The Bernard Schwartz Forum on Constructive Capitalism March 30 th 2006

1. FIXING GLOBAL FINANCE3. Task Unfinished: making global finance workMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times The Bernard Schwartz Forum on Constructive Capitalism March 30th 2006

2. Prologue: task unfinished “If you owe your bank a hundred pounds, you have a problem. If you owe a million, it has.” John Maynard Keynes. “Things that can’t go on forever, don’t.” Herbert Stein.

3. Prologue: task unfinished “Do we need an IMF? Is there a role for a multilateral institution in the management of the international monetary system? If so, what is it?” Mervyn King, governor of the Bank of England, February 20th 2006.

4. Prologue: task unfinished “Asia has become the source of finance, the source of savings. It now has the human capital to manage that well. Why doesn't it take the advantage of that opportunity to try and create financial markets that work better for the people of Asia?” Joseph Stiglitz.

5. Prologue: task unfinished • Remember what we want: • An international financial system that is reasonably crisis-free; • An international financial system that allows emerging market economies to import capital, net, without excessive worries; • An international macro-economy that is not unduly reliant for balance on the excess spending of the “sole superpower”; • An international monetary system that supports these goals; and • A set of international financial institutions that makes these objectives realistic • Is this feasible? Yes. Will it happen? Maybe.

6. Outline: task unfinished • Tackling the conjuncture: • the case for a change • desirability; • sustainability. • How to make the change.

7. Outline: task unfinished • Changing the structure: • An end to mercantilism. • A changing macroeconomic regime: • Exchange rates; • Exchange controls • Monetary policy; • Fiscal management. • A reformed financial sector. • Better global institutions.

8. 1. The conjuncture – case for a change • Why not just accept things as they are? • After all, there are substantial advantages to having the US accept the world’s surplus savings, for both sides: • In a dollar-denominated world, it makes sense for the country that issues the key currency to incur the debt. • The US also has the world’s deepest financial markets and the world’s biggest and richest economy, which makes large-scale lending relatively safe. • It has people (and a government) more than willing to borrow. • Things are not that simple.

9. 1. The conjuncture – case for a change • Advantages for the US: • As John Maynard Keynes said: If you owe your bank manager £100, you have a problem. If you owe him £1m, he has a problem. • With a current account deficit of close to 7 per cent of GDP, the US is able to borrow substantially more than its fiscal deficit and, for that matter, its spending on defence. • This then is guns and butter. • Should the creditors try to take their money out, the value will adjust automatically, as the dollar and asset prices adjust. • So risk is naturally well shared between creditors and debtors.

10. 1. The conjuncture – case for a change • Disadvantages for the US: • Industries producing tradable goods and services are weakened and protectionist pressure increases. • The household sector is being pushed deeper into debt. • If the fiscal deficit is to be reduced, the private sector’s financial deficit must be pushed upward to very high levels.

11. 1. The conjuncture – case for a change

12. 1. The conjuncture – case for a change

13. 1. The conjuncture – case for a change • More disadvantages for the US: • If credit were to be cut off, the dollar might plunge, inflation rise, interest rates jump and the economy suffer. • The bigger the net liability position, the greater the downside and the bigger the difficulty of managing the position. • Remember that even if the trade deficit stabilised as a share of GDP, US net liabilities would be on track to reach 70 per cent of GDP by 2016, even if there were no increase in the cost of US liabilities (currently a mere 2.7 per cent and so hardly a hedge against a dollar devaluation). • The creditors are not necessarily friendly: remember the Suez war in 1956, when the US threatened the UK and France with currency mayhem if they did not withdraw.

14. 1. The conjuncture – case for a change • Advantages for the creditors: • Avoidance of further crises; • Obtaining monetary stability and a monetary anchor, since dollar-pegging is a de facto route to an Asian monetary area; • Creation of a rapidly growing, export-oriented industrial sector; • Securing ready absorption of domestic excess savings; • Avoiding the difficulties (political and economic) of generating a more efficient and flexible financial system; and even • A way to “pay for” US-provided security or buy US acquiescence.

15. 1. The conjuncture – case for a change • Disadvantages for the creditors: • It may prove hard to sterilise the monetary impact of huge reserve accumulations; • Real returns on the assets creditors own are low and ultimately likely to be negative when currencies adjust; • Summers (2006) estimates the excess reserves of developing countries at $2 trillion and the minimum opportunity cost for the ten largest holders at 2 per cent of GDP; • So subsidising exports through an undervalued exchange rate and unhedged lending in foreign currencies is expensive; • Gifts are expensive!

16. 1. The conjuncture – case for a change • The discussion so far has focused on the pros and cons of change: the question of desirability. • On this, the argument is complex, but the most important point is the perversity of huge capital flows (about an eighth of the rest of the world’s gross savings) to the world’s richest country. The US is absorbing 70 per cent of the world’s savings surplus. • But maybe it is really a question of sustainability: • On this the big point is whether change can be avoided. As the late Herbert Stein said, ‘what can’t last won’t.’

17. 1. The conjuncture – case for a change • Four groups of economists have made somewhat different arguments that the present situation is sustainable for a very long time. • Proposition 1: Richard Cooper (2005) argues that the US is a natural borrower in a globalising world economy. Ricardo Caballero et al (2006) make a similar argument in a more sophisticated way: • The economy is saving enough, as is shown in the rapid economic growth; • Other high-income countries are naturally surplus (low population growth and low potential growth) – their savings surpluses are structural;

18. 1. The conjuncture – case for a change • Many emerging market economies cannot absorb all their savings at home; • Also, argues Caballero et al (2006), residents desire high-quality financial instruments that their repressed financial systems cannot provide. • A current account deficit of $600bn (nominal) is sustainable indefinitely.Even a current account deficit that is a constant share of GDP would be sustainable (with net liabilities ending up at 100 per cent of GDP). • BUT: • The deficit is exploding and likely to continue to do so. • 100 per cent of GDP would be an extraordinarily high level.

19. 1. The conjuncture – case for a change • Proposition 2: Dooley and others (2003) argue that China, in particular, is using the “undervalued” exchange rate as an indirect way to subsidise the growth of an internationally competitive manufacturing sector: • This “new Bretton Woods” is, they argue, comparable to the original one, which served this purpose (quite unwittingly) for post-war Germany and Japan. • This process will continue until China’s labour surplus is fully absorbed. • That could take ten to fifteen years.

20. 1. The conjuncture – case for a change • But: • There is little reason to believe the Chinese authorities deliberately chose the present situation; • The reserve accumulation is exceeding all reasonable bounds – at current rates, reserves could well reach $3,000bn by 2015; • As the current account deficit explodes, there is a substantial risk of a protectionist backlash. It is easy to imagine the surplus rising to $300bn, at the current exchange rate, over the next five years. • The costs of this form of export subsidisation look excessive – China could easily lose 50 per cent of GDP on the domestic value of its reserves when the currency finally adjusts.

21. 1. The conjuncture – case for a change • Proposition 3: Ricardo Hausmann and Federico Sturzenegger (2006) argue that there is no deficit at all. The US is exporting “dark matter”: • The underlying point is that, despite moving ever further into a net liability position, the net income of the US has not gone into deficit. • So Hausmann and Sturzenegger argue that US capital abroad is underestimated. It is exporting invisible services – insurance, in particular.

22. 1. The conjuncture – case for a change • This is a complex argument. But a meticulous analysis by Willem Buiter (2006) concludes that the argument is unpersuasive. • The net income figures may be seriously flawed. • While seignorage dark matter does exist, it accounts for at most a sixth of the H&S number. • Knowledge dark matter is no more likely to be embodied in US FDI abroad than in foreign FDI in the US. • Insurance premium dark matter cannot justify a permanent ex post excess return on risky assets: being a huge hedge fund is not a free lunch even if the bad things happen only rarely. • Buiter concludes that H&S are discounting risky streams using risk-free discount rates.

23. 1. The conjuncture – how to make a change • My conclusion is that the present solution to the global macroeconomic and financial challenges is neither desirable nor indefinitely sustainable: • The world cannot rely on ever growing US current account deficits. • Ideally, the deficit should shrink, though it certainly need not shrink to zero. A US current account deficit of, say, 3 per cent of GDP would work well. • This creates a challenge for the rest of the world, which must generate growth in demand at least in line with potential output.

24. 1. The conjuncture – how to make a change • That is a macroeconomic and a financial challenge. • Is it plausible that the surpluses will shrink automatically? • In Japan and western Europe, it is unlikely. These are natural surplus regions, though western Europe must do better. • In the oil exporters, it is quite likely, though they would be wise not to spend the windfall at once; • The crucial players are the Asian emerging countries, since they could afford to run current account deficits at least equal to the inflow of FDI, particularly since they are now more than adequately insured.

25. 1. The conjuncture – how to make a change

26. 1. The conjuncture – how to make a change

27. 1. The conjuncture – how to make a change

28. 1. The conjuncture – how to make a change • The big decision-maker is China: • It does not know how far to let the currency appreciate; • Above all, this is just not a high priority for its current leadership. • But how big a current account surplus and foreign currency reserves can it afford to create? • It is risking a serious backlash if it continues on its present course

29. 1. The conjuncture – how to make a change • The best approach would be a deal with Asia • Exchange rate adjustment • Fiscal tightening in the US • Expansionary policies in Asian emerging markets, together with structural reform • But this requires substantial reform of the structure of the world economy, to avoid a repetition of crises past • That is the subject of the next section.

30. 2. The structure: priorities for reform • None of this will happen satisfactorily without large-scale reforms: • An end to mercantilism; • A better macro-economic regime: • exchange rates; • exchange controls; • monetary policy; and • fiscal management. • A reformed financial sector. • Better global institutions.

31. 2. Priorities for reform - mercantilism • Export-oriented manufacturing has been the most successful route to development in the past half century: from Germany, to Japan, South Korea and now China. • Normally, this strategy has gone with low consumption, high investment, even higher savings and large current account surpluses • China is too big to pursue such a strategy successfully. • Today, its current account surplus is around $150bn. • If the investment rate were to fall by 5 percentage points of GDP and the savings rate were to remain the same, the surplus would rise by another $150bn. • Who is going to absorb this?

32. 2. Priorities for reform - mercantilism • China has to move to a lower saving economy, with more consumption and more efficient use of resources. • This, as Prasad and Rajan (2006) argue, demands a comprehensive set of reforms, which have become quite urgent: • Of the financial sector; • Of the legal system; • A move to inflation targeting, a floating exchange rate and central bank autonomy; and • More public spending on social capital.

33. 2. Priorities for reform - mercantilism • How big a current account deficit can an emerging market economy risk running? • If reserves are substantial, a deficit equal to long-term inflow of FDI seems close to risk-free. • For China that would be a deficit of around $50bn. Moving towards that would generate a swing of $200bn, which would be a big global contribution. • India is already running a deficit, which is helpful.

34. 2. Priorities for reform – exchange rates • In general, the move over the past twenty five years has been towards more flexible (which does not meanfreely floating exchange rates). That is sensible, in the light of experience with adjustable pegged rates. • The general inclination is also towards “competitive” exchange rates. • Concerns about the impact on the real economy of large movements in exchange rates largely explain what Reinhart and Calvo (2000) called “fear of floating”.

35. 2. Priorities for reform – exchange rates • Very hard pegs (currency unions or dollarisation- euroisation) can work, provided a country has a natural trading partner to which it can link (e.g. Estonia to the eurozone), an economy subject to similar shocks as the economy it is linked to, or a flexible economy (e.g. Hong Kong). • But – this is a big caveat – in a world of floating exchange rates, nobody has a fixed exchange rate. • As Argentina’s experience showed, countries can only choose how to float – either on their own or tied to someone else.

36. 2. Priorities for reform – exchange rates • The crucial point, however, is that in a world of multiple currencies, the safest way for a country to borrow is in its own national currency. That depends on the government’s ability to create a viable vehicle currency. • In that way, currency risk is borne by those best able to diversify those risk, namely, the creditors. • The ability to borrow in one’s own currency depends on a country’s ability to create a sound currency, backed by a competent monetary authority, disciplined fiscal policy and a liquid financial market. • In the absence of these things, large-scale foreign borrowing (as opposed to FDI or portfolio equity) is very risky.

37. 2. Priorities for reform – exchange rates • I don’t believe in “original sin”. It is rather a matter of history. Even small high-income countries have been able to borrow internationally in their own currencies, once they have persuaded their own citizens to lend to them. • That is the only viable future for large-scale international borrowing.

38. 2. Priorities for reform – exchange controls • In an economy that is open to trade, exchange controls are hard to operate effectively: they are very porous. • There is also now a developing literature suggesting that capital controls impose microeconomic costs. Forbes (2005) argues, for example, that they: • Reduce the supply of capital and raise the cost of financing; • Reduce market discipline in finance and on government; • Distort decision-making; and, crucially, • Generate corruption – they are intensive in precisely what most emerging markets lack: good, effective and honest government

39. 2. Priorities for reform – exchange controls • Developing countries are behaving as if they believed this – the direction is still towards liberalisation. • This is right, provided the risks are understood and managed.

40. 2. Priorities for reform – exchange controls

41. 2. Priorities for reform – exchange controls

42. 2. Priorities for reform – monetary regime • A floating rate needs an independent central bank with an inflation target. How far that means ignoring asset prices is an open question. • In some cases regional monetary arrangements may be superior to independent floating. This may be achieved by formal arrangements or informal targeting. • In Asia, a shift from (more or less loosely) targeting the dollar to targeting the Yuan-renminbi should happen automatically over the next 15 years or so.

43. 2. Priorities for reform – fiscal regime • Fiscal policy is ultimately quite simple. • A country should ensure solvency in the long run and flexibility in the short run. • This is easier said than done! But it must be. • Otherwise, a country cannot generate international demand for borrowing in the domestic currency.

44. 2. Priorities for reform – financial reform • It is no longer a great secret that financial sector (and associated legal) reforms is the most challenging of all tasks. • Much effort has, fortunately, been devoted to this since the 1990s. The evidence also suggests that much has been achieved. But much remains to be done, as well. And the new regimes have not been stress-tested.

45. 2. Priorities for reform – financial reform • What is required to make a financial system work tolerably well is evident from the experience of the high-income countries: • Reduce the moral hazard of deposit guarantees; • Generate legal backing for property rights (including bankruptcy procedures); • Create a requirement for transparent accounting; • Ensure adequate capitalisation of financial institutions; • Create strong and independent regulators; and • Allow in foreign competitors.

46. 2. Priorities for reform – the global regime • Reform is predominantly a domestic challenge • But what about the global institutions? What can they do? • The chief tasks are: technical assistance; surveillance; co-ordination; and crisis lending. • But there are the associated questions of institutional reform and representation.

47. 2. Priorities for reform – the global regime • The following bodies have been actively engaged in the development of new codes and technical assistance in implementing them: • the International Monetary Fund; • the World Bank and other regional development banks; • the Bank for International Settlements, the Basel Committee on Banking Supervision and the Financial Stability Forum; • IOSCO on securities regulation, IAIS on insurance supervision, the IASB on accounting and the IFA on auditing. • I presume this has all done some good!

48. 2. Priorities for reform – the global regime • The IMF is the body principally responsible for surveillance: • Rodrigo de Rato (2006), the Managing Director, has himself stated that “we need a sharper focus to our surveillance, particularly of the larger, systemically important economies.” • We need it, but can we get it with the current structure of the IMF, with the dominant role of the Executive Board? I doubt it. • As the Bank of England’s Mr King (2006) has argued, the Fund needs to be more professionally independent. • It also needs a head, chosen by the membership as a whole, of the highest possible calibre.

49. 2. Priorities for reform – the global regime • Exchange rates are, by definition, a topic that affects more than one country. • They are, therefore, an obvious topic for international co-ordination or at least frank discussion. • But that is not what happens now in international meetings. • Nor, in Mr King’s view, is the Fund using its power of analysis, persuasion and, in Keynes’ words, “ruthless truth-telling”. That phrase, he says, does not “conjure up memories of any of the international meetings I have attended”.

50. 2. Priorities for reform – the global regime • Finally, there is the question of lending. • At present, the IMF has only one large borrower – Turkey. Its balance sheet has shrunk to trivial proportions. • I think there remains a strong case for reserve-pooling and lending in the context of a liquidity crisis. • Such crises cannot be identified with certainty, but what the lender needs to ask itself is this: ‘if we make large emergency loans, is there a good chance of our getting the money back? If the answer is “yes”, we should lend.’