What can G20 do?
In 2008, G-7 finally came to the realization that the global power shift required greater legitimacy and newer, multi-stakeholder solutions, so that the G20 came to assume its place from a mere talk-shop to a more serious forum for more effective collective action for global problems. There is no doubt that G20 accounted for a larger and more representative share of global economic power, since the members account for roughly 85-90% of world GDP either on market exchange rates or PPP basis. G20 also accounts for roughly two thirds of global population.
Although there was much fanfare and hope over the growing power of the emerging markets, particularly BRIC countries (a term coined by Goldman Sachs), the reality is the shift in terms of voting power in the Bretton Wood institutions broadly preserved the status quo. True, there is greater representation in the upgraded Financial Stability Board and participation in the regulatory standard bodies, such as the Basle Committee for Bank Supervision, IOSCO and IAIS. But my personal greatest worry is whether the Emerging Market members, after they become members of the Club, would simply rubber-stamp the proposals of G7. After all, G7 has superior experience in global governance, institutional research capacity and policy analysis. Some of us have not forgotten that the best indicator of financial crises in recent years has been membership of the OECD. Almost every new OECD member, Turkey, Mexico and South Korea, experienced financial crisis fairly shortly after joining, because they probably liberalized prematurely without fully preparing for the potential global shocks.
The major issue before G20 is what can be done to ensure that future financial crisis can be prevented? This requires good diagnosis before prognosis, something that Posner had earlier indicated as premature. The obvious problem is that all global issues are multi-generational, multi-disciplinary and are interconnected, interdependent and inter-active, with no “one-size fits all” solution for all time. The gaming nature of nation-states and private sector behaviour is such that there is a race to the bottom. No country is able to tighten monetary policy alone for fear of inviting a ton of hot money that negates that policy. No country is able to tighten financial regulation for fear of business migrating to other financial centres. No country is able to raise taxation for fear of massive tax arbitrage.
Since the orthodoxy of democratic free markets demands greater public welfare expenditure in a situation of rising fiscal deficits, the world is in “bubble trap”, with loose monetary and fiscal policies financed through higher and higher leverage. The reverse side of the bubble trap is the Japanese liquidity trap. Basically, what the Japanese did to tackle the deflationary pressure from the bursting of the 1980s asset bubble was to replace banking and corporate losses in equity and real estate with a debt bubble – essentially replacing the bubble losses with a fiscal debt equivalent to twice the size of GDP. This debt bubble is sustainable only through zero interest rates. If inflation was to return and Japanese interest rate rises, the deflation in the debt bubble would result in massive losses to bond holders, which are mostly domestic retirees. In effect, instead of doing massive domestic restructuring, the problems of excess capacity were postponed to future generations.
Does this solution sound familiar?
Since the present rescue plans also involve massive pump priming to protect the banking system, annual fiscal deficits around 6-7% of GDP are replicating the Japanese dilemma, requiring the whole world to adopt zero interest rate policy (ZIRP), creating what I call the “bubble-thy-neighbour” problem. Instead of closing down zombie financial institutions, trying to keep them alive by giving them massive spreads causes huge distortions in the global real economy.
First, the bank management gets away with continued high salaries, since profits are subsidized through full deposit guarantees and government ownership. How much of current profits are due to management abilities? Secondly, it is impossible to price risks under ZIRP because the incentive structures are already distorted. Socially disadvantaged SMEs will face higher risk spreads and less access to credit, whereas state-owned enterprises and large multi-nationals will get privileged rates, if not further government aid. Third, to place the adjustments in the exchange rate alone will not help global adjustment materially, since the Japanese experience shows that despite huge revaluation, the economy still ran continuous large balance of payment surpluses. If the vibrant emerging markets also drift to slower growth due to exchange rate shocks as well as domestic bubbles ala the Japanese situation post-Plaza Accord, then global growth will further slow down.
What in effect the present rescue efforts are doing is to tax efficient real sector corporations and savers to subsidize zombie financial institutions on the presumed objective of keeping employment at socially acceptable levels. We need real sector solutions, not playing with funny money. In sum, a financial engineering crisis cannot be solved with more financial engineering. You need real sector surgery.
So what is the real problem?
If we agree that the problem began with excess consumption financed by excess leverage, then the realistic solution must be a gradual adjustment to more sustainable levels, with collective action agreement on the gradual transition to a more sustainable situation. Instant solutions tend to have long-drawn out poor outcomes.
Allow me to play the devil’s advocate in posing the issues starkly. If the core defect of central planning is ignoring market prices, ineffective bureaucracies and having no hard budget constraint, free market fundamentalism also has a problem of ignoring non-market risks, ineffective bureaucracies, no hard fiscal constraint and funding through limitless financial engineering. Central banks with compartmentalized mentality acted solely on consumer prices by ignoring asset bubbles. Supervisors ignored liabilities below the line and in offshore, unregulated special purpose vehicles. The result was massive embedded and hidden leverage in the financial system, since smart bankers realized that they could increase profits through increasing leverage at huge moral hazard risks. This crisis has proven them right – they were bailed out with fairly golden parachutes.
I can only agree with Lord Turner’s assessment that much of recent financial innovation has been of little social value, hidden by increased leverage in multiple forms and apparently sophisticated math models. Since increased risk-taking by financial institution is due to a distorted management compensation scheme, driven by the need to increase profits quarter by quarter, the management responded by embedding leverage in the system until it blew up in their face. Consequently, the simple answer to controlling excess compensation is to control excess leverage. This requires a profound change in regulatory policies and supervisory practices, beginning with the need to define what are overall leverage limits. For emerging markets, if in doubt, we can fall back on the historically accepted levels of 15 times net capital. Less profits, less bonuses and reduced risk-taking.
Putting together different components of the picture – the fragmentation of economic disciplines into silos that ignored disexternalities, the inability of fragmented national agencies to deal with global issues, a free market philosophy of growth for growth sake and the difficulties in getting collective action to arrive at a hard budget constraint, we are now able to piece together the global enigma.
In a nutshell, the Bretton Woods II regime of liberalized capital flows and flexible exchange rates does not quite add up in a small fragile interconnected and interdependent planet. Most advocates of free capital flows equated good long-term foreign direct investment (FDI) with foreign portfolio investment (FPI). What they ignored was the fact that increasingly, through financial engineering, FPI is short-term and highly leveraged, profiting from higher volatility and ensured if possible through market manipulation, especially in thinly traded markets. Indeed, the carry trade that arose from ZIRP following the Japanese deflation essentially subsidized hedge funds, investment banks and speculators to punt emerging markets. There was no way that emerging market central banks could defend their currencies because their reserves were very lowly leveraged (mostly through domestic savings or long-term debt), whereas the other side was hugely leveraged with massive momentum play. If the foreign exchange reserves were funded with short-term debt, then it was a no-brainer. Moreover, if the locals also believe that the exchange rate was indefensible, then the game was over. The conventional solution was a devaluation and switch to flexible exchange rates, using exports to solve domestic gaps. But this assumes that the export engine will be forever.
In short, the logical consequence of a monoculture of flexible exchange rates is an unstable race to competitive devaluation that can only end up in tears.
After the Asian crisis, when G7 refused to regulate the currency markets, the only way for Asians to defend themselves was through self-insurance, building up their savings and cutting leverage. The recycling of excess savings into the global markets increased the liquidity of G7 markets and created the prosperity which G7 central banks were reluctant to stop, resulting in the current crisis. But leverage can only “prosper” with lower and lower interest rates, bringing us into the never-never land of massive price distortion under ZIRP. Unfortunately, ZIRP also perversely accelerates the quantitative consumption of scarce natural resources, on the pretext of getting back GDP to positive territory.
Is the solution therefore in increased financial regulation? This is where the second piece of the puzzle falls into place. Suppose that G20 has assumed the mantle of supreme global authority to create the global financial regulator and global central bank that some academics argue for, would the global problems be solved? The surprising answer is no. The reason is that as the EU experience has shown, no regional central bank and super financial regulator can resolve regional and sectoral disparities without some form of central fiscal adjustment. And since we do not even have the elements of a global fiscal mechanism, the discussions about global financial regulation and monetary policy are somewhat futile.
In other words, we cannot have global monetary policy and financial regulation without some form of global fiscal coordination. The present fiscal trend of rising expenditure increases and tax cuts to rebuild an excess consumption/excess leverage model with limited global resources is a race to another crisis.
To put it bluntly, we cannot have a partial solution to a total problem. If we have global banking in life, we need global taxation because the only two things that are certain in life are death and taxation. For global institutions to continue to create global public goods, some form of global taxation is necessary. Since the financial sector is currently the “perpetual prosperity machine” with massive moral hazard, I would whole-heartedly agree with Lord Turner that a global “Tobin Tax” is probably what is needed as the first step in global fiscal reform.
Firstly, a turnover tax is a user-pay tax that is less regressive than other forms of taxation. It is like a gambling tax to tax socially negative activities for global public goods. Secondly, the turnover tax can be counter-cyclical, being increased or decreased depending on the level of speculative fever in the markets, raising taxation if the risks of bubble collapsing rises to fund safety nets for crisis resolution. Third, the turnover tax can be used to finance global public goods that currently have no other forms of financing. Fourthly, the tax will be paid by financial institutions which currently bear minimal transaction taxes, as stamp duty and other transaction fees were reduced almost to zero as part of the doctrine of creating frictionless financial markets. The reduced profits of financial institutions will reduce their capacity to pay excessive bonuses and compensation that promote risk-taking. Fifth, once turnover tax is collected, statistics on transactions would be tabulated that could monitor excessive speculation, market manipulation and insider trading that currently plagues effective global financial market supervision.
How much will the turnover tax raise? The global turnover in foreign exchange and derivatives according to the BIS Triennial Survey in 2007 was US$3.2 trillion daily. Assuming 250 trading days, the total annual value of FX turnover would be in the region of US$800 trillion. If we add to this the total value of share trading of US$101.2 trillion according to the World Federation of Exchanges statistics, then the total annual financial trading, excluding bonds and other OTC transactions, would be in the region of US$900 trillion. Using a turnover tax of 0.1% would yield an annual tax of US$900 billion, enough within three years to cover the global banking losses last estimated at US$2.8 trillion. Using a turnover tax of 0.005% would yield $90 billion, nearly double the aid to Africa required of US$50 billion annually.
What I am suggesting is not for individual countries to impose a Tobin Tax, but for G20 to agree for all members to impose a single, uniform rate of turnover tax of say, 0.005%. There can be no race to the bottom, if we all agree to impose the same rate of taxation. Since global bubbles are global problems, G20 can agree to change the tax counter-cyclically. National governments that collect the tax would credit the proceeds to a global fund, with a formula that would allow national governments to use part of the proceeds to resolve current crisis problems. A global turnover tax can fund non-controversial global public goods, such as Education for All initiatives, before moving to tackle other more controversial areas. This measure would put into place the module of fiscal standardization that improves conditions for future coordination in monetary policy and financial regulation.
Another possible measure to standardize the global fiscal regime is to agree on standard withholding tax rates, which for the sake of a number is put at say 15 or 20%. The agreement to have a standard withholding tax would make global taxation systems more uniform, allowing convergence in global tax regimes to reduce global transaction costs. If offshore financial centres could not compete through zero taxation, the incentives to create regulatory and tax “black holes” would be limited. Emerging markets have much to gain from stopping the loss of tax revenue to offshore financial centres. Improvement in domestic tax regimes would enable emerging markets to deal with many of the funding problems that are currently financed through external borrowing or hot money.
What I have tried to do today is to have a total picture of what impedes global progress to effective global solutions for complex global issues. If the arguments are somewhat unclear, it is because we are all dealing with something very new and yet very old – going back towards ancient philosophies that had a holistic view of man on earth, of either man exploiting man or man exploiting nature. Man’s success in pushing for relentless growth has partly been achieved through greater social inequality (disguised through leverage) but mostly at huge ecological damage. It is time for emerging markets and developed markets to stop shuffling deck chairs on the Titanic, and concentrate on what we need to do collectively to stop the Tragedy of Global Commons. If it means changing the definition of GDP to a green Quality of Life index, so be it. If it means getting global fiscal regimes in place, so be it. We cannot do this overnight, but we must begin the debate.
There are many things that individual emerging markets can do to achieve their own national goals, which may conflict with global goals. These would entail reforms to what used to be called “global best practices”. The irony is that what we thought were “best practices” turned out to be very poor practices. Global regulatory standards therefore should be made much more simple, understandable and more important, implementable. If I may be impolite, much of what is being proposed is still too complex, too theoretical and impractical for implementation for many emerging markets. Indeed, it is arguable whether these new regulatory standards, which are very expensive to implement, may not even prevent the next crisis, nor identify the real risks. As former Chairman of the Technical Committee of IOSCO, I bear part of that blame. But this does not mean that we should continue this drive towards adding complexity to greater complexity as a solution to our woes.
There is an oft-quoted phrase that says that the Chinese word for crisis is a combination of the words, danger and opportunity 危机. Most users forget that the Chinese word for assumption is False Certainty 假定。 This is another contradiction in terms. The political consequences of the economics profession are that by assuming what is false to be certain, we swallowed it hook, line and sinker. Time to get real.
I apologize for this blunt but somewhat tortuous analysis. My only excuse and hope is that it stimulates sufficient debate on the way forward in this time of global crisis.
2 September 2009.
 At the end of 2008, the US banking system still had US$201.1 billion of notional value of derivatives with positive fair value of US$7.1 trillion, but net capital of $1.149 trillion. Since other liabilities comprised US$11.1 trillion, the banking system had leverage of either 17 times (10 + 7 times fair value of derivatives) capital or 185 times net capital (10 + 175 times notional value of derivatives). Perhaps using notional exposure may exaggerate the leverage, but the experience with Lehmans is that when derivatives unwind, it is the gross unwind that is the killer, not the net unwind (Fed, op. cit. Table 2, p.A73
 Adair Turner, Speech at Turner Review Conference, Financial Services Authority, London, 27 March 2009.)
 How to tame Global Finance, Prospect Magazine, 27 August 2009, Issue 162;
George Parker, FSA backs global tax on transactions, 27 August 2009, FT.com.
 I am grateful to Dr Homi Kharas of the Brookings Institution for helpful comments in this area.