A Pint of Financial Challenges

GG 2020 - 23rd April 2010

By Rajeev Sibal

Thus far you have seen a few introductory posts on the GG2020 blog.  The next blog will begin to get into more specific and substantive debate about global governance, specifically in this instance, about finance.  In the next few weeks, you will see the fellows on our financial team offer a few ideas and opinions about the recent financial crisis, governance responses, and systemic challenges faced in global finance.

My flat-mate joked that while a pessimist sees a glass as half empty and an optimist sees a glass as half full, an engineer sees that same glass as being twice as large as it needs to be.  Since my first degree was in engineering I may have found more humor in that joke than most, but I thought the statement was quite appropriate.  Engineers are concerned with the logical sequence of an event and systemically analyze the source of any problem.  I decided to apply my engineering skills to the financial crisis.

The pessimist in me says that we are now too far removed from the crisis and that our window of opportunity for reform is just about closed.  Every day that passes without excessive market swings, we view reform with less urgency.

The optimist in me says that continued discussion in legislative agendas and popular media means that political will is sufficient to enable and attention is still focused on much needed regulatory reforms.

The political economist (and engineer) in me, instead, asks: why are we in this situation? Almost everyone has an opinion about how to fix the problem, but few know why we have a problem to begin with.  So I thought I would use the first blog on finance to review a key historical event that contributed to the recent crisis.

In 1971, the U.S. Government printed more money than it was supposed to and then closed the gold convertibility window.  Known colloquially as the Nixon Shock, it marked the beginning of the post-Bretton Woods era. A succession of countries soon liberalized capital flows.  The global economy was in for a dramatic change.

Embedded in the decision to remove currency controls and open up international capital markets was a broader trade-off: the promise of stronger economic growth in exchange for greater volatility.

Some argue that we should return to a Bretton Woods style system of global economic governance so that volatility will be minimized.  A return to capital controls and standardized currencies is untenable.  The de-standardization of the dollar in 1971 was a necessary adjustment , and historic attempts to control capital flows have proven equally as troublesome to manage.  Like it or not, the free flow of capital is here to stay.

Capital mobility, however, does not mean we cannot have effective regulation.  Some argue that regulation is unlikely because the power of government is severely diluted in a globalized environment. Inspection of empirical evidence, however, clearly demonstrates that the fear of a future filled with weak and feeble states is unfounded.  There remains ample capacity for states to create better regulation at both a domestic and global level.

The challenges we face in global financial regulation are complex. As an engineer, I would argue that if we have a system built on supply and demand, there should be rules in place to prevent deviations that undermine the operation of said system (i.e. curb currency manipulation).  As an economist, I would further argue that deviating from market oriented economic policies will hurt a state's long run ability to be competitive in global markets.  But, from the perspective of a political economist, the solution is not so simple because of the complications that arise when economies at different stages of development interact in a global market.

Everyone has an opinion about how to fix the crisis - fair enough - but before letting that opinion cement, take a few minutes to ensure you know the history and context.  Looking at the problem from a different lens would probably also help.

Rajeev Sibal is a MPhil/PhD candidate at the London School of Economics.