Political economy of resolving financial crisis and do we need a WFO?

WSJ Blog pointed this paper/commentary from Barry Eichengreen. Eichengreen is an economist with multiple hats. He has written insightful papers on financial history, great depression, capital flows, financial stability etc etc.

In this paper, he tracks the crisis from an interesting political economy angle. First he says:

 As a financial historian, I have come to expect phone calls from reporters whenever the stock market tanks. .Could this be the start of another Great Depression, they ask?. No, I respond, a stock market crash is not the same as a depression. More to the point, policy makers have learned the lessons of history. Ben Bernanke, the chairman of the Board of Governors of the Federal Reserve System, is a student of the Great Depression. He understands that policy mistakes were responsible, in good part, for the economic crisis of the 1930s. He is committed to avoid their repetition. What happened before will not be allowed to happen again, I confidently conclude. Now I have stopped taking reporters calls.

Then he discusses how Hoover admin raised taxes in 1929 and how unresponsive was monetary policy. However, this time Fed and Fiscal Policy have been more proactive. hence, we are much better off and would avoid great depression.

Then he comes to the global situation:

Why, given that this is a global credit crisis and recession, have policy makers in other countries failed to move as aggressively? And why have U.S. policy measures, if so appropriate and well informed, not halted the downward spiral?

The answer to the first question may be that the crisis has been slower to manifest itself in other countries. In addition, some countries, notably emerging markets with debts denominated in foreign currencies, have resisted loosening policy if this means allowing the exchange rate to weaken. They find themselves in the same position as countries whose central banks were prevented from loosening in the early 1930s by the restraints of the gold standard.

Another factor may be that policy in other countries, European countries in particular, isnot informed by the same powerful historical narrative in which the economic crisis of the 1930s was caused by the inaction of governments and central banks. There are no European counterparts of Milton Friedman and Anna Schwartz who devoted more than 100 pages of their influential monetary history of the United States to this interpretation of the Depression. Rightly or wrongly, Europeans drew other lessons from their economic history: the importance of  avoiding competitive currency depreciation and of keeping policies on a steady course.

This is excellent insight from economic history. Now why policy actions have not stalled the ongoing recession? 

As for why U.S. policies have not been more successful in containing the crisis, part of the problem may actually be the tendency for policy makers to take their history too literally…… Ironically, memories of the financial crisis of the 1930s, which was first and foremost a banking crisis, may have led our policy makers to focus on this segment of the financial system to the neglect of others. At first they lent freely to commercial banks but not to other institutions, and they have been playing catch-up ever since.  

There has also been a clear influence of ideology framing the response. The reluctance of the U.S. Treasury to use the Troubled Asset Relief Program (TARP) to inject equity capital into the banks reflected an ideological bias against government ownership of financial and non financial firms. For months Treasury Secretary Paulson was unable to utter the word .nationalization. despite the all-but-unanimous insistence of professional economists that capital injections were essential for stabilizing the banks.

He also talks about international cooperation in the crisis

There has also a good deal of international cooperation. Central banks have been in constant communication, which of course they also were in the 1930s. But in contrast to the thirties, this time there has been a readiness to back words with deeds.

This is quite unlike the situation in the 1930s, when France delayed and then scaled back the extension of credits to Austria through the Bank for International Settlements owing to talks about the formation of an Austrian-German customs union and Germany.s decision to build pocket battle ships, both in violation of the terms of the Versailles Treaty . a decision that allowed the European financial crisis to spiral out of control.

Superb. He then says what was seen then in Europe is now seen in Asia between Japan and China.

 Asia is the one place where there are audible echoes of the interwar tangle between France and Germany. Relations between China and Japan resemble those between France and Germany after World War I more than after World War II. While Asian countries have created a regional system of financial supports known as the Chiang Mai Initiative, they have not been  willing to activate it.

 To finesse this point, disbursing credits through the Chiang Mai Initiative, after the first 20 per cent, requires the recipient to negotiate an adjustment program with the International Monetary Fund, but with memories of the 1997-8 financial crisis still raw, governments are unwilling to approach the Fund. (Recall that the 1997-8 crisis is known in Asia as the IMF crisis.) Beijing prefers to see the creation of a more extensive financial support system within the region, while Tokyo resists this on the grounds that China would be the dominant party in that system. The Japanese government for its part would prefer recycling Asian reserves through the IMF, where it has twice the voting power of China and designates one of the deputy managing directors, whereas China, whose voting power in the Fund is roughly equivalent to that of Belgium, is understandably reluctant to go this route.

Then he says, China is not as big as US was then in 1929 and lot was dependent on US then and now as well. Despite this China has taken some initiatives like fiscal stimulus. It deserves a better deal and get appropriate representation in world institutions.

He says clearly that financial flows will slowdown and countries will be more receptive to accept capital. The countries that were more open to capital have done much worse.  I however doubt this as this is the case each time. Even in Asian crisis Korea suffered but opened up much more.

He then discusses what should happen to the international financial architecture. This is really interesting. He advocates 2 approaches:

1. A GATT-like process to foster closer cooperation on supervision and regulation, internalize cross-border externalities and avoid beggar-thy-neighbor financial policies has already been proposed, notably Gordon Brown. The brains behind this operation, which would describe best practice and define the obligations of members, would be the Financial Stability Forum of finance and supervisory officials. The result would be a college of regulators, where information would be shared and best practice would be defined. Where the FSF would provide the brains, the IMF would supply the brawn. Acting as the financial cop on the beat, it would monitor the compliance of countries with best practice and sound alarm bells on detecting violations. Naming and shaming countries would intensify both market discipline (and peer pressure)

2. A more ambitious alternative would be a World Financial Organisation akin to the World Trade Organisation. Membership would be obligatory for all countries seeking freedom of access to foreign markets for domestically-chartered financial institutions. The WFO would define obligations for its members; they would have to meet international standards for the supervision and regulation of their financial markets and institutions.

Hmm. Rodrik and Subramanian had raised similar point to set up an international organisation to manage capital flows. However, I am not sure whether a body like WTO will help? WTO itself has struggled to move the trade agenda forward. We have been stuck with Doha for so long. The first suggestion looks a better one.

An excllent insight in just 15 pages.