Towards a New World of Finance
This event, this Asia-Global Dialogue, is not in itself going to change the world. No single conference could possibly do that.
It is, nonetheless, truly significant. The Fung Global Institute is a symbol – and it will be more than a symbol – of both an intellectual and economic reality. Asia has rapidly – almost unbelievably rapidly – moved from a seemingly dependent and exotic satellite of the so-called “highly developed” world to a major force in that world. Within a generation, China alone will be far larger economically than either North America or Europe. Barring some great unknown catastrophe, Asia might eventually approach the size of the United States and Europe together.
That is a great leap forward. It is something that will take some getting used to – at least to those of us who have grown up thinking that the Western World, and particularly the United States, were naturally dominant. It will surely force adjustments in Asian thinking as well. Size and wealth imply new responsibilities, new attitudes, and more particularly open, outward-looking leadership. All that will be required, if we together are to look forward to a peaceful and prosperous world.
This Asia-Global Dialogue can be one step in accepting and adjusting to these new realities. I feel privileged by the invitation to take part.
My role is to look ahead, to signal out elements in the financial and monetary systems that need attention.
For sure, we have all had plenty of evidence that financial systems, first in Asia in the 1990’s and a decade or so later in the United States and Europe, have been vulnerable to breakdowns. The cost in interrupted growth and in unemployment has been far too large to be tolerated. We cannot accept failure in achieving sensible and needed reform. That need has been widely recognised in the efforts underway nationally and internationally.
I do not want to review all that work in detail, but a few points need emphasis. First, if there is not an international consensus on some key points, the reform effort will be greatly weakened if not aborted. Money, financial markets, and people are free to move – free to move to escape regulation and taxation. That is acceptable and even constructive as a brake on excessive and heavy-handed official intervention. It is not acceptable if in crucial areas, a kind of competition in regulatory laxity develops at the expense of needed standards of ethical and prudential behavior. Common capital standards for commercial banks is a leading case in point. So are the efforts of regulatory and supervisory authorities to maintain needed oversight of financial markets more broadly.
Given appropriate procedural safeguards, authority to intervene is needed if speculative forces run rampant or if innovative financial instruments and so-called financial engineering become so complex and opaque as to pose clear risk to stability. Better understanding of the clearing and settlement arrangements and other characteristics of the burgeoning world of derivatives – I am told there are nationally some 700 trillion dollars of derivatives outstanding - is another area where the implications respect no national borders. Perhaps most important – and certainly of relevance to Hong Kong where most of the largest trading markets and banks are active - is a coherent, consistent approach toward dealing with the imminent failure of “systematically important” institutions. The taxpayers and governments alike are tired of “bailing out” creditors, even stockholders and managements of failing institutions, for fear of destructive contagious effects of failure. The implication of that practice of encouraging excessive risk taking is by now widely understood.
By law in the United States, new approaches superseding established bankruptcy procedures dictate the demise rather than the rescue of failing firms, whether by sale, merger or liquidation. But success in that effort will be dependent on complementary approaches elsewhere, most critically in the UK but in other key centers as well, including here in Hong Kong. I understand there is indeed encouraging progress in achieving common understanding and consistent approaches in the two dominant financial markets.
Strict uniformity of regulatory practices in all respects may not be necessary. For instance, the UK and the US may be adopting approaches different in their specifics with respect to protecting commercial banks from more speculative, proprietary trading, but the policy concerns are broadly similar. Those concerns may not be so pressing elsewhere where banking traditions are different and trading is more restrained. But neither should other jurisdictions act to undercut the restrictions imposed by home authorities.
Those are matters that will occupy much of your attention during the Dialogue. I want to expand your thinking into the closely related area of the international monetary regime. By that I mean the collection of institutions, legal obligations, market practices and means of payments that should provide international liquidity, adjust international payment imbalances, and maintain confidence in the stability and usefulness of international money.
Simply by listing those criteria for a monetary system, you may legitimately question whether we have a “system” at all. Certainly it has been rather “catch as catch can” since the demise of the Bretton Woods arrangements and in sharp contrast to the seeming simplicity of the gold standard. None of the established international institutions, whether the IMF or the BIS, and none of the ad hoc committees and councils of financial authorities ranging from a G-5 to a G-20, have systematically and consistently been able to exert authority. There is no officially sanctified and controlled international currency.
The point has been made that efforts at a more organised system, whether in the 1920’s, at Bretton Woods after World War II, or the creation of the SDR experiment have not been sustained for long. Arguably, the ideal of a well-defined and effective monetary system becomes more difficult as markets and capital flows have become vastly larger and potentially more capricious. Indeed, the point is made that the world economy has grown, even flourished in the emerging world, without a more organised system.
Well yes, for a while. But what, to my mind, has too often been overlooked is that international monetary disorder lies at the very root of the successive financial crisis of the 1990’s and even more strikingly in the more recent crisis. The example of the sustained and, in a sense, complementary imbalances in the United States and in Asia stands out.
From 2000 to 2007, the United States ran a cumulative current account deficit of some 5 ½ trillion dollars. China and Japan together had reserve increases totaling close to the same amount. That symmetry was not accidental. China found it useful and convenient to run a large trade surplus as a means of supporting its industrialization and rapid growth. It generated both a very high rate of internal savings and inward foreign investment. The United States, in contrast, had much slower growth and stagnation in personal incomes. In those circumstances, it was content to sustain exceptionally high levels of consumption at the expense of personal savings. The differences were bridged by an inflow of capital from China and Asia to the United States in the form of short-term dollars at extraordinarily low interest rate.
The trouble of course, was that the imbalances could not be maintained indefinitely. It came to an end with a massive bubble in the housing markets in the United States, fed by low interest rates related to the strong inflow of foreign money. The speculation ended not with a quiet and orderly adjustment but with a very large and deeply disturbing bang.
I know that is a simplified account of a complicated story, but it has a central element of truth. It parallels on a grand scale, with the two largest world economies involved, the earlier and seemingly different financial Asian crises (and for that matter the Mexican crisis) of the 1980’s. In all these cases, large deficits were financed by a seemingly easy inflow of foreign funds.
The practical and inescapable lesson is that when any country is left to its own policy devices and preferences, those preferences may lead to prolonged and ultimately unsustainable imbalances. Then sooner or later adjustment will be necessary – if not by considered domestic policy or by a well functioning international monetary system, then by financial crisis.
Not so long ago, there was comforting theorizing that floating exchange rates generally practiced would themselves deal with the international adjustment problem in a timely and orderly way. The real world has not been consistent with the theorizing. Many nations, particularly but not limited to small open economies, simply find it impractical or undesirable to permit their exchange rate to float. Markets in any event have been volatile, often disturbingly so. And I am not providing any fresh insight when I point out that favored approaches by individual countries may conflict.
Nor, I must add, does it seem at all likely that refuge can be found in fixing exchange rates. The European experience in moving to the extreme of fixity - a common currency – amply emphasises that the need to deal with the basic adjustment problems cannot be neglected.
We are left with the certainty, however awkward, that active participation in an open world economy, with all the enormous benefits of international trade and investment, requires some surrender of economic sovereignty. Or, to put the point more positively, there must be a willingness to find means of coordinating policies more effectively. That is the essence of a well functioning international monetary system.
None of this is new ground, intellectually, or practically. What has been lacking is the determination to do something about it.
One might expect that the extent of the current crisis might stimulate not just analysis but action. Recent meetings of the G-20 have in fact alluded to the need for fresh approaches. Some broad and potentially useful ideas have been set out. However, in the midst of more pressing economic and political pressures those ideas have had little traction. I can only plead that that not be the case of the Fung Global Institute!
Permit me to make a few suggestions for your future work programme.
At the heart of the matter is, in the jargon, an effective international adjustment process. That is a natural concern of the IMF as well as of the more informal groupings of the largest economies. But the approach of expert analysis, consultation, and peer review simply has been ineffective. National thinking and policy approaches are not compatible. No effective pressure is brought to bear to force consistency. In a word, it is discipline has been absent.
What are the practical means of enforcing the necessary adjustment measures? Without being either definitive or exhaustive, let me review some of gather possibilities:
• Stronger surveillance by the IMF and a firmer commitment by nations to abide with “best practices” and agreed norms. • Direct and public recommendations by the IMF, the G-20, or otherwise, following mandatory consultation • Qualification or disqualification with respect to the use of IMF or other credit facilities (e.g., central bank swap lines). • Interest or other financial penalties or incentives along the lines under consideration in Europe.
If those approaches extending on unsuccessful experience in the past, doesn’t seem sufficiently effective, how about permitting or forcing the introduction of capital controls, at least as a temporary measure? Or, to get really serious, should we even consider authorizing trade restrictions as a kind of last resort against chronic surplus countries?
Perhaps a new approach toward exchange rate fluctuations may be more promising.
Conceptually, that would require some agreement about appropriate “equilibrium” exchange rates. A fairly wide band or zone around the equilibrium rate would allow for uncertainty and permit the market to exert its own discipline.
• But the central idea is that individual nations would direct their interventions and if necessary their economic policies to defending the “equilibrium rate”.
• One more radical suggestion is that aggressive intervention by trading partners might be authorised by an international authority to promote consistency.
An appropriate reserve currency and the provisions of international liquidity is the third area of concern in the design of an international monetary system. For years there has been no intellectually or theoretically agreed approach. Rather, the use of the dollar, and to some extent other national currencies, has been the pragmatic answer.
The nub of the matter is not, as I see it, the common complaint that the international use of the dollar provides an “inordinate privilege” to the United States. In the last analysis, it is not in the interest of my country to accentuate and extend our payment deficits at the expense of ever larger holdings of the dollar by foreign governments and central banks. We should want an internationally competitive economy with a strong industry and restrained consumption. And the rest of the world wants the usability and flexibility afforded by the currency of the largest, strongest, and most stable nation.
More than 30 years ago, the SDR was agreed and activated as a substitute for either gold or the dollar, depending upon one’s point of view. I happened to be the Undersecretary of the Treasury for Monetary Affairs at the time, still filled with hope that a more coherent international system could be negotiated. That hope has not been satisfied. Nor is there any clear path toward somehow mutating present currency holdings, dollars or otherwise, into SDR’s. In fact, any future usefulness of the SDR as the main international currency will be dependent on its usefulness in private markets. We are far from that today.
The characteristic of a useful reserve currency requires on the one side, that it be in limited supply, but on the other that it has sufficient elasticity in supply to satisfy large but unpredictable needs that may arise in a turbulent financial world. Through it all, it must maintain confidence in its stability and availability. All that has pointed to the practicality of a national currency, or perhaps a variety of national currencies. It is in any case a relevant area of study for the new Institute. One – maybe even more than one – Asian nation may be tempted to seek or at least tolerate, reserve currency status for its own money.
I am conscious that the currency issue raises directly the question of whether we are ultimately aiming at a “one world” monetary system or one based on two, three or possible even more regional areas. Do I detect a certain bias in the creation of the Fung Global Institute?
In any case, that is an important question with implications beyond the monetary system, including trading arrangements. All that is well beyond my remarks today, but it will be on the Institute agenda for years.
I am also conscious that I have said nothing about the make-up of governing bodies of the IMF or other international institutions. In my judgment, we will not solve the substantive issues simply by rearranging the seats at the negotiating table. But I do recognise the political implications and the need for a sense of legitimacy for any organised monetary system if it is to command respect and allegiance. That is why wider representation on the governing bodies of the established international institutions is indeed in order.
I want to end where I started. The rise of Asia in general, and China in particular, is reshaping the international order.
Hong Kong is a unique vantage point. It is a window into China, and a window out of China. The function of a window is transparency. It connotes exposure, openness, a willingness to study and learn. The new Fung Institute exemplifies those qualities.
The Victor and William Fung Foundation has provided the concept and the resources. Andrew Sheng has his shoulder to the wheel, providing both organizational leadership, much relevant experience, both here and beyond Asia, and a source of instant respect.
God Speed and good luck!
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