Globalization and Finance Project supported by the Ford Foundation www.bsg.ox.ac.uk

FINANCING GLOBALIZATION: LESSONS FROM ECONOMIC HISTORY

All Souls College 19 June 2012

CONTENTS List of participants Cyrus Ardalan:Vice Chairman:Barclays Foreward Hugo Banziger:former Chief Risk Officer:Deutsche Bank »» Ngaire Woods 2 Jaimini Bhagwati:Indian High Commissioner to the United Kingdom

Amar Bhide:Thomas Schmidheiny Professor, Summary of Proceedings The Fletcher School of Diplomacy: Tufts University »» Kevin O’Rourke and Philipp Hildebrand 3 Patricia Clavin:Professor of International History & Fellow: Jesus College, Oxford

Rui Esteves:University Lecturer in Economics, Brasenose Historical Lessons College:Oxford »» Hugo Banziger 5 Marc Flandreau:Professor of International History: The Graduate Institute, Geneva »» Rui Esteves 9 Macer Gifford:Visiting Research Fellow, Globalization & Finance »» Marc Flandreau 12 Project:Blavatnik School of Government, Oxford »» Harold James 15 Charles Goodhart:Professor:London School of Economics »» Catherine R Schenk 17 Philipp Hildebrand:Senior Visiting Fellow, Globalization & Finance Project:Blavatnik School of Government, Oxford Contemporary Challenges Roberto Jaguaribe:Ambassador of Brazil to the United Kingdom »» Cyrus Ardalan 20 Harold James:Claude and Lore Kelly Professor in European Studies:Princeton University »» Charles Goodhart 22 Rob Johnson:Executive Director: »» Rob Johnson 23 Institute for New Economic Thinking »» Pierre Keller 25 Vijay Joshi:Emeritus Fellow:Merton College, Oxford Pierre Keller:former Senior Partner:Lombard Odier & Cie, Geneva Policy Recommendations George Kounelakis:Managing Director: Morgan Stanley Principal Investments Group, Europe »» Amar Bhidé 27 Peter Kurer:former chairman:UBS, Zurich »» Peter Kurer 30 Walter Mattli:Professor of International Political Economy & »» Roberto Jaguaribe and Fellow:St John’s College, Oxford Augusto Cesar Batista de Castro 33 Kevin O’Rourke:Chichele Professor of Economic History and Fellow:All Souls, Oxford »» Vijay Joshi 36 Catherine Schenk:Professor of International Economic History:University of Glasgow George Soros:chairman:Soros Fund Management and chairman Open Society Institute Sir John Vickers:Warden of All Souls College and Professor of Economics:Oxford Ngaire Woods:Dean:Blavatnik School of Government, Oxford

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 1 FOREWORD

Professor Ngaire Woods

Dean of the Blavatnik School of Government As regulators across the world consider how to Two particular policy ideas are provoked for further constrain and regulate global banking, an equally investigation by the Ford Foundation Globalization and important question is being neglected. What forms Finance project: of global finance best serve global growth and 1. Focus on the link between global finance and development? This question is being probed by the real resources, and investment for development. Ford Foundation Globalization and Finance Program at Trade finance and mechanisms which allocate Oxford University’s Blavatnik School of Government. investment to areas where it can be most Economic history provides several insights. productive are vital elements of a global financial Specifically, by analyzing previous periods of system which supports growth and development. successful globalization, we can attempt to identify Yet these elements of global finance risk being what kinds of finance made them work. This neglected in the contemporary international debate report includes an overview of important themes (by about regulation. Professor Kevin O’Rourke and Dr Philipp Hildebrand) 2. Reinstate unlimited liability in banking? When and a set of memos prepared for the workshop by owners of banks have unlimited liability, or “skin participants. in the game” they have a sharper and more An overall finding of the meeting is eloquently immediate interest in prudence, scrutiny and summarized by participant Macer Gifford: “The earlier the sound management of the operations of periods do not necessarily support the argument their enterprise. Historically, when the liability of for global banks. Rather, that global rules written owners of banks was limited, this was in return for with a clarity of purpose (such as Bretton Woods) accepting accountability and transparency about and requiring bankers having ‘skin in the game’ (such their operations. But that deal is looking tattered. as Rothschilds and JP Morgan in the early twentieth Syndication, securitization, financial engineering, century) can foster prolonged periods of global implicit government guarantees, evermore growth.” detailed and incremental regulation, and rapidly evolving accountancy practices have all rendered accountability and transparency extraordinarily difficult. Perhaps instead of continuing down Sincere thanks this path, regulators across the world should be to those who made this workshop possible, and in particular: the support of Leonardo Burlamaqui at the Ford Foundation; reinstating unlimited liability among the owners of the intellectual leadership of Philipp Hildebrand and Harold James; banks. the terrific research and organization of Rahul Prabhakar, Taylor St John, and Emily Jones; and the design expertise of Toby Whiting.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 2 SUMMARY OF PROCEEDINGS

Professor Kevin O’Rourke and Dr Philipp Hildebrand

On 19 June 2012, the Globalization and Finance Project at the Blavatnik School of Government held a workshop on Financing Globalization: Lessons from History. The workshop brought together a unique combination of eminent economic historians, bankers and finance practioners to discuss what lessons might be drawn from the history of finance to inform today’s challenge of reforming the post-crisis global financial system. There are two periods since 1870, but prior to the 1990-2007 period, which are typically regarded as success stories: the nineteenth century, and the period from 1950 to 1972.

The nineteenth century was a period of impressive Professor Kevin O’Rourke Dr Philipp Hildebrand globalization, which was genuinely worldwide in scope thanks to the combined effects of steamships, The period from 1950 to 1972 saw the gradual railroads, telegraphs, and empires. reconstruction of the international economy, although this was only partial in two respects. First, while the »» According to Angus Maddison (1995, p. 38), OECD economies moved to reintegrate their markets, merchandise exports accounted for just 1 per cent Communist economies were moving in the opposite of world GDP in 1820, but 8 per cent in 1913 – a direction; and much of the developing world adopted substantially higher share than in 1950. In Latin inward-looking industrialization policies, following the America and India the 1913 levels of openness end of European imperialism. Second, the Bretton had not been recouped as late as 1992 (in the Woods settlement prioritized domestic monetary policy case of India they had not been recouped as late autonomy and fixed (but adjustable) exchange rates, as 1998) (Findlay and O’Rourke 2007, p. 510). meaning that capital controls were ubiquitous. »» International labour migration was much more extensive in relative terms than today. Roughly Despite these limitations, world trade grew extremely 60 million Europeans migrated to the New World rapidly during this period, as the figure makes plain: between 1820 and 1914, and there were also more rapidly than at any other time since 1870. sizable outflows from China and India. This was in part because of the extremely rapid economic growth of the period, but trade grew more »» Net international capital flows, as measured by rapidly than GDP, implying an impressive period of current account imbalances, were extremely large “reglobalization”. even by today’s standards. British capital exports averaged 4.5 per cent of GDP between 1870 and World exports, 1855-2010 1914, and reached 8 to 10 per cent during lending booms. A third of British wealth was held overseas in 1913. Countries like Argentina and Australia were extremely reliant on capital inflows: in 1913, foreigners owned almost half the Argentine capital stock, and a fifth of the Australian capital stock (O’Rourke and Williamson 1999, Chapter 11; Obstfeld and Taylor 2004; Taylor 1992). These developments were inter-related: capital and labour flowed from Europe, chasing resources elsewhere in the world – primarily, but by no means exclusively, land on the frontiers of the New World. Capital financed massive investments in transportation and other infrastructure, making it possible to bring Source: Findlay and O’Rourke (2007, p. 506), updated using data from WTO these resources into productive use, and hence Overall, what is striking is that history provides little generating flows of income which borrowers could use evidence that extreme developments towards cross- to repay their debts. Most of the capital flows involved border banking such as what the western world bond finance. witnessed between the mid-1990s and the outbreak of the Great Financial Crisis in 2007 are essential

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 3 to support inclusive and sustainable growth. This certainly does not mean that a fragmentation of the global banking system along national frontiers would be a desirable development. It does mean, however, that it is deeply flawed to argue that in an effort to support growth and employment, the aim of the on- going regulatory reform efforts should be to reinstate the largest global banks to anything near their pre- crisis size and prominence. Banks will continue to play a crucial role in any well functioning economy. Nonetheless, fundamental changes in the risk profile and the business models of word’s largest banks are urgently needed in a much broader effort to lead the world economy out of near five-year state of permanent crisis. History provides to evidence to the contrary.

References

Findlay, R. and K.H. O’Rourke. Power and Plenty: Trade, War, and the World Economy in the Second Millennium. Princeton: Princeton University Press.

Maddison, A. 1995. Monitoring the World Economy 1820-1992. Paris: OECD.

Obstfeld, M. and A.M. Taylor. 2004. Global Capital Markets: Integration, Crisis, and Growth. Cambridge: Cambridge University Press.

O’Rourke, K.H. and J.G. Williamson. 1999. Globalization and History: The Evolution of a Nineteenth Century Atlantic Economy. Cambridge MA: MIT Press.

Taylor, A. M. 1992. ‘External Dependence, Demographic Burdens, and Argentine Economic Decline After the Belle Epoque.’’ Journal of

Economic History 52: 907– 936.

Clockwise from top: Tea in All Souls between sessions: Patricia Clavin, The Old Library, George Soros in conversation with Ngaire Woods, Pierre Keller

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 4 Dr Hugo Banziger former Chief Risk Officer, Deutsche Bank Information Technology, modern communication introduced the risk of bank failure to society but with and the liberalization of markets were the primary equity typically making up 1/3 to ½ of the balance forces, which drove the globalization of finance and sheet, this risk was well buffered and affected only integration of financial markets over the last 30 years. wealthy families. Albeit bank runs did happen at the As a result, the financial industry is today the biggest time, they were usually caused by government defaults spender on IT and the majority of data pumped around on bank debt. the globe relates to finance. Indeed, financial markets Joint Stock Companies – pioneers of foreign are truly global and integrated. It is thus no surprise investments that the crisis of 2007, which had its origins in the US residential mortgage market, spread across the globe. In the 17th century, Europe started the long process It will not be the last one to do so either. The question of transformation from an agricultural to a modern, this paper tries to answer is whether the globalization monetized society. Some important steps were the of finance contributed to financial instability. By looking creation of the first stock exchanges in Antwerp, the at several waves of financial integration, I try to analyze establishment of Joint Stock companies such as the what it meant for the people at the time, whether Dutch and the English East India Companies and of it affected financial stability and when it did, how Government Debt Offices (Bank of England). At the societies responded. That domestic imbalances can exchanges, which spread quickly to Amsterdam and lead to financial instability is obvious. The collapse of London, physical commodities, government debt and the German Mortgage Banks in the late 1990 resulting the shares of the few stock companies were traded. It from a government sponsored real estate bubble after was this innovation that made the South Sea Bubble in the fall of the Berlin Wall is a less well known but good England and the Mississippi Bubble in France (Banque example. Given the magnitude of the question, my Royale) possible. Based on hyped-up promises of answers are summary in nature. future trading profits in South America and Louisiana, the companies issued stock or bank bills beyond Trade Finance – Netting The Risk their asset capacity. Some of the proceeds went As we know from archeology, long distance trade in invested abroad. But most were used to purchase metals, grain, wine, olive oil and spices started during government debt to finance the perpetual wars the Sumer Empire and the early Pharaoh kingdoms. between Spain, France and England. In 1720, both We know from fragmented records that these early companies spectacularly collapsed leaving the equity traders employed their families to conduct their and notes holders with huge losses. Before joint stock business. So far, no evidence survived as to how these companies came into existence, banks were owned trading activities were financed. The first clues date by a few rich families. The combination of joint stock from the grain trade in the Roman Empire, even though structure and exchange trading broadened ownership the records are few. To manage and finance the import and transferred risk to the wider society. There were of wheat from Sicily and Egypt, traders maintained a now merchants, scientists (Newton!), middle ranking large network of agents, which were mostly relatives. government officials, town mayors and village elders These agents not only purchased and shipped grain, among the investors. Not surprisingly, the collapse of they also acted as clearers in order to minimize the these two companies had wider political ramifications. risk of payment loss (pirates, loss of ship, fraud). To restore confidence in markets and the value of Receivables were netted within the widespread family money, both the French and the English government framework. had to intervene and resolve these companies. The public registration for stock companies became After the collapse of Rome, trade and related mandatory. For the first time, the public demanded financing disappeared from the western part of the proper accounting and disclosure standards. It was Mediterranean but survived in the Byzantine Empire also a novelty that a paper currency (bank bills of the from where it re-emerged with the crusades first Banque Royale) had to be depreciated. Joint stock in Venice and Genoa, later in Renaissance Italy. companies were established to reduce the risk of Banking families like the Medici were organized along individual investors and mostly achieved this goal. family lines with their branches in Europe typically However, it is fair to say that the concept of a public run by family member. Even Germany’s Fugger company promising future cash flows added a new who started with manufacturing and trading textiles systemic risk to the financial system. Over the next before becoming bankers, were a family bank. Whilst 200 years, there were several more bubbles, which both houses, the Medici and the Fugger, eventually had their root cause in hyped-up investment schemes, collapsed because of excessive lending to Emperor manipulation of accounts, missing or misleading and Kings, their trade finance business was as self- disclosure and lack of governance/supervision. By liquidating as it remains today. It reduced the risk to and large, the world had to wait for the Securities the system by using gilts thereby netting payments and Exchange Act in 1934 until these issues were and drastically reducing the amount of money, which fully addressed. Regrettably, the SEC framework did had to be physically shipped. The invention of gilts

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 5 not keep pace with the financial innovation over the institutions. However, the 2007 Financial Crisis cast last 30 years. The disclosure rules of 1934 proved serious doubts as to whether these schemes also inadequate for modern banks, derivatives and work for large, globally active banks. Lehman Brothers securitized products. A regulatory framework, which syphoned billions of deposits from Germany before it does not remain in sync with market development and collapsed in 2008. When it failed, losses in the range innovation, will become ineffective. of EUR 4bn almost bankrupted the private German deposit insurance. Also, the German HypoReal Estate Savings Banks – Unexpected Contributors to needed around EUR 100bn of government support Systemic Risk since its “Schuldscheindarlehen” counted as deposits. The industrial revolution in the 18th century not only Re-thinking deposit protection and insurance is thus transformed the way we manufacture and consume, mandatory, given the global dimension of today’s large it also profoundly impacted the use of money. In an banks. agricultural, self-subsistent society, the circulation Modern Capital Markets of money was limited. Farmers did not need a lot of money. All this changed with large concentration of The 19th century saw a rapid expansion of industrial workers in towns. They got a salary and international credit extension, underpinned by the had to buy their food and clothing in the market. fast integration of the world economy, which made Society was monetized. In the absence of a safety major progress with the Transcontinental Railway net, delaying consumption was the only way to protect in the USA and the opening of the Suez Canal in against rainy days. The safety of the resulting savings 1871. The demand for infrastructure financing in the thus became of paramount importance. Within a few developing world was matched by much improved years of factories being built, savings associations fund raising capacity of “new” types of banks such emerged everywhere in Europe. Traditional banks as Merchant Banks, Investment Banks and Credit were neither present in these new industrial centers Mobilier Banks. They were the key agents of the nor capable of handling small deposits. As traditional globalization of finance in the second half of the 19th banks failed in economic downturns, so did savings century. Whilst their specific business model differed, banks. But the consequences were different. Suddenly, all raised bonds and issued shares on behalf of other large numbers of less well off people were affected, companies. To minimize their risks, they formed large losing their protection against the avarices of life. underwriting syndicates, as we know them today. Thus, protection against individual risks created a Syndication was by and large the equivalent to re- new systemic risk. Also, since the rise of savings insurance, which was “invented” by Sal Oppenheim banks coincided with the development of capital in Koln at around the same time. Without any doubt, markets, savings associations also invested in bonds the syndication of underwriting risk minimized the risk of large foreign infrastructure projects. We are well for the participating banks. It allowed them to diversify aware of the losses resulting from large infrastructure their risks and to underwrite larger transaction than projects such as the Suez and Panama Canal, they could do on their own balance sheet. On the other various railway schemes in Africa and the Americas, hand, listing large numbers of shares and bonds on or even the Gotthard tunnel in Switzerland. That the exchanges introduced a new risk to financial stability: emancipating working class demanded corrective the psychology of bullish and bearish investors. political action is thus no surprise. Indeed the first, The period from 1870 to the First World War saw an albeit timid investment restrictions for savings banks increase in stock market panics with considerable emerged in the middle of the 19th century. In many decline of liquidity. Domestic stocks dominated the European countries, these restrictions (“investment exchanges at that time (rail, shipping, infrastructure, rules for widows and orphans”) were a nascent form later hydro electric power). But international stocks of banking supervision. The safety of our citizen’s were often amongst the most volatile. For a while, the deposits remains of paramount importance to this financial strength of large institutions could stabilize day. Both the collapse of the Swiss “Spar & Leihkasse the markets. JP Morgan’s intervention in the 1907 Thun” in the mid 1990 or the more recent failure of panic is legendary. However, even the resources of “Northern Rock” illustrate the point. The debate of how large banks became too small and in 1913, the United to best protect a nation’s deposits has been re-opened States had to establish the Federal Reserve Bank more recently in the UK by the Vicker Commission’s system as “Lender of Last Resort”, a concept now recommendation to segregate deposit-taking activities widely adopted throughout the world. In a nutshell, from other banking operations. Before the Glass- the development of modern capital markets reduced Steagall Act was suspended in 1999, the United the syndication risk for banks but it also increased the States not only separated commercial, deposit taking instability of financial markets and eventually required banks from investment banks but also went a step the creation of modern central banks. further by establishing the Federal Deposit Insurance Steps to Global Banks Corporation to insure all deposits. Sixty years later, the European Union followed with a Deposit Insurance The last decade of the 19th century also witnessed Scheme in 1994. With the exception of the US Savings the beginning of a development, which became & Loan debacle, deposit protection and insurance important one hundred years later. To support their schemes worked reasonably well for domestic national industrial champions, big banks began

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 6 to expand abroad by setting up foreign branches before the war, the losses may well have exceeded and subsidiaries. A good example is Deutsche their absorption capacity. Managing their asset and Bank’s expansion into Asia and Latin America liability mismatch, the Swiss unknowingly imported where subsidiaries were set up in the 1890s. These systemic country and currency risk into their financial subsidiaries conducted wholesale banking operations sector. (Trade Finance, Lending) in support of German Another good example of the dangers of cross- business interests. They did not engage in domestic border operations can be found in the time between or retail banking. As such, they helped to insulate their the two world wars. After the Dawes plan settled the multinational clients from financial volatility abroad questions of German reparations in 1924, American and provided a controlled mechanism for direct and British banks began lending short-term dollars investments into developing markets. Whilst severely and pound sterling again to Germany and Eastern limited during the two world wars and with some Europe. However, with the crash of 1929, the American international operations even confiscated by the allies, banks called these loans back triggering a de- this business model survived and proved useful until levering, which eventually resulted in 1931 in the the early 1970. failure of Creditanstalt-Bankverein in Austria and Danat With the process revolution in retail banking in the Bank in Germany. From 1930 to 1931, the supply of 1980s, things began to change. Many banks started to international short-term credit dropped by a staggering acquire foreign retail networks. We have seen Spanish 36%. The shockwaves from the collapse of these two banks expanding into Latin America, French, Italian institutions heavily damaged the European banking and Scandinavian banks into Eastern Europe, English system and also reached across the Atlantic. Whilst and American banks into developing markets. Whilst the banking crisis in the United States had mostly many of these foreign assets were purchased when domestic causes, the foreign dimension contributed they were distressed and the buyers were welcome at to the loss of confidence. To summarize, events in the time, the Financial Crisis revealed some tensions the inter-war period showed that systemic risk in in this business model. The losses in the early stages cross-border operations can arise from both maturity of the Financial Crisis affected the P&L of Italian, transformation and un-hedged currency exposure1. French and Scandinavian banks noticeably and led to Since financial institutions on both sides of the Atlantic a curtailing of lending in Eastern Europe. Also, without were involved, the systemic risk travelled both ways. the dollar liquidity from their Latin American operations, The challenges to the international financial system the Spanish banks would be in worse shape. and the solvency of states were eventually addressed Although no real accident has happened just yet, the with the creation of the IMF in Bretton Woods in 1944. tensions inside global retail banks clearly need to be But a good thirty years later, the system was under addressed. Cross-border activities, even when done stress again. The sharp increase in oil prices after within a global banking group, are not without risk as the Yom Kippur war in 1973 created the Petro and the next section elaborates. Eurodollar market. Banks were swamped with cheap Cross Border Lending dollar deposits from oil producers, which they used for extensive cross-border lending primarily to Latin There was a further development towards the 20th America and Africa. Both US and European banks century, which deserves our attention: the increase were involved. Borrowers were primarily governments. in cross-border lending. Banks in nations with high It took not too long until the bubble burst. Once the savings rates face a particular problem. They have Federal Reserve Bank started to sharply increase a structural liability overhang, in other words more fed fund rates in 1979 to combat inflation, troubles deposits than loans. With insufficient domestic credit started. Already in 1982, Mexico declared that it was demand, such excess liabilities can be used either unable to service its debt. But Mexico was not alone. to build up cross-border lending operations or make Other nations followed. In a few years, Latin America portfolio investments. There are several examples in quadrupled its foreign currency debt to around history for both. 50% of GDP. The losses for the US and European A good example is the Swiss-German cross-border banking system were so severe that the intervention lending at the eve of the First World War. Assuming that of the IMF and the US government was required. A both Gold Standard and fixed exchange rates were a permanent solution was eventually found in 1989 permanent feature, Swiss Cantonal and Savings Banks with the exchange of defaulted loans for new Brady built large mortgage portfolios across the border in bonds. Investors accepted discounts of up to 50% in southern Germany. Typically, they lent in Reichsmark exchange for collateralized new debt. Whilst the losses whilst the deposits were in Swiss Francs. The First for the banking system could thus be stretched over World War however shattered their assumptions. At the several years, the debt crisis was a serious blow to outbreak of the war, the convertibility of the Reichsmark Latin America’s economic development. Between 1980 was suspended. Within five years, the massive inflation and 1985, per capita GDP dropped by almost 9%. It reduced the value of Germany’s currency to almost took Latin America almost 30 years to recover. nothing, resulting in staggering losses for the Swiss 1 In 2010, there was almost an identical replay of this scenario. When lenders. Had the Swiss, for reasons which are beyond the US money market funds reduced their USD lending by about one the scope of this paper, not reduced their lending third, French, Belgian and Italian banks had to significantly reduce their balance sheet

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 7 The debt crisis in Asia in 1997 followed similar patterns Central Liquidity Management albeit portfolio investors and capital markets were the key drivers this time. Also, due to the strength Without spending time on the systemic risk of financial 3 of their export sector, the Asian countries recovered innovation , there is one management innovation faster. Whilst the IMF framework was a useful start, of significant importance. The rapid progress in it also showed its limitation. Asian countries started technology and communication makes today group to horde foreign exchange reserves in order to wide liquidity management possible. For most banks, never again become dependent from the IMF. Whilst which operate only in one country, this is not relevant. their motivation is understandable, it created a new But there are a few global banks, which could trigger imbalance. The large holdings of US Treasuries by serious disturbances if they transferred liquidity Asian countries contributed to lower USD interest unconstrained from one country to another. The rates. It was thus one of the factors that made the example of Lehman Brothers Germany has already high consumer leverage in the USA possible. Clearly, been mentioned. The transfer of prime brokerage the IMF framework needs to be strengthened and cash from London to New York on the eve of Lehman’s modernized. It must address structural financial collapse was another. It is a well-known fact that the imbalances. Global asset and liability mismatches and deposit base in Germany is larger than in Italy. Thus, large maturity transformation create global bubbles Italian banks with subsidiaries in Germany are always and systemic risk. Recognizing and managing them tempted to transfer excess liquidity to their home in a globally coordinated fashion is vital for Financial country. In effect, within a group, cross-border lending Stability2. takes place. Whilst global management of liquidity increases the efficiency of the financial system, in Systemic Risk from Portfolio Investments times of crisis some safeguards are necessary to keep Earlier, this paper mentioned that excess liquidity might the liquidity where it belongs. also result in the building of large investment portfolios. Conclusion This was indeed one of the transfer mechanisms for the Financial Crisis in 2007. For different reasons, Many innovations in finance started with the idea banks such as UBS, ING, Dexia, ABN AMRO (later of risk reduction or risk diversification. However, as acquired by RBS), the German Landesbanks or IKB this paper illustrates, there are often unintended all created large, un-hedged investment portfolios consequences, which are overlooked and create new with a significant share of securities related to the systemic risks at a later stage. The risks of what we performance of the American mortgage market now call globalization, has been with us for the longest (RMBS, CMBS, REITs). There are still no reliable time. The ever changing interconnection amongst figures available, but it is fair to estimate that the institutions around the world poses risks which are European banking sector bore about 20% of the difficult to perceive and even more difficult to manage. total US mortgage losses of USD 2.3tr. The collapse The individuals who head our public and private sector of the US real estate bubble thus directly translated institutions and are responsible for the management into the Eurozone and forced government to bail out of such risks are often the victims of their own limited their insolvent banks with support packages in three vision and aspirations. An experience I can confirm digit billion numbers. At the time of the build-up of from the many weeks I spent at the EU in Brussels these portfolios, they were seen as safe and profitable without finding people willing enough to listen to alternatives to risky lending. They also attracted less serious concerns. The contribution of globalization to capital. In the end, it became evident that they were systemic risk is probably neutral with benefits and new the very channels through which systemic risk reached risks keeping a close balance. What we need to learn Europe! from history is that every innovation has unintended consequences and thus new, unknown downside risk we need to explore before it is to late and that no regulatory framework survives intact without permanent adjustments to new market realities.

3 Derivatives were rather beneficial during the Financial Crisis. Without 2 The European sovereign debt crisis also puts its fingers on the derivatives, the volatility in foreign exchange, interest rates, equities and limitations of the IMF when dealing with weaknesses in a currency union. commodities would have overwhelmed several institutions

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 8 Dr Rui Esteves

University Lecturer in Economics, Brasenose College, University of Oxford This memo focuses on the political processes behind speed with which this transformation occurred. the first wave of financial liberalisation during the Before the war there was a broad consensus across nineteenth and early twentieth century and its demise the political spectrum about the advantages of not after World War I. As we live through a renewed period tampering with capital mobility. Only at the far left was of financial integration, the question of its sustainability there an uncompromising critique of capital exports naturally arises, while it is pertinent to know whether as instruments of the extension of imperialism, the we can draw lessons from history. ‘highest stage of capitalism’ (Hilferding 1920, Lenin 1916). The following picture illustrates this reversal by Not everyone gained from the process of globalisation tracing the de jure degree of capital account openness –of trade, labour, and finance–, which brought about over more than a century. important changes in the structure of the economy and the distribution of income in nations across the The overall story in this picture can be described in world. This idea of this memo is how the economic three stages. Financial integration was highest prior to incentives generated by these dislocations translated, World War I (a 100 value means full capital openness), through the political system, into choices about with hardly any variation across nations; the War put openness to foreign capital and financial integration. a stop to this state of affairs, despite some attempt In this type of study, the logic of political economy is at reintegration in line with the re-establishment of especially useful in cognate contexts, particularly the the gold standard until 1928. However, the Great attitude of countries towards protectionism (Frieden Depression elicited an even more autarkic reaction and Rogowski 1996) and the choice of exchange rate from most countries. Substantial variation across regimes (Eichengreen 1992, Gallarotti 1995). groups of nations also emerged in this period. A 1938 study from the League of Nations classified countries The history of financial openness and liberalisation in three groups according to their exchange rate has been less studied, although there is a vibrant policy since the demise of gold in the 1930s: ‘gold literature on the political drivers of the current process bloc’ countries that persisted in their pegs to gold of financial integration (Quinn and Inclán 1997, among until the second half of the decade; ‘devaluers’ that many). Despite Frieden and Rogowski’s (1996: 27) more quickly dropped their pegs and allowed their claim that “movements of services and capital are currencies to devalue; and ‘exchange-control’ nations analogous to those in goods and can be subjected that kept their pegs but only through imposing very to similar tools of analysis,” the former have attracted severe exchange and capital controls. This ordering much less attention in the historical literature than the is reflected in the average indices of capital openness latter. Apart from data limitations, this is probably due for the three groups of countries up to 1931, with to the relatively small cross-country variation in the ‘devaluers’ restricting financial openness less than explained variable. Indeed, up to 1914 there were ‘exchange-control’ nations. Relative capital market very little limitations to unfettered capital movements restrictions persisted throughout the Bretton Woods between nations, while most countries converted to period, and were only reversed since the late 1960s. controlling capital flows between the wars, albeit with Interestingly, there is persistence in attitudes toward varying intensity. Contemporary empirical studies are capital controls among groups of nations. The previous mostly cross-section and cannot be easily transposed members of the gold bloc were the first to liberalise to an historical setting with considerably less between after the war and mostly persisted on that track since, variation. while ‘exchange-control’ quickly reverted to greater Nevertheless, the within variation is sufficient to identify capital restrictions after the collapse of the Bretton the causes of the reversal in policies toward capital Woods system in 1971. On a de jure basis, capital openness in the interwar period. World War I mobility is censed to have remained below the pre- looms large in this reversal, as suggested by the 1914 levels almost to this day.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 9 Figure 1: Average Capital Account Openness, 1890-2004 Depending on the stability properties of the system, a small shock might be enough to disturb the prewar equilibrium. The two shocks of World War I and the Great Depression were not ‘small’ in any sense and triggered a course of economic and political disintegration that forms a mirror image of the years before 1914. These trends reduced and then reversed the distribution of economic gains from international liberalisation, which was then quickly reflected in the political fights of the period and the dramatic turn toward autarkic policies, especially after 1929. The extension of the franchise certainly helped in making this possible, although identical policies were taken up in democratic as in un- democratic regimes around the World. And yet, systemic crises were not new, which begs the question of why they hadn’t endangered the liberal status The widespread support for capital openness before quo before the war. There are several candidates for 1914 was attributed to the complementarities between an answer. Kindleberger (1986) and Mundell (1999) trade and factor flows, as well as to the network emphasise the role of the UK in preventing the most externalities from monetary coordination. In this sense, serious crises of the prewar period (1890, 1907) international financial liberalisation is best understood from threatening the stability of the system. This is in the context of the other aspects of the globalisation a straightforward application of a model of multiple process prior to the War. Countries that opened up equilibria, selected by the focal points provided by the to trade gained in terms of easier access to foreign hegemonic nations. The uncompromising isolationism finance, which gave them the means to invest in or inept policies of the US provided the wrong focus. transportation and communication infrastructure that Eichengreen (1992) prefers to stress the cooperation would enhance their comparative advantage. The between the authorities of the leading nations as well connection also operated for countries with excess as the limited franchise that insulated them from short- savings, since previous trade relations alleviated term political pressure before the War. Cooperation the informational asymmetries in investing in exotic and policy independence were in short supply while investment projects or securities. Capital further the world economy descended in the throes of the chased labour toward countries abundant in natural Depression. But we might also ask, with O’Rourke and resources but hardly in anything else. Finally, access Williamson (1999), whether War and Depression can to foreign capital facilitated a credible adherence to really be construed as exogenous shocks to which stable exchange rates (in the gold standard) and was an inept world leader could not react in a stabilising made easier by the reduction of the currency risk of way. The work of these two authors and others has foreign investors. This in turn made it possible for uncovered the latent political tensions from the countries to specialise in an unprecedented degree, distributional consequences of prewar globalisation. It because they were assured that specialisation would is possible to imagine a counterfactual world, without a not imply a current account constraint in bad times. World War starting in 1914, where these tensions could Although emerging economies were not immune to have lead to a backlash against globalisation anyway. financial crises and exogenous volatility their openness Much harder is to test it though. Compared to tariff to foreign finance paid off in faster convergence and policies and immigration restrictions, capital mobility higher levels of income. Of course, globalisation was relatively spared by these anti-globalising forces, if beneficial in aggregate also generates losers, which may be a reflection of the less adversarial who can block the process for lack of a credible consequences of capital openness alluded to before. redistribution mechanism of ex-post gains. However, Or it may be that we do not fully understand the the complementarity between trade and factor flows connection between economic incentives and political alleviated these distributional tensions, perhaps helped outcomes around financial integration. The example by the concentration of effective political power in of the literature on the political economy of financial elites that stood to gain more from the process. liberalisation in the late twentieth-early twenty-first The multiple positive feedbacks described meant that centuries shows the path for the further research only a shock to integration could disturb the system necessary to uncover the historical perspective on from a path of increasing economic integration. this topic. More and better data on capital market

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 10 frictions and capital flows is a good starting point References cited here. The literature has been arguing perhaps too Eichengreen, B. (1992) GoldenFetters. The Gold Standard and the Great much from the reconstituted series of capital exports Depression, 1919-1939, New York: Oxford University Press. from Britain before 1914 and the US after, without much consideration for the significant differences in Frieden, J. and R. Rogowski (1996) “The impact of the international economy on national policies,” in R. Keohane and H. Milner, eds., the patterns of investment of other capital exporting Internationalization and domestic politics, New York: Cambridge nations (France and Germany). Only then will we be University Press, pp. 25-47. able to follow on Frieden and Rogowski’s (1996) “plea Gallarotti, G. (1995) The Anatomy of An International Monetary Regime: to eschew impressionistic generalisations, instead The Classical Gold Standard, 1880-1914, New York: Oxford University attending consciously to the interests and incentives Press. facing all relevant individuals and working up from that Hilferding, R. (1920) Das Finanzkapital: eine Studie über die point to expectations about behaviour” that can be jüngste Entwicklung des Kapitalismus, Vienna: Verlag der Wiener Volksbuchhandlung, 2nd ed. tested empirically. Kindleberger, C. (1986) The World in Depression, 1929-39 (Revised and Enlarged Edition), Berkeley: University of California Press.

Lenin, V. (1934 [1916]) Imperialism: The Highest Stage of Capitalism, London: Martin Lawrence.

Mundell, R. (1999) “A Reconsideration of the Twentieth Century,” Nobel Prize in Economics documents 1999-5, Nobel Prize Committee.

O’Rourke, K. and J. Williamson (1999) Globalization and History. The Evolution of a Nineteenth-Century Atlantic Economy, Cambridge, Mass: MIT Press.

Quinn, D. (2003) “Capital Account Liberalization and Financial Globalization, 1890-1999: A Synoptic View,” International Journal of Finance and Economics, 8: 189-204.

Quinn, D. and C. Inclán (1997) “The Origins of Financial Openness: A Study of Current and Capital Account Liberalization,” American Journal of Political Science, 41(3): 771-813.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 11 Some Ideas on Financing Globalization: Lessons from Economic History Marc Flandreau, Graduate Institute, Geneva

Drawing lessons from the past is always a perilous exercise. One strong view I have about the study of economic history is that it mostly helps understanding how things are different today. In the following note I illustrate four areas where historical thinking can provide valuable perspective.

• Crises and globalization The international financial system is a place that may have governance, but lacks a government. As a result, its historical evolution has been haphazard, confused, chaotic. One thing that has been striking across history is the two-way relation between crises and international financial integration. An illustration is provided by the following graph, which shows the evolution of an indicator of international financial integration during the “Belle Epoque” of the late international financial system. The graph outlines this relation by showing the co-movements of an indicator of “Emerging markets risk” and the indicator of global financial integration. The effect of the Argentine crisis is very perceptible. This is a reminder of the relevance of crises and their handling for international financial integration. Now, Professor Marc Flandreau different crises have different effects and it is important to unpack the logic of the international financial system in order to be able to provide meaningful insight.

Graduate Institute, Geneva Figure 1: Financial Globalization and Market Risk 1880-1914 Crises and globalization Figure 1: Financial Globalization and Market Risk 1880-1914 The international financial system is a place that may have governance, but lacks a government. As a result, its historical evolution has been haphazard, confused, chaotic. One thing that has been striking across history is the two-way relation between crises and international financial integration. An illustration is provided by the following graph, which shows the evolution of an indicator of international financial integration during the “Belle Epoque” of the late international financial system. The graph outlines this relation by showing the co-movements of an indicator of “Emerging markets risk” and the indicator of global financial integration. The effect of the Argentine crisis is very perceptible.

Exchange Rate Regimes • Exchange Rate Regimes In their quest for a Holy Grail of international Table 1: DeterminantIn their quest forof Governmenta Holy Grail of Bond international Spreads financial (1880-1914) stability, economists and historians have put their stethoscopes on the international gold standard. In the interwar, many observers financial stability, economists and historians 2 1 5 8 9 blamed contemporary problems on the world not being the nice place it used to be. Because have put their stethoscopes on the 1.Structuralthe factorsWar had : led to the suspension of the gold standard, lack of a “gold standard discipline” international gold standard. In the interwar, Int.serv./Rev.was made responsible -for the evils9.308 at (7.96) work. There9.037 (7.12) has been8.776 some (6.52) debate7.677 on (5.35)that matter (Bordo many observers blamed contemporary Res./bankn. - - - -0.518 (-1.14) -0.402 (-0.83) problems on the world not being the nice Exp/Pop - - - 2.575 (2.38) 2.279 (1.95) place it used to be. Because the War had led Deficit/rev. - - - 0.723 (2.20) 0.747 (2.21) to the suspension of the gold standard, lack Exch. rate vol. - - - 23.906 (2.17) 13.104 (1.05) of a “gold standard discipline” was made 2.Reputation factors : responsible for the evils at work. There has - Default - 4.944 (16.10) 4.982 (15.79) 5.087 (16.20) 4.917 (15.48) been some debate on that matter (Bordo - Memory - 0.966 (2.62) 0.913 (2.40) 0.872 (2.26) 0.667 (1.62) and Rockoff’s gold standard as “Good 3.Policy/political variables: Housekeeping Seal of Approval Hypothesis”) - Franchise - - -0.040 (-0.80) -0.053 (-1.07) -0.072 (-1.39) but contrarian minority view illustrated by - Political crises - - - - F=1.889 (*) Table 1 (from Flandreau and Zumer 2004) 4. Gold Standard: is becoming majority view (See e.g. Alquist -1.546 (-5.13) 0.012 (0.06) 0.302 (1.19) 0.099 (0.38) and Chabot 2012 for recent corroborating Constant - - - - - SBIC 564.056 427.741 432.928 435.307 466.732 evidence). Log L. -539.174 -397.329 -396.987 -388.307 -369.967 Adj. R2 0.310 0.774 0.773 0.784 0.798 Market Discipline Number of Observations : 252. Not shown are the country-specific constants. Numbers in parentheses are heteroscedasticity consistent Student t statistics (corresponding Do markets provide discipline? This used to standard errors are computed from a heteroscedastic-consistent matrix (Robust-White)). be one of the basic tenets of Globalization.1 In all cases, F-tests choose Fixed Effects versus simple pooling. (*) F-test significant at (i.e. the Washington Consensus). Probably out 5%. Source: Flandreau and Zumer (2003) of laziness, many problems were outsourced to “markets”. This was done without due diligence, that is, without investigation of the specific conditions of individual markets. It is quite remarkable, in particular, that this was done in a way that was totally ignorant of history. An excellent example of this complacent and inadequate attitude has been the European Union. Europeans have turned to a reliance on “market forces” each time they could not agree on something, as was the case for the stability pact. The stability pact did not have teeth, and the theory was that market forces would take care of delinquent borrowers. For instance, in the late 1990s research had showed that “markets” could be quite

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 12 etc. but research needs to realize that the whole purpose of an effective governance of globalization is to prevent such things from happening. One theory is that the solution to international financial problems has much to do with resolving moral hazard. If “adequate” costs and penalties are inflicted to debtor when debtor defaults, then there should not be any default in the first place. I find this line of thought somewhat misleading. At the limit, if there is no default (say because the dominant power always sends the gunboats) then the moral hazard problem becomes bigger, not smaller. My own research has led me to uncover the crucial role of intermediaries in the debt market. Now, the important issue historically is that there has been a change in the role of underwriters. They used to have more “skin in the game” through a form of moral liability with foreign government debt (Figure 2). A consequence of this is that there is evidence suggesting that the international financial system has more “built in” risks than it used to (Figure 3). Does it signal the fact that we have better institutions today? And in which case, which are they? Or is the message that we are heading towards a major disaster and need to be careful?

happy with large public accumulation of debts during FigureFigure 2:Successes 2. Successes and Failures and ofFailures Gatekeeping of Gatekeeping (since 1815) (since 1815) upswings (e.g. late 19th century) but they suddenly became debt intolerant when the cycle reversed (see Flandreau, Le Cacheux and Zumer 1998). Gatekeeping More careful focus on international financial intermediation, and its history, should be a primary research topic. There is substantial work on defaults, committees etc. but research needs to realize that the whole purpose of an effective governance of globalization is to prevent such things from happening. One theory is that the solution to international financial problems has much to do with resolving moral hazard. If “adequate” costs and penalties are inflicted to debtor when debtor defaults, then there should not be any default in the first place. I find this line of thought somewhat misleading. At the limit, if there is no default (say because the dominant power always sends the gunboats) then the moral hazard problem becomes bigger, not smaller. My own research has led me to uncover the crucial role of intermediaries in the debt This showsThis shows Lorenz Lorenz curve curve for for failure rates. rates. Underwriters Underwriters are ranked are ranked from from the market. Now, the important issue historically is that smallestthe tosmallest the largest to the largest and their and theirmarket market share share are are ad addedded accordingly (x-axis). there has been a change in the role of underwriters. On the(x-axis). y-axis, On the the chart y-axis, shows the chart the shows share the of sharethe same of the group same groupin the in total volume the total volume of foreign government debt failures. They used to have more “skin in the game” through of foreign government debt failures. a form of moral liability with foreign government debt Figure 3. Speculative Grade and Investment Grade in Foreign Government Debt Markets Figure 3:Speculative Grade and Investment Grade in Foreign (Figure 2). A consequence of this is that there is (Interwar/Now) evidence suggesting that the international financial Government Debt Markets: (Interwar/Now) system has more “built in” risks than it used to (Figure 3). Does it signal the fact that we have better institutions today? And in which case, which are they? Or is the message that we are heading towards a major disaster and need to be careful? Empire and Contracts A little recognized contribution to the “high financial integration” shown by Feldstein-Horioka based measurements before WWI is that of the British Empire. Of course historians and economic historians have long recognized the special position of imperial Source : FlandreauSource: Flandreau et al. (2009). et al (2009) financial integration inside globalization (Davis and Huttenback 1988, Cain and Hopkins 1993). However, • Empire and Contracts it worth bearing in mind that the “folk sample” (BordoA little recognized contribution to the “Figurehigh 4.financial Surplus from integration Empire? ” shown by Feldstein- and Flandreau 2003) used to compute coefficientHorioka of based measurements before WWI is that of the British Empire (Flandreau 2006). Of financial openness before WWI has 25% of countriescourse historians Figure and 4 economic:Surplus form historians Empire? have long recognized the special position of in the British formal or informal Empire and in effect,imperial financial integrationD : Demand inside globalization (Davis and Huttenback 1988, Cain and their impact of result is, by construction of the F-HHopkins test, 1993). However, it worth bearing in mind that the “folk sample” (Bordo and enormous. The contribution of Empire to globalizationFlandreau 2003) used to compute coefficient of financial openness before WWI has 25% of countries in the British formal or informal Empire and in effect, their impact of result is, by has been noted by authors who have emphasized construction of the F-H test, enormous. The contribution of Empire to globalization has been the reduction of default risk (Davis and Huttenback noted by authorsiUK +s whoi have emphasized the reduction of default riskS1 (Davis: Sovereign and Huttenback 1988, Ferguson and Schularick 2006). However,1988, such Ferguson and Schularick 2006). arguments downplay an important cross-sectional iUK S : Colonies Table 2. Evolution of indebtedness (interest service as a share2 of budget) dimension of formal “Empire”, namely the difference between self-governing and dependent colonies. As shown in Figure 4, elimination of default risk when it takes the form of control creates apolitical economy of Qs S Q : amount of capital borrowed capture that turns “globalization” into something rather disastrous. On the other hand, as the experience of self-governing suggests, substantially higher level of international integration, even with high debt levels, can be sustained provided that adequate institutions are created enabling to cope with solvency and

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 13

Source: Accominotti et al. (2011).

Figure 3. Speculative Grade and Investment Grade in Foreign Government Debt Markets (Interwar/Now)

Source: Flandreau et al. (2009).

• Empire and Contracts A little recognized contribution to the “high financial integration” shown by Feldstein- Horioka based measurements before WWI is that of the British Empire (Flandreau 2006). Of course historians and economic historians have long recognized the special position of imperial financial integration inside globalization (Davis and Huttenback 1988, Cain and Hopkins 1993). However, it worth bearing in mind that the “folk sample” (Bordo and Flandreau 2003) used to compute coefficient of financial openness before WWI has 25% of countries in the British formal or informal Empire and in effect, their impact of result is, by construction of the F-H test, enormous. The contribution of Empire to globalization has been noted by authors who have emphasized the reduction of default risk (Davis and Huttenback 1988, Ferguson and Schularick 2006). liquidity at once (See Accominotti et al. 2009 and TableTable 2. Evolution 2:Evolution of of indebtedness indebteness (interest(interest service as a share ofof budget) Accominotti et al. 2011 for a discussion). Table 2 budget ) Most indebted governments ratio ≥ 2.5 right shows that “surprisingly”, self-governing Empire countries were the ones that accumulated the largest levels of debts. This is also a time of high infra- structure building and economic success.

References for readings: Accominotti, Flandreau, Rezzik, Zumer, 2010: Black man’s burden, white man’s welfare control, devolution and development in the British Empire, 1880–1914: European Review of Economic History. Accominotti, Flandreau, Rezzik, 2011:The Spread of Empire; Clio and the Measurement of Colonial Borrowing Costs:Economic History Review.

Flandreau, 2006: Home biases, 19th century style:Journal of the Source: Source: Accominotti Accominotti et etal. al (2011). (2011) European Economic Association. Flandreau and Zumer, 2003:The Making of Global Finance:OECD, Paris. Flandreau, Le Cacheux and Zumer, 1998:Stability without a pact? Lessons from the European Gold Standard:Economic Policy. Flandreau, Flores, Gaillard, and Nieto-Parra, 2010:The End of Gatekeeping; Underwriters and the Quality of Sovereign Bond Markets, 1815-2007”, NBER International: Seminar on Macroeconomics 2009.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 14 Professor Harold James

Claude and Lore Kelly Professor in European Studies, Princeton University

The assumption of policy-makers at the 1944 Bretton 4. A belief by some bankers that the encouragement Woods Conference was that cross-border capital of their governments of the recycling process movements would be restricted and controlled. They amounted to an implicit guarantee on the part of followed Keynes, and Ragnar Nurkse, in believing that governments. In the case of U.S. banks, bankers short term or hot money flows had been responsible when asked about the security of their syndicated for the destabilization of the world economy in the lending to Latin America referred to views in the 1930s. They thought a resumption of private flows State Department about the desirability of political unlikely; if there were to be large international capital and economic stability in the western hemisphere; movements, they would be official, and they might best German banks that lend considerable amounts be managed through the World Bank. to Warsaw Pact (Soviet satellite) countries, in particular Hungary and Poland, also liked to By the 1960s, there were already substantial cross- refer to their government’s interest in the new border flows of money. Notwithstanding extensive phenomenon of Ostpolitik. capital controls, there could be substantial short term movements – occurring, for instance, through channels 5. A lack of any detailed knowledge about the intended for trade finance, with early or late foreign extent of total exposure of banks through loans to exchange payments (leads and lags). An offshore developing countries, and a general regulatory bond market (Eurobonds) developed, and some big failure. Both the Federal Reserve System and U.S. banks helped to redevelop London as a financial the BIS tried to collect statistical information, but center for offshore finance. But banks remained largely largely failed because of bank resistance. It is not national (and old-fashioned or unadventurous or “retro” even clear that individual debtor countries had in Amar Bhide’s terminology) in their orientation. information about the total indebtedness of their public sector (because a multiplicity of state and The 1970s was the decade when internationalization para-state institutions was involved in the lending really took over banking. That revolution can be process). thought of as an outcome of 6. The low interest rate environment prevailing until 1. Changes in domestic finance, above all in the the dramatic shift in the policy orientation of the U.S. The development of a capital market made Federal Reserve in October 1979. With often bond financing available for large corporations. negative real interest rates, debt service appeared As a consequence, U.S. bank lending to industry unproblematical. diminished, and banks felt a need to look for 7. Nearly ubiquitous cross-default clauses in alternative or new borrowers. syndicated loan agreements made an isolated 2. An international imbalance issue, in the aftermath individual default impossible, and a collective of the two oil price shocks, with oil producers default triggered by such clauses would have such unable to spend the greatly enhanced revenues impossibly dangerous consequences that it was that followed the oil price rises. also unthinkable. 3. Encouragement by Western governments (in 8. Competition within different national banking particular the U.S.) for oil producers to “recycle” sectors for the lucrative activities associated with the surpluses through the banking system (rather recycling or relending oil surpluses and other than say through the official sector: though the deposits. Newcomer institutions that wanted to IMF came up with an Oil Facility that was intended expand quickly would be prepared to take greater to allow the funds of oil producers to ease the risks. adjustment in non-oil developing countries). 9. Competition between national banking sectors, On occasion, National Security Adviser Henry with Japanese and continental European banks Kissinger spoke directly about how the inclusion of gradually displaying increasing eagerness to catch Middle Eastern oil producers into an economic and up with British and American lenders. political “West” through the international banking 10. Within the lending banks, there may also system was a better way of securing an alignment have been agency problems. The individuals of their interests with those of the large industrial responsible for making loans saw their (highly countries than any sort of openly confrontational profitable) activity as a channel for rapid career course. advancement, and assumed that if there were to be problems regarding borrowers’ capacity to pay in the future, they would no longer in their old positions.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 15 The outbreak of a debt crisis in August 1982 with the Moreover, despite the obvious “reform fatigue” of possibility and threat of Mexican default created the Latin American electorates, the debtor countries had threat of a repetition of a 1930s style contagious and engaged in a substantial measure of reform. Before the general debt and banking crisis. A Mexican default Brady Plan was announced, Mexico had accepted a alone would have wiped out almost all the capital of wide-ranging Pact of Economic Solidarity and Growth almost all the substantial New York lending banks. which had an immediate effect in restoring confidence and reducing the very high domestic interest rates. What followed was a seven year play for extra time. The initial approach was to link policy improvement in The aftermath of the Latin American debacle was quite the borrowing countries with help from international long-lived in the sense that an immediate lesson about institutions, but also extra lending from the banks. The bank exposure to developing country debt was learnt. latter element seemed to defy the most elementary When capital movements start up in the second canons of sensible bank behavior. The aftermath globalization wave after 1945, they come in a rather of the Latin American debt crisis produced the different order than that of the nineteenth century wave. first systematic attempt at international regulatory coordination, culminating with the 1988 Basel 1. FDI was the first type to assume a major Agreement (with its notorious weighting system, under importance after the Second World War. It is which OECD country debt was assessed as risk free). associated with major flows of skills, technology and management. It often responded to trade Three years after the outbreak of the Latin American protection and closed off good markets, in that crisis, Treasury Secretary James Baker announced production moved to markets that would otherwise a systematization of the initial response. It was not have been inaccessible. The MNC was thus a very imaginative. Banks and multilateral development major bearer of the initial dynamic of the second institutions should all lend more, and the debtors globalization wave. MNCs play a large part in the should continue their efforts to improve their policy. transformation of European production, but also in The Baker Plan was a universal disappointment. development in Latin America. Growth faltered again, and the IMF actually reduced its lending. 2. Bank lending flourished in the 1970s, and then appeared to lead the world to near-catastrophe More than three years passed before a new Treasury and to more coordinated agreement on regulation Secretary, Nicholas Brady, set out a more satisfactory and especially on capital adequacy. program, in which banks would be given a menu of 3. Bond markets are a relatively late development options that included lower interest rates on the debt both for the official and the corporate sector (in and selling back the debt to the debtor at a hefty contrast with the nineteenth century experience). discount. If the banks were unwilling to accept some Indeed the bond market – and with it securitization form of restructuring, they would have to put in new - was given a decisive impulse by the policies money. The lending of the international institutions resolved to resolve the developing country bank might also be used for buying back discounted debt. debt crisis of the 1980s (Brady bonds). The The Brady plan was a great success. Confidence internationalization of bond debt, and the breaking returned, capital flight from Latin America was down of insulated or isolated domestic markets reversed, and the capital markets began to be willing (financial repression), is thus a relatively late to lend again. development that took off in the intensive wave of Why did it come so late? The most obvious answer financial globalization in the 1990s and 2000s. is that at an earlier stage in the Latin American saga, the banks simply could not have afforded to take such losses on their capital. They needed the seven years of faking the position in order to build up adequate reserves against losses. It is also important to recognize that the initiative for the Brady Plan really did not come from the official sector at all. It was the willingness of some big financial institutions to trade in discounted debt that established a market that would clear out the legacy of past policy mistakes. In particular, two institutions took a lead: Citicorp in the US, and Deutsche Bank in Europe. Their CEOs at the time presented their actions as motivated by a far- sighted benevolence and a concern for the well-being of the world as a whole. That may have been plausible, but these two banks also were playing in a competitive field and wanted to demonstrate very publicly that they had a better balance sheet than their weaker rivals. In Germany, the Dresdner Bank and the Landesbanken could not afford to take such a hit.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 16 Professor Catherine R Schenk*

Professor of International Economic History, University of Glasgow The eruption of the global financial crisis in 2007 has and the banking system to remain the foundation been blamed on many guilty parties: greedy bankers for regulation and supervision. Personal contact, seeking bonuses rather than sustainable growth, moral suasion, and the Bank of England’s practice of complacent bank board members, financial engineers informal ‘words in the ear’ of bankers who might be that created inscrutable products, poor home-owners engaged in imprudent behaviour was the model for borrowing beyond their means, savings ‘gluttons’ in regulation and supervision. This cozy atmosphere China and debt-dependency in the West. Over-arching was soon challenged, however, by the Eurodollar these actors in the drama, however, is the general market. Initiated in the mid-1950s by Midland Bank governance and supervision of the international to overcome the restrictions on bidding for sterling financial system. How did things get so far out of line, deposits, the development of an offshore market in the system so fragile, as to generate the ricochet of dollar deposits and loans in London quickly prompted panic and collapse across the globe? The effects of an invasion of US and other international banks into the the crisis certainly seem to warrant a reassessment of City to take advantage of this opportunity. Moorgate, how a more robust international financial architecture where many US banks found premises, became known might be built in order to support recovery and as ‘America Avenue’ and the Eurodollar market was renewed growth. How do we maintain the benefits of quickly dominated by American banks in London. financial innovation while managing risk? Realistically, In the process, the City changed from a cozy and we will be unable to regulate away all bubbles and uncompetitive haven to a much more dynamic and their inevitable bursting, but minimising the impact of rapidly growing sector. Regulators, however, were slow these bubbles and restraining their size and scope to adapt. should be within the realm of possibility. Current efforts The Bank of England continued its personal approach, in Basel, the IMF and in the G20 have a long legacy insisting that the market could not be regulated of experience on which to draw, and a considerable without imposing unreasonable reporting burdens on reputation for failure to overcome. banks, and that it should not be driven out of London. What is particularly vexing for those with a longer term Nevertheless, fears about an excessively risky term view is that the underlying factors that contributed structure of liabilities and assets in the market, lack of to the latest crisis have long been recognised. While transparency about ultimate borrowers of funds and there has been considerable commentary on the the ‘pyramiding’ of inter-bank lending encouraged lessons from the Great Depression, we don’t need to central banks elsewhere in Europe to refuse to host go back so far to identify financial crises that revealed similar markets in their jurisdictions. Imposing taxes failures in regulatory oversight. Although the process on interest payable to non-residents or higher reserve of regulating banking and financial systems began requirements on Eurodollar deposits were the most much earlier, the current structures of international common ways to ensure that an offshore foreign regulation were shaped by key episodes since the currency market did not develop. The distrust on the Second World War: this brief addresses the innovation Continent prompted considerable private discussion of the Eurocurrency market in the 1950s and 1960s in the BIS where European and American central and the advent of a new risk environment in the 1970s bankers debated what could be done to improve the culminating in the sovereign debt crisis of 1982. supervision of this new market, even while it grew exponentially. Suggestions to improve transparency The post-war international economic system was by collecting data from participating banks were designed to achieve stable exchange rates and resisted by many central bankers who viewed the promote freer trade in goods to give the best confidentiality of their relationship with their national prospects for economic growth and full employment; banking systems as sacrosanct. Some jurisdictions the two main goals of most industrialised states. did not collect such data and were not willing to begin International financial markets were blamed for doing so; others refused to share confidential market contributing to damaging flows of ‘hot money’ in information. In 1963 the collapse of a fraudulent the inter-war period, which were believed to have scam in the USA generated a series of defaults contributed to the contagious spread of the Great on Eurodollar loans. This sent a shock through the Depression. In order to sustain policy sovereignty market and brought monetary authorities back to the and stable exchange rates, international capital flows question of regulation and supervision, but plans for were tightly controlled and national banking systems an International Risk Centre were rejected in 1965. were insulated from competition. This complacent Instead, after much debate, the BIS began to publish environment, particularly in the City of London, allowed consolidated data on the size of the market from the informal networks between the Bank of England mid-1960s. * This brief draws on C.R. Schenk (2010) Are we bad students or do we have poor teachers: why don’t we learn the lessons from previous The failure to enhance supervision or to regulate crises?, Corporate Finance Review, 15 (2) and C.R. Schenk (2010) The Decline of Sterling; managing the retreat of an international currency, the Eurodollar market signalled several issues that Cambridge University Press. Research funded by ESRC Grant RES-062- were to have echoes in the global crisis of 2007. 23-2423. http://www.bank-reg.co.uk

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 17 First, financial innovation surprised regulators and the bud. But this required sharing information across they were caught on the back foot. Second, the borders, and there was no consensus among the innovation was considered highly complex at the time; members of the committee that this should be done. prudential standards should be set and monitored by In the end, George Blunden as Chair submitted a banks themselves rather than civil servants or other personal report to the BIS Governors suggesting independent parties. Third, the confidentiality of bank that members of the committee might share gossip information was a barrier to transparency. Regulators informally at their regular meetings and they were also clearly aware of the dangers of regulatory exchanged phone numbers. The Committee instead competition and the Bank of England argued that if focussed on making sure that all banks were at least London closed its market the business would merely supervised by one jurisdiction – although the Bank of shift to some less experienced financial centre, thereby England did not adhere to the eventual Concordat. adding to systemic risk. The Fed appreciated how the Any effort to standardise the rules of supervision and market relaxed pressure for loans from its domestic enhance risk management were hampered by the fact capital markets at a time of tight money. In addition, that control of national banking and financial systems the problem of identifying and enforcing common was a jealously guarded element of each state’s international standards across a range of different national sovereignty. As the chairman of the Basle banking systems and cultures was clearly identified. Committee, George Blunden of the Bank of England, Finally, as in the 2000s, the economic benefits of stated in 1977: providing global financial services were not to be The banking system of a country is central to endangered by restraining profitable new market the management and efficiency of its economy; opportunities. its supervision will inevitably be a jealously The undisputed success of the market endorsed the guarded national prerogative. Its subordination norms that were established when supervision and to an international authority is a highly unlikely regulation were debated. Whether the enhanced development, which would require a degree of capital mobility that brought down the Bretton Woods political commitment which neither exists nor is system between 1967 and 1973 was primarily due to conceivable in the foreseeable future.1 the Eurodollar market is open to debate – at the time, Thirty years later, it is unclear that central bankers’ experts at the BIS did not blame the Eurodollar market views had changed. per se. Indeed, the market was lauded for solving the problem of global imbalances by ‘recycling’ OPEC A further question was how to increase the flow of surpluses into loans for LDCs. information on lending and borrowing to enhance transparency, but little progress was achieved in The new floating exchange rate regime from 1974, collecting and publishing the sovereign debt exposure coming at the same time as commodity and asset of borrowers and lenders until the late 1970s. price volatility, ushered in a new risk environment for The distribution of the loan portfolios of individual which many banks and regulators were unprepared. banks was considered private valuable commercial The result was a series of bank collapses that information and there was resistance by banks and threatened cross-border contagion in an increasingly also by regulators to publish this data. Meanwhile the integrated international banking system. The rash of Fed began to collect and publish country exposure bank failures in the summer of 1974 exposed failures for US banks, the IBRD collected and published of internal and external supervision in international sovereign borrowing by state and the IMF also began banks and the dangers of inconsistent national to collect its own data and began a regular and prudential supervision. In almost all cases there frequent round of visits to international banks in various was evidence of fraud or rogue trading that had not financial centres in Europe and North America to gain been captured within rapidly expanding international market intelligence. The BIS data was considered most banks. The crisis also exposed confusion over which comprehensive, but it included only members of the jurisdiction was responsible for supervising and bailing BIS and there was a long delay before publication so out the increasingly global international banking that it was not very useful for market purposes. market. The Fed bailed out the National Franklin Bank, the Bundesbank let the Herstatt Bank fail and the In the end these efforts were too little too late to Bank of England partly bailed out the Anglo-Israeli prevent the crisis of 1982. Bank ex post. In Germany and the USA the national There was a range of market factors that shifted the banking system contributed to bail-outs through assessment of risk in international lending in the separate contributory institutions (in the UK this was 1970s. First, increased syndication allowed groups limited to bailing out domestic fringe banks through the of banks to share the risk burden of a loan. As each ‘lifeboat’). individual bank appeared less exposed to default this In 1975 the Basle Committee on Banking Supervision encouraged larger and more risky lending overall. was set up to consider the establishment of an ‘early Secondly, the loans were to governments rather than warning system’ that would allow national regulators businesses and it was difficult to price the default risk to step in to nip potential systemic bank failures in 1 Bank of England Quarterly Bulletin, 17, 3 (1977).

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 18 of states, partly because lenders have expectations that international organizations such as the IMF or World Bank will assist states in default to repay their debts. The expectation that the losses might be shared ex post with another body introduced moral hazard and encouraged more risky lending. Thirdly, the dramatic expansion in international financial activity in the 1960s and 1970s drew new lenders into the market over the decade. A loan in 1970 might have been rational for the individual bank at the time, but it was made more risky by subsequent lending from other banks that increased the prospect of an overall default. In this way the rapid accumulation of lending reduced the security of existing loans. The fundamental causes of the 2007 crisis can be clearly identified in previous rounds of turmoil. This is not merely hindsight; these problems were carefully deliberated over by governments, central banks and bankers themselves for over forty years. It wasn’t that policy-makers, bankers and stakeholders were unaware of the problems, but rather that they could not conspire to resolve them. More historical work is needed to identify the turning points and motivations that prevented comprehensive and innovative responses to dynamic market processes. Understanding how lessons were not learned from one crisis to another is fundamental to creating a sustainable framework for international banking and finance for the future. Some of the key issues highlighted by 1950s-1970s: »» Importance of information/transparency for efficient markets: role of trust »» Resilience to new risks: from financial innovation and changes in the external environment »» Supervision is national; market is international »» Effectiveness of internal vs external prudential supervision »» Need to ensure market compliance/engagement without regulatory capture in a competitive and dynamic market environment »» Skills gap between regulators and market »» Too many actors? national, international, multinational: regulatory competition

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 19 Cyrus Ardalan

Vice Chairman, Barclays Many of the characteristics of the 2008 financial crisis same time the interplay of macro and micro prudential are found in previous economic crises. History has considerations were not adequately addressed by an important role to play in helping us understand regulators. The consequences of excess leverage and deal with existing problems and avoid making seem to have been forgotten and overlooked as the same mistakes in the future. On the other hand, markets believed that we were operating in a new circumstances change and the lessons of the past paradigm. must be carefully aligned to the realities of today. To understand the relevance of history we also It is only through this careful synthesis of our past however need to identify the important ways the experience with the continuously changing world we markets and its participants have changed. Let’s live in, that we can help improve our decisions. consider some of the significant changes we have Financial markets have in the past few decades seen in recent years: undergone dramatic changes. Much of this has been »» Markets are significantly more complex: in the past made possible as a result of the huge breakthrough in three decades the derivatives markets have grown computer science and communications. These change from a negligible size to dwarfing the market in have greatly increased the range and complexity real financial assets. Derivatives markets provide of financial instruments, the size and importance of highly efficient means of taking market views, low the capital markets, the inter-connectivity of financial transactions costs, leveraged and in many cases markets, response times and transparency. more liquid than the cash markets. They are also Alongside this, there have been important structural opaque, have created huge interconnectivity changes in the financial markets. The role and range between market players and have led to the of institutional investors has grown sharply as has creation of highly complex financial products that the diversity of their motivations and behavior. These require sophisticated models to value; models that changes have been partly driven by the changes in in themselves are based on a view on how markets financial markets and partly by demographic trends. behave. As a result, the nature and motivation of market »» Markets are far more transparent: information is participants too has undergone significant change. available instantly and globally. At one level this These changes inevitably impact the way financial has been a very positive development allowing markets work. In the past few decades both the mode investors to make better and more informed of travel and its driver have undergone dramatic decisions. On the other hand it has in times of changes. As a result, financial intermediation, risk crisis adversely impacted liquidity and led to management and the speed and the way in which gapping in pricing and vicious downward price financial markets and flows respond to changing spirals. economic conditions and news are different. The »» The role of capital markets by comparison to banks feedback loops are similarly impacted. All these will has grown in the intermediation process: this have significant implications for the lessons we can has been a positive development in fostering the draw from history and their relevance to us today in growth of non-bank lending and helping diversify crafting a new regulatory framework. sources of funding and improve the efficiency of the intermediation process. On the other hand it The current crisis has elements that have been has added to the transparency of markets, the common to previous crisis. For example, the impact speed financial markets respond, reduced in some of rigid and fixed exchange rates as a source of respects accountability and amplified market economic instability has a long history. The current movements. The transmission mechanism for crisis has its roots in the large global imbalances monetary policy has changed. The differing impact between the US and Asia driven by rigid exchange on financial markets of the Latin American crisis rates. Similarly within the Eurozone, fixed exchange compared to the current EU crisis is noteworthy. rates have led to diverging economic performance creating over time large disparities in productivity, high »» The role of shadow banking has grown cross-border debt and credit bubbles that have been significantly. The securitization market has brought to the fore with the global crisis. until recently played an important role in the intermediation process and has the growth of Similarly the perils of excess leverage have also the repo markets and money market funds. The been a common theme throughout history. Monetary, impact of these developments has not been fully regulatory and tax policy across the West in recent understood and need to be considered. years encouraged the continued growth of leverage »» Trading behaviour has changed – Modern capital across the private and public sector. In the 2008 crisis, markets are characterised by low latency, high the regulatory apparatus did not identify and react to transparency, and complex algo trading strategies. the credit bubble around housing until too late. At the MiFID I and the development of genuinely high

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 20 speed computer trading happened in parallel in »» Consumer protection: How can we best protect the years immediately leading to the crisis. Market consumer interests? What is the tradeoff between participants are now able to internalise market data complexity and consumer interests? at unprecedented speed, which has contributed »» Recovery and Resolution: what steps need to be to atomisation of trade sizes. Participants are now taken to be able to resolve banks without the need able to spread capital across a huge number for tax payer money and avoid systemic risk and of small scale trades maintaining a very small contagion? risk exposure. The result has been a significant »» Systemic risk: How do we monitor and manage reduction in depth as liquidity has increased. Some systemic risk in an increasingly interconnected institutional investors have felt excluded from the world with large systemically important institutions? market, which has contributed to their looking to dark pools and other less transparent trading »» Regulatory oversight: what is the right structure venues. Equally, speed of data internalisation led for enhancing macro prudential regulation, micro to events like flash crash. prudential oversight of individual institutions and oversight on conduct? »» The role of institutional investors has grown sharply: This has changed in important ways the It is important that all of these questions are answered key players in the market. The growth of pension and more important that they are answered in a way funds, insurance companies and hedge funds has that ensures we do not end up being a hostage potentially important consequences for the way in to the past by addressing the weaknesses of the which markets operate. previous system and in doing so creating new risks or neglecting likely future developments. These developments have been important factors in understanding what is arguably the worst financial There is only one lesson from the history of financial crisis in history. The new fully globalised economic crises that it is difficult to dispute. We are not living in a system brings challenges of scale, regulatory new paradigm. We are never living in a new paradigm. arbitrage, and cross-border impact risks which are Crises will happen and what we need to try to ensure quantitatively new. This having been amplified and is that their damage is minimised. fueled by the transition of economic influence from In today’s world that involves ensuring that our the developed economies to the BRICs and other reforms are as well coordinated as possible across emerging markets. all jurisdictions. The G20 mechanism is not currently The regulatory response therefore needs to address able to manage the implementation of the regulatory both the historical lessons which may have been agenda agreed by its members, and as a result, there ignored, and have therefore contributed to crises and is divergence between jurisdictions. There is scope for on the other hand the many aspects of the crisis which a series of G20 working groups or colleges on each are new, and require new thinking. issue where officials from each state work together to maintain a harmonised approach. In doing so, it would also be useful to consider the appropriate regulatory response for each of the key It is also worth the respective jurisdictions taking elements of the regulatory agenda: the time to reach consensus on the direction of regulatory travel and a strong degree of agreement »» Resilience of banks: What are the appropriate on the specifics. While the momentum for change is requirements for capital, liquidity, and leverage always greatest while a crisis is with us, coordinated and maturity transformation? How do we deal with pro-cyclicality may be all we achieve from acting too global interconnectivity of systemically important quickly. In today’s fast moving markets, it can be a banks? case of the more haste the less speed. »» Structure of Banks: what is the appropriate structure of banks? Should there be a separation of banking and capital markets operations, ring fencing (ICB) or prohibition (Volcker) of some activities? »» Market Structure: should some of the structural aspects of the capital markets be modified to improve oversight, transparency and risk management e.g. central clearing of derivatives? »» Market Practice: what is the right balance between transparency and liquidity? Impact of transparency and real time data on market psychology? What steps can be taken to deal with the negative feedback loops?

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 21 Professor Charles Goodhart

Financial Markets Group, London School of Economics I am currently trying to do a research exercise border banks. On the other hand, and more commonly, examining three states which were all particularly most host countries fear that, if there is a shock in the badly hit by an asymmetric shock in, and after, the home country of the cross-border bank, that they (i.e. crisis of 2007/8. These states are Arizona, Latvia and the host country) would find that the home country Spain. I have not attempted to quantify the degree puts pressure on its own bank to lend at home, rather to which these states were asymmetrically adversely than in the host country. There is certainly evidence, affected, but it is reasonably clear that they all three particularly in Europe, that a great deal of this has suffered more from the shock than other states in been happening. The crisis has led to a considerable the same system. There was, however, no apparent amount of financial protectionism, whereby the problem for Arizona in remaining comfortably within the politicians in the home country put pressure on their monetary union of the United States. Latvia appears to ‘own ‘ banks to give priority to private sector lending be an example of a country which, although suffering at home, rather than abroad. In some ways, the a brief but intense downturn, nevertheless managed to Vickers Commission Report is an indication of the achieve an internal devaluation and adjustment while increasing tendency towards fragmentation back into remaining pegged to the euro. Spain on the other hand national banking systems, and away from cross-border has found the adjustment to be difficult, slow and on- banking. going. So, in response to a symmetric adverse shock, there My work so far, although it is far from complete, is some advantage in having banks headquartered suggests that the nature of the banking systems in in your own country, because you can put such each of these three countries played a major role in protectionist pressure on them. But this is a begger- determining whether the adjustment process would thy-neighbour policy. Which, though understandable, be more, or less, difficult and extended. The key point is not socially optimal. The implication is that in any is that the domestic banks in Spain did almost all the economic system, such as a federal country or intermediation in that same country, and only the two a monetary union, that banking should be cross- biggest, (Santander and BBVA), were international. border across all the states in that system, with the Accordingly the downturn in Spain, particularly in the responsible authority being at the federal or European housing market, fed directly through into weakness in level, rather than at the level of the constituent state. the Spanish banks, notably and particularly the Cajas. Nevertheless there are considerable obstacles to And the fiscal position of the Spanish government, doing this in the European Union, because supervision although initially relatively good, soon deteriorated to implies control of resolution and resolution can be a point at which it could not bail out the banks by itself fiscally expensive. He who pays the piper chooses the without weakening its own fiscal position excessively, tune. If resolution of a bank remains the responsibility (as with Ireland and Iceland). In turn the weakness of the nation state, then the nation state is going to in the Spanish banks made them less able to extend want to be in charge of supervision, to be assured that credit domestically, thereby amplifying the initial it is not so lax as to cause it additional expenditure. downturn. The problem with moving control over banks to the European level, much less to the world level, is that By contrast, the greater amount of financial there is not sufficient European (much less world) intermediation in Arizona was done by the large political and fiscal management and control at that federal US commercial banks, e.g. JP Morgan Chase level. and Citi. As a result, these banks were not particularly devastated by their Arizona results, a small proportion So, at the moment, when financial crisis strikes and of their overall book, and were therefore able to assess fiscal costs loom large, the European, and the global, demands for new borrowing in Arizona on a much financial system rapidly starts to fragment. In order stronger basis than if they had been focussed entirely to reverse this, if so wanted, there would need to be on that one state. By the same token, the main banks much greater centralisation of fiscal, and political, in Latvia, by size, were Swedish rather than Latvian. powers at the EU level than seems immediately likely, With Sweden getting through the crisis relatively well, though many would like to move in that direction. But, this meant that the Swedish banks in Latvia were not even if the continent should be willing to move in that dragged down by their Latvian exposures, though they direction, would the UK be happy to do so? were, in practice, severely damaged by them at one stage in 2008; and they were able again to avoid the amplifying cycle between local economic weakness leading to local bank weakness leading to less credit expansion leading to yet more local weakness. This suggests that states hit by an asymmetrically bad shock would benefit from having a large proportion of their financial intermediation undertaken by cross-

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 22 Dr Rob Johnson

Executive Director, Institute for New Economic Thinking 1. The immediate objective of the workshop is to potentially a lot to contribute to in both understanding examine to what extent historical insights about the and system design. It may also be a legitimate basis evolution of global banking can and should affect for recommending much larger capital buffers as the ongoing banking regulatory reform debate. testament to our lack of precise understanding which 2. Arguably, not enough emphasis is put on the is, of course, also characteristic of market participants question of what an ideal global financial system who are reliant upon the accepted state of knowledge would look like. about financial processes. 3. Globalized finance is said to enhance trade in The global financial system design of recent years goods and services, the global allocation of has proceeded along the lines of the logic of perfect investment capital, and the diversification of risk. markets. In such a vision of a system no entity has 4. But what kind of global finance and what kind market power and no external diseconomies between of global financial institutions best serve these one financial institution and another, or between purposes? financial institutions and the real economy, exist in a way that can do harm to those who are not directly 5. What does the historical record suggest? responsible for actions. All constraints in such an 6. What kind of global financial system will ultimately ideal system constitute inefficiencies, and should render globalization more inclusive? be removed if the logic of this vision is followed strictly. These constraints interfere with the wisdom Key questions and the role of historical evidence of market allocation of capital. We can refer to this as the question of the presence or absence of incentive The relative importance of alternative visions of misalignments where the social value of financial financial process should not be left to the Darwinist market activity is, or is not, equivalent to the private process of intimidation by vested interests through value of that system’s activity. repetition and amplification via marketing budgets. Theories adopted as conventional wisdom through A second question pertains to the ability of financial repetition and intimidation might just as well be filed markets to act as the conduits of value over time. They under fiction. Historical evidence can, and does, become the social mechanism to bridge between shed light on different financial system structures and present and future values. Expectations of future their costs and benefits for society as a whole. The developments are the key determinant of asset prices. relative reliance on the role of banking versus capital Modern financial theory works from the premise market finance, the role and impact of central banks in that an equilibrium point that anchors the system system stabilization, and the impact of short term cross in the distant future is knowable and well defined. border capital mobility can be studied as comparative This presupposition is not empirically derived, it is experiences through the examination of different assumed. historical institutions and examples. (Questions 4 and The fixed anchor in the future is not often modeled with 5 above) certainty (what economists call perfect foresight) but Studies like Robert Shiller’s 1981 seminal article in the with a certainty equivalent that is one step away from American Economic Review 2, which addressed the certainty. It is represented with a statistical distribution relative explanatory power of fundamental and rational whose parameters (moments as statisticians call them: financial theories in accounting for the variation in Mean, Variance, etc.) are known. What statisticians equity asset prices, are illuminating. He found that less refer to as the “ergodic axiom,” is assumed to hold. than 20 percent of the variation in equity prices can The ergodic axiom assumes that past is prologue. It be accounted for by orthodox theories. This finding, assumes that statistical distributions that are derived and the long history of what Charles Kindleberger from past experience are an adequate representation aptly called Manias, Panics and Crashes are, in of the future. This presupposition is to be contrasted my mind, sufficient evidence to embark upon this with the notion of radical uncertainty that has been important historical empirical inquiry regarding the identified with the thinking of Frank Knight, John nature of global financial systems and the alternative Maynard Keynes, F.A. Hayek and more recently, perspectives and findings for future design that it might Hyman Minsky and George Soros. reveal. Said another way, there is a great deal that our This presupposition has profound implications that orthodox framework does not account for. It provides result in a vision of the inherent stability of financial insufficient basis for confident system and regulatory markets. If ergodicity is valid then market participants design. Recent experience and the profound can work backwards from the anchored future to damage that our current architecture has inflicted on understand the price of assets in the present and the humankind suggest that we have a lot to learn and trajectory of their migration to that future “terminal 2 See “Do Stock Prices Move Too Much to Be Justified by Historical condition. If financial markets are not so solidly Changes in Dividends?” By Robert Shiller. American Economic Review, June 1981, pages 421-436. anchored then the question of the psychological

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 23 process employed by investors to achieve success in This design deliberately confines the spread of a very competitive world is reopened3. In addition the damage within the financial sector, and/or confines the notion of the interaction between expectations, asset damage of financial crises in ways that lessen to harm prices, incentives for the real economy and future to the real sector. In essence the vision of financial expectations becomes potentially indeterminate. process leads to vastly different designs of what is an ideal global system should look like. The combination of these two questions; the first related to the alignment of incentives within the In addition, the work of Hyman Minsky has offered financial sector and between finance and the real a vision where risk in a system is not an exogenous economy; and the second related to the inherent risk that is distributed through society by the financial stability financial markets, are vital ingredients to the system. Rather, Minsky raises the specter that the design of the financial system architecture and the design of financial systems can be an endogenous regulatory regime that is best suited to serve the well amplifier of the degree of risk that society will bear. being of mankind. (Questions 2,3 and 4 above) To the extent that the incentives of the system are designed in a way that leads to the misalignment It is here that historical experience and evidence from of the interests between the financial system and previous vivid episodes in the history of globalization the economic system as a whole one can imagine can shed light. While these issues are important to the a financial architecture that generates unnecessary design of a national financial system, the additional levels of endogenous risk and unnecessary losses. complexities associated with balance of payments adjustment, and with international regulatory harmony Financial system architecture is the creation of a increase the sensitivity of the vision of global financial human political/social system. Question 6 above markets to the two fundamental questions of financial speaks of the design of a system that is more process raised above4. inclusive, implying in my interpretation of that question, that the system leads to the betterment of more Using the logic of perfect markets and the anchor of people. Here it is important to examine the benefits stability in the future one is hard pressed to articulate and costs to financial capital, and the agents of a reason for capital buffers or cross border restrictions financial capital in the financial sector, in relation to the of short term capital mobility. On the other hand, if the well being of humans who derive their livelihood from spillovers from one financial firm to others (sometimes labor income, or other sources of income. The relative referred to as contagion) or from finance to the function power of these different actors in society can over time of the real economy are in fact large, then systems contribute to a distribution of power, and therefore design to maximize the mobility of capital might be income, that impacts the distribution of cumulative in actuality a design that amplifies the propagation benefits of global financial system design. The of disturbances occurring at any node in the system. question is very important in the current context where Furthermore, either as a cause, or as a consequence, the social mechanisms for sovereign debt restructuring of the propagation of a shock to the financial system, are of acute importance. In fact when the stakes of a system where a certainty equivalent anchor in the this dynamic interaction are examined through the future is absent, (a world of radical uncertainty) is not study of “vested interests” of various sorts one can a world that can count of the stabilizing tendencies better comprehend the process of how society arrives to grab hold and help the financial system exhibit at the system designs that we have experienced at resilience and restorative properties. various times in economic history and the various A system that exhibits this unstable nature may institutional arrangements associated with each. The be better modeled as an analogue to a network or logic of collective action likely illuminates some of this biological system where disturbances (epidemics) process. The relations of institutional power to system should be quarantined to diminish the propagation design is an important awareness to cultivate, both of the disturbances to attenuate their impact on the historically and in the present circumstance. As is economic system, and therefore enhance the system’s demonstrated in many aspects of life, might does not resilience. Thus a different vision of financial process always make right. Seeing things in a comparative leads to a different logic of regulatory and architectural historical perspective can perhaps illuminate how design leading to an ideal global financial system. various systems have come to be adopted and how human interactions have influenced the distribution of the burdens and the occurrence of unnecessary losses resulting from a particular system during over a variety of historical periods.

3 See David Tuckett’s The Mind of the Market for a treatment of psychological process of unanchored financial expectations. 4 On the international consequences of short term capital mobility within a system, particularly as they relate to the current design of the Euro zone, see Paul DeGrauwe’s recent paper entitled, “The Governance of a Fragile Euro zone.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 24 Pierre Keller

Former Senior Partner Lombard Odier & Cie; Geneva The key to a more stable international financial system solution but no absolutely satisfactory method has is to find a proper equilibrium between free market yet been found), forces and regulatory controls. Indeed, after the recent »» The supervision of non-banking financial economic and financial crisis we have experienced, institutions (assets managers, investment trusts, it would be difficult to defend the point of view that insurances, pension funds, etc), markets alone are apt to preserve or restore an »» The functioning of financial markets (transparency, acceptable degree of stability by themselves without derivatives, protection of investors, high speed the need for some supervisory regulations and controls trading, etc.), by the authorities. The question therefore is really what kinds of regulations and controls are necessary and »» Fiscal conformity and capital movements, what authorities should be designated to apply them, »» The organization of the respective supervisory without hampering the necessary flow of financing authorities, in our economies and above all without preventing »» The role of Central banks, the adjustments or innovations in the system which »» International governance in the financial field. might be required to improve its efficiency or to adjust it to changing conditions. In addition, there is the Being a practitioner, I can only make a very limited very important issue of international cooperation or contribution to this historical debate. I will therefore integration within the global financial system itself. I restrict myself to a few brief comments on three am a convinced defender of free enterprise, but I do specific cases where recent history has, it seems to believe that the above considerations should always me, clearly indicated the direction in which one should be kept in mind. go: hedge funds, derivatives and financial instruments and proprietary trading of banks. In trying to devise the main elements of a future international financial system, the Oxford Financial Hedge funds Globalization Workshop has rightly decided to look Originally, they were meant for sophisticated investors, first at what history can teach us in that field. While we who were conscious of the risk they were assuming. are operating nowadays in a different economic and While these funds are intended to achieve good technological environment - we are not anymore living performances in rising markets and less unfavourable in the world of the gold or gold exchange standard, ones in declining markets, their overall record is but with fluctuating exchange rates, huge capital actually mixed. Many have been created and many movements, instant communications and a financial have disappeared. Still, they represent, at this stage, a sector which has grown out of all proportions - there very substantial asset class that cannot be overlooked. are still undoubtedly lessons to be drawn from past But what is important for our discussions is that beside experience. In a wider perspective, I would assume the case of Long Term Capital Management - which that such an analysis will deal with the numerous was skilfully dealt with by the Federal Reserve of New financial crisis which occurred over the years and York - hedge funds have not been a significant factor which are so well described by Reinhart and Rogoff. of systemic risk in the recent crisis. This does not For other more specific or technical aspects, one will mean that some improvements are not called for, such probably have to look at more recent periods and as a greater transparency towards the supervisory sometimes even to some very near to us. Furthermore, authorities, the prohibition of naked short selling and one cannot overlook matters of economic and the possibility to limit leverage. As is well known, there monetary policy which are, of course, very closely are some attempts underway to tighten the rules for linked to any financial system. But this exercise should hedge funds, which in several cases seem to me to go certainly increase our understanding of the workings too far, but that some additional rules are needed is of an international financial system and contribute to clear. a reflection on the essential factors needed to make it Derivatives and financial instruments both more stable and more efficient. Then we should always try to relate this research to Their use has developed considerably in the last some of the specific questions on the organization few decades and they have become a major way and functioning of a financial system as we conceive it to control risk or balance portfolios, but conversely today. For convenience purposes, I list the main points they have also contributed to creating a new and in this regards below: significant element of potential instability into the financial system. Without adhering to Warren Buffet’s »» The organization and shape of the international famous remark, recent experience shows clearly banking sector (capital and liquidity requirements, that the use of derivatives and financial instruments size, scope and extent of its activities, systemic should be better organized and controlled. I fully implications (too big too fail) on which various share George Soros’ view that they should, above attempts have been made to find an adequate all, be standardized, more transparent and that their

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 25 transactions should be centralized in a regulated been achieved in this regard through central banks exchange with proper guarantees of collateral and cooperation, the multilateral financial institutions and joint responsibility for counterparty risks. With regard hopefully some regional institutions, but there is still to financial instruments – some of which have become a long way to go towards a more integrated world so complex that they are difficult to understand by financial system. ordinary people - one could envisage the creation of an international board granting certificates of quality for new instruments sold to the public. Proprietary trading of banks If there is one case where there is clear evidence that something has to change, it is that of proprietary trading of banks, which has produced huge losses in recent times and about which former Chairman Paul Volcker has proposed new rules restricting such operations. At the same time, it must be admitted that these restrictions are not so easy to carry out, because it is not always simple, in practice, to dissociate operations of market making which are legitimate from those which represent a real bet on the part of the bank itself (although the huge existing trading desks are certainly not necessary for mere market making). It would probably not be practical to go back to the old Glass Steagall Act, particularly on an international basis, but other methods of limiting at least retail bank’s trading activities or setting “ring-fencing” around them have been envisaged, such as those for instance suggested in the Vicker’s report. It seems to me absolutely essential to restrict the trading activities by bank which are basically financed by public deposits, are systemically important and in case of failure would have to be bailed out by the States, i.e. with tax- payers money. To revert to the broader context in which financial systems operate, I would like to call the attention of participants to four more general comments. The first concerns the use of monetary policy, which has led in the past to periods of very high liquidity and very low interest rates, and which is undoubtedly responsible, to my mind, for the extravagant level of credit creation we have experienced during the past 30 to 40 years and has contributed to a number of destabilizing financial bubbles. Secondly, there is the question of the economic and societal usefulness of the enormous increase in size of the financial sectors in our advanced economies which has occurred in recent times, with all the excesses that this evolution has entailed. As Lord Turner has mentioned a number of times, one cannot face such an extension without questioning whether it has really contributed to our general welfare. Thirdly, the current vicissitudes or the European currency have, of course, a very serious impact on the international financial system and can therefore not be completely absent of our reflections, but that opens a subject which might go far beyond the scope of the workshop. And above all fourthly, there is the crucial question of how one can arrive at a proper system of international governance in a field where globalization has reached an extraordinary high degree but where national governments are still the deciding authorities. Some progress has

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 26 Professor Amar Bhidé

Thomas Schmidheiny Professor, The Fletcher School of Diplomacy, Tufts University The globalization of finance5 supposedly enhances the The technology also tends to channel resources to allocation of capital and the distribution of risk. I argue activities that at least on the surface can be easily that it actually tends to misallocate resources and automated and modeled, such as housing finance and destabilize the world’s economy. I also suggest that derivatives trading and away from those, such as small the problems are better addressed by radical reforms business lending, where human judgment seems more within existing regulatory jurisdictions than by new obviously indispensible. Like Willie Sutton, the chief global rules. executives of banks tend to follow the money. Yet the capacity of banks to lend to small businesses remains The dysfunctions of mechanistic finance crucial to the economy. In my 2010 book, A Call for Judgment I offered the The new finance, said to improve risk bearing, in fact following critique of modern finance: makes economies less stable. Humans are fallible Funding requests (e.g. a homebuyer seeking a whether they are making case-by-case lending mortgage, an entrepreneur venture capital, or a small decisions or constructing a model. With traditional business a line of credit) originate in idiosyncratic lending however mistakes don’t imperil the economy forward-looking judgments. Financiers in turn need to unless there is a mania afoot. But when all lending make judgments-about-judgments. They must have is based on a few models, mistakes can trigger a ‘on-the-spot’ knowledge of the specific circumstances widespread collapse without any mania. and engage in a dialogue to understand the Arm’s length financing through standardized, assumptions and reasoning behind the financing liquid securities does allow easy diversification but request. On-going relationships are also valuable that doesn’t necessarily reduce risks. Effortless because they facilitate adaptations to unforeseen diversification in fact creates free-riding problems with contingencies. every security holder relying on the others to provide Although venture capital and small business lending monitoring and oversight. Collective action problems remains decentralized and based on judgment and also make ongoing adaptations (whose need is relationships, the vast expansion of finance in the last inevitable in a dynamic economy) difficult: the diffused three decades has been mainly through instruments holders of mortgage backed securities cannot easily such as asset backed securities and OTC derivatives renegotiate a delinquent loan. created through a mechanistic, arm’s length process. Model based finance undermines the ability of In fact computerized models are as essential for regulators to monitor the solvency and liquidity of modern finance as the assembly line was for the banks. A typical bank exam once included scrutiny automobile industry. Without such models derivatives of every single business loan and a large proportion outstanding could not have increased nearly sixfold of consumer loans. Capital adequacy was secondary from $95 trillion to $ 684 trillion between 2000 and mid- and a matter of judgment: examiners would figure out 2008. how large a buffer a bank ought to have, taking into The mechanization is lauded for reducing costs account its specific risks. As examination of individual and increasing lending. But, in finance, more isn’t risks became infeasible, regulators came to rely necessarily better -- how well bankers discriminate primarily on standardized capital requirements. The between responsible and reckless borrowers matters requirements were supposed to be risk weighted, but a great deal. And in this, mechanization offers a false the risks were defined in terms of broad categories, economy. not case-by-case. For instance under internationally agreed upon Basel rules, all business loans were Central planners misallocate resources, Hayek deemed to be five times as risky as all investment pointed out in 1945, because they have to rely on grade mortgage backed securities. highly abstracted statistics that ignore the unique circumstances of time and place. Automated model- The new technology has legitimized unmanageable based lending based on a handful of variables suffers mega-banks. The difficulty of managing individuals from this very problem. Moreover models extrapolate making judgments once limited the size and scope of from historical data, whereas an essential feature of the financial institutions, especially in contrast to industrial modern economy is unceasing human effort to make firms. The belief that mechanistic finance is amenable the future different from the past. to by-the-numbers control, has justified the creation mega-banks such as JP Morgan whose 250,000 plus employees now outnumber Dow Chemical’s 5 I use this term to refer to the purely financial cross-border transactions by about five to one. In reality the sprawl has made that don’t directly originate from trade in goods and services or the transfer of knowhow. Examples include German banks buying Greek effective oversight impossible even for the banks’ own sovereign debt and UK fund pension funds buying the stock of managers. Brazilian electricity companies. I exclude finance necessitated by “real” commerce, such as trade credit and investments in joint ventures. In other words my analysis of the globalization of finance does not cover the financing of globalization.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 27 Global Ramifications The sovereign debt malaise Mechanization has spurred an unprecedented The 2008 debacle has now morphed into a protracted globalization of finance especially in activities that sovereign debt malaise centered in Europe. Here too have nothing to do with real cross border commerce mechanistic practices have played a leading role. such as mortgage lending or speculating on the As Edmund Phelps and I have argued, countries default of government bonds. cannot get overly indebted on their own: excessive Traditional finance, based on on-the-spot judgment, borrowing by governments requires lenders who required a local presence. Venture capitalists rarely overlook the fact that sovereign debt is in many made investments further than they could drive. ways worse than unsecured private debt or junk Banks that did business outside their home markets bonds. Governments provide no collateral and offer focused on multinational clients and the financing of no covenants to restrain profligacy. As Greece international commerce. If they did seek domestic has shown, governments do not pay penalties for business abroad they established a local capacity to fraudulent accounting. There is neither a legal process make case-by-case decisions. for forcing a state to pay off creditors, nor a legal venue for debt renegotiation. This continues in activities and institutions that retain the traditional approach. U.S. venture capital firms Purchasers of sovereign debt, therefore, should be for instance have set up offices in Israel, China and extremely careful – either shunning spendthrifts or India. Sweden’s Handelsbanken (that now operates in demanding higher interest rates to offset greater risk. Britain and the Baltics) still follows the church steeple Making excessive borrowing expensive or impossible principle of branches lending to businesses visible would cap deficits. from the church steeple in the middle of their town. Unfortunately, banks enabled excessive borrowing Transactions in derivatives or asset backed securities by reckless governments by accepting interest rates created by mechanistic finance however can be that were only a bit higher than the rates that more done from afar. All the risks and returns are thought cautious governments had to pay. The 2008 crisis to be captured by a few variables whose values are should have served as a sharp reminder of the need available to anyone with a computer terminal. Indeed for careful credit analysis. Instead, banks increased claims whose values depend on what happens in indiscriminate purchases of government debt; their some remote place are thought to provide the kind financial engineers and derivatives traders also of diversification free lunch celebrated by Markowitz. turned to this debt as raw material after new subprime They elevate portfolios to a more efficient frontier. securities became unavailable. The new technology, not just the products it created, Banks had been burnt by sovereign borrowers before proliferated globally. Unlike traditional practices that but regulators apparently forgot and helped bankers are hard to codify and embedded in organizational to forget. As mentioned, top-down rules required traditions, the techniques of model based finance can banks to hold capital against broad categories be easily replicated; and, because they are based on of assets. Very little capital was required against principles that are supposed to universal, they can be holdings of sovereign debt, because it was ruled to applied anywhere. Mechanization also offers financial be virtually risk-free. In fact, holding government debt institutions everywhere the promise of rapid growth helped banks to meet their liquidity requirements. Not in profits – and compensation for top executives. It surprisingly, they loaded up on the highest-yielding makes no difference whether a chief executive is bonds, ignoring whether the extra interest justified the based in Frankfurt, Zurich, London or New York when risks. Blind bond buying in turn allowed governments quantified risk metrics constitute the sole control to accumulate debts and deficits on a scale that mechanism. virtually ensured defaults. Therefore even if many financial practices were Unilateral reform pioneered in the U.S., like the flap of the proverbial It seems natural to look for international solutions to butterfly’s wings they set off tornadoes afar in 2008. the problems of globalized finance but the realities As house prices in Las Vegas collapsed, subprime are daunting. If coordinated international action mortgages owned by Norwegian municipalities north of cannot stop brazen piracy off the Somali coast, how the Arctic circle plummeted. The once staid Deutsche effectively could it control the covertly risky behavior Bank was as exposed to financial losses, lawsuits and of financiers? Moreover while the international regulatory sanctions arising from its underwriting and standardization of weights and measures is a good derivative operations as Citicorp and J.P. Morgan. thing, one-fit-all banking rules such as the Basel Uncertainty about the solvency and liquidity of mega- capital requirements often do more harm than good. banks triggered a global bank run. Reforms tailored to domestic conditions 6 offer a more promising solution.

6 Or more precisely, to conditions in the same monetary authority. The absence of Eurozone-wide deposit insurance – with complementary bank-regulation -- poses a mortal threat to the common currency.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 28 Reinstating and expanding the 1930s Banking The reforms could also dampen trade imbalances Acts (aka Glass-Steagall) in the U.S. would be a and reckless excessive borrowing by governments. great advance. Specifically I have argued for fully Countries can import much more than they export guaranteeing all deposits – with tough limits on risk- -- and their governments can spend more than they taking by banks to offset moral hazard problems and raise domestically -- only if a foreign lender or investor make unlimited insurance credible. If losses are covers the shortfall. If banks weren’t allowed to lend, thought to be unbearable, guarantees are useless. many countries wouldn’t have large trade or budget deficits.7 Interest rate caps, indexed to T-bill rates, would therefore be reinstated, ending the competition for To conclude: mechanistic risk-taking by banks -- fickle yield-chasers that helps set off credit booms and be it through the securitized mortgages, complex busts. Attracting yield-chasers impels banks to take derivatives or dodgy sovereign debt -- is not just imprudent risks to pay higher rates and exposes them a problem for bank stock or bond-holders. Like to mass-withdrawals. drunk driving it is a public menace that must be proscribed, not merely discouraged through taxes or Limits on the assets and off-balance sheet exposures cushioned through capital buffers. And, it will take would be stringent but simple. Banks would be radical country-by-country reforms to restore case- restricted a few enumerated activities, principally by-case judgment, not a watered-down international making traditional loans and simple hedging consensus. operations. A landmark charter granted to the Commercial Bank of Albany in 1825 offers a good model. It gave the bank specific powers to carry on the business of banking—and excluded everything not expressly granted. No model-based risk-taking would be allowed; banks would be required to document their credit analyses for every borrower. And the terms of loans and hedges would have to be comprehensible to a regulator of average education and intelligence. If the average examiner couldn’t understand an instrument or contract, it wouldn’t be allowed. The rules would apply to any entity taking short- term deposits, terminating the shadow banking system. Banks would have to shed their derivatives business and end their involvement in asset securitization – no financing of warehouses of loans awaiting securitization, no lines of credit backstopping securitized assets and no buying of the securities. And without the involvement of banks the mass-production of derivatives and securitized assets would likely cease. (Five mega-banks, led by JP Morgan, now account for more than 90% of derivatives outstanding in the US because transactions with a too big to fail institution are regarded as having no counterparty risk. Concerns about the creditworthiness of non-bank derivatives dealers, whose liabilities weren’t guaranteed, would naturally limit the size of the market.)

7 The U.S. is a special case: purchases of U.S. Treasury bonds by the Chinese government have contributed more to financing the U.S. trade deficit than private lending. That bond buying, attributed to a “savings glut” in China, is said to have forced down interest rates and triggered a consumer borrowing binge in the U.S. Now try the following thought experiment: would consumer borrowing have exploded if lenders in the U.S. had been more prudent? And without credit-fueled consumption in the U.S., would China’s trade surplus and savings glut have been as large?

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 29 Dr Peter Kurer former chairman, UBS, Zurich Politicians, policy makers and regulators around the Since its beginning, presumably the active trade going globe dream of a global bank model which runs at on in the vast Roman empire, globalization evolves a low level of systemic risk but, at the same time, along the same trajectory: It starts with single trade supports and fosters economic growth. In contrast, I over long distances, then goes on to more organized would like to argue that there exists neither in reality export and import structures such as operated, in the nor in history a uniform or at least prevailing model of ancient world, by the Nabataeans or other trading a global bank which could meet these criteria. As a tribes in the Middle East or later by the Dutch, Scottish matter of fact, in real life there is no standard model at or Swiss trading companies; as a next step in the all. There are about ten banks in the world which one evolution comes local manufacturing by foreigners could call “global banks” but, upon closer scrutiny, and general foreign direct investments in real estate, each of them follows a special and distinct strategy infrastructure or technology; even later, investments which distinguishes itself very much from the one of start to flow in both directions; and finally, global its global competitors. A few of them are transaction- integrated structures are created, be it in technology oriented investment banks which concentrate on (Google), transportation (Star Alliance), finance (the trading, underwriting and corporate finance advice. global banks), global supply chain management or Others are universal banks, often with a bias for even fashion brands. a particular product such as retail, commercial A phenomenon closely attached to this evolutionary lending, infrastructure finance, trade finance or wealth concept of globalization is the rise of the middle class management. Still others essentially are a transnational in emerging markets. It also has a close association string of local retail banks, loosely held together by a with some aspects of our analysis, though not on first common roof of some limited corporate functions. sight but upon closer observation. Globalization is This absence of standardization makes it very hard about bringing poorer countries into the flow of goods to define an optimal model which would support and services of the broader world and thereby allowing globalization and growth at low risk. By the same them to grow their economy and erase poverty. You token, I reckon it will be difficult to find a historical bank can measure the stage of this evolution by many model which would serve as a lodestar for a more development parameters. But for this discussion, efficient and, at the same time, more secure global there are some simpler means to gauge the rise of a banking paradigm. Would it be the early merchant middle class. Look, e.g., at three things in a particular banks, established by the trading companies and run country: first, production and use of cement; second, by partnerships? Or the extension of a colonial retail the existence or absence of supermarkets; third, the and commercial bank bureaucracy which assures development of the retail banking system. In some a multitude of commercial banking transactions of the poorer countries of Africa, you will hardly find including lending to private households and small any cement production. But if you go to Nigeria or businesses but which shies away from capital markets, Thailand, some people have made huge fortunes by wholesale lending or financial innovation? Or huge, running big cement factories. By the same token, in highly efficient trading utilities which serve as reliable Ethiopia you will rarely find a supermarket, and retail brokers around the globe but are carefully ring-fenced trade is confined to street markets or mom and pop from any deposit taking or proprietary trading activities, stores at best. By contrast, in southern Africa or South following in the footsteps of the houses of Morgan or East Asia, you will find supermarkets which are at the Nomura? Or super-smart corporate financiers who same level as here (and sometimes higher). Again, put together the perfect deal, epitomized by firms like in lower developed countries, there are hardly any Lazard or Rothschild? retail banks, a minimal distribution of bank bills and transfers often assured by the central bank, whilst, I do not believe that history will yield such a model. to take an example, Namibia or the Philippines have Nonetheless, historic analysis is important here. sophisticated retail banking groups. All this has to But it should not centre around the search for a do with the rise of the middle class. If people leave defining model. Rather, I propose to make a kind of a subsistence agriculture, earn money beyond their daily functional-structural analysis of globalization, banking needs, start to save and can make some economic history and present day reality of global finance. choices, they need cement to build houses, they want The key questions in such an analysis are: what to go to supermarkets to buy branded products and, functions have to be fulfilled in a globalizing world finally, they need retail banks to keep their savings and and which financial structures are required to meet help them to finance their house. such functions? And which structures can act as a substitute for another; and if the functions develop and differentiate over time how will the structures adopt; and which policy supports fast adaption at lowest risk possible?

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 30 If you travel along this continuum of globalization, Thus, even though global banks fall short of the increasingly you will have very particular needs of expectations we might have for their contribution finance as the example of retail banking has shown. in a globalizing world, and even though they might For the purpose of this discussion and by way of be further weakened in the ongoing crisis and the simplification, we can distinguish the following of such regulatory response to it, there exist all the building financial functions: blocks for restarting global growth and further globalization. But the bleak reality is that the global 1. Trade requires the ability to settle accounts over finance system is dysfunctional in many respects. See long distances. the following examples: 2. Export/Import will need a more elaborate system of trade finance. »» Lending has become an issue and credit crunch a reality in many countries. Cross-border lending 3. Foreign direct investments demands a multitude is an even more serious issue in a fragmentizing of financial services such as corporate finance world where banks are called to the duty to advice, cross border and wholesale lending, finance local companies. Central Eastern Europe creation of local capital markets and sophisticated (CEE) was one of the fastest growing emerging forms of project finance and infrastructure funding. markets since the nineties. But the region 4. Global integrated systems will lead to global depended heavily on lending from Austrian and capital markets. other foreign banks. Now these banks have 5. The rise of a middle class needs, as shown, a to cut back on cross-border lending in view of functioning retail banking system which, in line new regulatory capital requirements and on- with the development of the middle class, has to going loss absorption. As a consequence, a add ever elaborate products such as new forms of local entrepreneur in, let’s say the Ukraine, has mortgage, credit cards, or saving instruments. to pay interest of 18 percent to its local bank 6. Once the top of the middle class gets wealthy, on a commercial loan which prevents him from it first requires functioning and internationally expanding his business. The same applies in versatile retail brokerage and then, at the top end, Poland, Serbia and most of the CEE which will a full-fledged wealth management. bring the region into a slump. 7. Along the lines, the exporting emerging markets »» Trade finance was a traditional stronghold of will build up currency reserves, create sovereign French banks which now leave this business; it will wealth funds and need institutional asset take years till other players will be able to fill the management services. gap. 8. An important aspect of globalization is bringing »» Capital markets, in particular debt capital innovation from highly innovative countries of the markets outside the U.S., are too weak to play old world to the emerging markets where they an efficient role in financing. Both in Europe and will be used in cheap mass production. This all the emerging markets, debt financing is still transformation of innovation to manufacturing and dominantly rendered through bank lending which sale needs risk financing, commonly called venture is dysfunctional in many respects: in a credit capital. crunch the whole economy is hit immediately; bank lending is exposed to political pressures and Most of these services can be provided by a global bargaining; and bank lending brings the heavy bank. And some of the global banks try to render concentrated risk which should be avoided as we almost all of these services. But this is only part of have learnt in the crisis. the story. Many of the functional requirements of a globalizing world are met by players other than global »» Public companies increasingly become victims of banks. There are many reasons for this. The global regulatory burdens, NGO attacks and over-zealous banks are too weak to guarantee market efficiency investigations. In the old world, their number has over the whole specter. Fortunately, there are many gone down and IPOs have become rare. This structures who can substitute: Settling accounts over weakens equity capital markets. long distance can be done by money transfer outlets »» One of the early victims of the crisis were monoline or credit cards; corporate finance can be rendered insurances. Since they are broken it has become by boutiques; wholesale lending can be replaced by very difficult to finance complex infrastructure efficient debt capital markets; private equity or family projects through insured bonds in the absence equity in Asia can step in for equity capital markets; of government funds or guarantees which have hedge funds can help non-performing loan or capital gotten rare over all the public debt issues. markets to work; fund managers and alternative »» Regulators around the world have increased investment managers provide high end wealth regulatory pressures on wealth management, management. asset management and alternative investment vehicles, often with the result that it gets more difficult for the wealthy to have their wealth managed on a multinational level.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 31 »» And in many places, it has become extremely difficult to open a bank account if one is not a resident. »» And to conclude with a brief, sad note on venture capital: In a world awash of liquidity, it is difficult to get finance for innovations so desperately needed for growth. Thus, a structural-functional analysis suggests that our main worry should not be the global bank concept but the stage of the global finance system. This system, I think, is not on the way to help restarting the global economy. Quite to the contrary, it loses ground and strength because politicians, policy-makers and regulators around the world fail to support it. So what should be done? I see the following policy requirements: »» Establish a policy agreement that a growth- oriented globalization needs a vibrant global finance system. This can and should not be left with the global banks. There are good reasons to cut back on their often excessive risk appetite. But then, policy-makers should do something positive about the rest of the finance world with a view to allow appropriate substitution. All this needs a complex policy mix. »» Deepen the capital markets with a view to make debt financing more efficient and take some of the concentrated risk off the shoulders of the big banks. »» Make the public company an attractive concept again with the purpose to make equity financing more efficient. »» Abstain from heavy-handed regulation of wealth managers, asset managers and alternative investment advisers such as private equity and hedge funds. These financial service providers import limited systemic risks and many of the regulatory efforts in this area are counterproductive and promoted simply for political reasons. The more we leave them freedom, the more they can fulfill their role as fast moving gap fillers. »» Support the creation of efficient retail banks in the emerging markets and help international banks to enter retail banking there. »» Cut excessive risks of the global banks but allow them to bring all their depth of knowledge and superior systems to the table and make money with this.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 32 Roberto Jaguaribe and Augusto Cesar Batista de Castro

Ambassador of Brazil to the United Kingdom, and Economic and Financial Affairs Officer, Embassy of Brazil Financial markets must support the development of the risk-taking whilst promoting a culture of responsibility, real economy. in which both managers and main shareholders are effectively liable for bad management. The ongoing economic crisis made dysfunctional elements of the global financial system all the more Under the right kind of incentives, Brazilian banks visible. These problems not only diverted the financial are very profitable and very conservative at the same system from achieving that goal but also set the time. Our regulatory capital requirement is 11% of context for the worst crisis since the Great Depression. risk-weighted assets, already above Basel criteria, but banks typically hold more than 16% of RWA. Around In our perspective, any long-term solution to the 90% of all transactions involving OTC derivatives challenges posed by the recent crisis must necessarily in Brazil are, furthermore, cleared through central deal with three main issues: counterparties. »» a full acknowledgement of the new international Another aspect of the Brazilian financial system, which economic order; has proved to increase the resilience of our economy »» a thorough reform of the international financial to external shocks, is the existence of development institutions (IFIs); and institutions. Created in a historical context of scarce »» a new institutional framework for the global finance capital flows to savings-thirsty developing countries, industry. those institutions are key to channelling much-need Brazil is fully engaged in the debate both at the resources aimed at long-term investments - for G20 and other international bodies on how to best instance, in infrastructure projects -, providing, at accomplish this agenda. In this paper, I would like to times of economic distress, a sound buffer against start by briefly highlighting some aspects of Brazil’s herd behaviour and the pro-cyclical nature of financial recent experience in reforming its financial system. markets. That may be useful to understand both our vision Although we are perfectly aware of our limitations and of a fair and inclusive financial system and also our the huge challenges that still lie ahead, we strongly standpoint at the international level. Secondly, I will believe that a healthy combination of strict regulation, try to summarize the latter, with a special emphasis transparency and disclosure, as well as an institutional on the requirements for the consolidation of a new framework able to counter pro-cyclical bias and international economic order, the reform of the IMF and other market failures, can make the interests of the the World Bank and the construction of an adequate financial institutions more aligned with those of other institutional framework for financial institutions. businesses, taxpayers and citizens in general. Brazil’s experience in reforming its financial system The underlying international economic order After a long period of high inflation, Brazil had to make The Bretton Woods monetary and financial order important adjustments in its financial system after the was somehow a compromise between economic macroeconomic setting was stabilized in the mid- integration and the construction of the welfare state. 1990s. Most banks and economic players struggled This ‘embedded liberalism’, in the felicitous definition to operate in the new economic environment, as they by John Ruggie, was then jeopardized by the were used to a short-term horizon of planning. In globalization of finance, especially from the 1970s addition, Brazil had many provincial banks engaging onwards. in quasi-fiscal activities and thus creating an unstable environment both for the financial system and for The new mind-set, for which the opening of the capital public finances. account became a new orthodoxy, supposedly found its justification in the expectation that freer capital Two governmental programmes, the so-called PROER flows would lead to a better allocation of resources. and PROES (Portuguese acronyms for Programme Furthermore, financial markets would provide the for Restructuring the National Financial System and much-needed discipline to profligate governments. Programme for Reducing the Participation of the State in the Banking Sector), implemented at the time, laid As we now know, several aspects of this new order the foundations for a healthy, highly regulated and have, however, been badly neglected by the new balanced financial sector. orthodoxy, namely: It is also worth noting that Brazilian banks and other »» financial systems across countries show a great financial institutions have been strictly regulated for a variation not only in terms of depth and breadth, long period. Since at least the 1960s Brazil has had but also in the nature of its connections to the real institutional instruments to intervene in banks in the economy (even within the G7, the so-called “Rhine case of misconduct or threats to the stability of the capitalism” is very different from the “anglo-saxon financial system as a whole. Our system, moreover, model”); has always been careful in preventing excessive »» there is no equivalent to a proper regulatory and

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 33 supervisory body at the international level – the The diversity of interests, of cultural backgrounds, paradox of a single integrated financial market of geopolitical concerns is not its weakness but the and fragmented polities has not received due very core of its strength. There has been an excess consideration; of the “like-minded” countries approach. No long- »» there is a considerable democratic deficit in term solution to any global problem is feasible without the way IFIs work and conceive of very invasive proper representation of diverse-minded countries in policies to fight economic crises, which, up to the global institutions. 2010s, were more common in emerging markets; Our common effort to reform these institutions should »» the mere harmonization of regulatory standards be regarded as an auspicious sign or the prelude of developed countries, therefore, might not be of a more democratic and plural international order. enough to prevent future economic crises. There has not been any strong revisionist impulse; no Although the prevalent mind-set has changed completely alternative order has yet been proposed. considerably since the Asian crisis and, more notably, Instead, big emerging economies are struggling since the 2007/8 crisis, we believe that a proper to make the same old international institutions reckoning of the mistakes and gaps in the previous more democratic and open to different – but not international economic order is still lacking. incompatible – views on security, development and other important issues on the international agenda. The updates in the membership of institutions such as For their own sake, Western countries must realize, the Financial Stability Board and the Basel Committee once and for all, that convergence will not be achieved on Banking Supervision; the consolidation of the by emulation of a pretence moral superiority but by a G20 as the main international forum for economic common endeavour by all actors to reach a shared cooperation as well as the ongoing reform at the centre. IMF are very important first steps in setting up a new international economic order, but which still fall short of The reform of the IMF and the World Bank completing the task. The resuscitation of the reform processes of the Most likely, we currently find ourselves in a kind Bretton Woods institutions, after the 2007/8 crisis, of interregnum, between the end of the old order seems to have been motivated more by fear of and the rise of a new one. We believe that the most irrelevance than by a genuine desire of more plural important thing at moments of this kind is to keep institutions. Self-insurance policies after the Asian one’s mind open instead of resorting to old prejudices crisis came close to making those agencies financially and intellectual constructs. As Keynesianism unviable. became the mainstream economic theory after the Although some progress has been achieved recently, turbulent 1930s, perhaps what we need now is a those institutions are still far from representing not only new economic and political way of thinking, capable the economic weight of emerging economies but also of (i) reconciling the neoclassical school with the their plurality of views. The formula on the basis of contemporary requirements of a new paradigm which the IMF quotas are allocated, for example, still of sustainable development; and (ii) laying the disproportionately values concepts such as ‘economic foundations for renewed cooperation among diverse- openness’ - less precise and measurable than the minded countries, in a context of continued increasing more objective ones such as GDP. interdependence. Another good example is capital controls. From hard We are not likely to be successful just by re-fuelling a orthodoxy, which came close to being included in model based on unrestricted credit for consumption. the IMF Articles of Agreement in the 1990s, the Fund At the same time, we shall not curb the fair aspiration has recently nuanced its view, recognizing the role of of billions of people that still do not have access to managing capital flows under certain conditions. This basic material comfort. Striking a fair balance between highly relevant intellectual reappraisal, however, has these seemingly opposite goals should be at the core not been translated into the political sphere. of any possible new economic model. At the G20, some countries seem yet reluctant to As far as the international monetary system is assess the effects of expansionary monetary policies concerned, we must not neglect the links between on exchange rates, whereas the same countries do the exorbitant privilege of issuing international reserve not shy away from reiterating the desirability of full currency and the build-up of global imbalances that commitments to the opening of the capital account. A paved the shaky ground to the latest crisis. Brazil and much more balanced approach is needed if we really other large emerging countries support further work on want to build confidence on the IFIs. a possible enlarged role for the SDRs, notwithstanding our recognition that a plain international currency Emerging economies will never have an appetite to requires governance mechanisms that do not seem fully commit to institutions that they perceive as mere feasible yet. As in the Chinese proverb, however, a agents of developed countries’ national interests. long journey always starts with one first small step. Needless to say, the selection of chairpersons and managers for those institutions, as well as the In this regard, we should be very careful about narrow persistence of a sort of veto power that some countries assessments of the potential of forums like the BRICS. enjoy, are also part of this equation.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 34 Development institutions such as the World Bank For this to happen, much more progress is needed must also wake up to the new reality. In the last in issues such as the shadow banking system, decades, the Bank reduced dramatically its loans to international resolution of financial institutions infrastructure projects in favour of concepts such as (especially the “too important to fail” problem) and the good governance. It has also been guided by the view regulation and transparency/disclosure of transactions that it should only focus on the poorest countries in the involving OTC derivatives as well as any other financial world. To a certain extent, the Bank has fell prey to aid products. Innovation in finance will only be a benign policies of developed countries. process if we can at least assess its implications for the real economy. Fortunately, for those countries where capital is scarce, traditional development institutions and donors are Conclusion no longer the only source of resources. International All we should offer, at this stage, as a sort of aid is not always conducive to development. The conclusion is what we consider to be the necessary latter involves a complex structural transformation of a foundations of a new international economic order in country and a society. The mere transposition of alien which the globalization of finance is an asset and not a institutions and notions of governance has already liability. proved to be counterproductive. 1. Firstly, a renewal of economic and political theory A new institutional framework for global finance capable - as Keynesianism was after WWII - It is a big mistake to see prosperity and innovation of reconciling integration with development, as the results of the free market forces exclusively. coordination and diversity. The strength of capitalism resides as much in 2. Secondly, a full acknowledgement of the new strong institutions as in the freedom of the players. reality, upon which the new international economic Unrestricted freedom leads to abuses and to order should be built. institutional capture. We need, furthermore, decide 3. Thirdly, international financial institutions that whether a financial market that is many times the size effectively translate that new order into proper of our real economies is really functional. economic governance. Economic development, moreover, is a complex 4. Fourthly, an institutional framework for global process that involves huge structural adjustments, finance that addresses the current fragmentation which are very unlikely to be achieved solely by the and lack of transparency. invisible hand of the market. All of that is far from secure. The slower we adjust our In our view, these very simple assumptions must guide mind-sets and institutions to the new reality, the riskier the construction of a new institutional framework for for the cohesion of global economic governance. global finance. The globalization of capital flows, especially from the 1970s onwards, has not delivered all of its promises. Economic crises and disruptions, many of which entail systemic consequences, became a recurrent pattern of our economic system. The question about the social desirability of such phenomena has been eluded and a thorough reform of the institutional framework for global finance has been kept at bay by the action of vested interests that benefit hugely from the paradox of an integrated financial market and hundreds of jurisdictions. Unlike the disciplines of international trade, guarded and coordinated by a single and elegant institution like the WTO, global finance has been the subject of a myriad of small fragmented agencies. Notwithstanding the merit and technical expertise of those bodies, a higher level of coordination is required to prevent future crises. In this regard, Brazil supports the strengthening of the Financial Stability Board, possibly at the core of an international regime for global finance in a near future.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 35 Dr Vijay Joshi

Emeritus Fellow of Merton College, Oxford 1. It has long been understood that the international nor by those countries (in particular the U.S.) that monetary system has to address two main benefit from their power to create global reserves challenges. The system must promote adjustment by running deficits. Thus, the system positively of balance of payments disequilibria. It must also encourages excessive imbalances. (Note that ensure that international liquidity is adequate (but some non-floaters, like China, which run balance of not excessive) to enable countries to finance payments surpluses are also able to sterilize their deficits and surpluses in order to smooth the monetary effects, which reinforces the imbalances process of balance of payments adjustment. tendency.) Before the recent crisis the dominant view was that 5. What then should be the shape of the exchange these challenges had been rendered obsolete by rate system for key countries? A fixed exchange financial globalization. We can now see that this rate would be inefficient and intolerable in the ‘new view’ was mistaken. face of asymmetric disturbances. A clean float Adjustment would occasionally produce insane exchange rate misalignments. That leaves two options. 2. Supporters of the new view thought that the Exchange rates between key currencies could adjustment problem would go away if the public float in unmanaged fashion most of the time but finances were kept in good order. Excessive with occasional coordinated intervention. (In current account deficits and surpluses would China’s case, this could only happen eventually, not emerge because rational private agents with negotiated exchange rate changes in the would respect their own inter-temporal wealth interim.) Or, as suggested by John Williamson, constraints. But there have been many examples of reference rates could be periodically agreed, countries getting into trouble despite having sound intervention being allowed (but not compelled) only budgetary positions. This is not surprising. Markets if undertaken to influence market exchange rates can and do fail; booms and busts driven by the in the direction of reference rates. None of this is private sector are entirely possible. Moreover, the going to happen soon. A rather crude, admittedly world is not composed only of small private agents imperfect, way forward would be to tax persistent but also of large government actors, which are in and excessive current account surpluses and charge of exchange rate arrangements that can deficits. (The numerical specification of ‘excessive’ provide faulty signals to private agents. and ‘persistent’, and the rate of tax to be paid to 3. Global current account imbalances were not the the IMF, would have to be agreed. The latter would main cause or trigger of the recent crisis but they have to be big enough to affect behaviour.)8 did play an important role in its build-up. It is International Liquidity also worth noting that a continuation of the trend of growing imbalances in the last decade would 6. The ‘new view’ also downgraded the importance of have led to a severe dollar crisis if the housing official provision of international liquidity. This was bubble had not imploded first. The fact that the on the basis of two presumptions. The first was that world dodged the imbalances bullet last time does the adoption of floating would reduce the demand not mean that it will do so next time. A necessary for reserves significantly. This has not happened. (though not sufficient) condition of avoiding Clean floating has been rare, confined to a few excessive global imbalances is an exchange rate advanced countries. Many governments have system that promotes adjustment. This point must exhibited ‘fear of floating’. They have maintained not be forgotten in the current focus on regulation intermediate regimes in order to damp down as the answer to the ills of financial liberalization exchange rate volatility. The second presumption and financial globalization. was that financial globalization would reduce the 4. Exchange rate arrangements today are need for reserves. External imbalances would be characterised by a laissez faire approach, based financed, and reserves obtained, by borrowing on the idea that each country should unilaterally and lending on the world capital market, as and choose a regime that best suits its goals and when necessary. But many countries have learned circumstances. This ‘non-system’ came into force by bitter experience that the capital market is a with the Second Amendment to the IMF Articles fair-weather friend. Loans become much more that was enacted in 1978, a few years after the 8 Some clarification is called for on how these considerations affect the breakdown of Bretton Woods. But this free-for-all, euro-zone. The euro is a key currency that is highly relevant for global especially as between the key countries, contains imbalances; so it would be an integral part of any global exchange rate arrangement for key currencies. Imbalances within the euro-zone are a a radical flaw from a systemic standpoint. Pressure different matter. Intra-union real exchange rate changes are necessary to adjust is felt neither by surplus countries to deal with large intra-union imbalances. Real exchange rate changes have to be effected via changes in inflation rates brought about by fiscal that practice ‘export-led growth’ on the back of contraction in deficit countries and fiscal expansion in surplus countries. undervalued exchange rates (Germany, China) A symmetrical adjustment mechanism of this kind does not currently exist in the euro-zone and is needed for its long-run viability.

Globalization and Finance Project, University of Oxford 19 JUNE 2012 / 36 expensive or dry up altogether during crises, 9. A more complete move towards an SDR system when they are most needed. So greater capital would require further changes. The first is the mobility has increased, not reduced, the self- institution of a ‘substitution account’ to mop up insurance demand for reserves, especially owned existing reserve currency holdings. This would reserves. The sure-fire way to accumulate owned raise difficult issues such as the sharing of reserves is to run current account surpluses. The exchange risk. The second is measures to increase consequential scramble for owned reserves has the appeal of the SDR by transforming it into an contributed to the excessive global imbalances. asset that can be held by the private sector. This is Reserve hoarders run large current account complex and will take time.9 But promoting greater surpluses while the U.S., the main issuer, runs central-bank use of SDRs, as advocated above, large current account deficits. As regards the need not wait on such changes. Right now, it is latter, the underlying behavioural connection with hard to think of any other improvements to the the current reserve system is psychologically and world monetary system that could achieve so much empirically plausible: the ‘exorbitant privilege’ as such little cost. conferred by the power to issue reserves weakens balance of payments discipline on the issuer country and tempts it to overspend. 7. The reserves system also continues to suffer from a long-standing problem. This is the potential instability involved in national currencies serving as international reserves: a modern version of the ‘Triffin problem’. If reserve issuers run persistent surpluses, the world is starved of liquidity; if they run persistent deficits, confidence in reserve media is threatened as the issuers’ debts increase. The number of reserve currencies is set to rise. Optimists hope that competition between issuers will discipline them. That may not happen. More likely, there could be destabilizing switches between reserve currency assets. 8. It is unlikely that the demand for reserves will slow down. There would be a significant improvement in global stability if a substantial portion (say a half) of the expected annual growth in demand for reserves were met by the creation of SDRs, rather than by expanding reserve currency holdings. In time, such a change would confer various benefits. Firstly, it would reduce the need for countries to earn reserves by running current account surpluses. This would serve to counter one of the two causes of excessive global imbalances. (The other cause is the obsession with ‘export- led growth’. Countering that would require reform of the adjustment process, discussed above.) Secondly, it would constitute a move towards a system in which international reserves do not consist of national currencies. This would tighten the balance of payments constraint on reserve issuers and reduce ‘exorbitant privilege’. Thirdly, it would begin to provide reserve holders with diversification benefits, more conveniently than by managing an equivalent portfolio of currencies. Fourthly, it would reduce the danger of large-scale switches between reserve currencies. Fifthly, it would distribute the seignorage from reserve creation more widely. Sixthly, it would reduce ‘reverse aid’ from developing countries to the advanced countries, which arises from the large 9 Some visionaries have imagined the IMF becoming a full-fledged global spreads between the cost of borrowing reserves on central bank, with the SDR as the principal, perhaps the sole, global currency. This would require the world’s governments to put their fiscal capital markets and the return on depositing them capacity behind the global central bank, just as a national government with reserve issuers. stands behind a national central bank. This is a far cry from the modest change advocated here.

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