chair, Gordon Brown, and in keeping with a commitment I had made to African countries two weeks earlier at an IMF conference in Tanzania, a decision was made to sell 400 tons of the Fund’s gold to help the poorest countries. This was the source of the funding for the interest-free loans made available beginning that summer. The keeping of this promise is surely at least in part responsible for African countries’ change of attitude toward the IMF.
The work of charting the future began at the G20 summit in Pittsburgh (September 2009), and the summit in Seoul (November 2010) marked the start of a Long March.
In Pittsburgh, the G20 decided to continue its cooperation. Each member was well aware that catastrophe had been avoided thanks to unprecedented international cooperation. This consensus to move forward on a multilateral basis was reflected in two major decisions: the development of the Mutual Assessment Process (MAP) and the reform of IMF governance.
The G20’s MAP holds the members of the group accountable to one other for implementing the policies needed to achieve better global outcomes. The MAP is based on the idea that there can be no domestic solution to global problems. This is why cooperation is essential to manage the “economic butterfly effects” that can magnify the impact of national policies as they reverberate around the global economy. The process, spearheaded by the G20, is supported by the IMF, which, in Toronto and then Seoul, provided the initial reports for comment by heads of state and government.
This understanding is also behind the “spillover reports” that the IMF will produce for five systemic economies—China, the Euro area, Japan, the UK, and the US. These reports will assess the impact of policies in these economies on the rest of the world, exploring the powerful economic and financial interlinkages through which they are transmitted.
It was also decided to make Financial Sector Assessment Programs mandatory for all systemic countries. In the past, these programs were purely voluntary, and among the large countries, the United States and China had not participated.
Seoul marked a turning point. The G20 entered a second phase, going from the crisis-era G20 to the post-crisis G20, even though the effects of the crisis are far from over.
During the acute phase of the crisis, the need for cooperation was obvious. From the first G20 summit in Washington to the summit in Pittsburgh, the world was afraid, its leaders were aware of imminent disaster, no one country tried to stand apart from the others, and for once the common good easily trumped national interests. With the global economy on the mend, the temptation for leaders to focus once more on their domestic problems naturally grew stronger. As a result, there was a grave risk that the G20 would become a largely irrelevant institution. I would not say that this risk has been completely averted—far from it—but Seoul showed that a second phase is possible. It will include highs and lows—some summits will be devoted to negotiation, others to decision-making. But bolstered by the MAP, the spillover reports, and by the work we have been asked to do on global imbalances, I believe that the G20 can deliver.
The Fund’s resources were increased substantially, and it was important to use these funds responsibly. The countries hardest hit needed to be helped. With this in mind, lessons were drawn from the programs put in place during the Asian and South American crises. Fund-supported programs since 2008 have been streamlined to focus on solving urgent problems, not on fixing everything wrong with an economy. And, importantly, they take as full account as possible of the affected country’s historical and political context and provide for support to the most vulnerable segments of the population, the ones who suffer most during periods of adjustment.
The International Monetary and Financial Committee (IMFC), the IMF’s governing body, also asked the Fund to review its instruments. We created the Flexible Credit Line and then the Precautionary Credit Line to provide contingent support, allowing countries to free up resources for more productive uses, as they would no longer need to hold such large reserves.
Measures such as the financial safety net and agreements to work together with regional organizations—the European Union today and maybe the Chiang Mai Initiative tomorrow—are decisive steps marking the IMF’s return as key element in global governance.
This reflects the IMF’s return to its original mission
A new balance has arisen between regulation and the markets, and the IMF has a role here. In the macroeconomic and macro financial arenas, the idea that it was possible to rely solely on the market to ensure strong, sustainable growth has lost credibility. The crisis showed that this was wrong. It also showed that the public sector had a key role in repairing the damage, and could have minimized—or even prevented—the crisis had governments acted with greater foresight.
It is important to apply new rules to the financial sector. We need supervision that is not afraid of saying no to powerful interests. We need a comprehensive macroprudential framework to monitor systemic risk. We also need coherent resolution mechanisms—both domestically and across borders—to allow failing firms to be wound down with minimal cost to taxpayers and to end the scourge of too-big or too-important to fail. Ultimately, we must extricate ourselves from the ruinous cycle of privatized gains and socialized losses. When the next financial crisis hits—and it is a matter of when, not if—we must be prepared. And we cannot expect taxpayers to once again foot the bill. This is why the financial sector must shoulder a substantial yet fair share of the costs that risk-taking imposes on the economy. That is why the IMF has proposed a tax on financial activities, although so far without success.
International institutions such as the IMF and the WTO must play a key role in this renewed economic governance. But their mandates need to adapt to the changing global economy. The task of redefining the Fund’s mandate and then amending its Articles of Agreement is as urgent as it will be lengthy. Regaining the role that the IMF’s founding fathers envisioned for it in 1944 and adapting it to the new economic order—that must be our aim.
Renewed legitimacy is essential. The cooperation that has, so far, tamed the Great Recession originated with the G20—a small group that nevertheless accounts for more than 80 percent of the world’s output. But this is not enough. The IMF has 187 members. How can the G20 be legitimate when it excludes 167 countries—representing a third of the world’s population?
This is why the recent IMF governance reforms are so important. We can only be effective if we are legitimate, and we can only be legitimate if we are representative. Building on an earlier reform in 2008, our members have just approved a shift of over 6 percent in quota shares to dynamic emerging market countries. Brazil, China, India, and Russia will now be among our top ten shareholders. With the voting shares of the poorest countries protected, it was essentially the rich nations—with the European countries topping the list—that made this rebalancing possible. Moreover, the advanced European countries will give up two seats on the Executive Board. We are moving to an all-elected Board, which makes the IMF more democratic. This is a momentous change, unparalleled in the history of our institution.
These changes are paving the way for the progress I envision. Ultimately, we need closer alignment between the composition of an expanded G20 and the 24 countries on the IMFC that represent the 24 constituencies into which the Fund’s 187 members are grouped. This would give the expanded G20 a legitimacy it currently lacks. It would provide a solid foundation for the new global economic governance and may even be necessary for the G20’s survival.
As we seek to build a new framework for global cooperation, we need to remember that this is not just about achieving higher and more sustainable growth—it’s about fostering democracy and, ultimately, about securing peace. When the IMF’s founding fathers gathered at Bretton Woods in 1944, peace was foremost on their minds. They had seen the economic conflicts of the interwar years devolve into the military battles of World War II—with human costs unprecedented in human history. And so they created a system of institutions—including the IMF—charged with finding cooperative solutions to global economic problems.
We are now facing a similar challenge. Today, as in the past, when economic and financial problems worsen, they upset the social balance, undermine democracy, weaken trust in institutions, and can degenerate into war, civil or foreign.
By renewing global economic governance and making it more effective and more legitimate—more effective because more legitimate—we are reconnecting with our mission and we are working for peace.
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Let me wrap up. The choice is clear. At a time when no one knows what the future may hold, at a time when the fiscal imbalances of certain countries threaten global equilibrium, at a time when the accumulation of external surpluses by some and of deficits by others sets the stage for new clashes, the international community must choose. It can seek out a new growth model for a new world, or it can choose inertia, fall back on national positions and risk years of instability, the breeding ground for yet another crisis. A new growth model requires a new governance model. That is the real and lasting lesson of the crisis. Let’s make sure we heed it. That is our mission.