Highly Distingueshed Guests,
Ladies and Gentlemen,
Never before has the financial sector played such an important role in the world economy as in the last few years. Financial markets triggered the economic crisis. Failure to reform them is endangering prospects for economic recovery. There is growing consensus that unless the international monetary and financial system is overhauled, long-term, stable development will be undermined.
A sound financial system is at the heart of any economic organization. As recent history has shown, turmoil in the financial world can cause prolonged, irreparable damage to the functioning of the real economy. Only a well-regulated global financial system will guarantee the future of each and every one of us. Yet it is all too evident that we are still a long way from achieving that goal.
Bretton Woods: a world long gone
At the root of this predicament is the global political situation. But to explain this we must take a quick step back in history.
The Bretton Woods Agreements that regulated the world economy for decades were possible because in 1944 the United States was the undisputed global power of the day. As a result, the international economic order was based on this unchallenged pillar. Everything worked fairly smoothly as long as the American economy dominated the world economic scene. Things started working less smoothly with the end of the immediate post-war period and the rise of other economic powerhouses. The new situation was apparent as early as 1971. With the end of the convertibility of the dollar. This signalled that the United States was no longer the world’s only economic pillar. After that, monetary and financial management became increasingly complex and is certainly no easier today in a period when the redistribution of economic power is now accompanied by progressive change in the balance of political power among players on the world political stage. The long transition from a monopolarism to multipolarism has certainly not increased the likelihood of reaching agreement on new global monetary and financial regulations.
Historically dominant countries – first among these, the United States – tend to slow down any process of change in order to preserve their privileges as holders of the world’s reserve currencies. Countries enjoying vigorous growth – like China – have the long-term objective of radically changing the system. They are fully aware, however, that achieving this takes time. They need time first and foremost to ensure that the new balance of power is both consolidated and perceived as definitive. And they need time to prepare their domestic market for the convertibility of their currency, and adapt their banking system to the prevailing international rules. Ascending countries have clear long-term objectives; they want to see a multi-player international monetary system. They know, however, that if they are to achieve a system that reflects the new world situation, their approach must be gradual and prudential. The goal is clear but achieving it requires a long-term strategy, not least because excessive haste could place harmful tensions on the world economy as a whole and slow their own development as a result.
The recent BRIC meeting on the island of Hainan was highly significant in this regard.
While participants reiterated their common interest in changing the balance of power also in the monetary and financial sphere, they were only able to take limited-scope decisions. They asserted the intention of making increasing use of their national currencies in trade relations with each other, and underlined their common will to reform the working of Special Drawing Rights. They also pledged to add other currencies to the four that make up the SDR basket and represent only the US, Europe and Japan. The meeting did not, however, produce more than this declaration of principle. This was firstly on account of the enormous technical problems that need to be solved and secondly, because the long term interests of the BRIC countries do not always coincide. We have started down the road of international monetary reform but the journey will be a long one. When, at the height of the financial crisis, the G8 finally gave way to the G20, some believed that this would step up reform of the international monetary system. However, things turned out very differently from their initial promise. Reforming zeal has weakened with each successive meeting. Although this may be accounted for in part by the slowdown of the economic crisis, it is, however, also due to the objective differences among G20 members. The G20 agendas from the London to Pittsburgh summits through to the present day have gradually lost their punch and sense of urgency.
The Delicate Balance that is International Cooperation
We have had to admit how difficult it is to regulate international economic relations and build cooperation based on a future balance of power agreed by and favourable to all.
Nonetheless, the shift from the G8 to the G20 remains an event of fundamental importance. It marks an acknowledgement that no decision that will influence the future of our planet can be taken unless all the world’s major economic and political players are party to that decision. This, however, is not sufficient to usher in a new era of international cooperation, first of all because of the limits of the G20 organization itself, which lacks the stable, robust scaffolding required to carry out preparatory work. The G20 is still coming to terms with the idea that to be effective, complex multi-party international organizations must have a strong permanent secretariat to back them. As the scant results of the Nanking conference showed, this cannot be replaced by hurried preparatory meetings geared especially to the domestic political agenda of one member country. G20 action to instigate new international relations is further weakened by its slowness to acknowledge that we have entered a new era in relations between the different countries. The changes in the balance of power I mentioned before create a cacophony around the G20 table that makes any agreement on the reforms needed for the ordered development of the world in the future an arduous task. Even if considerable strides forward have been made on important technical issues – especially as a result of the work of the Financial Stability Board – there has, however, been very little change in the international monetary and financial system, because it is difficult – very difficult – to achieve harmonious regulation of the global economy in a world that remains politically fragmented.
Regulation is becoming increasingly difficult for the very reason that finance and the Economy are becoming more important in the political arena than military strength itself.
While the mere authority of one country (the United States) no longer holds, it is equally true that rules cannot be dictated by a two-way dialogue –between China and the United States. Today’s world can only be managed by a large number of players.
The Legacy of the Financial Crisis
Let us go back and examine the recent economic crisis.
In terms of magnitude and speed with which it spread, it was no less dramatic than the Wall Street Crash of 1929 that lasted many long years and led to the general impoverishment of the whole planet. While I do not want to dwell on the differences and similarities between the two crises, it must be said that because of past experience, governments today are better prepared to take remedial action.
The first big difference in the reaction to the crisis on the part of governments was not to succumb to the temptation to introduce protectionist trade measures, as happened in 1929. Governments everywhere understood how disastrous that would be for everyone and, despite strong calls to go in that direction, warded off attempts to dismantle the free flow of trade that contributed so much to the expansion of the world economy in previous years. This does not mean that further decisive steps need not be taken in this area, not least because the on-going changes in the political and economic balance of power make it difficult to see what future interests are at stake. For this reason, even if we have not fallen into the protectionist trap, the Doha Round dedicated to improving the rules governing international trade drags on without achieving any real results. A further difference between this and the 1929 crisis is that the governments of the United States and China injected huge sums into the economic system. America’s eight hundred billion dollars and China’s five hundred and eighty-five prevented the world economy from going into a tailspin. It should also be remembered that the crisis had its roots in the economic policies of the United States. Most important was the policy of low interest rates to facilitate home ownership and sustain the economy after the Internet speculative bubble and following 9/11. Secondly, there was ineffectual supervision of financial markets at the very time when these were quickly expanding in quality and quantity.
The Risks of Creative Finance
Deregulation effectively removed the protective barriers that appropriately separated investment banks from ordinary high-street lending institutions. At the same time, with interest rates being kept as low as feasible, surplus liquidity was created that constantly moved around in search of the highest earnings. This in turn created a series of speculative bubbles in diverse sectors: property, raw materials, equity markets and so on. In the wake of deregulation and low interest rates came financial innovation for which the classical economic-policy instruments of the past proved ineffectual. Indeed, financial innovation, which should have served to reduce investment risks and hence, encourage growth, caused the most devastating fall in confidence of past decades. Financial innovation in fact simply spread much of the risk onto unsuspecting investors.
World finance suffers from a deep-rooted contradiction: increasingly global in its reach, it is unable to give itself global rules. This has led to financial innovation taking ever-increasing risks only to offload them for the most part onto investors who are unable to assess what they are getting into.
Nor do I believe this is a thing of the past. In the last few months the large investment banks have resumed their old habits, which led to the crisis in the first place. The financial instruments have different names but the players are the same and their investments are similar in risk and opacity to the derivatives that fuelled the financial crisis. Decisive headway must be made on the regulation front, never forgetting, however, that the task is fraught with difficulties since diverse countries are competing fiercely with each other in order to achieve standards that do not put their own operators at a disadvantage.
We are not yet out of the “moral hazard” that characterised the behaviour of banks and financial institutions considered too big to fail.
And here I would like to stress another point. Creative finance that takes no account of any underlying social or economic situation does not just cause harm when something goes wrong. It is the source of continual market disruption, causing turbulence in the prices of raw materials, oil and food commodities.
When financial transactions exceed by ten or one hundred times the number of “real” operations, the result is permanent disequilibrium of prices that is deleterious to the Economy. In a situation like this, it is statistically more likely that commodity-importer countries will be hardest hit.
The Contradiction between Global Markets and National Controls
Obviously, things cannot continue in this way for long. While globalisation is a boon, its excesses must be kept in check and the weaker players protected. Otherwise globalisation will be politically unsustainable on account of the risks it poses.
I am a profound believer in the market economy; but I also believe that the market works well only when checked by strict rules and controls. We cannot continue a contradictory system that operates across global markets with national rules and controls. Global markets require global rules.
One could counter by saying that in many countries supervisory bodies have grown and multiplied. There are regulatory bodies for banks, insurance companies, stock exchanges and so on. But these regulators, despite the repeated warnings of the Financial Stability Board, are clearly insufficient and in any case, prevalently national in their reach. This is in contradiction to the global economic context.
A common strategy cannot confine itself to a series of abstract rules but rather must:
a) Set down agreed market control measures;
b) Prevent deposit banks from taking speculative risks;
c) Adopt transparency rules and fiscal instruments to limit the continued explosion of so-called “derivative” products;
d) Set down mortgage loan rules in the property market;
e) Impose strict professional conduct rules on rating agencies.
We are still far from achieving these results. Indeed we seem to be reluctant even to start down that road. The large investment banks are once again acting as before, confident they are too big to fail. Even the exorbitant earnings of their top executives have starting creeping up again as if the crisis and its root causes were a thing of the past. Only a short time after the worst financial crisis in the last 80 years, financial speculation is being resumed as strongly as ever. They’ve changed their name but not their spots! The lack of transparency and risk-taking is the same as for the worst speculative operations that led to the crisis. On the eve of the new G20, scheduled to discuss measures to curb excessive financial speculation, there is no agreement in the offing between those countries, like France, for example, which are calling for a tax on financial transactions, and those, like the US, that want stricter capital adequacy rules for financial institutions dealing with highly speculative instruments.
The Case of the Euro
Progress towards harmonisation and oversight of financial policies is proving extremely difficult even in a single currency area and largely for the same reasons. The case of Greece and other similar tensions in the Euro area are in fact a direct consequence of the fact that when the single currency was first established, the larger European countries refused to accept any form of European oversight on their national accounts. This mean that it was impossible to gain an understanding of the enormous overruns countries like Greece were amassing and the unsustainable burden taken on by others, like Ireland, to guarantee the indebtedness of their banking system. The concept of national sovereignty – still pretty much taboo – became a stumbling block preventing the smooth working of the economy for the reason that although many aspects of the markets are global, supervisory rules and systems remain strictly national. It would, however, be wrong to draw the conclusion that the Euro has no place among the key pillars of the world Economy. The rumours and insinuations regarding its possible disappearance from the world economic stage do not take into account how things stand on the ground and that no European country, starting with Germany, has any interest in returning to a system of national currencies, which would be tantamount to splitting Europe into a strong north and a weak south. Certainly in Germany, as in many other European countries, there are strong populist calls for a return to old national values, which leads politicians to delay the necessary decisions or adopt them in a shroud of caution and hypocrisy. It is equally true that Germany’s hesitation, dictated by understandable electoral concerns, has only made the Greek crisis more difficult and complex. It is undeniable, however, that the economic and financial sector in Germany is fully aware that it is thanks to the Euro that Germany has been able to build a trade surplus which in percentage, is higher than China’s. Before the birth of the Euro, Germany would never have been able to accumulate such a surplus because every time its trade balance showed signs of running a surplus, other European partners swiftly proceeded to devaluate their currencies. To give you an idea of how important this phenomenon is, let me just say that when I started my academic career – and it wasn’t centuries ago! – you needed 145 Italian lire to buy a German mark but when the exchange rate was fixed to enter the Euro, it was 990 lire to the mark. For years, devaluations of this kind prevented Germany from creating a surplus; very different from today when in the last 12 months alone, the country has created a foreign trade surplus of 200 billion Euros. And this will be one of the strengths of the German economic system, not just today, but also in the foreseeable future. So even in the event of serious political tensions, it is highly unlikely that any country would relinquish such an advantageous position. In addition, despite the arguments, the political debate and academic analyses into the Euro’s frail prospects, markets continue to sustain its value against the dollar.
It is also worth remembering that today the European economy leads the field in terms of GDP, industrial production and exports. So when people ask me about the pillars of the international monetary system ten years from now, I have no doubt in answering that the world economy will be based on a basket whose major currencies will in any case be the dollar, the Euro and the Yuan, even if most probably they will share that basket with other currencies. Which and how many these currencies will be will depend on circumstances that are difficult to gauge today. Certainly, however, there will be many more voices heard around the G20 table, and finding a consensus will not be easy.
China’s Role and Responsibility
I have neither the authority nor the necessary competence to proffer any suggestions as to the road China may or should take to assume a growing and more concrete position of responsibility within the framework of the international financial and monetary system. This is the topic of ongoing debate within the country itself, in the most diverse academicsettings throughout the world and among the world’s top financial and monetary institutions. Moreover, any decision in this sense will be closely linked to the general economic policy framework the Chinese government intends to implement in the future, especially in the light of the guidelines emerging from the XII 5-year plan approved by the National People’s Congress in March 2011. The problems of capital flow control and the workings of the banking system still have to be tackled in the light of the growing international responsibility China will have to assume in the near future. It will be the task of the government and the Chinese people to take the most appropriate decisions regarding wage levels, the balance between the different provinces, the building of the new Welfare State and the balance between savings, consumption and investments. As to what the international community expects from China, it is that China will cooperate actively in the area of international economic relations. This choice will also depend on the sustained growth objective China still needs to maintain in the long term to complete the great transformation started in 1978. Fostering active cooperation is a primary interest for China but also a necessary task vis-à-vis the whole international community. How to accomplish this function, whether with adjustments to the exchange rate, measures to increase domestic demand or with a mix of both, is the exclusive responsibility of the Chinese government. In the long run, it is certainly a Chinese interest to have a transparent financial system with a free flow of capital in and out. And as a consequence of capital inability a flexible exchange rate.
Many years will be needed (we in Europe did in thirty years) but the opening of the banking and monetary system is indispensable. It is not necessary to do it immediately but to be persistent in this direction.
The direction is important. Non the speed. The greatest concern today and certainly the greatest danger for the future of the Chinese economy is inflation. For many years, China served the function of containing the prices of industrial goods on world markets both through national entrepreneurial initiatives and through multinational companies located in China. In an initial phase, Chinese competition was founded especially on low wages. In recent years however, increases in productivity have sustained production costs or made them even more competitive despite the strong wage increases. Not to be forgotten either is the transfer of less specialized production to the poorer provinces and their replacement by high value-added and research activities in the most developed areas. This virtuous transformation might be threatened or even stopped by inflationary trends fuelled by a combination of increased international prices and increased domestic production costs. Even if technological innovations, especially in the alternative energy sector, succeed in alleviating the pressure on demand, China will always be a huge importer of food, energy and raw materials. No one can foresee with certainty how future price trends will develop, but all the elements we have today lead us to believe that this will be an upward trend, both on account of a larger world population but especially because of a strong growth in demand thanks to better standards of living enjoyed by hundreds of millions of people in many countries around the world.
Over and above the particular domestic real estate situation in China, there are risks that prices will increase in those sectors where rising international prices are not easily offset by growth in domestic productivity. The greatest risks are obviously in the food and transport sectors, where the most affected will be lower income populations. Failure to keep inflation under control would naturally force the introduction of adjustment measures, with consequences that would severely affect not only China but also the entire world economy. We should not forget that it was only dynamic growth in China and other developing countries that prevented the financial crisis from turning into a global tragedy and the world economy from stagnating for many more years than it did.
The Growing Interdependence of the Global Economy
The picture I have perhaps too hurriedly sketched out leads us nonetheless to the undeniable conclusion that the most salient feature of the world economy is its interdependence. Just think for a minute of another recent fact, the negative outlook issued by Standard & Poor’s on the American sovereign debt. In theory, this announcement should have been of concern to the United States alone. In fact, it caused anxiety throughout the world, starting with China, which holds a conspicuous slice of the American public debt. We live in a world full of contradictions. In the popular imagination, China on the one hand, and the United States – and Europe – on the other, have opposing interests. But then it becomes evident that any inflation in China would be very detrimental to Western economies and any increase in the American debt risk is viewed with terror by institutional investors, including the Chinese government. We should also reflect on the fact that the largest energy importers in the world – which include China, the United States and Europe – would have every interest to cooperate when it comes to deciding on supply security issues. I could continue to give examples in many other fields before coming to the general conclusion that economic and financial security has to involve convergent strategies agreed on by the world’s major economic players.
Building a Multilateral Future
Building convergent strategies at a time when power has become fragmented is an extremely difficult task. This is because a system of scattered power does not just involve relations between sovereign states but also with industrial enterprises, banking and financial organisations, pressure groups and NGOs, all of which, albeit to a lesser degree than the power wielded by states, are having an increasing impact on world political decisions. With so many players, it is becoming increasingly difficult to run institutions and construct adequate collective responses.
This assertion is certainly a valid general statement. But if we confine ourselves to the economic and financial relations among states, it is obvious that regulating surpluses, deficits and imbalances requires not a bilateral but a strongly multilateral approach, one that rests on the pro-active role of the large supranational institutions like the United Nations, the International Monetary Fund, the WTO and all the other organisations that arbitrate between the different countries. So tackling the world’s financial problems within a wider framework than the existing political context is a must.
At this point we are faced with the difficulties I outlined at the start of this talk when I said, that in this transitional phase, players believe they can achieve results that best serve their interest delaying the agreements in the longest possible timeframe.
My final message is that this approach is deeply flawed. A global agreement is indispensable if we want to surmount the crisis and if we want to go down the road towards harmonious development of the world economy. A multi-polar world is a world based on mutual interdependence.