From the perspective of Financial Architecture, the G20 communiqué represents a major and positive change in the way world leaders view financial crises. They have definitely moved from a view according to which crises are largely homegrown, to a view that allows for the existence of systemic crises, chain-reaction accidents involving many innocent bystanders.
To appreciate the change, it is useful to compare how international financial institutions are handling the present situation relative to, for instance, the way they did in response to Mexico’s 1994/5 (Tequila) crisis. The Tequila crisis was met by an innovative $50 billion IMF-orchestrated bailout package, half of it funded by the US. The package took highly pro-active and courageous leadership on the part of the Fund and the US Treasury. However, the package took three months to be implemented – long enough for the market to conclude that Mexico’s economy had become a “basket case” – and was laden with pro-cyclical conditionality.
Compare this with the kind of policies that the G20 are now implicitly endorsing, like the brand-new and large IMF Flexible Credit Line, FCL. Mexico has already applied for a hefty $47 billion FCL and is likely to get it even though the economy is still far from a balance-of-payments crisis. Other credit lines that are in accord with the communiqué are the large currency swaps that several countries arranged with the Fed a few weeks ago.
These are anti-cyclical liquidity-enhancing instruments, intended to prevent a crisis from happening. They protect countries from systemic capital market shocks and, thus, mimic those that would be employed by a Global Lender of Last Resort, GLLR. By their size, timing and automaticity they are quite different from those employed under a typical Stand-By Agreement. These new facilities are welcome addition because when the capital market is the source of the shock, expectations take the center stage. Thus, preemptive action is essential. Moreover, the sums must be large because capital-market crises involve stocks, e.g., bank deposits (although actual disbursements may be small if preemptive and timely action is timely taken). Finally, the funds must become available on the spur of the moment without many strings attached (automaticity) because in the financial sector partial bankruptcies are as bad as full-fledged ones. The communiqué sends a clear signal that the G20 are coming to grips with these issues, and are groping towards a GLLR. This alone is good enough reason to celebrate.
The communiqué, however, represents work in progress and there are many details that will have to be hammered out. The sums involved are large but there is no guarantee that they will be large enough to combat the deleterious effects of Sudden Stops in emerging markets. A national Lender of Last Resort (typically central banks) does not have an upper bound on lending; the main reason is that it is hard to know how much it takes to forestall a bank run, for example.
There is no doubt that the G20 will come forward with larger funding proposals if it becomes evident that the current sums are insufficient. But I am worried that this “behind-the-curve” strategy may not achieve its ultimate objective. This concern is heightened by the fact that fiscal stimulus packages in advanced economies could represent an additional drag on capital flows to emerging markets.
A better solution would be to make the IMF operate more like a central bank by, for instance, giving it free rein to issue SDRs (along the lines of the original Keynes’ plan). A big advantage over the current procedure is that lending decisions would be left in the hands of a technical institution which is better suited to monitor the global situation on a daily basis and, thus, better able to provide timely and preemptive lending. This would not interfere in any way with full IMF accountability. The main difference is that instead of establishing somewhat arbitrary and possibly politically motivated upper bounds on IMF loans ex ante, the G20 would be able to evaluate IMF policy ex post and, if desired, change its operating procedures. If adopted, these procedures call for major governance restructuring. As it stands, the IMF would rank as the world’s least independent central bank.
A related concern is that financial regulation appears to capture the imagination of the G20, a fact that is reflected in the space the communiqué devotes to these matters. This is understandable because even an economic illiterate knows that the crisis revealed the existence highly improper financial schemes. However, there is the risk that regulation will take center stage and distract attention away from establishing an effective GLLR. As I argued in http://www.voxeu.org/index.php?q=node/3327, global financial stability is likely to require not only a revamped regulatory system but, equally important, an effective GLLR. If financial stability relies entirely on financial regulation, the financial sector may come to a standstill and become a drag on global integration and growth.