III-1.6: Global Financial Integration, Thirty Years on. From reform to crisis

“Global Financial Integration, Thirty Years on. From reform to crisis” mainly describes the several reform movements in financial governance which occurred before the 2007-9 crisis. The volume suggests analyzing the several reasons why the pre-crisis global financial governance revealed itself as incapable of preventing such new crisis. The volume first suggests the last two decades have witnessed tremendous changes in the nature of the state’s involvement in the economy and important changes in the balance of power. Western States along with International Financial Institutions (IFFs) have embraced and encouraged the shifting of part of the responsibility for regulating and monitoring markets from the hands of regulators into the hands of private investors themselves. Such behavior denoted a dramatic shift in power in the global financial realm away from states.

 

Moreover,with financial globalization the influence of private market actors have increased within policy process, leaving aside broader sets of interests and obliging public authorities to respond by adopting market-based approaches to regulation, supervision and corporate risk management. Policy makers deemed that markets were best at understanding and pricing risk while governments’ interventions were usually inefficient and distorting. The pre-crisis financial governance was therefore characterized by a change in the balance of power between public authority and private interests and an accompanying transformation in the notion of the public interest that defines the financial order, posing problems in terms of accountability and input and output legitimacy.

 

And while regulatory change in financial system was always a source of convergence, US and European institutions supported deregulation while developing countries were caught in deliberative forums (Basel Committee, IOSCO) in which their vote was either nonexistent or undermined. Such trend led to developing cross-borders market-oriented standards, whether they were appropriate for developing countries or not. This led to the spreading of market-based international standards. The latter though were yet either too flexible in their application or lightly enforced in domestic law due to the influence that national-level private sector actors have on constraining, modifying and sometimes blocking the implementation of international standards at the domestic level.

 

Contrary to the view that liberalized financial markets would play a disciplining role, dependence on financial swings and private sector influence have encouraged the adoption of pro-cyclical monetary policies, although we know today thanks to the recent crisis thatgovernance of the system should not reside completely in the private domain of the market. Indeed, the volume demonstrates that unaccountable private actors participated in a somewhat closed policy community which have led to policy capture and therefore to some countries’ defiance towards such western standards. Inevitably, the flawed input-side of financial governance (due to capture or lack of emerging countries representation) polluted its output (its effectiveness and its implementation potential). It is today recognized that policy failures which led to the crisis originally laid behind the G7 reforms which had encouraged financial governance to be overly responsive to private sector preferences.

 

In this view G7 pre-crisis reforms were either too market-oriented to be efficient or simply not implemented by certain countries which did not feel as through such standards had neither the input-side legitimacy nor the out-put side legitimacy to implement them. Such trend encouraged regionalism and decentralizing trends in global financial governance. Therefore, the pre- 2008 crisis regulatory environment was made up of incoherent systems of global financial governance, with public authorities in different parts of the world working in different directions.

 

 

The volume asserts that the global financial architecture needs to be more compatible with legitimate national economic development aspirations, political processes and distributive justice (whereas pre-crisis financial governance occurred in a fragmented and decentralized international political environment).Indeed, developing countries have had relatively little influence on the development of the existing international financial architecture, whereas the latter have much been under policy capture, indicating a lack of input-side legitimacy within the current international financial architecture, thus in turn limiting the out-put side legitimacy (or effectiveness) of global governance. Authors take the example of the highly pro-cyclical and market-based nature of the system to point out such limited output legitimacy as well as its limitation of policy space for developing countries.

Authors suggest that the major function of an effective international financial architecture should be to improve the input-side governance of the system and give developing countries sufficient representation to reflect their growing role in the world economy, while more attention should be paid to avoiding policy capture by private interests. Indeed, the input-side influence on the design of the international financial architecture of the very private financial interests which stood most to benefit from the facilitation of cross-border market integration and activity is today directly associated with the causes of the crisis.

 

The volume argues that global financial governance should make the appropriate and politically sustainable balance between private and public forms of authority which should include the interests of emerging market and low-income countries.Indeed, the general message of the volume is to encourage more heterogeneous forums of discussion, which would at least attempt to realize some degree of deliberative equality and would constitute a reasonable first step towards achieving a more inclusive, socially aware and progressive system of global financial governance.The output-side of financial regulation would be in such way improved (more efficient because more appropriate), as well as its input-side (legitimacy due to its policy makers).

 

In a nutshell, by mainly focusing on the input-side and out-put side of global financial governance, the volume encourages enhancing legitimacy on both sides in order to have standards both effective and well-accepted. As Geoffrey R. D. Underhill and Xiaoke Zhang underscore, “legitimacy could be substantially enhanced through better and broader representation based on a range of principles, thus increasing the likelihood of embedding a more acceptable spectrum of norms in global financial governance. (…) in order for the reform agenda to become more legitimate and therefore more achievable, developing countries and broader publics in the developed world will have to be given a major say in the setting agenda” (p.301).

 

 

The first contribution of the volume is provided by Randall Germain (“Financial governance in historical perspective: lessons from the 1920’s)” who suggests to put financial governance[1] in historical perspective in order to carry historical comparison between the past and the present. He provides for interwar years data on financial governance (1920-1930). His main argument is that, because financial governance is defined by a national/international tradeoff[2], markets need and have always needed careful government oversight to operate; such oversight which at the same time also needs to be supported by an international infrastructure. “Financial governance works best when robust international institutions support strong national authorities” (p.27). Whereas in the 1920’s or today, states require powerful and active international institutions to legitimately govern internationally financial markets.

 

Germain describes, with Braudel, how finance was traditionally governed by national institutions, before financial institutions adapt to imperial ambitions of the political world while coping with powerful nation states and centralized national economies. Yet, swiftly, the “Haute finance” (Rothschild, Lazard Frères, Morgans) and the dominance of London Based private financial institutions over global flows of capital, provided for the basis of global governance with their own norms, best practices and world credit practices. Therefore, faced with the high degree of centralization in the global financial system (central banks etc.), their gentlemanly codes of conduct led to the determination of publics goods by private interests.

 

In order to cope with such imbalance, states increased control over their economies (currency manipulation, capital controls, trade etc.) which required international cooperation with new emerging institutions to address issues associated with cooperation between states. At the national level, states started managing their public debt through monetary policy (allowing for tighter control on the activities of private sector financial institutions), through central banks (required to establish modern standards of financial governance), and through regulatory agencies.

At the international level, Germain identifies several first steps towards the emergence of a genuinely international system of financial governance. It was the beginning of multilateralism, used in order to recalibrate the calculated costs associated with the trade-offs between national and international pressures. First, the involvement of public authorities in the international organization of credit led to the creation of the Bank of International Settlements (BIS) in 1930. Moreover, the Agent General for Reparations payments (in order to reconcile war debts and reparations with postwar economic and political realities) is deemed by Germain as an important milestone “not only in assembling the required machinery to make international transaction workable, but also in establishing the principle that the vulnerable or weak have an important stake in the construction of the apparatus of decision-making”. Therefore, already at the time, there was an admission that cooperation requires an international institutional infrastructure beyond what markets could provide. And although states’ effort to resolve the conundrum of inter-allied wartime debts and reparations ultimately failed, they provided much of the basis for the subsequent Bretton Woods negotiations.

 

When comparing the interwar period with the 2008 crisis period, the author first notes that international cooperation has proven far most effective in the management of the current crisis that in the interwar period : lessons were learned. Moreover, Germain suggests that from a political point of view, both periods were seeing tremendous changes in the nature of the state’s involvement in economy and important change in the balance of power. Moreover, in both periods, financial governance occurs in a fragmented and decentralized international political environment. Moreover, a parallel made be made in the powerful nature of the global pressures driving financial governance: capital mobility, privatizations, deregulation and securitization, a system that Helleiner and Pagrilari will later call in the volume “standards-surveillance-compliance regime”. Such key pressures and drivers explained the need for international efforts to improve financial governance.

 

Yet both periods depict the worrying reluctance of states to support and extend the international infrastructures which supports domestic initiatives to govern financial networks, although sustainable financial governance requires a balancing between national and international imperatives. The two decades preceding the credit crisis was characterized by an attempt to re-embed liberalism, a period during which there was little cope for national policy objectives that might be at odds with a global governing consensus. “In short, global cooperation ahead of the credit crisis was no longer a complement to national policy-making, safeguarding the efficacy of the latter- it was a substitute, with national authorities relegated to implementing a globally agreed “best practice”” (p.39).

 

Germain therefore worries that, in a context where priority is put on capital mobility and thirst for private gain, states have a predisposition to cede authority to independent central banks and to parcel out the regulatory patchwork to statutory independent organizations and committees, which threatens to undercut the very political support they will need to reassert public control over global financial networks. On the contrary, international cooperation needs to accommodate legitimate national concerns, and requires that the conceptual frameworks and the institutions preserve international financial openness while enabling governments to find national answers to painful reductions of public debts.

 

Germain concludes that, based on such historical comparison, financial governance has been necessarily global in scope and national in execution. Therefore, liberalism demands a robust global public infrastructure that works to support national goals. Indeed, “a historical perspective provides the key insight that strong national states buttressed by strong and well-embedded international institutions have historically been the most viable means of creating effective, efficient and legitimate governance mechanisms” (p.41).

 

 

Eric Helleiner and Stefano Pagliari’s contribution, “Between the storms: patters in global financial governance, 2001-2007”, underscores how states are less eager to change financial governance in periods of calm (e.g. 2001-2007) rather than in period of turmoil (e.g. 1994-2001), since states would rather react to economic phenomenon than prevent them. The authors recall such trend because when several crisis in the 1990’s occurred in emerging countries, (Mexico, Argentina, East Asia), the G7 launched a set of ambitious regulatory reforms to create a “new financial architecture” (NIFA). The latter was however weakened by, first, the subsequent period of calm (2001-2007) which hurt the urgency of the reform and scaled back the level of states’ ambition, and second, the reaction of emerging countries to 1990’s crisis, which differed from the G7’s one. Therefore, the pre- 2008 crisis regulatory environment was made up of “incoherent system of global financial governance, with public authorities in different parts of the world working in different directions” (p.43).

 

Helleiner and Pagliari suggest that the G7 reaction to 1990’s crisis in emerging countries was supposedly disoriented for two reasons: first because it blamed the regulatory framework of emerging countries (whereas the 2008 crisis came from Wall Street), and second because it adopted a market-based form of governance, mainly privileging soft law (standards, codes of conduct etc.) made up by private actors. Indeed, after the 1994-2001 crises, the G7 urged emerging countries to adopt Western Standards in terms of transparency and supervisory systems by formulating and disseminating a common set of international best practices standards and codes. Whereas the first standards were mainly macroeconomic (in response to Mexico’s excessive borrowing) in cooperation with the IMF, the G7 expanded their agenda to microeconomic factors (such as prudential requirements). Western countries therefore formulated for the entire world standards on banking, securities, accounting, auditing, corporate governance, while also introducing a new ‘Financial sector Assessment Programme” (FSAP) and compiling “Reports on the observance of Standards and Codes” (ROSCs). A ‘standards-surveillance-compliance’ regime was therefore put in place by the G7[3], along with the Financial Stability Forum[4] to rectify the lack of coordination between regulatory agencies, central banks and treasuries. Moreover, the G7 not only blamed emerging markets’ lack of regulation for the 1990’s crisis, but also western countries’ own rescue packages (via the IMF) as it appeared to have created ‘moral hazard’ at the international level[5].

 

But the apparent calm of the 2001-2007 periods downgraded the G7’s priority given to the NIFA, and other issues such as money laundering or terrorist financing were preferred. Moreover, whereas the IMF, through Anne Krueger, suggested in 2001 a new IMF-led Sovereign Debt Restructuring Mechanism (SDRM), the latter was rejected in 2003 by G7 policy makers which deemed it to bureaucratic, as opposed to a more market oriented Collective action clause approach to debt restructuring, which soon became a market norm. Other alternatives to the SDRM were put forth by private institutions (i.e. the Institute of International Finance) such as private sector voluntary codes of conduct to govern debt restructuring processes, designed to influence the behavior of both investors and debtor governments with respect to information sharing and transparency. Other codes of best practices were encouraged by the G7 and the FSF, such as those regarding hedge funds, for which the FSF repeatedly refrained from recommending direct regulation. Same went for accounting and auditing standards, set out by private groups named the International Accounting Standards Board (IASB) and the International Auditing and Assurance Standards Boards (IAASB). As for prudential standards set by the Basel Committee, requiring that banks hold capital equal to at least 8% of their risk exposure, they allowed the most sophisticated financial institutions to use their own international models and databases to self assess their risk exposure. Basel standards also encouraged the use of credit rating agencies to assess the risk of less sophisticated financial institutions. “This was representative of a broader trend which culminated in this period of shifting part of the responsibility for regulating and monitoring markets from the hands of regulators into the hands of private investors themselves” (p.48).

 

Such behavior denoted a dramatic shift in power in the global financial realm away from states. Yet, one must understand that states also played a role in encouraging this trend, since for example the G7 triggered the emergence of market-based governance mechanisms by delegating regulatory functions. One of the reasons of such shift of regulatory authority to the private sector is ‘policy capture’ (or regulatory capture). Indeed, “public authorities found market-based governance mechanisms attractive tools to help them to ‘walk the fine line’ between stability and competitiveness’ (=the regulators’ dilemma). At the time, policy makers deemed that markets were best at understanding and pricing risk while government intervention was usually inefficient and distorting.

 

As for emerging countries’ reaction to the 1994-2001 periods, they did not understand these crises as domestic regulation’s failure but rather as a consequence of crony capitalism. The IMF’s intervention was unwelcomed and the NIFA agenda and its “one-size fits-all” best practices did not content such countries with different tradition that western’s ones, and during the elaboration of which, they were lightly heard. In reaction to G7 initiatives, many emerging countries took steps to boost their policy autonomy: accumulation of foreign exchange reserves (which contributed to the buildup of global imbalances and feeding the bubble mounting in the American economy through the sustained inflow of cheap credit), regional agreement to protect regions from external influences (such as the ASEAN’s Chiang Mai Initiative). In this view the NIFA encouraged regionalism and decentralizing trends in global financial governance (e.g. Asian countries even considered creating “Asian Basel”).

 

In a nutshell, the 2001-2007 periods saw western and emerging countries working in two separate directions, creating an incoherent system of global financial governance. The NIFA had failed because it had deemed that 1990s crisis were rooted in emerging countries’ regulatory system, encouraged best practices which were not at all well implemented even in western countries, and reforms decided in 1990 were never completed. In the author’s view “these differences make the crisis a turning point in the evolution of global financial governance, opening a different cycle from the one that emerged from the crises of the 1990s” (p.55). Moreover, private actors such as private banks (and their Flawed Basel II application), credit rating agencies (and their conflict of interests or hedge funds (self regulated) suddenly appeared undeserving of trust.

 

In a nutshell, when financial stability ended in 2007, the most financial issues became politicized and the “shadow of the state quickly loomed much larger on market-based governance mechanisms, and regulators did not hesitate to assume regulatory roles that had previously been delegated to the markets” (p.49). Regulators finally endorsed that markets could not be left self regulated. In this view, the new cycle in global financial governance is much less likely to rely on market-based forms of governance as described in Helleiner and Pagliari’s paper. For example, the G20 already reformed the IMF twice in two years (mandate, scope, voting representation, budget) and other key institutions such as IOSCO, FSB, Basel Committee also expanded their membership to include systematically important emerging countries. The authors therefore seem confident that, although it is too soon to know how the decentralizing trends in global financial governance as well as the relation between private markets and public authorities will turn out, the era described in their chapter and fostering such trend has ended.

 

 

Andrew Baker, in his “Deliberative financial governance and policy forums”, also takes interest in the mechanisms that form global financial governance. Amongst the world’s international financial governance and deliberative institutions, Andrew Baker suggests studying the impact and efficiency of apex policy forums. Such term refers to forums bringing together the most senior national figures from national finance ministries and central banks, to engage in processes of recurrent informal deliberation with the intention of formulating international consensus (consensus on strategic priorities, agendas and normative parameters for our global financial governance etc.). Such forums include the G7 and the G20 since 1999. Based on the assumption that there is a clear relationship between input and output, Baker suggests that although apex policy forums do have a certain amount of powers, there are so homogeneous that they form restricted input which causes flawed outputs (based on error of judgment in policy making, lack of implementation etc.), as the recent 2007-9 crisis demonstrated.

 

Apex policy forums operate at the highest levels of national officialdom and seek to define priorities, directing, steering and framing work conducted elsewhere. Their deliberations and statements (or communiqués) design strategies, agendas and policy orientations to national authorities, markets, press and other specialist bodies or committees involved in the global financial architecture (IMF, Basel Committee, FSB etc.). Whereas the G10 was created in 1962, little macroeconomics policies or exchange rates debates were recently debated, but rather normative consensus about what the global financial system should look like (its functioning, its values etc.). For example, the G20 played a politically significant role when implicitly mandated to define post-crisis agreement on international and domestic action, arrangements on crisis prevention or consensus on the decision-making in other institutions such as the IMF.

Although G’ groups have no formal or legal mandate, Baker estimates that they have 3 powers: first, the power of veto which influences how other multilateral institutions can function or adopt proposals (e.g. the G7 finance ministries and central banks decided to reject the SDRM proposal, that the IMF therefore had to retract). Second, they benefit from an instigation power as they set broad agendas and priorities for the wider institutional complex of global financial governance (often staffed by less senior officials whereas apex policy forum are staffed at the most senior level). Third, they have a power of endorsement, such as the approval of the findings of more specialist committees that produce norms and technical reports such as the Basel Committee, IOSCO, the FSB and the IMF (which, to enjoy political authority, need the approval of apex policy forum). In a nutshell, they “light fires under civil servants and bureaucrats” (p.62) and give a sense of urgency.

 

Whether or not powerful, apex policy forums and their output (standards, agendas etc.) however suffer from their input. For example, during the 2002-2007 calm period, apex policy forums managed to endorse and reinforce a neoliberal model of financial based on an Anglo-American-centric view of the world, simply because forums were far from neutral and value free deliberative process. Baker gives the example of a G20 workshop held in 2004 on the development of capital markets, during which the only private/civil society representative was an economist from the Institute of International Finance (IIF) representing the largest international banks, while any form of dissent appeared to be absent. Such forums are defined as relatively isolated from perspectives outside the forums’ normative parameters, consensual forms of deliberation and composed of ministers and governors with strong social bonds based on similar shared academic background. Moreover, because they are informal, there seems to be group pressure to conform with participants unwilling to too openly dissent from the majority opinion (Baker gives the example of a Chinese representative who was dissenting with the G20 pro-capital account liberalization but did not disclose it due to group pressure ; he however showed doubts within the IMF, a more formal institution). “In this respect, the context in which debates take place (input) appears to have a powerful influence on the resulting consensus (output)” (p.64). In a nutshell, because such forums are rooted in the social, political and intellectual dynamics of apex policy forum decision-making mechanisms, and do not give a fair hearing to other arguments, such forums can be defined as a “limited argument pool” involving ideational bias and creating powerful conformists affects.

 

Due to this “limited argument pool” issue, the standards and codes agenda of such forums did not encounter the success expected, whereas due to cost implementation, lack of adequate technical assistance, their lack of appropriateness in particular national contexts or their poor implementation record in many developing countries. The author suggests that “these problems are directly related to the restricted input process (the limited argument pool) which has constrained debate in apex policy forums, and has allowed flawed intellectual assumptions to reign unopposed, resulting in the adoption of questionable outputs (standards and codes)” (p.66). Indeed, standards and codes as edited by apex policy forums were all based on the prime assumption that crisis are rooted not in the nature of financial market, which are efficient and rational, but in the lack of transparency, which will automatically be implemented by national policy makers as they fear investors will withdraw their money. Baker also suggests that these codes were never taken into account by market or investors themselves to guide them in investments decisions, but solely by regulators and national authorities. Baker argues that the reason why such assumption that markets are rational was spread globally without dissent from other countries is due to the “limited arguments pools” and social pressures within apex policy forums. In Baker’s view, the content and detail of the macro prudential regulation agenda emerging from the current crisis will without doubt be minimized and diluted by private actors, through national lobbying and expert contributions to the reports and recommendations of bodies such as the FSB, IOSCO and Basel. Because G20 officials resonate with their own intellectual beliefs and prejudices (Baker suggests that they have a genuine intellectual faith in Wall Street’s ideas which come to resemble an ideology), this leads to “enclave deliberation”.

 

On the contrary, heterogeneous deliberative forum must be preferred to deliberation among like-minded people. Baker, setting aside issues such as legitimacy, focuses on mere likelihood of error: in such instance where certain policy are favored not because of their merits but because of social dynamics and limited nature of counter argument, limited input processes directly damage output efficiency and legitimacy. According to Sustein, “what is necessary is not to allow every view to be heard, but to ensure that no single view is so widely heard”. Such enclave deliberation should therefore be limited as much possible, especially because of the influence and the normative setting of such forums.

 

Baker concludes that only a more heterogeneous forum that at “least attempted to realize some degree of deliberative equality would constitute a reasonable first step towards achieving a more inclusive, socially aware and progressive system of global financial governance”. Yet Baker seems optimistic as his recommendation (that heterogeneous groups generally produce better judgments because they consider more information) seems to have been heard by the G20. The latter’s recent communiqués have expressed support for something resembling a more interventionist top-down rules-based form of macro prudential regulation, due to the recent summits which led to emerging markets developing a more distinctively vocal and assertive position.

 

 

The assertion that only heterogeneous forum will lead to legitimate output is backed up by the study of Danny Cassimon, Panicos Demtriades and Björn Van Campenhout, “Finance, Globalisation and economic development: the role of institutions”, which demonstrates the heterogeneity of national reaction to financial integration and the role of institution in coping with such issue. Cassimon, Demtriades and Van Campenhout argue that the relationship between financial integration/openness (the virtues of capital mobility) and economic development (in theory, financial development is good for growth as it allows for the efficient mobilization of savings for productive investments) vary considerably across countries. Moreover, while the development of financial systems and banks can have a positive effect on economic growth (it was the basis for the 1980 and Washington Consensus financial architecture), poorer countries risk entrapment in a vicious cycle of low financial integration and encounter no relationship between cross-border financial integration and economic development. Authors suggest studying the role that institutions play or should play in financial and economic development, especially in emerging countries. They argue that the absence of financial integration is mainly due to the low quality of institutions.

 

Authors underscore many exceptions to the assertion that development of financial systems and especially banks can have a positive causal effect on economic growth. Indeed, based on a study made on sixteen emerging countries, it is economic growth that causes financial development and not vice versa. Other studies show that financial development has greater effects on growth when the financial system is embedded in a sound institutions framework. Therefore, the finance-growth relationship is sensitive to the level of economic and/or financial development, as well as to the institutional development, including institutional quality. “Financial developments may thus not be the quick fix to promote growth in those parts of the world that most need it, such as Sub-Saharan Africa, unless it is accompanied by the strengthening of institutions such as rule of law and property rights” (p.77).

 

The authors put forth four different theories why financial development varies sharply around the world, with some countries experiencing low levels of financial developments. Authors recall the “legal origins hypothesis” (common law countries are more apt than civil law countries to handle market-based financial integration), the “political view of state owned banks hypothesis” (the effect of state owned banks on countries on credit or depositors’ protection), the “initial endowment hypothesis” (such as the effect of colonization on institutions) and the “incumbents and openness hypothesis” (the idea that opening both trade and capital accounts is the key to successful financial development) while not accepting that such hypotheses are relevant to developing countries today. On these different theories, the authors conclude that “financial and industrial incumbents, income and wealth inequality and institutions appear to be the players which interact to determine whether financial development in any given country takes off at a particular point in time” (p.80).

 

The authors further suggests that the neoclassical growth theory (which predicts that integration of local financial markets in the global financial system will boost economic development) is not correct, especially because capital flows from rich to poor countries are far less than the theory predicts. Based on empirical evidence of the continuing divergence in capital flows between groups of developing countries, the authors argue that certain threshold conditions need to be in place to reap the benefits of financial globalization. The empirical data put forth by the authors suggest that financial market development, institutional quality, governance, macro-economic policies and trade integration are these preconditions. However, the authors suggest that policies matter less that institutions since it is the institutions which place constraints on the executive, guarantee property rights, a minimum amount of equal opportunity, broad based education, which all lead to higher growth and less volatility. Authors agree with studies which, “controlling for the quality of institutions, they find macroeconomics policies do not play a direct role, and thus view distortionary macroeconomic policies not as the cause of low growth or high volatility, but as a symptom of weak institutions” (p.82). Therefore, the credibility of policies will depend on as good or bad institutions are.

 

Based on the several data used by the authors and other studies they rely on, if financial globalization occurs in the context of weak institutions, there is no or low GDP and TFP growth, while the probability of crises increases. Many reasons support that volatility and financial globalization are directly linked to institutions. Indeed, in institutionally weak societies, there are few constraints on rules, and any changes in the balance of power may lead to politically ascendant groups to redistribute assets and income to themselves, which creates economic turbulence. Moreover, weak institutions will drive entrepreneurs to invest in sectors in which they can swiftly withdraw their investment, also contributing to economic turbulences.

 

Finally, authors provide for empirical validation of thresholds and multiple equilibria in the dynamics of financial integration. They sustain that an economy characterized by poor property rights institutions will not attract a lot of sovereign capital, and that if global financial integration was to strengthen such institutions as collateral benefits, “we again have a self-sustaining effect of poorly integrated economy trapped at a low level equilibrium (…). Economies that do not have the preconditions in place will find it difficult to integrate in the world economy” (p.85). Authors therefore expect multiple equilibria in the dynamics of financial globalization to disappear once we control for the quality of institutions, and to persist when we just control for policies. Based on a stock-based indicator of financial integration, authors find that there are non-linearities in its “dynamics adjustment to the low-level stable equilibirum is faster than adjustment to the high-level stable equilibrium” (p.88). Authors underscore the difficulty to qualitative data furnished by international organizations with their qualitative measure based on multivariate analysis. Therefore, they conclude that “political economy explanations of financial (under-) development –focusing on the role of incumbents, income and wealth inequality and the evolution of economic institutions- are promising as hypotheses, but need to be further tested” (p.88). They also conclude that controlling for the institutional context eliminates the multiple equilibria (itself based on contract viability/expropriation risk, payment delays, corruption).

 

Based on these findings, the authors conclude that “global financial architecture focusing on the promotion of openness and its primary policy output is insufficient to produce economic growth (...). The system remains exclusionary, as poor countries are not only underrepresented in international policy forums, but also underserviced (…) [which] implies that financial integration cannot replace country-specific development strategies focusing on the improvement of domestic institutions” (p.89). In this view, along with other proposals made in the volume, such as amending contra-cyclical frameworks (Ocampo and Griffith-Jones), challenging the IMF intervention on private financing for low-income countries in debt workout (De Jong and Van de Beer), or to find a new aid paradigm (with donors seeking alignment with recipient country priorities and systems, Claessens, Cassimon and Van Campenhout), the authors insist that there is a case to be made for public intervention directly targeting and supporting the development of better institutions.

 

 

Indeed, if institutions are not improved, the chance of national regulatory fragmentation will remain, as Andrew Walter suggests in “Adopting international financial standards in Asia: convergence or divergence in the global political economy?”, where he demonstrates how Asian countries’ financial regulation and implementation creates important gaps in global coordinated regulation. Walter first recalls how the last wave of crisis (1990s) triggered a reform project for financial governance led by the G7 targeted at emerging countries, although the latter had little input into the development of these standards. The author argues that although emerging countries’ regulation quality has increased ever since the 1990s, there remain important implementation gaps, first because of the difference between official policies and actual behavior. Second, the lack of systematic convergence with western regulatory standards by emerging countries is also due to the remaining national “policy space” in financial regulation, either because international standards are flexible in their application or because enforcement by international actors is of limited effectiveness. Third, implementation gaps may be explained by the influence that national-level private sector actors can have on constraining, modifying and sometimes blocking the implementation of international standards at the domestic level.

 

Walter suggests demonstrating the unevenness of financial regulatory convergence by taking examples such as the Basel Core principles, the OECD’s principles on corporate governance, the IFRS and the IMF’s Special Data Dissemination Standards (SDDS). Whereas Basel I implementation is universal, SDDS and IFRS is more variable.

But the real issue to the author is not the “official” implementation of such standards but the “effective” one. Indeed, the author suggests taking into account the important factor of “mock compliance”[6]. The latter can occur for different reasons such as low bureaucratic enforcement capacity or corruption, deliberate regulatory forbearance by the governance or its agencies, and behavior by private sector inconsistent with the intent of the rule. For example, on IFRS, the survey put forth by the author suggests that, although mock compliance certainly exists on a certain level in the USA and UK, “the quality of corporate compliance in countries like China, Indonesia, Korea and Thailand lags well behind that in the USA, UK and regional leaders such as Singapore” (p.102).  On matters such as banking supervision, implementation and mock compliance even diverge on a regional scale: Singapore and Honk Kong show high compliance whereas China and Thailand are at the bottom; and beneath these country average lie even larger variations in the degree of corporate compliance with international and domestic standards.

 

The author explains this uneven convergence first because market incentives for substantive compliance are often weak even when formal compliance is ubiquitous, as is the case for Basel 1. Private actors can also be thrown by the fact that some stocks of companies with worse corporate governance practices tended to perform better than average. Finally, standards setters and IFIs enjoy limited influence over substantive compliance and many emerging countries, although member of such IFIs refuse to participate in a Financial Sector Assessment Programme review (FSAP, organized by the IMF).

 

Walter believes that the reason why domestic political resistances to substantive convergence vary greatly from one area to another is because governments often underfund regulatory agencies or subvert regulation in other ways if the political incentives favoring mock compliance are strong. Moreover, his explanation is that “public and private sector actors are likely to prefer mock compliance when visible non compliance and substantive compliance are both costly to powerful domestic actors (…) Once [adoption achieved] much depends on the interaction between the domestic private sector costs of substantive compliance with particular standards and the difficulty that outsiders encounter in monitoring the quality of compliance” (p. 105). The difficulty for third party monitoring will also affect the degree of pressure on the government and on the private sector to comply, because when such monitoring is hard, third party sanctions are unlikely to be deployed. IFIs have no mean of detection or sanctioning non observance within the public or private sectors. In the author’s view, the difficulty for external actors to assess compliance is the main factor which, next to the fact that private domestic interest coalitions have too much to lose from the international standards agenda, will not make divergence stop.

 

This is particularly true when it comes to implementing standards which often leave room for national interpretation or to regulatory capture, such as Basel II standards. Stijn Claessens and Geoffrey R. D. Underhill describe in “The political economy of Basel II in the international financial architecture”, how Basel II established a new approach to measuring capital adequacy of internationally active banks in a context of consolidated supervision of increased cross-border banking activities. The authors suggest that Basel II and its market-based approach is the result of regulatory capture on the input side which led to a skewed output, both for western countries as it enhances risk taking, and for emerging countries which are more sensitive to pro-cyclicality and for whom there are high costs of implementation.

 

The authors first recall the origin of the Basel Committee which helps understand how private sector actors managed to make their way through the negotiation of Basel II standards. Indeed, because capital adequacy norms can affect the costs of competition among banks, the Committee early on called for impact assessment on the banking sector, and for that purpose directly consulted with the private sector, particularity with the Institute of International Finance (IFF), representing today 350 banks worldwide. During negotiations, the IFF’s positions were mainly unchallenged and far more pressurizing than that of emerging countries (simply absent the Committee) or even civil society argument (consumers etc.) which were neither represented. IFF preference managed to be transposed into Committee Policy. “In essence, financial globalization had rendered the supervisory process increasingly difficult and beyond the reach of national supervisors. The conclusion of the report argued that regulatory agencies should rely more on the private institutions that they supervised and that the private institutions themselves would accept more of the responsibility to improve the structure of and the discipline imposed by their international risk management mechanisms” (p.118). There lie the origins of the market-based supervisory approach contained in the three pillars of Basel II. Indeed, although the Committee invited broader consultation for its Basel II proposal, the IFF remained its main interlocutor. Comments were mainly coming from European and American financial institutions, whereas the voice of academics, agencies, chambers of commerce, where less and less taken into account, even though skepticism towards market-based approach to supervision was already being pointed out. Doubts were already focused on the risk of pro-cyclicality of lending and risk taking by banks, leading to asset bubbles and an increased tendency toward the occurrence of crises. 

 

The authors further describe how Basel II works: based on three pillars[7], its main evolution is that banks supervisors would no longer be exclusively responsible for specifying and monitoring levels of capital adequacy. Three different option for measuring risk became available: for less sophisticated banks, the standardized approach based on external credit assessments, such as by export credit rating agencies ; ‘Fondation’ International Rating Based (IRB) approach to risk management based on international Value at Risk models (only the probability of default is calculated by the banks, other ratio are left to supervisors); and for largest sophisticated banks, ‘Advanced’ IRB approach, in which all aspects of credit risks are estimated by the bank itself.

 

Due to the dangers promoted by such international risk measurement, the authors further describes the impact on systemic risks of Basel II, mainly in regards to pro-cyclicality and volatility of financial markets. Authors argue that the IRB approach favors the very sort of financial innovation and risk management practices which led to the current financial crisis. Further, smaller US/EU banks and banks from developing countries were already at a competitive disadvantage in cross-border markets, and now face higher Basel II capital charges. Basel II also encourages the risk reduction effects of portfolio diversification, leading to a higher concentration of lending in less risky, but more correlated segments of the world economy, leading to higher systemic risks (such as the sub-primes). Moreover, the question of the role of credit rating agencies is also crucial (they are involved when banks are stuck with the Standardized approach), particularly regarding the incentives they face (conflicts of interests) and their effects on macro-prudential and systemic risk. Finally, EU and US supervisors have been applying it quite differently within their own jurisdiction while recent G20 reform discussions encourage harmonization.

 

Moreover, the authors devote a particular section to the impact of Basel II on emerging countries. The economic survey shows that there is little impact on the cost for developing countries. However, they underscore that Basel II may “adversely affect developing countries by reducing the availability of and increasing the volatility and pro-cyclicality of external financing. Under Basel II, banks, relying more on their risks models, may more automatically decrease/expand their lending at time when asset prices are already depressed/elevated, thereby further lowering/raising economic activity and asset prices and producing crises/bubbles” (p.129).

 

In conclusion, the authors suggest ways of improvement for Basel standards. First, sophisticated institutions should have equal or higher, not lower, capital ratios relative to Basel I. Second, “if it is true that Basel II encouraged the very risk management practices which led to the current crisis, supervisors need to be far more skeptical about the claims made about the low risks of new product rangers characterized by securitization, and adopt a “precautionary principle” whereby the onus is on banks to demonstrate over time that new innovation deserve low capital charges because they have limited both bank and systemic risks” (p.132). Third, it is evident that banks need to be assessed in their entirety, including their off-balance sheet activities and unregulated affiliates. Finally, the authors state the from now on obvious: supervisors and market agents must put into place better macroeconomic tools to assess financial systems as a whole in order to prevent bubbles or reveal that banks have taken too much risk relative to capitalization.

 

The authors’ main conclusion is therefore that notwithstanding the mandatory or efficiency of Basel Standards, the most urgent objective is to improve institutions and the tools they need to participate to market stability. A similar argument on institutions is made on a whole other matter by Eelke de Jong and Koen van der Veer in their analysis of “the catalytic approach to debt workout in practice: coordination failure between the IMF, the Paris Club and official creditors”. Indeed, they observe how, in order to obtain a certain effect, such as market stability or reinserting growth in crisis-hit countries’ economies, international institutions need to improve the methods employed. Authors illustrate their argument based on the study of “the catalytic approach”. The latter is a strategy of the International Financial Institutions (IFIs) to involve private creditors in solving a country’s balance of payments difficulties (i.e. the belief that IMF intervention triggers renewed private capital inflows) in times of crisis resolution in order to restore market stability. Indeed, by signing an agreement, official creditors signal that a country has sound financial institutions and follows sensible policies, which attracts private investors. The catalytic effect arises if private sector inflows successfully complement official creditors’ contributions to fulfill the gross financing requirement.

 

 Authors suggest that the catalytic approach, the goal of which is to involve private creditors in crisis resolution, which is necessary to prevent moral hazard and because official creditors generally lack the resources to fully meet the financing needs of the crisis-hit country, is not as effective as proven by 1990s crisis in emerging countries and therefore requires the reform of the international financial architecture. Indeed, their study show that a catalytic effect is at best present only under certain specific conditions, as it is only triggered by bilateral loans or precautionary IMF programmes.

 

The authors suggest two reasons why the catalytic approach is not always efficient: first because in 25% of cases, the total amount provided by official creditors exceeded the debtor’s financing needs, which facilitated private sector withdrawal (bail out) rather than incentives for additional capital inflows. Moreover, a core concept of all IMF programmes is the country’s “financing gap”, which is the difference between what a country needs to raise to pay its maturing debts, IMF payments and ongoing deficits, and what it is projected to be able to raise from private creditors. For the catalytic approach to work, the total sum of the official financial package must fall short of the financing gap, so that additional capital can fill the remaining gap. However, the IMF projection of the amount it can loan to a country is always too optimistic, including the availability of private capital, in order to get large programmes approved by the Executive Board of the IMF. IMF estimations are thus unreliable for estimating financing gaps.

 

Second, the catalytic approach requires a coercive instrument to first bail in private creditors, such as the bilateral creditors assembled in the Paris Club[8]. However, this coercive instrument, based on the Paris Club debt restructuring, contains a condition held in the “comparability of treatment” clause according to which the debtor country must seek debt restructuring with other bilateral and private creditors on comparable terms. Failure to do so involves losing the Paris Club agreement and therefore the bailing in of private creditors. The authors findings suggest that unfortunately, in order to counter such clause, which excludes short term debts[9], private creditors actually bailed in are in for short terms debts which does not help the country’s overall balance sheet and therefore do not structurally improve its situation. Such coercive instrument is therefore inefficient as it does not encompass all types of private capital flows. “In addition, even if the Paris Club through the clause is successful in involving private creditors with outstanding accounts, private capital markets may more generally shy away from investing in countries where they perceive they may be forced to agree to less advantageous interest and repayments conditions in the future” (p.145). In such view, the study led by the authors concludes that the Paris Club clause generally did not have the intended effect on net total private capital flows. The Paris Club agreements only “gave rise to additional inflows of private capital only in low-income countries that had signed a PRGF and where the Paris Club had decided to reduce bilateral debt” (p.148).

 

The authors therefore conclude that such coordination failures among official creditors (IMF, Paris Club) have not contributed to efficient catalytic effect. Authors suggest that a more coercive instrument to bail in private creditors be implemented, encompassing all types of private capital flows (including short term debt), such as debt standstills. Because international catalytic effect is still not efficient due to IIFs flaws, the reputation and efficiency of international financial governance, along with its institution, have decreased in Asia after Asian countries’ 1990s crisis. They have therefore embraced other financial governance mechanisms.

 

Such is described by Xiaoke Zhang in “Global markets, national alliances and financial transformations in East Asia”, who argues how East Asian countries, most specifically Taiwan and Malaysia adapted to the liberalization and globalization of financial markets over the past two decades. The authors suggests that East Asian countries, traditionally bank-based systems, have encountered the exponential growth of stock markets, especially because of equity finance which has fuelled incentives for industrials firms to rely on stock markets rather than on banks for external financing[10]. As previous contribution in this volume, the author recalls that the securities market orientation taken by East Asian countries differs from the anglo-saxon conception market model, both regarding corporate governance as well as regulatory regimes.

 

The first reason for such divergence given by the authors is due to input-side issues. Indeed, the international financial architecture did not balance policy imperatives with national configurations of power and interests, whereas effectiveness requires the articulation of national preferences on the input side, and policy space on the output side. Without legitimate input-side mechanisms, national systems will react against the architecture proposed. Faced with the potential yet real tensions between harmonizing liberal market and national institutions legacies and political imperatives, the author’s main argument is that complex interplay of external and internal factors characterizes financial reform which encourages that “global governance standards consider input legitimacy in order to make them fit better with national political conditions” (p.205).

In this view, large-scale convergence of national systems on a particular model of financial governance is therefore unlikely in the near future, as it was demonstrated for the Basel II standards, and how the study of financial development in Taiwan and Malaysia proposed by the author suggests.

 

Indeed, the author describes the political process which led to financial transformations in Taiwan and Malaysia. For example, Zhang describes how “The political incentive to facilitate market-oriented changes derived in part from politicians’ desire to use the stock market to privatize state-owned enterprises (…) In Taiwan, effort to promote a financial market economy have geopolitical significance as well (…).They hoped pro-market policies would promote the overseas profile of the island and render it more admissible to multilateral institutions and processes” (p.209).

 

However, Zhang underscores how such financial transformations have diverged significantly from typical cases of financial liberalism. For example, although both countries’ financial development led to exponential capital market based stock market growth, the western model of corporate governance was not adopted, banks have acted as market markers[11] and regulatory agencies have operated under the direct influence of state and societal actors to pursue their policy interests. In this view, the author agrees with the volume’s main proposition, that market-oriented model of financial governance does not transfer well from one national context to another, while domestic dynamics will almost certainly mediate the impact of systemic pressures on patterns of market reform.

 

The author’s empirical findings lead to conclude that “international policy makers must adequately recognize the ways in which common external stimuli for national market change unleashed by global market integration are mediated by the incentives, preferences and strategies of domestic political actors” (p.218). The author therefore recommends finding the right balance between legitimate national political processes and systemic pressures for institutional change as this need for greater attention to the diversity of national political structures is what underpins financial markets as well as the need for more policy space than what is currently allowed in the international financial architecture. The latter recommendation were clearly ignored during the 2002-7 “period of calm” during which the EU and the US focused and spread their own notion of market-based financial governance, certainly creating transatlantic convergence but letting aside other parts of the world, and more importantly imposing to them standards which will soon appear to be flawed since their own market conception was too.

 

Indeed, in “Changing transatlantic financial regulatory relations at the turn of the millennium”, Elliot Posner describes EU-US relations in regards to regulatory regimes during the 2002-2007 “period of calm”. The author highlights the role of political authorities and institutions in amending transatlantic regulatory cooperation. The authors’ main argument is based on several diplomatic transatlantic accords, such as the “EU-US Regulatory Dialogue on Financial Services”, or the “Framework for advancing transatlantic economic integration”, as well as on several “disputes” between regulatory authorities on regulatory matters, such as the Sarbanes-Oxley Act, the accounting norms[12], the Market in financial services Directives etc.. Based on the evolution of such cooperation, dialogues and dispute management reflecting either US preferences or EU preferences, the author proves that relations between transatlantic authorities (such as SEC-CESR) have changed, in particular in terms of “rule makers” and “rule takers”, but also how most of them ended in mutual accommodation. 

 

Posner suggests that notwithstanding the traditional American hegemony over financial regulation, which for a long time meant that the USA did not need to adjust its own policies in response to external pressures, the structural power of a regional policy such as the EU, with a “centralized “ regulatory authority, has led the US to compromise and modify its legislation in order for regulatory cooperation and coordination to be truly effective for markets actors involved in transatlantic relations. Indeed, regional cooperation as well as EU effort to harmonize rules and centralize rule-making (through the Financial Services Action Plan and the Lamfalussy Process) increased EU influence. Moreover, the SEC had responded largely to the lobbying of American investment banks, concerned about the possible negative implications of the new EU financial architecture, such as the new conglomerates directive, to their European businesses. The author’s interviews on both sides of the Atlantic confirm the role of lobby groups in convincing US authorities to make adjustments, end regulatory disputes and institutionalize transatlantic regulatory dialogue. “The US made concessions because Wall Street firms argued that making no adjustments would place them in a precarious positions and would jeopardize the role of the SEC as their primary regulator” (p. 236).

 

Yet, such private sector influence on public authorizes is no case of capture. The chapter demonstrated that private influence was a necessary but not a sufficient condition for the observed changes, since it was also the internal EU regulatory centralization which changed the market opportunities and expectations of US-based multinational firms, the breakdown of which was deemed unacceptable by US officials. In Posner’s words, US officials therefore had to find ways to accommodate EU positions.

 

The author therefore concludes that the EU’s role as a global rule-marker improved regulatory effectiveness. Yet, Posner tempers his finding based on the current financial crisis. Indeed, although transatlantic regulatory coordination is deemed by the author a success in term of mutual concessions, such coordination only accelerated and intensified the convergence and spreading of the “orthodox” market model, which is deemed by the volume as one of the causes of the crisis. In this view, it is for the EU, with its acquired international role and interdependency with the US, to use its influence today in the area of financial governance and put on the transatlantic table certain issues, such as the most important one in the author’s view, cross-border prudential supervisory arrangements.

 

Indeed, without proper common standards and supervisory mechanisms, no regional nor global financial governance will be effective. This is what Heribert Dieter’s contribution called “monetary and financial cooperation in Asia: improving legitimacy and effectiveness?” focuses on, authors demonstrating how southeast and east Asia have been embracing since the turn of the century regional cooperation and integration in monetary and financial affairs in order to flee western countries orthodox view of the market.

 

Indeed, the 1997-8 Asian crisis, demonstrating the lack of option for emerging economies in financial crisis –therefore creating doubts towards the IMF-, as well as the recent collapse of the Anglo-Saxon model, have both encouraged such process. Because Asian countries started doubting both the input side of global financial governance (its legitimacy) and well as its output (its effectiveness), monetary regionalism[13] and other bilateral agreement have increasingly received attention in Asia.

 

The author first describes the rationale for monetary regionalism, seeing in the 1997 Asian crisis the most important reason for pursuing monetary cooperation in Asia. First, because countries affected by the IMF’s provision of liquidity, which was much too slow in 1997, felt as they had little to say in the formulation of its policies. Second, because regionalism aims at increasing the ability of countries to pursue domestic objectives while encouraging intraregional capital flows, an impossible thing to do with a global financial architecture the input-side of which had proved deficient in terms of legitimacy. Moreover, “the frustration of Asia-policy-makers with the slow reform of the international financial architecture and the dominance of Washington in regional and global affairs is equally important” (p. 243). Therefore, understanding that such reform would unlikely happen quickly, whereas national regulation had become insufficient, the region appeared as better able to provide solid structures. 

 

The author subsequently describes the evaluation of Asian regionalism since 2000 and how Asia’s regional monetary cooperation is currently four leveled: the networking of currency swaps under the Chiang Mai Initiative (CMI) ; the monitoring of short-term capital flows and other surveillance measures ; initiatives to strengthen regional bond markets ; and the emergence of cooperation on exchange rate.

 

Whereas Asian regionalism seems to be on the right track, the author raises two obstacles which could hinder its development: the regional capacity to be sufficiently integrated economically, and the capacity of countries to cooperate politically, especially China and Japan which seem to struggle for superiority and are the main problem to today’s progress in monetary regionalism. The authors notes that currently, “there has been very little debate [on exchange rate cooperation]: exchange rate policies in the region are set unilaterally, and the trend is towards managed or independently floating rates rather than a cooperative exchange rate arrangement” (p.250).

 

 To cope with such issues, the author suggests four paths for successful monetary integration: first, to develop a single currency ; second to agree on a regional exchange rate mechanism similar to the Exchange rate mechanism in Europe : third, countries could abandon their dollar pegs and jointly agree to peg their currencies to a single currency from the region (yen or yuan) ; fourth, countries could peg their individual currencies to a basket of currencies. Finally, the author recommends an enhanced regional surveillance for deeper cooperation in monetary affairs, not only to further integration but to combat the risk of contagion.

 

The author therefore concludes that Asian countries may, through regionalism, “enhance the input side legitimacy by strengthening cooperation and participation of Asian countries in determining their destiny in the global monetary order, and simultaneously enhance output-side legitimacy and policy effectiveness by better aligning policy output and results to their interests and normative preferences” (p.255). Such input-side improvement is necessary to stop the trend of expanding globally standards which are not appropriate to all countries’ national characteristic. Such is the case of the pro-cyclicality of financial governance induced by skewed input-side mechanisms.

 

 

José Ocamp and Stephany Griffith-Jones focused on pro-cyclicality in the international financial architecture. In “Combating pro-cyclicality in the international financial architecture : towards development-friendly financial governance”, the authors mainly focus on the negative impact of pro-cyclicality on developing countries. As already mentioned in the volume, developing countries have had relatively little influence on the development of the existing international financial architecture, whereas the latter have much been under policy capture, indicating a lack of input-side legitimacy within the current international financial architecture, thus in turn limiting the out-put side legitimacy (or effectiveness) of global governance. The authors take the example of the highly pro-cyclical and market-based nature of the system to point out such limited output legitimacy as well as its limitation of policy space for developing countries. Authors suggest that the major function of an effective international financial architecture should be to “mitigate the pro-cyclical effects of financial markets and to open “policy space” for counter-cyclical macroeconomic policies in the developing world (…). The input-side governance of the system should give developing countries sufficient representation reflect their growing role in the world economy, while more attention should be paid to avoiding policy capture by private interests” (p.270).

 

Authors first describe how financial governance is tainted with the pro-cyclicality of the contemporary market-based order, enhancing highly pro-cyclical volatility in developing countries’ external financing. Authors describe the danger of volatility as following: “Volatility is associated with significant changes in risk evaluation, involving alternating period of “appetite for risk” (more precisely underestimation of risks) and “flight to quality” (risk aversion). (…) Furthermore, due to information asymmetries, different assets tend to be pooled together in risk categories viewed by market agents as strongly correlated. These practices turn such correlations into self-fulfilling prophecies. These problems have been dramatically evident in 2007-8, particularity in the United States.” (p.273).

 

Due to such volatility, authors maintain that developing countries therefore lost their policy space to adopt autonomous counter-cyclical macroeconomic policies and had much trouble creating deep financial markets which participate to economic development. As Cassimon et al. had already underscored, “a vicious circle emerged involving pro-cyclical financing, underdeveloped financial markets and institutions, and external constraints on macroeconomic policy autonomy” (p.273). Indeed, while developed countries can counter pro-cyclical effects of credit and asset prices by implementing counter-cyclical macroeconomic policies, developing countries are on the contrary forced to adopt pro-cyclical macroeconomic policies that reinforce the movements of financial markets. Such pro-cyclicality is unfortunately also encouraged by the private financing sector during booms since unstable external financing distorts incentives that private agents and authorities face throughout the business cycle. “Increased exposure to financial market risks has replaced Keynesian automatic stabilizers with automatic de-stabilizers. Contrary to the view that liberalized financial markets would play a disciplining role, dependence on financial swings has encouraged the adoption of pro-cyclical monetary and fiscal policies” (p.275). In such view, pro-cyclicality of financial markets increased growth volatility, efficiency gains from financial market integration having been swamped by the negative effects of growth volatility, and have not encouraged growth in the developing world.

 

Therefore, the origin of the problem lies in the fact that prudential regulation (through Basel Standards), which focuses too much on microeconomic risks, exacerbates such pro-cyclicality, whereas risks often lies at the macroeconomic level. “In particular, by failing to consider the benefits of international portfolio diversification, capital requirements for loans to developing countries will be significantly higher than is justified on the basis of actual risk”. The introduction of counter-cyclical elements within prudential regulation and supervision should be a central concern for the Basel Committee and developing countries should also adopt specific regulations aimed at controlling currency, maturity mismatches and at avoiding the overvaluation of collateral generated by asset price bubbles.

 

As a remedy, authors suggest counter-cyclical instruments for developing countries such as GDP-indexed bonds or local currency bonds. They also suggest counter-cyclical guarantee facilities put up by financial institutions (IMF, Multilateral development banks) to cope with the fact that financial markets overestimate risk in difficult times and underestimate it in good times. Authors also suggest that appropriate facilities for international provision of counter-cyclical official liquidity include a liquidity provision to cover large capital flow reversals and volatility in real export earnings (in order to cope with the fact that recent crises in emerging markets have been triggered by self-fulfilling liquidity runs). Finally, authors conclude that while the IMF has facilities to compensate for terms of trade shocks, they are too limited, and should be significantly expanded to compensate the too much larger proportion of losses caused by temporary shocks.

 

 

The volume’s last contribution deals with “public interest, national diversity and global financial governance”. Suggested by Geoffrey R. D. Underhill and Xiaoke Zhang, the chapter first describes how the input-side influence on the design of the international financial architecture of the very private financial interests which stood most to benefit from the facilitation of cross-border market integration and activity is directly associated with the causes of the crisis. Indeed, the crisis was not just a market failure but a policy process problem (such policy based on liberal order and market-based approach). In this view, authors argue that a more effective and legitimate governance of global finance lies in explicit consideration and incorporation of essential political and normative prerequisites.

 

Authors recall that legitimacy in governance is premium and can only be created if norms are elaborated in manner that their policy makers will be accountable for them towards their constituencies. “Legitimacy is about satisfying enough of the people enough of the time” (p.289). Such legitimacy is difficult to achieve at the global level since in a parallel manner, financial integration intensifies while domestic governance is undermined, therefore creating sovereignty –legitimacy- issue. Legitimacy is however enhanced if states and transnational actors could be held accountable for their decisions and if the output-side of the process would descript a certain consensus on norms while representing the interests of the ruled. In such view, more representative and transparent input could lead to output perceived as legitimate. Institutions therefore need to be more inclusive and responsible for their impact in order for their policy output to satisfy a broader range of interests.

 

The chapter focuses on two prerequisites for global financial governance. The first one is that “the international financial order be predicated upon an appropriate and politically sustainable balance between private and public forms of authority, which should include the interests of emerging market and low-income countries”. In other words, the governance of the system should not reside completely in the private domain of the market. Indeed, it has been showed that unaccountable private actors participated in a somewhat closed policy community which have led to policy capture. Such trend is due to the broader reconfiguration of the role of states as both promoters of market-based global integration and managers of its consequences. “This trend (…) does not imply that states are in retreat or could not implement alternative options. With financial globalization has come a change in the balance of power between public authority and private interests and an accompanying transformation in the notion of the public interest that defines the financial order, posing problems to input and output legitimacy and to accountability” (p.293). Indeed, with financial globalization the influence of private market actors have increased within policy process, leaving aside broader sets of interests and obliging public authorities to respond by adopting market-based approaches to regulation, supervision and corporate risk management.

 

In the end, private firms managed to have their own risk assessed and managed through complex mathematical models implemented under the approval of supervisory agencies. Such firms managed to have their way with agencies as their relationships with regulatory agencies were for the least sometimes very close, with frequent delegation of oversight to self-regulatory processes (authors cite the example of the Basel Committee, a public-private think-tank which consecrate a “Group of thirty” market based vision of financial governance). Such self regulation and public/private relation were enhanced by common professional norms within G7 economies’ firms. Slowly, “clear definition of the public interest distinct from the particularistic claims of private market actors had thus become increasingly difficult” (p.294), and the transnational financial system became more and more regulated by agencies constituting regimes that were more responsive to private interests than providers of collective goods. Yet, as the crisis demonstrated, “allowing those with pecuniary interest in lowering the costs of supervision to define the system is surely a flawed public policy process on both the input and output sides, and there appears to have been a very low level of accountability until the crisis struck” (p.293).

 

Authors therefore underscore how financial governance is flawed in terms of input-side legitimacy and argue that encouraging private sector involvement is problematic if it fails to represent broader social constituencies and aligns notions of the public interest “with reducing risks and losses for those who profit most from financial markets” (p. 295) –which is precisely what seems to have caused the subprime crisis. Inevitably, the flawed input-side of financial governance polluted its output, as it is recognized that policy failures which led to the crisis originally lay behind the G7 reforms which had encourage such financial governance to be overly responsible to private sector preferences.

 

The second prerequisite for the legitimate governance of global finance is that, in the same way that the previous chapter argues, the global financial architecture needs to be more compatible with legitimate national economic development aspirations, political processes and distributive justice. “A major plank in the reform process was the promulgation of a range ‘global’ standards in the domains of macroeconomic policy, financial stability, accounting and corporate governance” (p.296). And while regulatory change in financial system is a source of convergence, US and European institutions have long claimed for deregulation while developing countries were caught in deliberative forums (Basel Committee, IOSCO) in which their vote was either nonexistent or undermined. Such trend led to developing cross-borders market-oriented standards, whether they were appropriate for developing countries or not. Indeed, as authors note, convergence could not have worked since historically, few paths to capitalist developments have converged for long. “Where tensions between harmonizing liberal market structures and local contexts and institutions become overwhelming, capitalist development and market-based society may prove politically unsustainable or simply ineffectual” (p.298). Moreover, even though convergence to market oriented practices may be beneficial in an aggregate and long-term sense, it necessarily involves important short-term costs for more vulnerable players (financiers over workers, rich over poor).

 

Therefore, although convergence is indeed necessary for cross border finance to be efficient, the standards and practices which base it must be perceived as legitimate. In such view, the input side flaws of the current financial architecture as described by the authors can only produce outputs that conflict with certain norms of domestic governance. If norms which are bound to be global are actually only shared and agreed with by a narrow group of actors, international cooperation may only be ineffective.

 

To conclude, authors argue that the ongoing potential for capture suggest that a clear definition of the public interest distinct from the particularistic claims of private market actors is the key to ensuring the predominance of the public good in the financial system. In this view, the “policy implication once again is that input legitimacy could be substantially enhanced through better and broader representation based on a range of principles, thus increasing the likelihood of embedding a more acceptable spectrum of norms in global financial governance. (…) in order for the reform agenda to become more legitimate and therefore more achievable, developing countries and broader publics in the developed world will have to be given a major say in the setting agenda.” (p.301-303). 

 

 

Daniel Mügge, Jasper Blom and Geoffrey R. D. Underhill conclude the volume on the same stream of ideas: governance should not be one watertight set of rules but a much looser framework of cooperation that consciously acknowledges the needs and legitimacy of national idiosyncrasies. “Such an order would come much closer to what Keynes had in mind when negotiating Bretton Woods: a financial and monetary regime that bolsters rather than constrains governments’ ability to make financial policy in the public interest”. Moreover, broadening input may strengthen the legitimacy of global agreements, while at the same time decreasing the chance the agreed rules turn out to be inappropriate (as for example Basel II), thus in turn ultimately enhancing the effectiveness of an emerging multilevel pattern of governance. Authors also add that “even with successful regional arrangements, the contemporary financial order also exhibits seriously global patterns of integration and imbalances, so better governance will need to be a multi-layered governance” (p.311).

 

As for the notion of financial order and governance which should prevail and underpin the process of reform, and the interests of whom should be protected, authors agree that the interests of the broad public will need to be those in front and centre in any system of financial markets and governance, as they are those who will remain the guarantors of the risks taken by financiers with other people’s money. “Our financial order should first and foremost serve these needs because these are the very people on whose modest resources financiers and the economy in general ultimately rely when they take risks that may or may not pay off, the end costs of which are potentially collectively to be borne. (…) Finance must take place in ways which are compatible with the broader and mostly simpler needs of this wide range of “publics”, spread as they are across a range of poor, emerging market and developed countries” (p.315).

 

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