The Making of a Mess: Who Broke Global Finance, and Who Should Pay for It?

    EDITOR'S NOTE: Solving the current financial crisis requires the International Monetary Fund to act and world leaders to take a closer look at China's financial model, says Harold James, the director of Princeton University's program in contemporary European politics, in an essay published by Foreign Affairs magazine. For the full article, please visit the magazine's Web site magazine. A few excerpts:

    The current financial crisis poses a fundamental challenge to globalization and to its many analysts. Which global institutions might manage the international economy, and how? They all wonder.

    What kind of crisis is this, and what are its likely implications? Some crises are cathartic and push policymakers to take corrective measures; others, like the Great Depression, are radically destructive. Over recent decades, there have been blowouts at the financial center and storms at the periphery. Is the latest financial collapse a first step on the road to a profound backlash against globalization? A decade ago, after the Asian financial crisis, Washington and various international financial institutions held up the U.S. system as a model to Asian governments. Today, it is Asia, especially China that may be entitled to give Americans a lecture.

    Massive failures

    Martin Wolf, the Financial Times' chief economics commentator, has been a persistently insightful analyst. He has not forecast that financial globalization will necessarily end in disaster, but he has warned of its dangers and tried to address its shortfalls. Most recently, he has done so in Fixing Global Finance, an extremely helpful guide to the origins of today's problems and to possible solutions.

    Fixing Global Finance begins by surveying the achievements of finance-driven economic integration over the past two decades and the vulnerabilities caused by the system's periodic crises.

    In a move that may seem odd today, given the current talk about the end of capitalism, Wolf's book casts the American model of financial liberalization as a hero and Chinese mercantilism as a villain. Wolf argues, for instance, that China's "inordinately mercantilist currency policies" have caused dangerous imbalances.

    For Wolf, "The United States is at least as much the victim of decisions made by others as the author of its own misfortunes." But instead of quietly expropriating assets held by the Chinese by gradually devaluing the dollar, the borrower of last resort got into trouble itself.

    In the United States and in Europe, the hope is that governments will assume many of the risks inherent in this uncertain valuation-and tame the wild beasts of the financial jungle through state-backed and state-run banking systems. To some, this is profoundly ironic.

    Free fall

    In a Financial Times column last March, when U.S. government efforts to rescue the investment and brokerage firm Bear Stearns seemed to indicate that everything would soon be all right again, Wolf wrote, referring to the day of the bailout, "Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died." Just six months later-and a decade after it lectured Asian governments-Washington seemed to adopt a Chinese-style solution to its escalating financial problems: greater state intervention to restrict the movement of capital.

    But there are dangers and limitations inherent in this approach, too, especially given that, as Wolf warns, instability and vulnerability will not be confined to the United States and that "financial crises are most significant when they are international." This crisis may have originated in the United States, but it has rapidly become global.

    The possibility of geopolitical turmoil is all the greater because so far the bailouts have been handled in a purely national context, while international institutions have been nervous and hesitant. The discussion has been entirely domestic in the United States and, more surprising, in Europe, too.

    But in these days of high capital mobility, this appears to be a very poor solution. It is likely only to prompt a wild rush of fund transfers as governments try, in their own idiosyncratic ways, to prop up their banking systems and as depositors move their assets away from countries at risk of needing bailouts.

    Meanwhile, international financial institutions have largely stood on the sidelines of the meltdown. Since the end of World War II, there has been a belief that international cooperation can tackle major problems. But that faith is now being tested. The current financial collapse is the first international financial crisis since the 1944 Bretton Woods Conference in which the International Monetary Fund has played no role at all in tackling the causes of the problem and only a secondary part in managing its consequences. In addition, the current financial crisis threatens to trigger trade protectionism precisely at a time when the sputtering of the Doha Round of multilateral trade negotiations has weakened the World Trade Organization. Institutions such as the IMF and the WTO have become largely ineffective and irrelevant because of a general shift away from the belief in a rule-based international order and toward a Machiavellian view of the world in which power is all-important. Critical decisions about an international response to the financial crisis have been left largely to the G-7 (the group of highly industrialized states), a patently unrepresentative body that excludes major new centers of global savings and trade surpluses, such as China.

    A new Bretton Woods

    It is thus both bold and constructive for Wolf to see current financial problems as global issues requiring global answers. In a late chapter, "Toward Global Reform," he calls for the big emerging markets, especially those, such as China, with large savings ratios, to abandon capital controls, allow their exchange rates to float, and begin borrowing mostly or entirely in their own currencies.

    But Wolf rightly argues that international action is also required. In his view, the IMF should better represent the new centers of global growth: its voting rules should be altered accordingly, and its managing director should no longer be a European appointment. Wolf also proposes that the IMF more actively manage currency reserves. He advocates greater pooling of assets in order to establish funds that could be tapped promptly in times of crisis.

    The logic of these proposals is sound, but they should be extended: as the economist Michael Bordo and I argued in an article for VoxEU.org last June, under the present circumstances, the IMF should take on the role of asset manager.

    Stabilizing action by the IMF would benefit both the global economy and the reserves' owners, which, simply by virtue of their accumulated surpluses, share an interest in the world's financial and economic stability.

    In the course of developing new functions for the IMF, it would be important to distinguish between day-to-day transactions and crisis management, much as central banks and national regulators do.

    The IMF's enhanced asset base would also enable the fund to switch into crisis mode without long discussions and formal negotiations. It could respond quickly and, like other asset managers, without setting off a geopolitical debate about the strategic implications of the investment.

    Given widespread suspicion in emerging markets about the IMF's motives and standards, expanding the IMF's power would require reforming governance at the organization.

    If the IMF were to become a reserve manager, it might be possible to substantially reform the organization's voting rules: for example, a country's voting clout on the IMF's executive board could be partly determined by the amount of convertible currency it voluntarily deposited at the IMF.

    A Beijing consensus

    A crisis with global origins cannot be adequately tackled in purely national settings, even in a country as large as the United States. An effective international financial system is needed, as well as strong incentives for powerful states to act within it. Without such an international order, countries are left to act on their own. Big countries might do a better job of this than smaller countries with more open and more vulnerable economies. But since even geopolitical giants are likely to resort to the solutions that appeal most to their domestic constituencies, they will tend to insulate themselves from the rest of the world. And that protectionist reflex could return the world to the misery of the 1930s.

    The need for managed international action raises the question of which country should be its main driver. Like the United Kingdom during the Great Depression, the United States today is unwilling, and probably unable, to act as the world's stabilizer. Meanwhile, China, the preeminent holder of global savings, may now be in a position comparable to that of the United States in the 1930s, when isolationism at home stymied any chance that Washington would take action abroad. Like the United States back then, China today cannot hope to stabilize the world on its own. It would need to work through an institutional framework. But Beijing is unlikely to take on a key role in reconstructing the global financial system without guarantees that its interests would be recognized in the new order.

    One can only hope that this new approach will not reflect an autarkic or nationalist policy, whereby the Chinese stand by and continue to save (and suffer) while the world's financial order collapses. That would really spell the end of globalization-and of the prospects for a peaceful world order.

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