Anthony Elson

The Current Financial Crisis and Reform of the Global Financial Architecture

The current financial crisis has sparked an active debate about the adequacy of the global financial architecture (GFA) or the collective governance arrangements for promoting the stability of the international financial system which are mainly centred in the operations of the Financial Stability Forum (now Board) and IMF. There are three areas in particular in which the governance arrangements for the GFA did not work effectively in the lead-up to the current crisis: the oversight of global financial system stability, the coordination of international financial regulation, and the provision of a lender of last resort mechanism. In the light of recent G20 decisions, proposals for reform in each of these areas need to be discussed.

Financial Globalization and the International Financial Architecture

This chapter provides a brief review of the recent evolution of financial globalization and examines the rationale for the international financial architecture (IFA). It also describes the main institutional features of that architecture, as it existed before the current global crisis. The succeeding chapters (chapters 3–5) attempt to explain how it came to take the shape that it has.

The Evolution of the Global Financial Order

This chapter provides a brief historical background for the development of financial globalization in the late twentieth and early twenty-first centuries described in the previous chapter. Although financial globalization has taken on many new forms since the 1980s, it is not a new phenomenon. International banking can be traced back to the Middle Ages, but financial globalization on a large scale began to take hold in the period of the international gold standard (1870–1914). This period was followed by a collapse of financial globalization due to the breakdown of the international economic system caused by two world wars and the Great Depression. This chapter traces out the rise, decline, and resurgence of financial globalization in the period since the gold standard and the origins of the present-day IFA in the early post-World War II era.

Financial Globalization and the Onset of the Global Financial Crisis of 2008–9

This chapter focuses on the antecedents and causes of the current financial crisis that erupted in the United States in mid-2007 and was then transformed into a global financial and economic crisis in September 2008. After the cascade of emerging market financial crises during 1994–2002 and the events surrounding the terrorist attacks of September 11, 2001, there was a period of relative calm in international financial markets. In this environment, a new wave of financial globalization unfolded that would intensify financial linkages among the advanced countries, as well as those between the advanced and emerging market economies.

The Breakdown of the Bretton Woods System and First Reform of the International Financial Architecture

This chapter focuses first on the efforts that were made to support the Bretton Woods system and the factors that led to its breakdown. This discussion is followed by a review of the multilateral debates that led to the first reform of the IFA. At this stage of its evolution, the primary focus of the IFA continued to be on improvements in the international monetary system. However, the outcome of efforts to improve the system was profoundly influenced by the growing force of capital flows within the international financial system. The result of this reform effort was a more decentralized and fragmented structure of the IFA. The chapter also highlights the important changes that occurred in the activities of the IMF and World Bank, and the emergence of the G7 as a de facto steering committee for the IFA.

Emerging Market Financial Crises and the Second Reform of the International Financial Architecture

The second reform of the IFA followed an unprecedented expansion in financial globalization from the mid-1970s until the mid-1990s that encompassed both advanced and emerging market economies. This period of financial globalization was encouraged by the onset of floating exchange rates among the major advanced countries, the removal of capital controls in these countries, and the liberalization of their domestic financial markets. The growth in international financial flows involved at first large banks in the major financial center countries of Europe, Japan, and North America during the 1970s and 1980s and then spread to private portfolio capital (bonds and equity) and foreign direct investment in the 1990s (see figure 2.3). These two periods of sharp upswings in the flow of foreign capital, followed by major reversals, were later repeated in the run-up and aftermath of the current financial crisis. The volatility of these flows has been a continuing problem for the stability of the international financial system.

The Challenge for Developing Countries in a World of Financial Globalization

The expansion of financial globalization to encompass a number of middle-income countries after the mid-1980s has raised a number of challenges not only for those countries, but also for other developing countries that have not participated in this expansion. The onset of financial globalization has also posed a challenge for the role of official development finance, as private flows to developing countries since the early 1990s have risen to a level well in excess of ODA flows from bilateral and multilateral sources. Within the IFA, the role of official development finance is to fill a missing market in the channeling of financial resources to those developing countries that do not have access to international capital markets. This gap has been filled predominantly by the World Bank, along with other multilateral development banks, and by official bilateral aid flows. The IMF has also been called on to play a role in development finance, although its net contribution has been relatively small in relation to other institutional players. This chapter examines first the changing pattern of private capital flows to developing countries and then the challenge for low-income countries and the official aid community arising from the growing influence of private capital flows.1

The Role of the International Financial Architecture in Crisis Prevention and Crisis Management

The emergence of the global financial crisis in 2008–9 was clear evidence of a system failure of the IFA in terms of crisis prevention. Although some policy analysts and institutions were raising concerns about the build-up of risk within the “shadow” banking system and the sustainability of global imbalances, most policy makers in the advanced countries were not prepared for the severity and swiftness of the events that transpired in the final quarter of 2008. Why then was the IFA unable to prevent the outbreak of crisis, given its responsibility for maintaining global financial stability? Once the crisis erupted, how has the IFA responded in terms of crisis management? These are the major questions that this chapter attempts to address.

The Third Reform of the International Financial Architecture

The current global financial crisis has revealed clear problems in the functioning of the IFA, mainly in respect of crisis prevention. An international effort spear-headed by the G20 has been under way since late 2008 to address some of these problems, but it is not yet clear how far this process will go. The purpose of this chapter is to examine the broad scope of the global reform effort that is needed and to consider alternative proposals for addressing specific aspects of the reform agenda. In this commentary, areas where the reform considerations of the G20 fall short are identified.