3.5.5  Restructuring Global Financial Governance

(This is an archived extract from the book Patterns of Power: Edition 2)

A financial system is essential to the creation of wealth (3.2.7).  Nowadays many financial institutions are global and funds can be rapidly transferred from one country to another, so the financial system is largely a global structure even though a lot of its governance is organised nationally.  No country can act in isolation in financial matters, though, because business would simply shift to the least regulated centre.  The purpose of global financial governance might be defined as the maintenance of stability and the creation of optimum conditions for the global economy to grow.  Its performance has been patchy.  There has been huge economic growth since the Second World War, but there have also been many crises and there is much unfulfilled potential in poorer countries.

Regulators, shareholders, banks and ratings agencies all failed to exert governance over the financial markets prior to the 2007-8 financial crisis (3.3.4.3).  Agreed standards and collaborative regulation are needed – to protect but not to control.  As Hayek wrote:

“The need is for an international political authority which, without power to direct the different people what they must do, must be able to restrain them from action which would damage others." [1]

Following the 2008 crisis much effort has been directed towards financial regulation.   In September 2011 the European Commission suggested two substantial changes: to increase the independence of auditing companies and to introduce a tax on financial transactions (often referred to as a Tobin tax).[2]  There has been significant opposition to the Tobin tax, mainly on the grounds that it would be ineffective unless it were possible to implement it everywhere and close the obvious loopholes,[3] but there are also arguments for it: in support of its possible role in increasing stability,[4] and in its probable impact in improving corporate governance (as described later: 3.5.6.3).  

There are also arguments for and against the prohibition of some of the more complex financial instruments, including derivatives, as a way of reducing risk.[5]  Despite the efforts and suggestions there had been little progress in setting up an appropriate framework of regulation by the end of 2011, partly due to genuine disagreements about economics but partly because politicians are placing national interests first and are reluctant to empower collective institutions – as discussed later (6.6.4.2).

None of the existing global economic institutions is without its problems.  The International Monetary Fund (IMF) was created to ensure stability in the global financial system, by being able to lend money to governments that are overstretched, but it applies policies that are unhelpful to the borrowers.  Joseph Stiglitz argued that it needs comprehensive reform to enable it to avoid doing damage to countries it lends to; he quotes Russia as having experienced a 40% reduction in GDP which was largely attributable to IMF policies that he describes as pre-Keynesian,[6] making the same mistakes which were made in the 1930s: applying policies which reduce growth at precisely the time when recovery is needed.  At least part of the reason for this is that the representation on the IMF board is very unbalanced, reflecting the balance of power in the world immediately after the Second World War.  For it to have more legitimacy and to be better able to do its job it needs some representation from the borrowers, for example African countries; and America's blocking vote is now looking increasingly inappropriate.

Stiglitz, writing in 2006 – before the economic crisis of 2007-8 and the Eurozone crisis of 2010 – also argued that the global financial system is unstable:

"Many of the problems in meeting debt payments arise not from mistakes on the part of developing countries but from the instabilities of the global economic and financial system.  The need for better mechanisms for sharing risk and for resolving debt problems will continue to be great so long as the international financial markets continue to be marked by such instability." [7]

This was remarkably prescient, given that both these crises were directly related to financial instability on a scale that had not been predicted in the risk models used by ratings agencies and others.  He continued by arguing that the global reserve system is a potential source of instability because the American dollar’s status as a reserve currency has enabled America to run up huge debts to other countries – notably China.  Any instability in the value of the dollar would now cause instability in the world as a whole.  Even if people disagree with Stiglitz’s analysis of the global financial system, they would find it difficult to disagree with the proposition that it lacks stability.  The empirical data from 1970 onwards suggest that it is only a matter of time before the next crisis will unfold. 

Designing a more stable system, as Stiglitz suggests,[8] would require more international cooperation than has ever been achieved hitherto, except to solve crises which have already happened – like the Second World War, which precipitated the formation of the United Nations (UN), the World Bank and the IMF.  It seems more prudent, rather than waiting for the next comparable crisis, to cooperate now to find stabilising mechanisms.

© PatternsofPower.org, 2014