Fabrizio Saccomanni: Managing international financial stability
Edited text of remarks by Mr Fabrizio Saccomanni, Director General of the Bank of Italy, at a
meeting at the Peterson Institute for International Economics, Washington DC, 11 December
2008.
* * *
I am delighted to be here at the Peterson Institute to present my views on international
financial instability before such a distinguished audience of eminent scholars and officials,
among which I am fortunate to count many old friends. This is my first visit to the Institute
since I was invited to join its Advisory Committee and I would like to express my gratitude to
Fred Bergsten for the invitation. I am honoured to participate in this important body of the
Institute and I look forward to contributing to its activity in the promotion of policy-oriented
research in the field of international economics.
Instability in the age of globalization
International financial instability is a subject that has fascinated and intrigued me since when
I was a young economist at the IMF and witnessed with considerable anxiety the collapse of
the Bretton Woods system on August 15, 1971. The ensuing decade of instability was mostly
attributable to the shock of the downward floating of the dollar and the resulting two
oilshocks of 1974 and 1979. After some unsuccessful attempts to rebuild Bretton Woods, the
negotiations for the reform of the international monetary system ended in 1976 with the
legalization of freely floating exchange rates and that seemed sufficient to fix the problem. A
tired US Treasury Secretary, William Simon, commented: "All is well that ends".
At the beginning of the 1980s, following the process of liberalization, deregulation and
privatisation set in motion by Margaret Thatcher and Ronald Reagan, it was widely expected
that full international capital mobility would interact with floating exchange rates to ensure
adjustment of balance of payments disequilibria and a stable financial environment. Instead,
these new conditions paved the way for the emergence of a global financial system in which
financial innovation and the ICT revolution combined to produce an extraordinary expansion
of financial sectors and markets compared with the real sector in both industrialized and
emerging countries. The seeds of instability were thus planted on fertile soil. Indeed since the
1980s financial disturbances have occurred with increased frequency and intensity and have
entailed major international repercussions.
I will not review here the long list of debt crises, currency misalignments, illiquidity in credit
markets, asset price bubbles, that have characterized the age of globalization, a subject to
which I have devoted considerable attention in the last few years.1 I would rather quote from
a paper written by Michael Bordo, Barry Eichengreen and others in 2001 on "the crisis
problem":
since 1973 crisis frequency has been double that of the Bretton Woods and classical
gold standard periods and matched only by the crisis-ridden 1920s and 1930s.
History thus confirms that there is something different and disturbing about our age.2
So, given that the situation has not improved since 2001, what is different and disturbing
about the age of globalization? Here are some features that I regard as crucial.
What is different
•
The world economy operates under a "market-led international monetary system" in
which market forces determine exchange rates and the international allocation of
capital. This is the key point of a paper Tommaso Padoa-Schioppa and I wrote for a
conference organized by Fred Bergsten and Peter Kenen at this Institute to
celebrate the 50th Anniversary of the Bretton Woods System in 1994.3 In the paper
we underlined the risk that the increased globalization of financial markets could
lead to "disturbances that may have an impact on the stability of the financial
system".
•
Global financial intermediaries operate in a highly competitive environment, but with
essentially uniform credit allocation strategies, risk management models and
reaction functions to macroeconomic developments and credit events.
•
Financial innovation (mainly through securitization and derivatives) has greatly
enhanced the ability of global players to manage market and credit risks.
What is disturbing
• There is no stability-oriented anchor for the macroeconomic policies pursued by
systemically relevant countries.
• Monetary policies targeted exclusively to consumer price inflation are not likely to
prevent unsustainable trends in credit flows and in asset prices (equity, real estate,
bonds, foreign exchange).
•
The procyclicality of the financial system has been enhanced by factors leading to
excessive credit creation followed by sharp credit contraction. These factors are
related to both market dynamics (underpricing of risk, overestimation of market
liquidity, uniformity of financial strategies and of risk management models,
information asymmetries, herd behaviour) and to financial regulation (capital
requirement, fair value accounting).
•
Perverse incentives and loopholes in the regulatory system have made it possible
for financial innovation to transfer credit risks to unregulated entities.
•
Widespread conflict of interest, between originators of financial products, credit
rating agencies and law firms, has facilitated the dissemination of highly complex,
risky and opaque instruments among investors with inadequate risk management
culture.
The response to financial instability
The response of the international community to the episodes of instability that have affected
the world's monetary and financial system since the 1980s has been on the whole conducted
on a case-by-case basis, with an emphasis on "domestic" factors and circumstances, rather
than on "systemic" determinants. This has reflected the prevailing conventional wisdom
according to which crises are inevitable as they are mostly the result of immutable human
factors like greed and gullibility. Crises are also seen as part of a physiological process
whereby "unfit" market participants are eliminated and the "fittest" survive and become
stronger. In this context, market excesses are tolerated in the conviction that they will
selfcorrect in a relatively short time. From a policy point of view, the conventional wisdom
recommended the so-called "house-in order-approach". This assumes that all imbalances
have a domestic origin and that, if all countries adopt appropriate policies at home, there
would be no systemic problems to cope with and therefore no need for an internationally
coordinated response. Obviously, domestic factors do play a role in triggering crisis
situations, but they are often amplified and propagated by the operation of global financial
markets. Thus a balanced response to crises should ideally address both types of factors.
In reality, the policy response has been generally biased towards adjusting the domestic
causes of imbalances, such as in the case of IMF financial support packages to emerging
countries during the 1990s. Actions targeted to tackle systemic problems have been sporadic
or partial in scope. Occasional interventions to correct exchange rate misalignments of major
currencies have been conducted by G7 countries, but have been mostly of an "oral" kind in
recent years, despite some evidence of success in arresting unsustainable or unwarranted
trends, such as the appreciation of the dollar in the mid-1980s, the appreciation of the yen in
1995 or the depreciation of the euro in 2000.
Also the much-hyped "reform of the international financial architecture" (IFA), launched by
the G7 countries after the Asian-Russian crisis of the 1990s, turned out to be focused
essentially on the need to strengthen financial systems in emerging market countries, mostly
through the adoption of a series of standards and codes of good conduct. The plan drew
criticism from a high level Task Force, set up by the Council on Foreign Relations and led by
Morris Goldstein,4 for not addressing more fundamental issues, like the moral hazard implied
by IMF sponsored bail-outs or the overlapping of roles of the IMF and the World Bank in
crisis management and resolution. A minority of that Task Force, including Fred Bergsten
and Paul Volcker, criticized the plan for ignoring the question of reforming the world's
exchange rate regime, an omission that they equated to "watching Hamlet without the Prince
of Denmark".
In the end the IFA reform obliged the IMF to invest a large amount of resources in a Financial
Sector Assessment Program (FSAP) which produced reports, highly valuable but not widely
read, on almost all its member countries, but with the significant omission of the United
States and China. Another main objective of the reform, that of closing loopholes in the
financial regulatory regime, again forced the IMF to concentrate mostly on the activity of
offshore financial centres based in exotic islands, rather than on hedge funds and other
unregulated financial market participants of greater systemic relevance.
At a conference on "Reforming the IMF for the 21st Century",5 organized in 2006 by this
Institute, the mandate of the Fund, its governance and resources, were thoroughly reviewed
by an impressive range of academics and officials, including the Managing Director of the
Fund. In that context it was recalled that financial sector supervision had led to "a mission
creep" in the IMF, diverting resources from its key institutional task of conducting surveillance
on macroeconomic and exchange rate policies of member countries. This concern way
bluntly underlined by a senior US Treasury official, claiming that the IMF had been "asleep at
the wheel of its most fundamental responsibility - exchange rate surveillance".6 However,
this unexpected "wake-up call" turned out to be less motivated by global stability
considerations, than by more prosaic concerns about the widening bilateral trade gap of the
United States with China, entirely attributed to the undervaluation of the renminbi. Ted
Truman, who had chaired the conference, concluded that: "The IMF is in eclipse as the
preeminent institution of international financial cooperation. Consequently, the world is worse
off."
To have permitted this "eclipse" is probably the most crucial flaw in the response of the
international community to the challenges of globalization. It led to the perception by the
markets, and the public opinion in general, that widening global payments imbalances,
exchange rate misalignments, fast growing monetary and credit aggregates, exceptionally
low risk premia, were not seen as posing a threat to global financial stability. This perception
was reinforced by the recent decision taken by the IMF shareholders to "downsize" the
institution because its lending activity to members had shrunk to almost nil in the high tide of
international liquidity, as if it had nothing else to do.
The international community thus went on to confront the worst economic and financial crisis
since the 1930's with unjustified complacency, ill-prepared, and with its key institution
weakened by internal policy disagreements.
The response to the current crisis
In reviewing the response to the current crisis, I will not address the unprecedented array of
immediate crisis management measures undertaken by central banks and national
Governments in the major countries to underpin banking and financial systems and to
support economic activity. I will rather concentrate on the longer-term work being undertaken
in the IMF context, in the G20 and in the Financial Stability Forum (FSF) to reform the
international monetary and financial system in order to make it less crisis-prone than the
present one and more resilient to shocks. On this more systemic issue, a lively debate has
developed involving politicians, academic economists and financial analysts. A recurrent
theme in the debate is the call for a "new Bretton Woods" and the recent meeting of the
Heads of State and Government of the G20 here in Washington last November was seen by
many observers as the starting point of a process that could lead to a fundamental reform of
the world's monetary and financial system.7
If by a "new Bretton Woods" one means a system built upon the foundations of the "old" one,
it may be appropriate to recall how this was shaped. In essence, the Bretton Woods system
was based on three main pillars: (i) a stability-oriented anchor for macroeconomic policies,
operating through the par-value regime for member currencies in terms of gold and the US
dollar; (ii) an obligation to maintain freedom from restrictions for trade and other current
international transactions; (iii) the possibility of introducing restrictions on capital movements
for restoring equilibrium in the balance of payments. Obviously, in any reform project, these
pillars would have to be adapted to the new reality of financial globalization. Leaving aside
for a moment the "anchor" question of the first pillar, it must be noted that in the G20 Summit
Declaration of November 15, 2008 one can find encouraging language on the issues covered
by the two other pillars.
As regards free trade, paragraph 13 of the G20 Declaration has strong words on the
"importance of rejecting protectionism" and a firm commitment both to "refrain from raising
new barriers to investment or to trade in goods and services" and to strive for "a successful
conclusion of the WTO's Doha Development Agenda with an ambitious and balanced
outcome". This is a rather non ritual language and it sounds pleasantly out of tune with the
widespread feeling that protectionism is on the rise again as a result of the crisis.
As regards financial regulation, paragraph 9 of the G20 Declaration broadly outlines an
approach that rules out any form of old-time restrictions that would impede or distort the
operation of financial markets. This is good, and it should allay the fears of a return to the
past. However there is a strong commitment "to ensure that all financial markets, products
and participants are regulated or subject to oversight as appropriate to their circumstances".
The G20 further outlined the need to strengthen transparency and accountability, to promote
integrity in financial markets and to reinforce international cooperation in the regulatory field,
broadly endorsing the program and the division of labour agreed upon in this field by the
Managing Director of the IMF and the Chairman of the FSF. The FSF, in the words of
Chairman Draghi, is working in particular to ensure that financial systems would have more
capital, less leverage and would be subject to more effective regulation. This would imply,
inter alia, reducing the procyclicality of the regulatory framework and its reliance on
"selfregulation" by market participants, which paves the way to "regulatory capture". This is a
welcome change from the attitude that allowed in the past a growing proportion of markets,
products and participants to go unregulated on the grounds that "they have no systemic
impact". This is the attitude that brought to us the "shadow banking system" made up of
unregulated SIVs and conduits, distributing opaque structured products containing subprimes
and other risky assets with the active marketing of unregulated rating agencies.
Obviously, the systemic impact of these G20 commitments will depend on the actual
outcome of the negotiations underway in the relevant trade and regulatory bodies.
Turning, finally, to the anchor question I must say at the outset that this is the area where
little progress has been made so far in official fora. The G20 Declaration mentions the need
to reform international financial institutions, but mostly to reflect more adequately "changing
economic weights in the world economy in order to increase their legitimacy and
effectiveness". How can we be sure that these steps will ensure that a global crisis such as
the present one will not happen again? Pro-cyclicality is an inherent feature of all financial
systems and it is likely that a mere rebalancing of power would not achieve significant results
in the absence of effective supra-national mechanisms to promote stability-oriented
macroeconomic policies at the national level, especially by systemically important countries.
Unfortunately, the G20 Declaration has placed insufficient emphasis on measures against
the perpetuation of policies that led to unsustainable imbalances at the global level in the
recent past.
These are difficult problems, but the time has now come, perhaps, to have a fresh look at
what are the possible technical solutions. I do not think that the "old Bretton Woods" can offer
a viable arrangement for the 21st Century: fixed exchange rates are gone. And yet one must
admit that freely floating exchange rates have not really helped the adjustment of global
imbalances. Perhaps this is because currencies have now become financial assets that are
traded for profit motives with little or no relation to the economic situation or the balance of
payments of the issuing country: the exchange rate has thus become more part of the
problem than of the solution.
From this point of view it would appear more logical to look again at anchors based on a
system of target zones for key currencies or to a substitution account that would replace
national reserve currencies with the SDR, which I presume is still alive somewhere. But
although logical, a revival of these proposals seems hardly promising for reasons that are
perhaps more ideological than practical but that are still strongly held.
Realistically, the only anchor that one can think of today is an institutional anchor, i.e. an
anchor based on institutions endowed with effective multilateral surveillance powers. This,
again, is easier said than done. Willem Buiter, with his typical bluntness recently wrote:
"Don't waste time on multilateral surveillance. The IMF will never have any influence on large
member states with strong government budgetary positions and strong external positions".8
This is a valid point and indeed so far IMF surveillance has not been very effective despite
various attempts to strengthen it. Yet, in my view, a further effort by the international
community in this direction is needed.
As I argue in my book, the IMF, drawing also from the expertise of the FSF and other
relevant international institutions and standard-setting bodies, must be entrusted with the
task of identifying unsustainable trends in payment imbalances, credit flows, asset prices,
exchange rates, and of formulating specific policy advice to the relevant member countries to
promote monetary and financial stability. This is an area where additional research is
required and where the IMF could supplement the analytical work conducted by the Bank for
International Settlements and in the central banks' community. Monetary policies and
regulatory measures should be designed to complement each other in the context of a
"macro prudential approach", whereby the objectives of fighting inflation and preserving
stability in financial systems could be jointly pursued.
If the policy indications formulated in the context of IMF multilateral surveillance are not
followed, the IMF should make its own assessment known to the public opinion. It is possible
that this may create a certain volatility in financial markets, but it will also strengthen the
market perception of a two-way risk, thus contributing to brake unidirectional unsustainable
market trends that inevitably lead to credit booms (and busts), bubbles, and misalignments.
In the end, I think that the gravity of the present crisis requires a strong determination to
correct the flaws and the inadequacies of the present market-led international monetary and
financial system. In embarking in this difficult effort, the international community should follow
the good suggestions that Barry Eichengreen and Richard Baldwin outline in the Introduction
to the book I have already quoted: "strengthen existing institutions; start thinking outside the
box; do no harm".9