Time to Address Real Economic Reform

Financial markets have painfully short memories. With the Dow hovering above 10,000, last year’s near-meltdown has been forgotten. As a result, the movement for international financial change, so strong just a few months ago, has dissipated. The key nations are stalemated over reform. This week in Germany, the Group of 8 will convene for its annual economic summit. Its immediate preoccupation likely will be Kosovo, but the seven industrialized nations plus Russia should also break the economic-reform logjam because it carries far greater risks than the Balkans.

Everyone has heard about the political difficulty of world financial reform. But that’s like Los Angeles learning a major earthquake is imminent yet being told its City Council can’t agree on a preparedness plan.

The system is rickety and must be strengthened before the next crisis. Necessary steps include dramatically enlarging the International Monetary Fund, straightening out its role relative to the World Bank, strengthening the medium-sized currencies and installing a real financial early-warning system. With leadership, these can all be taken.

There should be little doubt about the inevitability of renewed financial crisis. Remember Mexico in 1994, Asia in 1997 and Russia in 1998. The recent Brazilian crisis was especially sobering.

Six months ago, the Asian financial crisis abated, and world markets were temporarily calm. In this environment, the IMF painstakingly assembled a $42-billion precautionary credit line for Brazil’s economy. This was a new approach, a standby financing so big as to deter a currency crisis in the first place, not just clean up after one had already struck. But without warning, almost before the ink was dry on the IMF loan documents, markets blew right through it.

Confidence in Brazil suddenly ebbed. Its currency plunged 40% in three weeks, capital poured out of the country, interest rates rocketed up and recession set in. All global markets were shaken amid fears of renewed contagion. It seemed the world economy was headed back to the precipice.

All except the unfortunate Brazilians ended up dodging this bullet. But, these recurrent near-misses signal danger. The Brazil case reveals that the world financial system’s shock absorbers are still not strong. Frequent trips to the edge of the cliff eventually result in a plunge.

Right now, world markets are beyond the reach of any regulator or nation. They will probably stay that way. But that doesn’t mean we simply cross our fingers, hoping against a global crash. Or just wait for the next regional collapse. It is folly to stick with an international monetary architecture that worked for the 1960s but is defenseless now.

Here is what should be done. First, the IMF is the emergency lender to governments, and the system needs this bulwark more than ever. But in financial terms, the IMF is too small for the crises that nations will face in the new financial order. Indeed, until its modest multilateral replenishment last year, IMF resources had dwindled to approximately $50 billion. That would only have bailed out one medium-sized developing country. Even now, at $300 billion, the IMF is undercapitalized.

The resources available to the IMF should be doubled, to roughly $600 billion, and simultaneously indexed to an agreed upon, global economic growth rate. This could be done without any new money from national legislatures. Indeed, a moderate leveraging of the IMF balance sheet would work. This could mean that the IMF, whose credit rating is impregnable, would borrow from private markets. Or it could guarantee borrowings by member nations in distress.

Second, the wasteful overlap between the IMF and the World Bank should be ended. In the future, the IMF would be the only handler of emergency financing. It would withdraw from shaping longer-term economic-recovery programs. In contrast, the World Bank’s main role would return to overseeing all sectoral reform, particularly for banking systems, and all financing for social-safety nets. It would no longer serve as another, short-term emergency lender.

Third, the current exchange-rate system for semi-industrialized countries needs modification. Among the big three currencies--the dollar, the euro and the yen--trading relationships are fine. But certain currencies of semi-industrialized nations, including the Mexican peso or South African rand, are far more vulnerable to sudden capital overflows, as was evident in Mexico in 1994 and Indonesia in 1997. Some need greater protection.

The currency-board systems of Hong Kong and Argentina, while not identical, are relevant here. They stood out like lighthouses during the recent international financial crisis. Despite currency collapses all around, these currencies maintained their values. The key was an “iron linkage” to the U.S. dollar, supported by large dollar reserves maintained by the currency board.

Washington, in particular, should encourage adoption of such “hard” dollar-based systems. The most obvious immediate candidate is Mexico, then perhaps Brazil. Such approaches do not apply universally, however. A monetary system as weak as Russia’s, for example, could not sustain it.

This is also a natural moment for U.S. Treasury Secretary-designate Lawrence Summers to take the lead in advocating such measures. This week’s economic summit is the right forum in which to press these ideas.

Fourth, the IMF should impose tough new standards for financial disclosure and banking supervision as conditions for membership. The international financial crisis exposed deep failures in these areas. Indeed, it was only when previous appearances of healthy banking systems and corporate balance sheets proved false in places like Thailand and Indonesia that the crisis became contagious.

Finally, the world needs a financial early-warning system to detect a nation’s financial weakness before it collapses and drags others down with it. The right mechanisms involve the same combination of credible credit-rating agencies and capital markets reacting to them, as operates so successfully in the United States. But the IMF should require that its members cooperate with these agencies by providing full and timely disclosure.

Less than a year ago, the worst international financial crisis in 50 years still gripped the world. It took global finance to the edge of collapse. Since then, reforms of the financial system have been few and far between. Achieving real reform is the responsibility of the leaders of the Group of 8. The homework on potential improvements has been done. What is needed is the political will to produce an agreement. If they can remain united on bombing Yugoslavia for 10 weeks, they can deal with the bigger threat of a global crash.