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Redesigning the International Financial Architecture

THERE was a general sense that the global capital markets have run a little ahead of their regulators. Nobody disputed the idea that the recent crises in emerging markets should be blamed primarily on the countries concerned. But many people thought that the recent series of dramatic upsets also seemed to highlight failings within the international financial system. The regulators present insisted that these failings were now being addressed. But many of the other participants remained sceptical.


The recent crises were different from previous ones. Capital flows are both bigger and quicker than before. The current crises tend to involve the Capital Account rather than the Current Account. Such crises do not happen in more developed markets. The basic response has thus been built around two ideas: to strengthen domestic regulation in the countries concerned; and to improve the monitoring of emerging markets.

In practice, that means six steps. The first is to create standards of international behaviour for countries: in most cases (accounting is the obvious exception) these standards are easy to create, but they have been hard to implement. The second Step is the G7's Financial Stability Forum which brings together all the main regulators and international institutions: it has set up committees to look at short-term capital flows, hedge funds and offshore banking centres. The third push is for greater transparency: more of the IMF's dealings are now being made public. The fourth is an attempt to "bail in" the private sector. The fifth is the establishment of contingency credit lines.

The sixth is less a step than an observation: the spread of flexi-

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ble exchange rate systems. Every crisis has involved a failed attempt to defend a pegged exchange rate. However, flexible countries have tended to do much better. Countries are now much more likely to let their exchange rates float freely -- though a few may follow Argentina down the road to extremely firm currency board systems. Either way, artificial pegs seem to be out of fashion.


It is worth noting that this is the first Bilderberg meeting where the Euro is a fact rather than the topic of a discussion. The redesign of the financial system, which is now under way, also needs to be set in context. From 1944-73, there was a system of fixed exchange rates. Since then, there has been only piecemeal reform. In the 1970s there was good deal of talk about whether the IMF should exist at all; in fact it has increased and changed its role. But the basic trend has been very unsystematic. Each crisis has called for a "special facility" of one set or another.

Why do we need to change? The globalisation of capital markets has happened much more quickly than the globalisation of their regulatory systems. The advances in electronic data processing combined with financial liberalisation have made capital flows much swifter and also more uniform: all the big investors are following the same benchmarks and being judged on the same quarterly performance, so they tend to act in an even more herd-like than usual.

The IMF should look at these flows, but it should be aware of its limitations. It is very difficult to be right in a world where money moves so quickly. The IMF should set standards for transparency. But perhaps it should leave the job of assessing them to the private sector. If the IMF says that a country is in good shape, it gets into trouble if that country crashes. But if it says that it the country is unhealthy, it gets accused of starting the crash.


There are grounds for being cynical about financial reform. Fear, greed and ignorance remain as ever the main motors of markets. A leading cen-

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tral banker has dismissed the attempts to rebuild the financial architecture as a little interior decoration. There have always been crises -- and by many standards the 1980 debt crisis was much worse than what we now face. But globalisation and the advance of information technology have upset the balance in financial markets. What is needed is not so much one massive redesign as a process of permanent adaptation.

Co-operation is the key. The world's regulators are coming together in more ways than most people realise. The Financial Stability Forum is a good example. Transparency is also important as a way of limiting the herd instinct of investors. What we need to do is to encourage best practices on the regulatory side as well.

None of these things will happen without courage. The IMF has actually exhibited quite a lot of bravery in telling governments what to do. But we must find ways to introduce the private sector. We cannot suppress risks, but we should make sure that the balance between those risks and rewards is clear.


Most of the steps outlined so far make sense. But it is important to realise the limits. Throughout history, people have imagined that they have found the magic solution. But each system from the gold standard to the ERM has run into trouble.

The existing system failed because it allowed enormous crises to take place in emerging markets; and also because the regulatory response to those crises was unsatisfactory. The main blame certainly lies with the emerging countries themselves. They adopted pegged exchange rate systems, they borrowed too much and they did not reform their financial systems. But the IMF also seems to have overstepped its responsibilities. It is not clear that financial decisions about lending money should be tied to causes like trying to reform corporate governance or trade union rules.

What should be the targets? First the IMF should not try to refashion economies. Its lending should be based on short-term, small packages, rather than big, long-term ones, tied to broad

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reform proposals. Next the emerging countries should bear the main responsibility for making their systems more transparent. And they should find a way of increasing their liquidity. Back-up lines of credit look good in theory; but may not pay out in practice. It is vital that the emerging world feels more secure; otherwise it will close off its markets.


The moderator began by throwing out a number of challenges that set the tone for much of the subsequent discussion. Given the IMF'S increased importance, is it a properly accountable body? What is the G7's role and is it the right shape? Given the introduction of the Euro, is it really necessary for so many European countries to attend G7 meetings? How can one begin to establish international regulators when there are such conspicuous rivalries between regulators within countries, especially America? And how do you design a system that bails in the private sector?

Several participants returned to the basic theme that the markets have globalised but the regulatory systems have not. Two European speakers thought the answer is to give a greater role to regional institutions, such as the European Union. One of the panellists was sure that if the Euro worked, more regional currencies would emerge. Others raised the question of dollarisation as a possible cure. One of the panellists disagreed. Argentina and Mexico both face a very difficult question. The only possible reason for surrendering control of your monetary policy to Washington (where nobody would ever make decisions on the basis of what mattered in Buenos Aires) is the fairly rotten financial records of the governments concerned. It would thus be a sign of defeat. Another American participant agreed. Mexico and Argentina both went through recessions just to hold onto their pegs. it is to be hoped that they can run their economies well enough themselves.

There was also a long discussion about how to give the private sector a greater role. One European panellist stressed that

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bail-outs should not just be based around public-sector money. An American participant said that there had been a clear progression between South Korea and Brazil. In the first instance, the private-sector banks had effectively been strong-armed in; but with Brazil, they had come more willingly. An American economist pushed this point a little harder: what about changing bond contracts and introducing collective action clauses for sovereign debt?

Several private-sector bankers rose to defend their profession. One American banker pointed out that creditors have often been extremely flexible, not least in the bail-out of Long Term Capital Management. The public sector is simply behind: witness the delays in changing the rules about investment banking in the United States. A British banker believed that trust is key. Bankers will "stay in" as along as they can be sure that their rivals have been persuaded to do the same. Another European banker said that banks simply do whatever makes it more likely to get their money back. That is the point, agreed one panellist: co-operation is the obvious way for everybody to gain.

Several people looked at the political side of international regulation. An American participant pointed to the crucial position of the big western economies in most negotiations. For instance the recent rounds of discussion about bank supervision included 136 countries, but most of them were really backbenchers. One panellist returned to the moderator's questions about the composition of G7 meetings. Europe, he stressed, is not a superstate. It is thus correct for countries like France and Germany to keep their individual seats at the table.

Nobody questioned the need for the IMF, but several people questioned its abilities. One participant wanted to give a greater role to ratings agencies. Another pointed out that the IMF has no independent directors. A Briton accepted that there is a good case for a lender of last resort, but only if it lends money at a penal rate. Several people objected to the way that financial reform has been put to the people. One Turkish participant

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pointed out that nobody explains to voters how, say, reforming social security and taming inflation might be related.

One panellist reiterated his view that the IMF should become a much narrower institution. Another wondered if it really is the lender of last resort and not the subsidiser of last resort -- though he added that the tough medicine handed out to some Asian countries had been justified. The third panellist wanted to see the IMF become a catalyst for change; if not, capital controls will be more likely. The first panellist admitted that the IMF has not always explained its case well. But he argued that the question of the power of a lender of last resort is tied into that of how to bail in the private sector. Until a way is found to keep the private sector involved, it will be very difficult to have an effective lender of last resort.