Wednesday, April 15, 2009


At last week's Workshop for Ethics in Business on Restoring Trust in the Global Financial System a certain consensus emerged: the trust lost in the recent financial crisis can only be restored through the introduction of a fair, transparent, and most of all international regulatory regime.

There was, however, another consensus reached by the panelists, Neal Flieger, Stephen Jordan, Seamus McMahon, Christian Menegatti, Tom Donaldson - that while the goal of creating a new system of financial governance is noble, it is also unattainable. The blame-game and a competitive scramble to re-capitalize and re-regulate the financial sector is in full swing. Continental Europeans blame the Anglo-Saxon model for the recent crisis, Russia and China are calling for a new reserve currency (a concept also articulated in a recent Policy Innovations article by Korkut Erturk), and the US Financial Accounting Standards Board just changed unilaterally the way banks value their assets - and thus their losses. The spirit of cooperation is nowhere to be seen.

A comment by Stephen Jordan helped me to put it all in perspective. He called the structure of the financial system pre-Lehman collapse a giant poker game, with none of the participants knowing what the others were holding in their hands. This was also a major argument put forward by Neal Flieger, who proposed that the current crisis, and the Obama administration's response to it, has been an "opportunity to be transparent and honest." One can assume this means the present system is anything but. We are thus provided with an explanation for why, according to Seamus McMahon, trust levels in the banking sector and the stock market are below 20%.

Why, then are we not seeing the development of a consensus on a universal regulatory regime? Tom Donaldson identified three causes of the current crisis: (1) a pattern of paying for peril, (2) a normalization of danger, and (3) the tech shock that created financial instruments too complex to understand or regulate. As the world emerges from this economic disruption, and financial institutions begin to rebuild their balance sheets, should we expect a return to the behaviors of the past?

The discussion of a global oversight body, the rebuilding of trust, and multilateral agreement on restraining the most egregious behavior, brought to mind another upcoming round of talks, those on a successor to the START treaties. Nuclear disarmament talks gained momentum during the Regan administration - a president not known for being soft on the Soviet Union. What drove Regan then was the repugnant nature of the nuclear weapon, along with the realization that the arms race, at least in the nuclear sphere, got out of control.

And here the parallels between the current financial crisis and the nuclear disarmament talks crystallize. Just as we continue to live with the specter of mutually assured destruction, we have gotten a taste of what can happen when the financial markets implode and take the global economy with them. Little wonder Warren Buffet called some instruments "financial weapons of mass destruction." The arms race, or the recent regulatory race, created the untenable situation of governments compromising on safety for the sake of building a more potent arsenal (of warheads or international financial institutions). Both situations also resemble the classic prisoner's dilemma - the only way out is for all parties to trust each other and coordinate their actions.

The agreements entered into by the Soviet Union and the US required both to cede some degree of sovereignty. Both countries agreed to restrain their weapons build-up. Both also agreed on an inspection regime more intrusive than anything seen before. This "trust and verify" approach, as President Regan dubbed it, became the foundation for all future US-USSR treaties. It can also form a solid foundation for a new international financial markets regulatory framework.

That the US will need to restrain its financial sector is also the theme of Martin Wolf's column in today's Financial Times. Aligning that restraint with others, however, has so far only been advocated by the likes of Merkel and Sarkozy. It was the Europeans who have advocated for a convergence of regulation, and placed it on the agenda at the G20 summit in London. Nevertheless, we may not be too far off from the day when this idea takes root in the US as well. After all, if Washington is willing to compromise on such a sensitive issue as defense policy, what is to stop it from ceding a bit of sovereignty and allowing a body like the IMF to scrutinize its financial regulation? We already know the costs of inaction.

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