I was recently invited to serve as commentator on a panel at the American Society of International Law 2009 Research Colloquium: Current Research on International Economic Law. The principal papers were:
- Tim Canova (Chapman University School of Law): Financial Market Failure and the Economics of Control: Rethinking a New Bretton Woods
- Efraim Chalamish (Latham & Watkins LLP): Rethinking Global Investment Regulation in the SWF Era
- Jeffrey Atik (Loyola Law School, Los Angeles): Basel II and Extreme Risk Analysis
My remarks follow:
The root cause of the financial crisis of 2008 was a systematic failure of risk management. Both private sector actors and government regulators failed adequately to identify, prevent, prepare for, and respond to the numerous risks facing the financial system in recent years. What all of the papers presented today have in common, at least to some degree, is figuring out how to do a better job of managing risk next time.
Professor Atik's paper addresses the Basel II accords, which provide a set of international regulatory guidelines for determining the minimum acceptable levels of capital financial institutions need to protect themselves from market, credit, and operating risk. Although the Basel II framework was designed for banks and Atik's paper thus focuses on risk management by banks, it's worth noting that Basel II has become extremely influential in the risk management industry generally.
As Atik suggests, some argue that even top risk managers could not have anticipated the financial crisis that struck in 2008. As the argument goes, risks fall into three broad categories: known problems, known unknowns, and unknown unknowns. "There is a view that the financial crisis—while clearly a high-impact; rare-event risk—was unpredictable and possibly unmanageable, an unknown unknown." In fact, however, there were warning signs of an approaching crisis in the housing market, including "easy home-mortgage credit terms combined with rapidly accelerating home prices and reportedly lax credit standards," which in turn signaled risks for the financial services industry and then the economy as a whole.
Evaluating such extremely low probability but very high magnitude risks is challenging because the outcomes associated with such risks do not follow a normal distribution. Instead, they tend to have long or fat tails. Because risk management is focused on extreme events, requiring one to quantify the probability and magnitude of severe loss events, an uncertainty generating such a fat- or long-tailed distribution poses "a severe problem for risk managers." Indeed, there is considerable evidence that such risks are approached in "a sort of lax, undisciplined way" that results in them being "undermanaged before they first occur and overmanaged afterward." Nonetheless, "it is simply unacceptable to chalk such an event up to 'not manageable' and focus on the more predictable, tameable and probably less-severe risks."
Professor Atik focuses on one possible solution to the problem of extremely low probability but very high magnitude risks; namely, a lender of last resort that would store additional capital outside individual institutions and would make such capital available in response to extreme conditions. Clearly correct, I think.
Yet, as his conclusion perhaps suggests, additional risk management techniques deserve consideration. In general, firms have four tools for managing risk: (1) transferring risk to third parties through hedging and insurance, (2) avoiding risk by choosing to refrain from certain business activities, (3) mitigating operational risk through preventive and responsive control measures, and (4) accepting that certain risks are necessary to generate the appropriate level of return.
Because there are limits on the ability of capital requirements to deal with extreme events, a Basel III accord needs to engage all four of these strategies. Consideration might be given, for example, to the question of whether certain firms should be prohibited from engaging in lines of business that pose particularly high magnitude operational risks. Should banks whose depositors are protected by federal deposit insurance, for example, be allowed to invest in high risk securities where losses caused by rogue traders might threaten the viability of the enterprise.
At the same time, however, we must be conscious of Professor Atik's concluding warning that we need to avoid "over-engineering and fighting last wars."
Corporate and financial scandals are always good news for proponents of an expansive regulatory state. After every bubble bursts, going all the way back to the South Sea Bubble, new laws have been enacted. After all, there is nothing a politician or regulator wants more than to persuade angry investors that he or she is "doing something" and being "aggressive" in rooting out corporate fraud.
Bubble laws typically have the following characteristics:
- Panic leads to populism which is captured by long-standing interest group pressures
- Because "SOMETHING MUST BE DONE RIGHT NOW" there is no careful balancing of the costs and benefits of regulation.
- They fight the last war: Regulators more likely to react to past market mistakes than to prevent future mistakes
- Post-bust regulators ignore benefits of market flexibility and, therefore, impede risk-taking and innovation
Which leads me the papers by Chalamish and Canova.
A year ago at this time, a lot of pundits were deeply worried about sovereign wealth funds. Even though sovereign wealth funds accounted for only 2-3% of globally traded securities, they were being set up as the next villains of international finance.
This always seemed implausible. Investing abroad for profit is hard enough: recall Japanese companies' bubble-era forays into Hollywood and New York. Investing abroad for political power is even harder. It's a recipe for huge losses rather than world domination: look at the history of France's Crédit Lyonnais or China's state-owned banks.
Today, in any event, sovereign funds seem passé. Like the rest of us in the investment world, sovereign funds have suffered immense losses. Persian Gulf sovereign funds, for example, are estimated to have lost 27% of the value of their assets in the last year.
Not surprisingly, sovereign funds are becoming more risk averse. Chinese funds, for example, have been selling Fannie Mae and Freddie Mac bonds and buying Treasuries. Gulf state funds have been switching out of equities into cash and gold.
Third, in many countries, the ongoing financial crisis is forcing sovereign funds to switch from global to local investments, so as to bail out local businesses.
Finally, with oil prices and those of other raw materials having fallen dramatically, sovereign funds in places like the Gulf and Russia have substantially less surplus cash to invest.
Given all this, it is hardly surprising that sovereign funds have largely fallen off the regulatory radar screen. Having said that, however, there was a serious risk this time last year that many countries would respond to the influx of sovereign fund investments with the sorts of financial protectionism Chalamish identifies in his paper. In the current environment, with economic nationalism again rearing its head, there is a risk that the sort of sovereign fund barriers that were under consideration back then might be enacted now as part of a larger protectionist package. Chalamish's paper thus offers a useful reminder of the international legal rules that will govern such efforts.
Turning now to the last of the three papers; Professor Canova's is the most ambitious in its policy aspirations. A 21st Century Basel Accord is one thing; a 21st Century Bretton Woods pact is quite another.
Canova's argument begins by seeking to rehabilitate the general concept of Keynesian financial regulation, so as to clear the way for regulating "such significant international economic institutions and conventions as hedge funds, derivative financial instruments, hot money capital flows, exchange rate regimes, and international accounting and capital standards."
Canova starts with a response to the economic analysis of the New Deal proffered by a number of libertarian economists, who contend that New Deal policies actually delayed economic recovery in the 1930s.
This debate inevitably reminds one of Harry Truman's search for a one-handed economist. The answer you get depends a lot on how you frame the question. Your choice of metrics inevitably colors your conclusion.
The libertarian critique of the New Deal, however, does not rest solely—or even mainly—on economic data. The better argument is that the New Deal—particularly, but not exclusively during the first Roosevelt term in office—was less Keynesian than it was corporatist.
Corporatism views free competition as a destructive force that has to be both controlled and channeled through institutions that practice fair, but not free, competition under the watchful, mediating power of the government. In corporatism, fair competition means the "stabilization of business" with prices at levels that simultaneously assure fair wages, yield an adequate return on invested capital, and support high levels of employment.
The high water mark of New Deal corporatism, of course, was the passage of the National Industrial Recovery Act as the centerpiece of the early New Deal.
The Act was administered by the National Recovery Administration, whose leaders were committed corporatists. They sought to replace the individualistic—and supposedly selfish, hyper-competitive—free market system with one based on concerted activity under government supervision.
Eventually, of course, the Act's political base became unstable. It had rested on an untenable alliance of New Deal corporatists and old school antitrusters.
The Act, in sum, was terminal even before it was put to rest by the Supreme Court in Schechter. But corporatism did not die with it. Full-blown corporatist policies returned with World War II in response to the need for increases in production of war machinery. Given the exigencies of the war, Roosevelt replaced the NIRA's soft sanctions with heavy-handed, authoritarian sanctions. The war policies included wage and price controls and a low tolerance for even lawful work stoppages by unions. When dispute resolution failed, the government had a new policy option to help the parties resolve their disputes: executive orders allowing the government to seize companies.
The United States never became a truly corporatist state, of course. American interest groups have been too diverse. Government has itself been fragmented, divided at each level among executive, legislative, and judicial branches and dispersed among the national, state, and local levels in a federal constitutional system. Lastly, the American economy is vast and complex. To bring it within the effective control of a few hierarchical, noncompetitive peak associations, is almost unthinkable.
Nevertheless, recent American history has brought forth a multitude of little corporatisms, arrangements within subsectors, industries, or other partial jurisdictions. National emergencies create conditions in which government officials and private special-interest groups have much to gain by striking political bargains with one another. The government gains the resources, expertise, and cooperation of the private parties, which are usually essential for the success of its crisis policies. Private special-interest groups gain the application of government authority to enforce compliance with their cartel rules, which is essential to preclude the free-riding that normally jeopardizes the success of every arrangement for the provision of collective goods to special-interest groups. Crisis promotes extended politicization of economic life, which in turn encourages additional political organization and bargaining.
In U.S. history, quasi-corporatism has risen and fallen over the course of national emergencies, but each episode has left legacies, accretions of corporatism embedded in the part-elitist, part-pluralist structure of American government. By now these accretions, taking the form of disaggregated neocorporatist arrangements scattered throughout the economy, add up to a significant part of the political economy. All of which libertarians would find objectionable even if it lead to an economic utopia.
Turning to Canova's proposal, there is an odd dichotomy between his effort to rehabilitate Keynes and the history of the original Bretton Woods system. The conference that gave birth to that system was dominated by two rival plans developed, respectively, by Keynes and Harry Dexter White of the U.S. Treasury. The compromise that ultimately emerged was much closer to White's plan than to that of Keynes. Bretton Woods itself thus might be characterized as Bastard Keynesian.
In any case, the post-war optimism that characterized Bretton Woods proved utterly Panglossian. Monetary relations after the war were anything but stable, the transitional period anything but brief, the Fund's initial resources inadequate to cope with emerging payments difficulties. Hence after a short burst of activity during its first two years, IMF lending shrank to an extremely small scale for over a decade. Instead, the burden was shifted to the one actor at the time with the financial and economic resources needed to shoulder responsibility for global monetary stabilization; namely, the United States.
For reasons of its own, the United States was not only able but willing to take on that responsibility, in effect assuming the role of global monetary hegemon: money manager of the world.
Though multilateral in formal design, therefore, the Bretton Woods system in practice quickly became synonymous with a hegemonic monetary regime centered on the dollar, much in the same manner as the classical gold standard of the nineteenth century had come to be centered on Britain's pound sterling. For gold exchange standard, many said, read dollar exchange standard.
A 21st Century Bretton Woods must find a way to deal with the political and economic realities that drove both the classical gold standard and Bretton Woods to rely on a single global hegemon. Like it or not, the present era seems to be one of increasing multi-polarism. Would the BRIC—Brazil, Russia, India and China—tolerate US financial hegemony in the long-term?
In sum, something does need to be done to choke off the resurgence of economic nationalism. No one wants a return to the disastrous trade and financial policies of the interwar period. I am not persuaded, however, that neo-Bretton Woods-ism is the right answer.
Thank you.
