The points are developed more fully in turn.
Financial openness: Beneficial but inherently instability
Historical experience has shown that financial liberalisation and market integration produce benefits, if asymmetric. Theory (Minsky 1982) and historical experience (Bordo et al. 2001) told us financial markets had a strong tendency towards instability and crisis. Avoiding persistent market failure requires robust systems of governance at the level appropriate to the extent of market integration.
This implies regional and international institution-building. The dilemmas of such institutional design and the appropriate policy mix have been well-known since the 1920s at least (Germain 2010), and certainly since the Bretton Woods conference.
Despite this knowledge and the frequency of episodes of financial crisis in the 30 years of liberalisation from the 1980s on, a crisis-reform-crisis cycle only led to the complacency of the Great Moderation (Helleiner 2010). Financial globalisation was furthermore known to be particularly problematic for developing countries (Cassimon et al, 2010, and Ocampo and Griffith-Jones 2010). The institutional and economic weaknesses of the European monetary union were likewise well-known and exhaustively discussed in the literature (Underhill 2011a).
Systemic flaws known before the crisis
Our system of debt-crisis workout has long pointed the finger at debtors. IMF programmes available to debtors seeking to avoid default to public and private creditors involved a combination of emergency loans, enhancing the debt burden, and structural adjustment measures. These latter often come with substantial distributional costs for the borrowing nation, often its poorest citizens. There is substantial evidence that these programmes have too often failed to stimulate economic recovery and growth (Vreeland 2003). The argument that structural adjustment leads to a ‘catalytic’ restoration of private investor confidence likewise does not appear to hold (de Jong and van de Veer
Financial stability: Where it went and from whence it might return
2010). The Argentine default in 2001-2 saw the country emerge from crisis as well or better than orthodox Brazil, which took the full ‘medicine’ (Klagsbrunn 2010).
The system of international banking supervision was equally flawed. The first effort – from the Market Risk Amendment to Basle I in 1996 through to the finalisation of Basle II in 2004 – relied on self-supervision by large banks. The key tool was internal risk assessment and attendant controls. In essence, it was a micro approach to risk management based on market price signals, risk ratings and weightings, and a range of financial ‘governance’ standards.
This market-based approach to the financial sector, or “governance light”, was amply criticised as procyclical and dangerous (Persaud 2000, Ocampo and Griffith-Jones), and it neglected the macroprudential dimensions of systemic risk (Claessens and Underhill 2010). The system furthermore provided direct competitive advantages to the same large-bank constituency that had proposed the idea in the first place. Moreover, it involved a substantial rise in the cost of capital for poor countries and their populations who had no access to the decision-making forum (Claessens et al. 2008).
The theories and argument pools from which the new policies were drawn became tilted towards particularistic interests; state officials and the private sector came to share interests and approaches to governance in a club-like setting (Tsingou 2012). There was a serious policy rent-seeking and capture problem in the financial policy community – the input side of the policy process was flawed (Claessens and Underhill) and idea-sets on stability of the market skewed as result (Baker 2010). As a result, regulation backfired. Policies adopted to secure financial stability were those least likely to achieve it! Rather, they provided material advantages to the large financial institutions that benefited most from financial liberalisation in the first place.
So the 30 years of global financial integration lurched from crisis to skewed reform to crisis once again. Much of the burden of reform was on the emerging markets and developing countries that experienced crises most frequently. Their experience led them, particularly after the Asian crisis, to question the market-based approach to
financial governance and to choose a different path. Most took liberalisation seriously, implementing reforms in their own way (Zhang 2010; Walter 2010) often while introducing innovative forms of capital controls aimed at ensuring greater stability.
Asian countries began to go their own regional way in terms of regional cooperation (Dieter 2010). In the end, only the emerging market countries genuinely rose to the challenge of reform, avoiding the recipe of the advanced financial centres and largely avoiding the global financial crisis of 2007-9 as a result.
Financial Stability: From whence might it return?
Despite proposed improvements in the level and quality of capital required of large banks, the underlying market-based approach to financial governance and supervision has not changed (Underhill 2012). There are still many reforms in the pipeline, but if they are to be enduring and successful, new policy idea-sets must be developed.
The most innovative turn in the reform process is towards a macroprudential approach aimed at better management of the systemic dimensions of risk. Yet it is not at all clear that there is yet a coherent set of ideas, least of all concrete measures. Successfully operationalising macroprudential oversight requires institutional innovations across national and international levels to “join the dots” among policy domains. Until now, such domains have been treated all too separately, for example:
• Global imbalances and macroeconomic adjustment.
• Monetary policy in relation to asset markets.
• Multilateral surveillance mechanisms.
• Debt loads (public and private).
• Financial system monitoring.
• Firm-level risk management.
Financial stability: Where it went and from whence it might return
This requires a more integrated institutional setting for policymaking and implementation.
Linked to the issue of macroprudential oversight, there is little sign of a much-needed debt-workout regime in either the Eurozone or the global financial system.
New ideas are unlikely as long as there is no substantial shift on the input side of the policy process.
• A broader range of stakeholders must become systematically involved in decision-making if policy output is to change.
For instance, citizens whose pensions are at considerable risk should have a say (Leijonhuvud 2011).
• Institutional change in the policy process could also provide insulation from the threat of policy capture.
The interests of those who ultimately underwrite financial bailouts – the taxpayer – must be far more robustly defended by public authorities.
• The sharing of responsibility and of the burden of adjustment imposed on debtors versus creditors needs to be seriously rebalanced.
This is especially the case in the Eurozone, where the benefits of monetary union are so skewed towards the surplus/creditor countries whose banks finance debt, both public and private.
Yet this rethink is not happening. The Eurozone crisis is being managed under the principle of IMF structural adjustment on steroids. Policy space is being dramatically diminished, instead of being enhanced through the pooling of reserves and risks.
Why does this matter so much? The answer has to do with the long-run sustainability and legitimacy of financial openness and capital mobility and whether we wish to have continued access to the benefits it offers. The issue requires institutionalised attention in a reformed policy process. Our research has shown that financial liberalisation is better sustained in economies that mitigate the risks of liberalisation through welfare
and other forms of compensation for the vulnerable (Burgoon et al. 2012). Centre-left parties in stable democracies have often sponsored financial liberalisation traded off against a functioning health care and welfare system. Developing countries that receive compensation in the form of international aid flows also support financial openness more readily. Nurturing these underpinnings of open finance requires the very policy space that recession and austerity based workouts are closing down.
Meanwhile, electorates are rebelling against solutions that “pool” sovereignty just as market integration makes national policy less effective. The risk is that failure to think systematically about the emerging legitimacy deficit could lead to a rapid political radicalisation.
Centrifugal populist political forces have already been generated by the process, sometimes deliberately by politicians but more often by the nature of the solutions developed. This context will continue to aggravate the difficulties of reaching workable solutions to governing Eurozone or global finance and may call into question the institutional and ideational plumbing of the system: the benefits of openness, the autonomy of regulatory of agencies and central banks, and eventually the ability of states to cooperate to reform financial governance.
In short, we need a financial system and Eurozone that not only saves banks, but also citizens!
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About the author
Geoffrey Underhill is Chair of International Governance is a political economist who works closely and co-authors with economists and political scientists alike. He is a specialist on the financial governance, macroeconomic adjustment and governance, and international trade work packages, and will work with Burgoon on the issue of the sustainability and legitimacy of (trade and financial) liberalisation.
Xavier Freixas
Universitat Pompeu Fabra and CEPR