We are negotiating in Washington repeat Washington. Fig leaves that pass muster with old ladies in Threadneedle Street wither in harsher climates.
John Maynard Keynes, 1945

Shock Proof?

Reforming the current international financial architecture is a daunting prospect. It involves addressing a host of inter-related issues, organizations and markets, but without the benefit of a centralized authority structure and within the context of extensive, ongoing and unpredictable financial turbulence. In short, in many respects it is a worst-case scenario, attenuated at the present moment only by an apparent reprieve from 'actually existing crisis'.

At the same time, it is also a necessary undertaking, as even a cursory survey of the immediate past makes clear. Within the space of a few short years, the world has witnessed the collapse of the European exchange rate mechanism (1992/93), a Mexican peso debâcle (1994/95), an Asian financial crisis (beginning in July 1997 and affecting Thailand, Malaysia, the Philippines, Indonesia, and South Korea most dramatically) which has yet fully to run its course, a de facto Russian debt default (August 1998), and a Brazilian currency devaluation (January 1999). Additionally, we have witnessed the surprise collapse both of long-established investment banks such as Barings (1995) and new hedge funds such as Long Term Capital Management (run by Nobel laureates no less, but which went bust rather spectacularly in September 1998), a simmering banking malaise in Japan since the bubble economy ended in the early 1990s (and which is now necessitating drastic government bailouts), and a near-run stock market meltdown (October 1998). And who can forget that a brand new international currency was launched on 01 January 1999, complete with a new and untried institution at its heart, the European Central Bank.

At one level we should be quite impressed that our present financial architecture has coped so well. Designed in the main for a world of relatively segmented markets and insulated national financial systems, it has adapted to the brave new world of global finance with much aplomb: the regulation of currency, credit and capital markets has been regularly updated; the system of international settlements — the unseen plumbing network through which most international financial transactions flow — has been made progressively more efficient; mechanisms and procedures by which individual crises in countries on the periphery of the global financial system have been fashioned; and 'best practice' to reduce distortions and enhance the 'smooth' flow of capital around the globe have been developed and disseminated. Ethan Kapstein was more than partly justified when he claimed as late as 1996 that the global financial system was indeed 'shock proof'.

He was at the same time, however, overly complacent in two important ways. On one hand, there was apparent in his analysis the time-honoured view of 'if it ain't broke don't fix it'. Kapstein claimed that international supervision of financial institutions, based on the principle of home country control, had successfully negotiated the treacherous waters of the 1990s: BCCI and Barings were contained; capital adequacy and risk management improved. Every internationally-active financial institution now had a regulatory 'home', and this new development (a post-1970s phenomenon) made the global financial system much more sound.

While this conclusion rings true in certain respects, it also fails to recognize the key problem highlighted by recent crises. The Achilles heel of today's global financial system lies not so much with private financial institutions as with governments, and especially with how they establish and defend their currencies and finance their expenditures. Private financial institutions have an important place in how governments do their job, as will be discussed later, but they are a second-order problem. The first-order priority is how governments are equipped and able to undertake their responsibilities. And here we have to ask how well the present international financial architecture facilitates governments in their duties.

This observation leads to Kapstein's second complacency, which I would argue is his focus. His analysis makes it clear that good government is a prerequisite for efficient and effective markets to operate, and that the progressive advance of what many term globalization has not altered this basic equation. In fact, he is adamant that states play just as important a role in the international financial system today, under conditions of globalization, as they have always done. His frame of reference, in this sense, is what governments can do to allow markets to work properly. This is of course a necessary corrective to those analyses which argue that governments, and even national economies, are just about through as regulatory and constitutive ideals. Kapstein is arguing for a political economy approach to understanding the public/private relationship in the modern economy, and in this he is absolutely right.

What is problematic about this position, however, is the complacency surrounding the assumed relationship between public and private. From Kapstein's perspective, we can only ask what government can do for private internationally-active financial institutions, in order for them to get on with what they do best (facilitate the efficient allocation of capital, contribute to the growth of economic activity, generate profits, etc..). We do not ask what these firms (or markets) can do for governments in order to allow them to get on with what they are supposed to be doing. But this complacency obscures a crucial problem in today's system of global finance, namely that governments cannot always get on with doing their job because of the deleterious consequences of the way in which financial markets operate, including most spectacularly the occurrence of financial crises. This system does indeed seem to be 'broke' if measured against its record of recent years, and therefore we have a responsibility to look more closely at it, perhaps even with an eye to fixing it if that seems to be necessary.

And here is where things get truly complicated, for we are immediately confronted with a number of obstacles which, even if we accept the genuine need for reform, stand in the way of successfully achieving it. Forget for the moment the problems of intruding on sovereign jurisdictions, reconciling divergent national interests, solving the free rider problem, or even assessing and then acting on the collective public good (the stock-in-trade of good international relations scholarship). These obstacles are tricky enough, but they have been overcome in the past with hard negotiations undertaken in the long shadow of financial crisis: think of the Bretton Woods negotiations, for example, or those that led up to the 1988 Basle capital adequacy accord.

What I would argue today is that we are confronted with a potent mix of peculiarly 'political' obstacles. On their own, each of these are potentially at least capable of being resolved, but together they admit of no quick negotiated fix. In ascending order of significance, I would call these obstacles problem identification, institutional melding, and political resolve. They are all political because each is concerned explicitly with how government or public agencies relate to, react against or regulate financial markets and institutions. Equally important, they are also in a critical sense contingent. That is, there is no external, objective body of knowledge or point of view to which we can turn for a solution. Whatever solution is constructed will be played out against the context of the power relations of the relevant participants and the plausibility and/or credibility of the arguments they use. In political terms, the reform process is far more likely to reflect the art of the 'possible' than the best of all possible worlds.

Reforming the international financial architecture means first creating a consensus around a particular analysis of the problem. Once that is accomplished, the second task requires melding the key institutions (national and international) in such a way so as to overcome the regulatory gaps which have plagued past attempts to identify and contain the international dimension of financial crises. Finally, it means mobilizing the requisite political resolve to realize the institutional changes suggested by the dominant consensus. As a political process, therefore, reform is a daunting prospect, but it is greatly facilitated by making a realistic assessment of our current situation. For at least one conclusion is certain: making the international financial architecture once again a robust foundation of the global political economy is as necessary at the start of the 21st century is it was in the middle of the 20th century, when John Maynard Keynes was negotiating the reform of the postwar monetary system.