From global imbalances to global reorganizations: towards a more stable & equitable IFS Robert Wade LSE Sep 09

The current world situation Sep 08 – Mar 09 = panic stage: talk of 2nd Great Depression Now clear: no 2nd Grt Depression Also clear: return to ”normal” growth & high empt will take long time in West. Dev’ing c’ies – many face ”new development crisis” (NDC) Goals for global policy community: define (a) shape of new economic world, (b) means of achieving.  DIIS conference

GROUNDS FOR PESSIMISM Conference prospectus says there is now ”a determination to cooperate interationally & to take bold measures” to reassert public authority in global finance. Who are the ”agents” of bold measures? G20F has been almost silent on financial reforms.

GRNDS FOR PESSIMISM Financial Stability Board (FSB) – no reason to think it will become effective global regulator. Same modus operandi as predecessor, FSF. Staff of only 9 = no independent analytical capacity. Dependent on views of member states

GROUNDS FOR PESSIMISM UN Commission on the World Financial and Economic Crisis (= Stiglitz Commission) Came up with radical ideas US and other G7 eviscerated it almost completely before approving as UN document

CONCLUSION ON INTERNATIONAL COOPERATION Not much sign of major states being willing to cooperate to push real reforms. US and UK especially resistant G20F and G20L have achieved little consensus beyond platitudes FSB unlikely to be effective global regulator UN marginal However, grounds for optimism in regional arrangements

GROUNDS FOR OPTIMISM Debate about reform of IFIs has to rest on understanding of how financial mkts work, & causes of fin crises in gen & GFC in particular 2 new lines of argt abt fin crises: (1) micro theory of momentum trading, based on assumption of rationality; (2) macro theory of global imbalances. They have implications for mandate & scope of IFIs.

DRIVERS OF FINANCIAL INSTABILITY: MICRO STORY The efficient-mkt hypothsis (EMH). No momentum trading (bubbles & trubbles) Bernanke: house price increases “largely reflect strong economic fundamentals” (2005) Greenspan EMH underpins IMF’s objective: “restore confidence of financial mkts” Recent criticisms of EMH assume investor irrationality

MICRO STORY: RATIONAL MOMENTUM TRADING New theory shows how rational individual end- investors can produce collective irrationality (inefficiency, momentum trading, fragility) Key: (a) information gap b/w end-investors & their agents (fund managers, brokers, company directors); (b) employment contract of agents. Implication: IMF wrong to presume that financial mkts make correct judgements about countries & their policies, & hence that its job is to restore “confidence” of fin mkts.

DRIVERS OF FINANCIAL FRAGILITY: MACRO STORY Many commentators ignore or deny role of global imbalances. GFC results fr confluence of (a) micro failures of fin mkts, and (b) macro global imbalances & their associated capital flows. Two blades of scissors. The global economic growth model of past decade: US consumers are main source of end- demand; debt is main way consumers finance consumption.

MACRO STORY US deficits, US borrowing from surplus countries, growth of creditor-debtor relations around the world  increasing fin fragility. External deficit implies capital inflows and “currency recycling”; currency recycling implies “credit recycling”, in form of fiscal deficit or borrowing by households & firms. The GFC caused by rupture in credit recycling, not in currency recyling.

CONCLUSIONS FROM THE MICRO-MACRO STORY The ”globalization” growth model was flawed. Depended on rising US indebtedness. Flexible exchange rates do not curb imbalances Export-led growth model unviable. Need more emphasis on domestic demand.

WHAT SHOULD BE DONE? Key: (1) establish ways to curb external surpluses & deficits; (2) develop a global currency. International Clearing Union. Multilateral coordination of exchange rates, so as to stabilize real exchange rates. Capital account management (CAM)