The demise of the Bretton Woods system in the 1970s was epoch-defining; it constituted a massive shift of financial risk-bearing from the public to the private sector. One aspect of this was the progressive international financial liberalisation that followed, and a by-product of that, the ever increasing ‘financialisation’ of our economies. This shift also marked a fundamental change of economic philosophy.
The Bretton Woods institutions, the International Monetary Fund (IMF) and International Bank for Reconstruction and Development (IBRD), survived but did so by adopting the role of leading advocates of the new religion. These institutions have demonstrated an ability to change and are doing so again.
This is well-illustrated by their attitude to free international flows of capital. Though the original articles of the IMF never advocated such liberalisation, by the late 1990s they were part of every “solution” advanced by the IMF and culminated in the (rejected) attempts to modify those original articles. This was the new orthodoxy.
Regulation of the private sector moved from the control regulation of Keynes and White, to the risk-based (self) regulation with which we are all familiar; a process of regulatory capture by common philosophy, which greatly benefited regulated financial sector insiders. The exponential growth in credit, financial market activity and contractual complexity, the increased ‘financialisation’ of our economies, which accompanied this, can be only partially justified by the increase in risk faced by the private sector.
It was also notable that these inside financial institutions also changed character by merging and incorporating within a single institution many of the traditional activities of distinct categories of financial institution, notably insurance and banking.
The Asian crisis of 1997/98 was, perhaps, the turning point. The excoriating criticism of Dr Mathahir Mohamad and Malaysia on their introduction of exchange and capital controls in crisis response verged on demonisation. Hindsight places those controls in a very different and positive light. The 2010 Seoul G20 declaration and numerous recent IMF and other official publications have now thoroughly legitimised this behaviour.
The debate is now not over minor detail of the phasing and sequence of capital account liberalisation but, rather, of more fundamental questions, including the optimal size of the financial sector, the role of international capital flows and their appropriate control mechanisms.
Financial stability and the economy
Though it is trivial to demonstrate that capital account controls can be used to manipulate exchange rates and the terms of trade, the current debate is not about trade and globalisation, or even protectionism, but about financial stability and the economy.
International trade can be expected to continue to increase, perhaps reaching 40% of global GDP in the coming decades. It is notable that the empirical evidence in support of the theoretical economics of free international capital flows was always rather mixed and ambiguous. The development arguments of the liberalisation philosophy were certainly confounded by the observation that, for the decade prior to the crisis, the capital flows were from the less-developed to the developed world.
The current problems of the eurozone can also be seen in this light; free movement of capital (even within a common currency area) without concomitant co-ordination of fiscal policy (including taxation) can be profoundly problematic.
Re-evaluation of the financial system, its role in the economy, and society more generally, has been proceeding apace; amidst a literature which is often confused and confusing, Michael Sanders’ What Money Can’t Buy and the Skidelskys’ How Much Is Enough are notable for their lucidity.
Alongside unprecedented official actions to resolve the problems arising from the crisis and its lingering effects, we have seen numerous regulatory proposals, littered with technical jargon such as pro-cyclicality, with an apparent ambition of “never again”. In academic circles, these have been broadly divided into micro-prudential extensions and alterations of the pre-existing regime and new macro-prudential regulation concerned specifically with stability.
One related manifestation: the various examinations under way of the short and the long-term: the Kay Review, a forthcoming EC Green paper, an ECMI/CEPS task-force, the Long Finance Initiative and many other influential private groups.
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