Systemic Failure: Lessons from the World of Trade for the World of Finance
Why have the trade and finance systems performed so differently in the financial crisis?
June 17, 2010
As the dust settles from the destruction of almost two years of economic crisis and as millions of people worry about where to recover their lost jobs, it is somewhat surprising how many questions remain to be answered by the Financial Crisis Investigation Commission.
We know there was a systemic failure that had global ramifications. We know it was centered in the world of finance. What we do not seem to know — or at least agree upon — is what caused the crisis, what kind of a crisis it was and how it can be avoided in the future.
Was it a policy crisis caused by too much money chasing too few assets? What role did global imbalances play? Was it a regulatory failure? Or, like 9/11, was it also a failure of imagination?
One thing seems certain: We have been here before. The Great Depression is the baseline for our understanding of global crises. It taught us some critical lessons about the costs and benefits of globalization — as well as the need to create institutions and rules to prevent or mitigate a system-wide breakdown.
It may have taken us almost 20 years, a world war and a fair number of the wrong answers. But ultimately, the set of rules and institutions that came to be known as Bretton Woods put us on a path that has been extraordinarily successful in promoting global welfare.
How did this become possible? Simple — by focusing resources and attention on what have become the three worlds of trade, finance and development.
That raises the pivotal question: What happened in the 60-some years since then to make us so vulnerable to another systemic failure — one that threatens to undo a great deal of the good that globalization has created over the ensuing decades? Was there an institutional failure — and, if so, is there an institutional fix?
If insanity is doing the same thing over and over while expecting a different outcome, are we undertaking a kind of collective intelligence test? Is doing nothing a special form of insanity? Can we tinker at the edges — and really hope that the world will go back on its own to the way things were?
Let’s start with the worlds of trade and finance — and ask ourselves how they performed in this crisis. What is striking is that the trading system performed well in maintaining a set of “rules of the road” that were generally followed. It thereby minimized the decline in trade and allowed trade to lead the way to recovery.
Meanwhile, the finance system came to a screeching halt, moving from asset bubbles, to a liquidity crisis, a solvency crisis and ultimately a worldwide recession.
Getting the right fix in place seems all the more critical in light of the uncertainty of the nascent recovery that is raising once again protectionist pressures — all the more so because the trading system is being asked to carry the weight of a financial system that has yet to reform itself and thereby restore confidence in its capacity to support robust growth.
Why these two systems — trade and finance — performed so differently is one of the central policy challenges for those who would create a more stable international system. We know they came out of a common historical heritage, were conceived by the same policy architects and were targeted at reducing risks inherent in a globalized economy.
And we know they were designed to mitigate the uncertainty that comes with moving goods and capital across national borders, as well as to use the authority of the rule of law to harness the strength of the global economy in the service of global welfare.
It is also helpful to remember that both systems were initially opposed by some of the strongest vested interests of the time, from the U.S. Chamber of Commerce to the National Bankers Association.
What is fascinating is that within the Bretton Woods bubble in which we all grew up, there evolved two very different cultures. The worlds of finance and trade are now truly two very different global systems.
Many financial executives argue without a tinge of cognitive dissonance that the world of finance is too innovative or too complex to be regulated — the market is the best regulator, especially when combined with the insights of self-regulation.
Mao said that a journey of a thousand miles starts with one step, but what he did not mention is the importance of heading in the right direction. Financiers and policymakers alike should ask themselves this question: When you spend decades heading for the distant Shangri-La of a world unfettered by rules of the road, is it any surprise that you eventually get to a place where no one observes any speed limits?
When self-supervision is the ultimate regulatory model, is it so surprising that corporate icons like Sandy Weill, Hank Greenberg and Jack Welch simply moved aside those whose sense of risk put them in the way of visions of financial profits? When you foster a culture of non-transparency, is it so surprising that material information is not disclosed to the public, even with the blessing of top regulators?
Even with some consensus that regulatory failure was a major factor in the crisis, you still have to overcome the resistance to addressing the problem at the international level.
Here it is helpful to remind ourselves that both the IMF and the GATT/WTO systems were created to prevent regulatory capture from frustrating the goal of global welfare.
Global welfare is not a term that is very popular these days, but it embodies the fundamental principle that you should assess what you are doing through its impact on the greatest possible number of people. And you should place a heavy burden on those actions that individually or collectively have an unacceptable impact on others.
We know that avoiding regulatory capture means getting the incentives right — and this is where trade has some critical lessons for finance.
Through negotiations that were driven by principles of reciprocity and mutuality of benefit, agreements were concluded that translated the potential beneficiaries from trade into actual interest groups that now thrive on competition for the $14 trillion in exchange every year.
And if you think free trade means no rules, just ask a negotiator how many pages of rules it takes to conclude a round of global trade negotiations — or to capture the latest free trade area agreement.
Threaten to take away from those interest groups, be they corporate or consumer, their benefits from regulated (free) trade — and you will see what political accountability is about.
The second thing we know is that it will take time, perhaps even a generation to evolve a set of rules of the road that ultimately could be enforceable by the international community against itself.
This kind of self-enforcement is the signature feature of the WTO and explains more than anything why it has withstood the test of time and crises. Peer pressure — as, at best, prevails in the world of finance for now — is nice, but everyone now knows that binding rules and dispute settlement work much better.
So, what rules would have made a difference in the crisis? Certainly, no one is going to dictate those rules, and the international community has some arduous negotiations ahead. But if you accept the proposition that a set of rules could make a difference in preventing or mitigating the next crisis, here are some areas to consider:
- Start with the core rules of integrity: Don’t lie, cheat or steal. Do not create nor support havens for people who lie, cheat or steal — whether in the government or in the private sector.
- Ensure transparency that provides customers, regulators and the public the information they need to understand what they are buying and regulating — and the impact their actions have on the overall market.
- Establish some basic constitutional principles that, like MFN and national treatment, protect against beggar-thy-neighbor practices and policies. If the prevention of systemic failure is the core function of financial regulation, then there should be an international commitment that no nation will regulate its financial system in such a way as to cause systemic failure.
- Develop a common-sense view of what too-big-to-fail means and what is the right size for the financial market that allows it to foster growth without creating undue risk.
- Provide standards for ensuring capital adequacy and protection against regulatory arbitrage.
- Ensure appropriate standards for prudential supervision.
- Establish rules that prevent global imbalances from being a source of systemic risk.
The great Crisis of 2008-09 may well be to finance what the Great Depression was to trade — namely, an inflection point that changes our view of the interplay of capitalism, globalization and sound regulation.
The world may not be ready for a World Finance Organization in the near future. However, the WTO system should be a source of inspiration for a global set of rules enforceable on a peer-to-peer basis.
This may be the best mechanism to hold us to our commitments to make the financial system accountable for its impact on global welfare, to protect us (and our regulators) from ourselves, to make sure we take away the punch bowl before the party gets out of hand — and ultimately to ensure that trade and finance work together in the single world of the global economy.
The great Crisis of 2008-09 may well be to finance what the Great Depression was to trade.
We have been here before. The Great Depression is the baseline for our understanding of global crises.
The set of rules and institutions that came to be known as Bretton Woods put us on a path that has been extraordinarily successful in promoting global welfare.
The trading system performed well in maintaining a set of "rules of the road" that were generally followed. Meanwhile, the finance system came to a screeching halt.
Avoiding regulatory capture means getting the incentives right — and this is where trade has some critical lessons for finance.