Bretton Woods II: Why and How

 

 

A high degree of activism continues to pervade without interruption the unfolding of the financial crisis. The most recent significant episode was the visit of Presidents Sarkosy and Barroso to President Bush, last Saturday, during which an agreement was concluded to convene a Conference aimed at a profound reform of the international financial system.

 

At this stage, very few things have been settled other than the fact that the Conference will be divided in stages, the first of which should be held at the level of Heads of State in New York during November and that, in addition to members of the G8, the main emerging market countries and raw material providers should be invited. Such an evolution constitutes the recognition by the industrialised countries which have dominated the world economy since Bretton Woods I, that an irreversible shift has occurred in the equilibrium of economic and financial power towards a multi-polar structure in which the new entrants are being invited as “full” members.

 

The magnitude of the current crisis has demonstrated that the system, inherited from the aftermath of the 1929 crisis and codified at the end of WW II, is no longer capable of providing a sufficiently robust framework to ensure the stability of financial markets. The main element that is lacking at present is “Confidence”. It is therefore to the reestablishment of the latter that the political leaders must devote their undivided attention, be it those who will participate directly in the Conference or those who might be only represented indirectly. Indeed, if there is one fact that nobody contests, it is that financial markets have become “irrevocably” global and that, consequently, their regulation must partake in a consensual system to which all parties should find a strong motivation to adhere.

 

Nobody can deny the benefits that have been derived from the extraordinary economic expansion that spanned the second half of the XXth. Century. It is also true that these benefits have been divided unequally and that this inequality has tended to increase along with globalisation which itself has been conducive to deregulation and has ultimately led the whole system to the verge of collapse. Let us not overlook, however, the fact that globalisation has also allowed hundreds of millions of people to escape poverty; it is therefore of paramount importance to ensure that these virtuous aspects are not only preserved but, to the contrary, amplified by framing the new financial system within governance principles that are respectful of the interests of citizens, whatever their degree of economic development may be.

 

This imposes on the richer countries a first obligation: convince their respective public opinions of the necessity to fully take into account the challenges of poverty and underdevelopment, not in the name of high moral principles (though they should not be denied), but because such an approach is in the best interest of all. Taking these facts into account implies the “representation” of all countries at the Conference, because any new system will be only as strong as its weakest link.

 

It is in the same spirit that any attempt to instate protectionism should be strongly resisted. One should recall that the most devastating effects of the depression of the 1930’s were created by protectionist reactions, mainly in the United States.

 

The question of representation will also surface at other levels, in particular within the European Union. The leadership in crisis management, seized with an unarguable panache by President Sarkosy, was assumed in the name of the EU rather than of France. Will it be possible, on the eve of the Conference, to draw the appropriate conclusions? Ideally, to create the necessary confidence and benefit from sufficient influence and credibility, the EU should speak with one voice (as it does in the WTO through the voice of the European Commissioner responsible for Trade). In view of the high stakes involved, an ad hoc structure should be created to ensure the appropriate European representation. It would aim at reconciling ahead of the meeting the respective interests of the main financial areas (Eurozone and the UK), while allowing other Member States to express their views. It is also clear that the outcome of this most important question will entail consequences that will reach far beyond the reform of the financial system. It is more than likely that the new equilibrium of the forces carrying out the negotiations on financial reforms will spill over to other areas such as the composition of the U.N. Security Council or the representation of the EU within a series of international organisations, etc.

 

The example that the EU could set would also be helpful in convincing the acceptance by other countries of an “indirect” representation at the Conference that could be organised, for instance at regional level, so as to limit the debate to a reasonable number of negotiators. If, on the other hand, nationalist claims gain the upper hand, one should fear that the ultimate result will be limited to litany of common sense principles, the implementation of which will remain uncertain.

 

The formula agreed upon in Camp David, recommending a succession of meetings, appears well adapted to address this difficulty pragmatically. Indeed, the intervals between plenary meetings could be devoted to making progress along two priority axes: consultation on a regional basis of countries not directly represented and the organisation of technical specialist groups charged with formulating proposals on the different aspects of the new regulatory framework.

 

Another fundamental aspect to take into account is the profound difference between the structure of the financial markets as it existed at the time of Bretton Woods I and its current physiognomy. After the war, each financial market was independent, defined by its State borders (corresponding to a given monetary area) and linked to others nearly exclusively through the foreign exchange market, itself under strict control of national authorities. Financial institutions operated essentially within their national borders. Today, the foreign exchange market is but one among many channels through which financial flows travel around the globe. Institutions operate freely in many countries. The freedom of capital movements has created a deep interdependence between all economic actors: entrepreneurs, government operators, consumers and investors. The instant transmission mechanisms, made possible through the incredible progress in communications, has, on the one hand, led to an unprecedented explosion of global wealth but, on the other hand, has considerably increased the vulnerability of the system as a whole. Indeed, limiting regulation to the self regulation mechanisms imbedded in free markets has abundantly demonstrated its limits: it has allowed the USD, currency of the biggest world power, to infiltrate so deeply in financial and economic circuits (through financial products and its derivatives) that it has led to the contamination of the entire international financial system.

 

If the option to return to an old fashioned “exchange control” regime must be discarded if one wishes to avoid suffocating the world economy and killing any hopes of progress, in particular in the most destitute countries, it is equally illusory to aim at implementing a universally applicable detailed regulatory framework. Such an objective would correspond neither to the needs of the great majority of actors neither to the demands of efficiency. 

 

Before addressing the question of the contents of new regulation, it is important to define its overall architecture. A pyramidal approach would appear to be most appropriate, allowing for reconciliation between the universality of basic principles and their application to global actors and regional and national specificities for operators whose activities are wholly contained within such smaller areas. This approach is similar to the proposals that are being considered for the regulation of EU banks where it is envisaged that only some 40 banks that operate trans-nationally would be subject to supervision at Union level, leaving the greater number of institutions accountable to their national authorities. Within the new universal regulatory framework, it should be possible to operate on three levels: global, regional and national.

 

Another axis of “tax havens” should be addressed. The capacity to operate as a financial institution, anywhere in the world, should be subject to a licence granted by a State that is a Member of the universal regulatory system. This licence would be global, regional or national and would entail direct and indirect supervision accordingly: even if local authorities were entrusted with routine supervision within their jurisdictions, the beneficiaries of regional or global licences would be open to inspection by corresponding authorities on demand. A procedure of universal “exchange of information” should be instituted, the acceptance of which would be a prerequisite to partake in the world regulatory system which alone can provide suitable protection for the consumer and would largely put an end to damaging tax competition. The aim is absolutely not to institute any form of uniform taxation, because competition between States through an advantageous tax regime of its residents is a legitimate and healthy competitive tool. On the other hand, what is unacceptable is the protection of “non residents” by aiding and abetting them in their attempts to avoid their national tax obligations.

 

Another classification concerns the nature of the institutions subject to financial regulation. The current crisis has pinpointed the inability of the current framework to regulate properly the activities of institutions whose operations have progressively extended to new areas in parallel with liberalisation and/or deregulation.  The suppression of the Glass-Stiegel Act, the acceptance of the concept of “bank-insurance” and the explosion of the unregulated CDS market constitute three examples among many others of instances where the regulatory framework was not adapted to corresponding market developments. While Secretary Poulson has already expressed himself in great detail on this subject in the American context, it is of great importance that it be considered from a multilateral viewpoint so as to ensure appropriate coherence of the new framework. 

 

As President Trichet so aptly put it during his interview on French television, regulation is aimed at framing risk not at eliminating it: “without risks there would be no need for regulation and… risk taking is an essential element in fostering growth.”  It will therefore be necessary to adapt regulations to the type of institution concerned: banking regulation should be distinct from “Hedge Fund” regulation. It is important that the latter be allowed to take risks in line with their financial models, as long as they are transparent and subject to appropriate supervision that prevent their operations from having systemic consequences capable of destabilising the financial system as a whole.

 

Another theme that will be central to the negotiations concerns responsibilities. It is essential to lay out precisely the degree of responsibility assumed respectively by market participants, regulators and political and monetary authorities. Particular attention should be devoted to supervisory procedures (both internal and external) as well as to enforcement measures that should be dissuasive to forestall improper behaviour. Concrete measures of international judicial cooperation must be added to existing agreements if one wishes to re-establish the confidence of ordinary people in the financial system. It is obvious that this is a very delicate problem because it confronts different concepts of “justice” that are deeply embedded in national traditions that are as different as they are legitimate. It will certainly not be the easiest subject on which to reach a consensus but it would be very dangerous to overlook it.

 

Conclusion:

 

The non exhaustive list here above of complex matters to be considered by the Conference implies careful preparation, all the more that the negotiating process is aiming in itself to contribute the reinforcement of confidence which is re-emerging very slowly.

 

A structure of staged meetings – inspired by the Vatican Councils formula – seems most suitable to meet the challenges on hand. It would allow for:  the creation of a “Permanent Secretariat” which would coordinate the work in progress; the establishment of specialised “Working Groups” benefiting from the advice of qualified specialists (including market participants) who would prepare the decisions to be taken at political level; the inclusion in the process of the greatest number of future  Member States in such a way that each one can assume ownership of the outcome and sell it to their respective public opinions. 

 

If, at the time of the first meeting in New York, which must take into account the imminent change in the American Administration, an agreement, limited to the framework of the negotiation could be achieved, an enormous step forward would have been accomplished. It would be the best possible omen for the success of an ambitious reform that will need to be implemented progressively over the coming decade.

 

 

Paul N. Goldschmidt

Director, European Commission (ret); Member of the Advisory Board of the Thomas More Institute.