Let’s not have a revolution

The last time the leaders of the Group of 20 met, in Pittsburgh in September of last year, there was comparatively little disagreement. The world was still reeling from the shock of the 2008 financial crisis, and the unity of purpose the group had found at its first meeting in Washington that calamitous autumn was still in evidence.

But now it’s 2010, and the G20 will likely discover its members, without a worldwide crisis to lash them together across their vastly different cultures, interests, ideologies and economic circumstances, are less likely to agree on a common approach. Indeed, several European states are now heartily repenting of the group’s earlier consensus in favour of massive fiscal stimulus: government deficits there are now widely seen as the biggest threat to the economy, rather than the saviour of it. They will be unwilling to defer to the Obama administration’s more leisurely deficit reduction schedule.

Good. Consensus in international affairs is overrated. Either it entails countries agreeing to do what they intended to do in any event—in which case, why wait upon the rest of the world to agree to do likewise?—or it compels them to do things against their will, and as often as not against not only their own interests but the world’s. The Plaza accord of 1985, committing the United States to devalue the dollar and Japan to strengthen the yen in the cause of reducing trade imbalances between the two, was hailed at the time as a landmark example of international ­co-operation. Yet it caused both countries to pursue monetary policies that were inappropriate to their domestic situations—too loose in the U.S., too tight in Japan—forcing both into subsequent corrections and counter-corrections that ultimately resulted in the stock market crash of ’87 in the U.S. and the “lost decade” of the 1990s in Japan.

Perhaps that was what led China to pre-empt the G20 meeting with last week’s announcement that it would unpeg the yuan from its present artificially low rate against the dollar. There’s no doubt this has contributed to rising trade tensions between China and the U.S. But it’s not at all clear that China should be browbeaten into making such adjustments for the reasons cited—to reduce the “imbalances” between China and the U.S.—rather than being allowed to do so in its own good time, and in its own best interests. The yuan peg has only been maintained, after all, by pushing loads of yuan onto the market, the symptoms of which—rising wages and prices, inflated asset values—are beginning to appear. Many worry that China is the next bubble; popping it will be a delicate task, best left to the Chinese themselves.

Certainly those “imbalances” can have had little to do with the financial crisis, or not in the way that is often claimed. Yes, its roots can be found in a spendthrift, borrow-now, pay-later culture that took hold across much of the developed world, most notoriously in the U.S. But while the U.S. may have saved too little, it does not follow that the Chinese saved too much. All that China’s “excess” savings did was to replenish the deficiency in U.S. savings—surely no bad thing. It was what was done with those borrowed funds that was the problem.

As the G20 turns its attention from rescuing the world from the last financial crisis to preventing the next, that’s worth bearing in mind. Whatever reforms of banking regulations are in order, they must flow from a clear understanding of what actually caused the problem. That realization seems to have been dawning on many member states: with the benefit of nearly two years of hindsight, perhaps aided by the intervention of a few good lobbyists, some of the more sweeping post-crisis prescriptions for regulatory reform, indeed for a “capitalism 2.0,” appear to have been watered down or discarded altogether. And whatever individual countries decide to do, it is unlikely the G20, with their divergent interests and approaches, will be able to agree on much.

Again, on balance, good. To be sure, the same waning of reformist zeal, collectively and individually, makes less likely some of the policy changes I might prefer, particularly in the United States—abolishing mortgage interest deductibility, shutting down Fannie Mae and Freddie Mac, repealing the Community Reinvestment Act and other contributors to the epidemic of dodgy mortgage lending that helped create the U.S. housing bubble: the heart of the crisis, whatever the secondary shenanigans in derivatives markets. But if it also means we will never see, say, a global tax on banks, the proceeds to be used to bail them out in some future crisis—a favourite proposal of the French, inevitably—that’s a chance I’m willing to take.

Much though the G20 may be disagreed, however, there are certain broad reform themes we are likely to see emerge over the next few years, whether in member countries or in international forums like the Basel Committee on Banking Supervision. Some of these are quite sensible. They include:

• Higher capital requirements. This seems obvious—setting aside more capital against loans outstanding makes a bank more resilient to downturns—and is often cited as the reason for Canada’s success. But care must be taken not to overdo it, or to over-rely on this one instrument. Banks in Canada typically exceeded their regulatory requirements. For that matter, the top U.S. banks typically had higher capital ratios, going into the crisis, than the Canadians.

Moreover, the Basel committee’s last attempt to set such standards, known as “Basel II,” are now seen as having exaggerated both the bubble and the bust. Under the rules, the more the economy boomed, and the higher the price of the assets on banks’ balance sheets, the more they could lend out, encouraging still faster growth; conversely, as asset prices collapsed, banks were forced to cut back lending even more. So expect some attempt to fix this “procyclicality” in Basel III.

• A bigger role for central banks. Few countries may go so far as Britain, which last week announced it would abolish its existing regulator, the Financial Services Authority, in favour of the Bank of England. But in general, there is greater acknowledgement of the need for a “macro-prudential” approach to regulation: that is, regulation that is aimed, not just at the safety and stability of individual banks, but of the system as a whole.

Certainly, as the institution responsible for regulating the supply of money and credit to the economy, central banks have an interest in ensuring the safety of the transmission mechanism in that process, that is, the banking system. Whether that extends to using monetary policy to prick asset price bubbles, as some now urge, rather than the traditional central bank objective of maintaining a stable unit of exchange, is another matter.

• Ending “moral hazard.” Insurance can have the perverse effect of encouraging the very thing it insures against, and certainly that has been the effect of the policy, unstated but widely assumed in all Western countries, that certain large banks could count on being bailed out in the event of failure, for fear of the economic dislocation that would otherwise result. Banks therefore had every incentive to take on greater risks than would be prudent, on the sterling investment principle “heads we win, tails the taxpayer loses.”

Different countries will take different routes to dispelling this “too big to fail” doctrine. The United States appears headed, pending reconciliation of the House and Senate reform bills, toward preventing banks from becoming too big in the first place, perhaps requiring them to spin off subsidiaries that engage in riskier forms of lending. Other reforms would aim, in effect, at outlawing failure, by subjecting institutions like investment banks, once they reach a certain size, to much the same regulation as commercial banks.

But the most hard-headed approach, and the one favoured by Canada, is to establish, once and for all, that nobody is too big to fail: that is, to put in place an orderly process for winding down failed banks and disposing of their assets. That’s a difficult enough threat to make credible at the best of times. But it dissolves altogether if countries are at the same time collecting taxes from banks to pay for bailouts, which accounts for Canada’s opposition to the concept. (A proposed Canadian alternative, requiring banks to issue debt, called “contingent capital,” that could be converted into equity in the event of a crisis, appears to have been shelved.)

There are the major areas of reform that are likely to come up for discussion. There are others: requiring the complex derivatives that were some banks’ undoing to be traded through clearing houses, in the name of greater transparency; obliging banks to keep some “skin in the game” on securitized loans, rather than simply off-loading them to the nearest buyer; and, perhaps most controversially, regulating compensation packages for senior bank executives, to align their interests with shareholders and discourage excessive risk-taking. They all make sense, to a greater or lesser degree, but they hardly amount to the sort of revolution many predicted 18 months ago.

Again I say: good.