Wasting a good crisis?

Whether in South Korea or in Brussels, negotiations on financial regulation have been going the wrong way.

It has not been a good two weeks for international financial diplomacy. In Gyeongju, South Korea, on 23-24 October, a meeting of finance ministers and central bank governors from the G20 countries, preparing for this month’s summit of national leaders, confirmed the doubts of long-term sceptics. The conclusions once again defined, but did not narrow, the differences between their competing national interests.

Yes, a further tentative step was taken in the direction of reforming the International Monetary Fund (IMF) to give larger, developing countries more votes and a bigger say in its operations. Since 2007, the IMF has shown that it still plays a vital role in promoting global stability, so who can argue with that?

But reforming the governance of the IMF has been on the agenda for most of the past decade and the changes will only slightly reduce the excessive influence (and voting power) of the IMF’s European members. In 2012, two smaller EU states may give up their permanent seats on the IMF’s 24-member executive board. This is small beer.

Whatever the positive post-meeting rhetoric may have claimed, there will not be any significant move by the G20 to tackle global economic instability. US calls to work formally towards diminishing international current account imbalances and so, potentially, to reduce speculative currency flows and calm currency volatility will remain merely hot air designed to put pressure on China to revalue its currency.

But discussions involving China and the US about who is to blame for global economic imbalances have been going on behind closed doors for much of the past decade; to little effect. History – the Bonn summit of 1978 and the Plaza Accord of 1985, which many in Japan blame for its two decades of stagnation – says that such agreements are likely to do as much harm as good to at least some of the participants. China is not going to repeat Japan’s mistakes.

European concerns

What was more worrying was the outcome of the European Council meeting in Brussels last week (28-29 October). It had been hoped that, by agreeing reforms to economic governance, this meeting would demonstrate that the EU (or at least the eurozone) could take a giant step towards better co-ordination of economic policy. This would lay robust foundations that would buttress both the Union’s recently threatened financial stability and the status of the euro. It might also help raise Europe’s anaemic potential growth rate.

For weeks, commentators had been warning that the taskforce on economic governance chaired by Herman Van Rompuy, the president of the European Council, which was called upon to propose new rules, might prove a damp squib.

Alessandro Leipold, a former top IMF official and now an economic adviser to the Lisbon Council, a Brussels-based think-tank, produced the most illuminating and balanced assessment as early as mid-September. He wrote that the national leaders should resist any temptation to “political weakening” of the proposals for governance reform made by the European Commission and European Central Bank (ECB), which, “if fully implemented, would represent appreciable steps forward”.

If EU leaders failed this test, he wrote, “Europe will have let ‘a good crisis go to waste’”.

Leipold listed the issues that he believed had to be addressed. Financial (not just economic) stability had to become an explicit objective of the new governance regime. Member states had to be encouraged to buy into the reforms, partly by strengthening, in a co-ordinated way, their national institutional arrangements for promoting budget discipline, and partly by providing incentives to good behaviour as well as threats that indiscipline would be automatically punished. A permanent crisis management and resolution mechanism had to be created to replace the European Financial Stability Facility (EFSF), the temporary €440 billion rescue mechanism scheduled to end in June 2013.

Evidence of backsliding surfaced on October 18 when Angela Merkel, Germany’s chancellor, and Nicolas Sarkozy, France’s president, cut a deal watering down the automaticity of fiscal penalties for miscreant member states. They did this (apparently) behind the backs of Van Rompuy’s taskforce, which was hunkered down in Luxembourg on the very same day finalising its report.

This decision drew sharp dissent from a disappointed Jean-Claude Trichet, the president of the ECB.

In the event, the Council conclusions duly endorsed the Franco-German deal, trading off the automaticity of sanctions against German demands for treaty change to allow a permanent successor to the EFSF.

Flawed framework

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History suggests that politicians may well have found a way around even even automatic penalties for budgetary indiscipline. But without a high degree of threatened automaticity, what looks like a tough new fiscal governance framework is likely to fade when put to the test.

Leipold observes from IMF experience that implementing Van Rompuy’s pet-project, a new macro-economic oversight framework, will be harder to achieve operationally than it looks.

As things stand, the technical work for macroeconomic oversight will be placed in the hands of the Commission’s directorate-general for economic and financial affairs. So what will be the role of the new, ECB-based, European Systemic Risk Board (ESRB), which is also charged with overseeing macro-prudential stability? It was barely mentioned by Van Rompuy. Are the foundations being laid, not for joined up thinking but for a muddling of responsibilities between Brussels and Frankfurt in what, in economic policy terms, is an experimental field of economic policy practice for which there is no precedent?

The ECB, through the ESRB, its links to the strengthened financial market supervisory authorities and its informal capacity to exert pressure on both governments and banks (the latter through its refinancing operations), could inject a much-needed level of discipline into the EU economy. That would be all the more effective if financial markets were encouraged to believe that countries should continue to face punitive market borrowing costs until they have committed themselves decisively to the paths of fiscal righteousness.

If the ECB is to play such a delicate role, it will need deft political leadership and an untainted reputation for sound economic judgement. The involvement of Brussels is unlikely to make the task easier.

Stewart Fleming is a freelance journalist based in London.