The Shape of Things to Come

• Author: Brad Setser
• Position: Fellow in Geoeconomics at the Council on Foreign Relations
• Pages: 36-39

Page 36

National decisions, not international summits, will remake the global financial system

After Asia's financial crisis, the world's leading economies launched a major effort to remake the international financial system. Ten years later, they decided to try again. The 1998 effort to revise the world's "financial architecture" followed a crisis that had originated in the unwinding of the external deficits in the emerging world-deficits that were for a time willingly financed by banks and private investors in the world's wealthy economies. The second effort will follow a systemic financial crisis that started in the United States, spread to European banks that had borrowed dollars to buy U.S. securities, and then infected most of the world economy.

A downturn in U.S. home prices that led to large losses at the large banks and broker-dealers triggered the current crisis. But the household deficit of the United States, the United Kingdom, and many euro area economies couldn't have been financed for as long and at as low a rate without an unprecedented increase in the assets of the emerging world's central banks and sovereign funds. Private investors were never that keen on financing large deficits in the slow-growing United States; they wanted to finance the fast-growing emerging world.

The 1998-99 effort never quite lived up to its name: "architecture" suggested building new institutions or at least remodeling existing institutions for international economic and financial cooperation. That clearly didn't happen. What emerged instead was a host of suggestions to help emerging economies reduce their vulnerability to sudden swings in capital flows-along with new "restructuring" clauses in international sovereign bonds governed by New York law and new IMF lending facilities designed to help countries facing crises stemming from sudden swings in capital flows.

At the same time, the global financial system that emerged from the last crisis was fundamentally different from the financial system that existed before the crisis. A world where unprecedented growth in the foreign assets of emerging economies' central banks helps finance a large U.S. current account deficit at low rates is not the same as a world where private investors in the United States finance deficits in the emerging world. Neither the IMF nor the G-7 changed all that much. But the world around them did.

Decisions, decisions

The most important lesson from the past is that the international financial system is defined more by the decisions key countries make during and after a crisis than by carefully chosen communiqué language. The architecture for responding to "capital account"crises emerged from the U.S. decision to lend large sums to Mexico when it couldn't refinance its dollar-denominated bonds in 1995, the IMF's subsequent decision to take the lead in providing large-scale financing in the Asian crisis, and the conditions the IMF attached to its loans to Asia. The G-7's Koln Communiqué-which explicitly tried to lay out the G-7's vision for the financial architecture-didn't define the world's exchange rate regime. That emerged from the collapse of Argentina's currency board, the success of Brazil's managed fl oat, the persistence of currency boards in many Eastern European economies, the Gulf's ongoing dollar peg, and-above all-China's decision to maintain its link to the dollar even after the dollar started to depreciate in 2002. The regulatory regime was defined as much by the deci-Page 37sion not to rein in the shadow financial system-the largely unregulated or lightly regulated institutions that came to play much the same role in the economy as banks-as by the work of the Financial Stability Forum.

Three additional lessons from the 1998 architecture debate-and subsequent debates on the global framework for preventing and managing international financial crises-are worth remembering.

Getting the right group of countries around the table doesn't guarantee results. Real change happened when there was a broad...