Repairing the Global Financial Architecture: Painting over Cracks vs. Strengthening the Foundations

Components of the package outlined below have been circulating as separate reform proposals—some on the IMF and/or G-7 reform agendas, others struggling against Washington and IMF resistance. Combined they are an updating of the Bretton Woods architecture commensurate with today’s changed economic and political environment. They would help restore some of the stable, equitable, economic growth of yesteryear, while supplying institutional building blocks for erecting a genuinely integrated global economy in the future. The components are:

  1. A target zone arrangement to limit exchange rate fluctuations between the Big Three currencies: the dollar, euro, and yen.
  2. A uniform tax on global foreign exchange turnover, a.k.a. the Tobin tax.
  3. Increasing capital requirements on interbank loans in the Basle Capital Accords.
  4. Equalizing the prices of over-the-counter derivatives with those on the organized futures markets by imposing appropriate capital requirements on the derivative-issuing banks.
  5. Curbing the use of offshore havens to evade taxes and regulations.
  6. Reauthorizing developing countries to impose capital controls as needed.

Limiting fluctuations between the Big Three currencies is a looser equivalent of the Bretton Woods exchange-rate regime, which relied on the fixed-dollar price of gold. This time, the Big Three central banks would agree to intervene jointly in the foreign exchange market to keep fluctuations within chosen limits, and, with open capital markets, they would also have to subordinate other policies to this task. Moreover, the ease with which rampaging capital flows shattered the 1987 Louvre target zone agreement and the ERM makes it clear that curbing such rampaging is essential. A global Tobin tax would not only help perform this task but would also substantially reduce the subordination of other national policies required to sustain the target zone.

The Tobin tax is a “market friendly” alternative to direct capital controls, since the tax leaves the screening out of hot money flows to the markets. Around 80% of the $1.5 trillion daily foreign exchange turnover comprises legs of round trips spanning a week or less. Most relate to arbitraging and open speculation by banks, investment houses, hedge funds, etc., that are taking large, short-term positions to exploit transitory, usually small, profit margins. A small tax would cut deeply into these margins and slash the return on capital.

On the other hand, the tax bite on the profit margins from trade and foreign direct investment, which involve much longer round trips, would be minimal and would be offset by the reduced exchange risk and hedging costs that would result from stabilizing Big Three rates. The transaction tax revenue would increase official resources for intervening to stabilize exchange rates while providing more scope for national economies to implement full employment and other welfare goals without being sandbagged by anticipatory capital flight. As Nobel economist James Tobin emphasized when offering his tax proposal over two decades ago, it would slow the reaction speed of the globalizing financial markets, allowing time for welfare-oriented policies to manifest results.

Increasing capital requirements on interbank loans and over-the-counter derivatives would further reduce financial rampaging. The interbank market has been the major channel for moving funds to conduct arbitraging and speculative gambits, and over-the-counter derivatives have been elements in risky strategies by hedge funds, which fuel contagion. (On their role in spreading the Asian crisis to Brazil, see Folkerts-Landau and Garber.) Higher capital requirements raise the costs of the financial leveraging underpinning the massive movement of funds for arbitraging and speculation. And curbing the use of offshore havens to evade taxes and regulations would, of course, facilitate the enforcement of the above four components.

Finally, sanctioning capital controls by developing countries would reduce their vulnerability to capital flows that could otherwise overwhelm their thin financial markets. Article VI of the IMF’s Articles of Agreement already authorizes capital controls, but this fundamental part of its charter has been honored only in the breach by the IMF. Instead, the IMF has been pressuring countries to avoid capital controls. The re-authorization of Article VI would call off the dogs.

Obstacles to Implementation

In combination, the six components of the alternative reform agenda reinforce each other’s effectiveness. And although implementation raises technical issues requiring further study, the main obstacles are political. In the case of the target zone and the Tobin tax, the challenge is how to get these proposals on the official reform agenda for study. In the case of the other four components, which are already on the agenda, it’s how to overcome “the least common denominator approach that emphasizes financial interests and is unlikely to deviate substantially from the views of the U.S. Treasury.”

The adoption of this reform package depends on a buildup of political pressure sufficient to force finance ministers and central bankers, who currently monopolize the reform agenda, to put unemployment and income inequality ahead of facilitating trading opportunities and capital movements. That is made more difficult because the major media rely almost exclusively on spokesmen from financial houses to interpret global financial events, and those spokesmen understandably take the banker’s point of view. The recovery of Brazilian share prices is headlined; rising double-digit unemployment in Brazil is not. Financial market decontrol and deflationary crisis solutions are still touted as the only way to go, etc.

The pressures for change are, however, mounting. At the G-7 meeting of finance ministers last March, the French, German, and Japanese ministers tried to put the Big Three target zone proposal on the agenda. Washington quickly shot down this proposal. But with double-digit European unemployment and the deterioration of the Japanese economy persisting, the need to create a more propitious financial environment for expansionary policies becomes more compelling. Shortly after the target zone squelching, Finance Minister Miyazawa announced his support for “market friendly” regulation of capital flows.

Washington has gone to great lengths to keep the “market friendly” Tobin tax off the agenda. The U.S. squelched the attempt by the United Nations Development Program (UNDP) to promote international discussions of a volume of papers by prominent economists—which the UNDP had sponsored—that assesses the feasibility and benefits of the Tobin tax. This didn’t keep a Canadian coalition of NGOs, academics, and unions from obtaining a 2 to 1 vote for a House of Commons resolution in March 1999 urging the Canadian government to “enact a tax on financial transactions in concert with the international community.” The finance minister has promised, accordingly, to introduce the Tobin tax proposal at the next G-7 meeting. ATTAC, a French grassroots movement similar to the Canadian coalition, is demanding comparable action from the French government and has organized sister movements in other EU countries.

There is no such grassroots activity in the U.S. as yet. Partly, this may reflect the fact that the U.S. economy has thus far benefited in various ways from the global crisis. These include seignorage profits. Over two-thirds of U.S. currency is held outside the United States. Some is drug money, but mainly it’s the increasing use of the dollar as a store of value by middle- and lower-income households in developing countries upset by the instability of the local currency. The difference between the face value of the bills and the minor cost of printing them, adds up to annual seignorage profits of about 0.5% of GDP.

Another boon to the U.S. economy has been the flight to U.S. treasury bonds by foreign investors, whose share of all private holdings of such bonds rose from 21% at the beginning of 1995 to 38% at the end of 1998. In addition, developing countries, which in 1997 already held 55% of global official reserves—mainly U.S. treasury notes—though transacting only 25% of world trade, have been desperately trying to regain the confidence of the financial markets by increasing their dollar reserves. This has meant curtailing imports and promoting exports, which has severely depressed world prices of their chief exports: primary goods and labor-intensive manufactures. Thus the U.S. has been able to increase its foreign liabilities to cover its rapidly growing trade deficit without having to raise interest rates, as the rest of the world has to do, in order to get foreigners to hold its currency and securities.

The dark side is that U.S. residents whose income and wealth derives from owning financial assets, or who are employed in skilled jobs in the nontraded goods sector have garnered the lion’s share of the benefits. In contrast, workers in the exporting and import-competing industries have lost high-paid jobs and have had to migrate to lower wage, service sector jobs. With their profits squeezed by unusually low prices, agriculture, mining, steel, and other material-producing industries with political clout are joining with labor in demanding import protection. Washington’s attempt to ride both its high horses—free trade and free capital mobility—is becoming politically precarious.

Concern that the momentum may be with inward-looking Main Street is evoking fearful memories of Smoot-Hawley protectionism among academics and pundits. Will this resurgence of Main Street-Wall Street tensions persuade Washington to constrain Wall Street in order to save free trade, or will it fall between the two steeds trying to accommodate both? Given the current level of Washington statesmanship, the odds favoring the second outcome are high.

Still, as Martin Mayer observes: “All countries have signed off on Article IV of the Articles of Agreement of the International Monetary Fund, requiring that ‘each member shall: (1) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability…[and] (2) seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions.’ These, not the facilitation of trading opportunities or capital movements per se, are the relevant objectives. It’s the economy, stupid, not the market for paper.”