New Bretton Woods Or Globocops?

A new multilateral regulatory structure seems unlikely now, given that the Fed and some central banks would not like to be told what to do. But, there is bound to be greater global coordination between central banks

A FEW days ago, the US Federal Reserve opened swap lines of $120 billion with four countries — Brazil, Mexico, Singapore and South Korea — to keep international liquidity pipelines unclogged. A few days before that, the European Central Bank entered into foreign currency swaps with Iceland and Switzerland, even though they are not part of the Eurozone. A $12-billion swap line was also established with Denmark. ECB also offered Hungary a $6.4-billion loan to tide over its temporary liquidity shortage. The objective of these swap lines is the same — to ensure that the global financial system, especially the countries that are “systemically” important to the US and European economies, do not suffer from a temporary shortage of dollars or euros, leading to a further deepening of the global credit crisis.

Traditionally, this job should have gone to the International Monetary Fund. Conspiracy theory proponents will undoubtedly detect a dishonourable political design here — with developing countries demanding a more egalitarian shareholding structure in the multilateral institute, this is the only way in which both the US and Europe can maintain their sway over the global financial system. But, such extreme hypotheses apart, the IMF normally takes some time to design restructuring packages for distressed economies, while the Fed and ECB are more concerned with overnight and short-term liquidity issues. Plus, here’s the biggest difference — central banks can print money, while IMF has to depend on shareholders’ largesse. So, given the severity of the global financial crisis, both the Fed and the ECB are not leaving anything to chance, or to the IMF’s time-consuming methods.

They are now stepping into a role that is not specified in their mandate. For instance, ECB’s twin-edged mandate is to maintain price stability in the euro command area and to support the general economic policies of the European Community. The Fed’s conventional role, on the other hand, was to ensure full employment, but the oil shock of the 1970s saw US lawmakers adding inflation combat to that traditional mandate. With the current global financial blowout, both the Fed and ECB are now trying to broaden their usual role into some form of “global lenders of last resort”. They are now ready to provide liquidity to liquidity-starved nations in exchange for marketable and non-marketable instruments, even though such paper may be below the normally accepted credit-rating threshold.

This marks a sharp change from the way these central banks have operated over the years and may even provide some clues about how they will conduct their business in the future. The question that arises immediately, therefore, is: are central banks world-over going to morph into something different?

One thing is definite: henceforth, the Fed is sure to get responsibility for ensuring “stability in the financial system”. The Fed’s hands-off policy with regard to Wall Street and its high jinks has not gone down well with millions of US taxpayers who feel burdened with the responsibility of having to bail out errant banks and financial institutions. Academic and quasi-academic literature over the past few weeks is full of references to how central banks must now build efficient radar systems that can detect incipient trends of financial turmoil and head them off before they can grow in size. However, that’s easier said then done. Experts agree unanimously that it’s also very difficult to pinpoint asset-price bubbles early on in the game. Yet, the political impact of the recent experiences is likely to see lawmakers foisting central banks with some accountability.

As a corollary, central banks the world over will now find it difficult to keep monetary policy and bank supervision separate. There are already rumblings that central banks should have oversight over all components of the financial system, especially when recent experiences have shown that it takes no time for the contagion to spread from one segment to the other.

At a recent conference in Chile, Sveriges Riksbank’s deputy governor Lars Nyberg said: “I want to emphasise that monetary policy is perhaps not the most efficient instrument for preventing crises from happening. Even though a too loose monetary policy may contribute to the build-up of a bubble, it is less clear to what extent monetary policy can prevent such a build-up. It is quite likely that substantial interest rate increases, that central banks would find it hard to implement, would be required to achieve this. More moderate rate increases may, of course, still have an effect at the margin, not least as a signal from the central bank that there are certain concerns linked to prevailing developments. But a more capable line of defence to prevent financial crises is to have proper rules and effective supervision in place.”

Transparency is another word that is likely to be heard with increasing frequency in coming months. The demand that central banks lift the veil from their operations is being heeded in degrees, some with a greater extent of openness than some others. And then there are some which operate in a completely secretive environment. Add to this the fact that most financial markets are still opaque and you have a lethal combo. The extreme opacity in the way financial markets created and traded financial instruments is a major reason behind the current crisis. In the days ahead, lawmakers are certain to demand a greater measure of transparency from both central banks (since many commentators have also blamed central banks’ easy money policy for the turmoil) and financial markets.

Finally, will there be new Bretton Woods institutions, responsible for global financial governance, or will central banks become the new globocops? A new multilateral regulatory, institutional structure seems unlikely now, given that some central banks — especially the Fed — would not like to be told what to do. But, there is bound to be greater global coordination and a higher volume of data exchange between central banks. For instance, jointly, both the RBI and Fed should now be able to wring more data out of financial institutions on the sources behind participatory notes.



Published as Op-Ed in The Economic Times (November 14, 2008)

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