Masaaki Shirakawa: International financial stability as a public good
Keynote address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a high-level
seminar, co-hosted by the Bank of Japan and the International Monetary Fund, Tokyo,
14 October 2012.
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Introduction
Once again, it is a great pleasure for me to welcome you to Tokyo on the occasion of the
annual IMF-World Bank Meetings.
About two years ago, at the Per Jacobsson Lecture in Basel, my old and respected friend,
the late Tommaso Padoa-Schioppa, offered his insights on how to strengthen the governance
of the rapidly integrating global economy.1 Since then, the subject has been in a corner of
my mind. Today, I am happy to co-host with the International Monetary Fund a high-level
seminar devoted to that topic.
Many of you here today probably heard Tommaso forcefully present his case, but for those
members of the audience who were not on hand at that time, I would first like to offer you a
brief summary. Tommaso observed that one of the causes of the Great Financial Crisis
was the failure of national governments to properly rein in market forces, which were fast
becoming global in nature. He saw that the increase in cross-border financial activities
required a corresponding increase in the provision of basic facilities or services - supporting
or facilitating those activities - including prudent regulation and supervision from a
cross-border perspective. Nevertheless, the supply of such facilities or services was deficient
or lacking because national governments inherently could not provide for them. The
solution, he argued, was to enhance supranational governance of the global economy.
I. The Great Financial Crisis and the supply of global public goods
As Tommaso and many others have pointed out, the Great Financial Crisis has exposed the
naïve simplicity of the view that, if
the economic policies of individual economies are
geared towards domestic economic stability, and private actors are allowed to operate freely
in such an environment, the global economy would be all right. The painful realization is that
the self-correcting power of the market goes only so far. Markets must sometimes be
nudged, pushed, or even forcefully shoved off their existing trajectory so as to prevent them
from running into disasters. In order to function properly, markets also depend on things
that are not provided spontaneously by themselves, such as the rule of law, respect for
private property, and the safety and freedom of passage. "Public goods" is the name
ascribed to these facilities or services in economics textbooks, and global public goods are
those needed for the global economy to function properly.
So, what are the global public goods that support the functioning of the global financial
system?
One obvious but only partial answer is the appropriate regulation and supervision of
cross-border financial activities. The Great Financial Crisis has demonstrated that there
were many shortcomings in this area, and the international community has taken steps to
correct them. Good regulation and supervision are important, but by themselves are not
sufficient. The soundness of individual financial institutions is one building block of
financial stability. In this sense, the international public good supporting global financial
markets is not provided solely by regulators and supervisors. Various agents, including but
not limited to central banks, ministries, and regulatory boards, work together to realize a
stable international financial environment through conducting prudent monetary policy,
performing effective regulation of financial actors, and promoting robust market
infrastructures.
By looking at international financial stability as a public good, we can apply a well-established
microeconomic analytical framework to it. A public good is a good that is both non-rivalrous
and non-excludable: that is, one's use of a public good does not reduce the availability to
others and one cannot effectively prevent the use by others. Consequently, two important
features of public goods are that they will not be provided if left solely to the market, and
that they tend to be consumed excessively when they are provided at all. The latter
insight allows us to interpret the Great Financial Crisis as being the consequence of
overconsumption of a public good - namely, international financial stability. Financial
institutions took stability for granted and shouldered excessive risks. This exaggerated the
impact when the risks were manifested; markets could not regain stability by themselves
and had to wait for interventions by the public sector, including the coordinated provision of
liquidity by central banks.
II. Providing global governance in a globalized world
In a world where globalization is deepening, and where national financial systems are
becoming more interconnected, financial stability must increasingly be achieved at the
global level. To make this happen, good governance at the global level is essential.
Fortunately, nobody is against strengthening global governance as a concept. Everyone
instinctively realizes that something must be done to ensure the proper functioning of the
financial system, which has expanded beyond national borders and has become global.
Unfortunately, progress, though accelerated by the Great Financial Crisis, has still not been
fast enough.
Why is this the case?
Professor Dani Rodrik of Harvard University has offered us an informative perspective.2
He claims that hyperglobalization, the nation state, and democratic politics cannot be
maintained simultaneously. For example, in recent years, the advances in information and
communication technologies have enabled financial institutions to expand their activities
across borders. As we have seen recently in Iceland and Ireland, such institutions could
get into trouble because of activities outside their home markets. When the government of
the home market attempts to bail out these institutions without destabilizing the global
financial markets, the cost could be so huge that it would exceed the ability of the
home-country taxpayer to pay, thereby compromising democracy. If we wish to avoid this
outcome, we would either have to opt for a democratically elected global government that
could provide a global safety net, thus compromising the nation state, or opt to restrict the
global activities of financial institutions to the extent manageable by democratically elected
national governments, thus compromising globalization.
Of the three potential outcomes, Professor Rodrik prefers the third one, calling not for
hyperglobalization but "smart globalization." Many reasonable people would probably
agree. In view of the slow and limited progress in strengthening global governance, and
without any meaningful prospect of acceleration, such a choice seems sensible.
The problem, however, is that it may be difficult to restrain globalization effectively. The flip
side of overconsumption of public goods is insufficient internalization of the costs for
providing such goods. This could imply that profit opportunities arising from globalized
financial activities may be sufficiently large such that there is a strong incentive to circumvent
any restrictions. At the same time, the advances in transportation, and in information
and communications technologies, make it ever easier for private actors to dodge
inconvenient rules and regulations. From our experience, we know very well that the
ingenuity of the private sector in this regard should never be underestimated. We all
remember the Bretton Woods System, which was an attempt at smart globalization, and the
collapse of this system offers us a cautionary tale. Furthermore, in a world where public
and private actors taking part in economic activity are becoming ever more diverse, it would
be quite a challenge to agree on what is desirable globalization and what is not. If, in
despair, unilateral action, such as trade bans, mandatory domestic incorporation, or forced
repatriation, is taken, everybody would become worse off.
Is there a way out of this predicament?
If the objective of global governance is to secure global financial stability, and if global
financial stability is a public good, global governance can be analyzed as a microeconomic
problem regarding public goods. There are well-known options to solving the problems
posed by public goods. The most straightforward is to have the public sector provide the
public goods. Alternatively, rules could be established regarding the consumption of public
goods. Another option is to tax the consumption of public goods or subsidize the
production thereof. There are still other options, such as changing the public character of
the goods by increasing their exclusivity. Not all may be applicable to international financial
stability, and some may be more easily implemented than others.
In view of the discussions during various international fora in which I have participated, I
have a feeling that we are making it more difficult for ourselves by opting for the seemingly
most obvious option - tasking the public sector with providing international financial
stability. As Tommaso observed, there is a limit to what individual nation states can
provide as global public goods. A coherent set of public goods provided by a single global
public entity would be desirable, but there is no workable way of introducing such an
arrangement consistent with our democratic principles. International organizations are often
criticized for deficits in democratic accountability. On the other hand, a democratically elected
world government with the power to tax is unthinkable in the near future. The current
situation in the euro area is an example of this intractable problem.
We therefore should aim for a more practical approach, combining various options that are
known for solving the public good problem. Some public goods, such as effective supervision
of globally important financial institutions, could be provided at the national level.
Supranational institutions could be asked to take on specific tasks, such as monitoring global
financial developments and identifying macroprudential risks, without undermining
democratic principles. Private actors could be made to follow certain rules, such as the
Basel rules on capital adequacy, which are in fact rules regulating the consumption of global
financial stability. It may even be possible to devise ways to influence the behavior of
these actors through taxes and subsidies. For example, capital adequacy standards could
also be seen in this light, considering that they would increase costs of engaging in
riskier behavior. Some might even argue for financial transaction taxes as an option,
though I do not believe that benefits would outweigh the costs, such as their impact on
market liquidity. In any case, we must be willing to adopt a flexible and multi-tracked
approach to global governance, which should be more adaptable to and consistent with the
increasingly diverse global landscape.
III. Global governance and central banks
Turning to what central banks could do in the context of global governance, they are
without doubt important actors given their role in monetary, prudential, and payment systems
policies. Stable and sustainable growth in individual economies, which is the ultimate
objective of central bank policies, is an important building block of a stable global financial
environment. In times of emergency, as we have seen during the Great Financial Crisis, the
coordinated provision of liquidity by central banks plays an important role in maintaining
financial stability. Central banks are deeply involved in international rule making as well.
At the same time, a central bank is constrained by its mandate, which is granted by the
nation state (or nation states in the case of the European Central Bank). While it is
independent of the national government, its actions must be accountable, ultimately to the
people of the nation. The central bank must be conscious of the legitimacy of its actions.
Nevertheless, if this prevents it from thinking outside the box, when that is necessitated by a
changing economic environment, a good outcome cannot be ensured. The gradual and
sometimes spontaneous evolution of central banking since the middle of the 19th century
underscores this point. One issue that immediately comes to my mind in this regard is the
international spillover and feedback effects of monetary policy. Global financial stability
would be elusive if these effects were not sufficiently internalized.
Concluding remarks
Every so often, we are tempted to say that big problems need big solutions. The reality,
however, is that the best big solution turns out to be an aggregate of small steps. Global
problems, therefore, require global solutions, but such solutions can be broken down into
more manageable parts. I hope that all of you find today's seminar to be such a small but
important step forward.
Thank you for your attention.