The G-20 Sings a Song of Sixpence

The emergency meeting of the Group of 20 this Saturday, November 15, was called because the world’s financial system is broken. The crisis is shredding financial markets around the globe:

• It is driving currency markets into turmoil: currency devaluations are threatening all currency markets. Note the table below on the effects on the currencies of both developed and emerging markets:

• Capital markets are plunging into record declines. Just when they need foreign reserves to defend their currencies, Russia and Brazil, just to name two, are seeing massive outflows of capital.  The graph below shows the stock markets for Brazil (EWZ), Mexico (EWM), Turkey (TUR) and Russia (TRF) over the last three months:

• Banks around the world are reeling from taking record write-downs of their loan portfolios. This has the effect of freezing lending to the business and consumer sectors.
• A world-wide recession is spreading and threatening to turn into a deflationary depression.

We urgently need the system fixed. The currency markets need to be stabilized; capital markets need confidence that their economies can be mended; banks need stabilizing regulation and recapitalization, and most economies need a massive dose of fiscal stimulation. It’s a tall order, and too much to expect from a single meeting, especially one led by a lame duck president with no idea of how we got where we are.

Even with this grim an outlook, however, I am optimistic that the coming meeting will be successful in beginning the process of recovery. It is too important to allow failure, and I believe that most of those in attendance know this. At the worst case, I look for this meeting to lead to another meeting next year, after our new President takes office. 

Background of the G20

The G20 nations consist of 19 of the world's largest national economies, plus the European Union. These 20 economies are among the world's most strategically important. Collectively they comprise 90% of global gross national product, 80% of world trade and two-thirds of the world's population. 

At a preliminary meeting last week in Brazil, the G-20 members met to discuss the upcoming conference in Washington. From the tone of that meeting, we can expect a different atmosphere than greeted the 44 nations that met in Bretton Woods, NH, in 1944—the last time economic circumstances demanded this kind of action.  At the New Hampshire meeting all the attendees ultimately agreed with the plan offered by John Maynard Keynes, the great British economist and currency trader. His plan provided the structure of what would become the Bretton Woods Agreement. This landmark agreement provided for the Charters of the IMF and the World Bank, and it laid out a framework for international currency standards. The U.S. dollar was defined in gold, and all other currencies would be pegged to the dollar. The agreement is widely seen as facilitating the rebirth of world trade after the great depression and WWII.

We shouldn’t expect this kind of sweeping deference to the U.S. or any of the G7 members this time around. The emerging markets are no longer comfortable playing lap-dog to their richer neighbors.   Mr. Bush tried to limit the solutions by trotting out all the old bromides about preserving “free market forces,”  as if he has learned nothing from the current financial crisis.   Mr. Luiz da Silva, President of Brazil, answered this with a statement of his own:

We need a new, more open and participative governance. This is not the moment for narrow-minded nationalism or of individual solutions.

There are two caveats that must be asserted in making any prediction about the ultimate outcome of this conference. The first is that little will be decided at the initial meeting. Mr. Bush, as the host,  is the lamest of ducks on the American side, and it is not his time to be exerting leadership on an issue such as this. Furthermore, Mr. Obama, as President Elect, is not attending and will not meet with any of the foreign leaders during their stay. Mr. Obama did, however, announce late on Wednesday, that the former Secretary of State, Madeleine Albright and Mr. Jim Leach, a former Republican Congressman from Iowa,  will be available to meet with foreign leaders on his behalf.

This is an awkward time in American politics, and Mr. Obama is probably correct in staying out of it in the first round. When the second meeting occurs he will have had time to consider the issues more thoroughly and will have the full force of his office behind him.

The second caveat is that neither this meeting,  nor the second one, will likely directly address banking regulation. There will be fierce resistance by the American financial community to international regulations, so this issue is most likely to be left again to each nation to address.   I hope that at the least there will be some consensus about minimum standards of protection of depositors, reserve requirements and full transparency of financial statements. 

The main focus of the first meeting will be on getting the currency markets stabilized. The list of nations experiencing destabilizing currency movements is long.  The approach up to now has been to take each country as a unique case. Russia, Poland and Hungary will probably be loaned massive amounts by the IMF to defend their currencies. Turkey is being pressed to borrow to support their lira, but they are resisting, trying to go it alone.   Iceland has already received billions in aid from its Nordic neighbors, and more will come from the IMF. But these are all piecemeal solutions that beg for a more cohesive approach.

Currency issues will probably dominate much of the conversation of the first and second meetings. It will be a significant challenge to Mr. Obama to craft a solution from among these diverse nations. The old days of the United States dictating to everyone else are probably over; it will have to be a collaborative effort, supposedly something Mr. Obama is good at orchestrating. 

Other items on the agenda have already been discussed by some of the participants. Europe has signed off on a proposal to increase the role of the IMF. They would give it increased powers to curb financial crises with more money to aid troubled economies. But this probably will not be sufficient to satisfy Brazil and other emerging markets. Brazil has long complained their representation in the IMF and World Bank is insufficient, and Mr. da Silva on Saturday said the G-20 is better positioned to forge new international financial regulations, because it more broadly represents both rich and developing countries. Expanding IMF membership may, therefore, become an important issue.

The last item on the agenda will be something of a coordinated fiscal stimulus to shock the economies out of their current doldrums. China has already announced a huge public works package, and the U.S., Britain and Germany are also considering spending measures that will help bring their economies to positive growth once again.   A coordinated approach would strengthen investor confidence and go a long way in beginning the healing process. The amounts needed are huge. 2% to 3% of GDP are estimated to be required for the U.S. alone. Whatever they come up with will be shocking.

There will probably be some members who will suggest we return to the Bretton Woods Agreement. As a nostalgic idea, it has strong appeal. In my view, however, we should not look for a repetition of Bretton Woods. It served well in its time, but it would be insane to implement the same kind of specie arrangement today that was used until 1973. We abandoned the gold standard for good reasons, and we should stay off of it for the same ones.   We cannot tie the world’s economies to the production of gold, platinum or any other commodity. There is much more to international monetary stability than any commodity can furnish. World prices tied to the luck of the mining industry are arbitrary and inadequate. Also, without the global respect that John Maynard Keynes commanded when he came to New Hampshire, the members will have to cobble an arrangement together that includes the needs of all participants, and that does not look to be easy.

The G-20 meeting is vitally important to the future of world trade, and I hope it will be successful in facilitating the financial recovery of all nations. If so, it could usher in another century of sound economic expansion. If not, we will be in for a long, slow recovery, and many of the emerging markets could be a generation away from recovering.  

For currency traders, the situation presents a huge opportunity if they guess right, and a similar magnitude of punishment if they guess wrong. I am guessing on the eventual up-side for emerging market currencies, but I am skeptical about any immediate recovery. The wheel is in spin but when or where it will stop is far from certain.

Comments

[EUARTE:]

The IMF lost any meaning for decades and is still around. Useless and best know for pasture and reward for political hacks and people needing a line on their resume.

If every country is near broke where will this IMF get the money to shore up Iceland, Russia, etc.?

This crisis lacks anyone who really understands what is going on and who has the following to push a solution through.

2008 Nov 13 10:04 AM

[Ray Hendon:]

The major contributors to an expanded IMF fund would be Europe, America, Japan and Saudia Arabia. All these nations have good supplies of foreign reserves, and could make contributions in the hundreds of billions of dollars if needed.

I agree with you that the Bush Administration has used the IMF and the World Bank as dumping grounds for washed up hacks. But it hasn't always been that way, and it will not be in the future, at least is the G-20 members gave their way. Also, some of the past Administrations have actually put good people in these positions.

Best Wishes,

Ray

2008 Nov 13 11:54 AM

[Obama is Bu...:]

??? Keynes was not the principal architect of Bretton Woods -- he was merely the British negotiator, and his opinions were largely ignored. Incidentally, he was also the British negotiator at the end of World War One, where his solution was less than "brilliant".

Most academics and political scholars would say Harry Dexter White was the architect of Bretton Woods.

You also discredit yourself by blaming Bush for stuffing the IMF with washed up hacks. You are a college professor, so I suppose an extremist bias is to be expected. The facts are that the IMF hasn't been relevant since 1972 -- no President has paid much attention to it or the World Bank.

Bush has done plenty of bad things -- but you attributing super-human evil powers to him is ridiculous and makes you sound foolish.

Finally, you are pretty much alone in expecting great things this weekend. The biggest economy in the world is represented by a lame duck president -- with the president elect not even present. The French delegation thinks it can impose some sort of Francophile system on the rest of the world -- a strategy that has failed miserably within the EU never mind globally.

The IMF isn't relevant because its mission WAS to maintain a currency system that ceased to be more than 30 years ago. It has been floundering in search of a purpose ever since.

Its unlikely to become relevant this weekend. Just as an example, France thinks it should retain its influence (and voting power), but its economy is now much smaller than that of Brazil, which has less voting rights. China's economy is also substantially bigger than its voting share.

The only way the IMF can become relevant is if the "insiders" (basically the western powers) give up a lot of power and influence to emerging economies. The long standing tradition of having the president of the world bank and IMF come from western Europe and the US respectively can't continue if either organization is to be considered relevant.

Finally, the emerging economies generally have a very poor opinion of the IMF and its policies; so they are unlikely to support any regime that resembles the IMF of the past.

2008 Nov 14 05:42 PM

[Obama is Bu...:]

BTW -- it should also be mentioned that, under John Maynard Keynes "influence", the British empire went from being the world power before World War II to being an IMF bailout candidate in the 1970s.

Keynes economics were simply a means to an end -- he believed in central economic planning by all-knowing government bureaucrats and elitist academics like himself, which melded well with socialist ideas of the time. That makes him in the right place at the right time -- but hardly worthy of being called "brilliant"

2008 Nov 14 05:45 PM

[Ray Hendon:]

I suggest you do a little more research on J.M. Keynes, including his role at the Bretton Woods Conference, and his place in establishing macro-economic theory. If you look at any elementary economic text book for the last forty years, Keynes' theories and policy recommendations have dominated about half the volume.

I also reject any bias because I use to teach economics and finance in college. No one deserves to be assigned either a liberal or conservative label just because they chose that profession. Economic theory does not come in flavors of liberal or conservative. It comes as a study in trade-offs between competing goals with limited resources.

If you want some current relevance of Keynes, study his liquidity trap theory, which thoroughly explains our current situation of trying to use monetary policy to get out of a serious economic downturn.

Lastly, I did not expect any great things from the meeting of this week. I suggest you re-read what I wrote. I think the next meeting, in 100 days or so will be the more meaty of the two. All participants need some tome to study their options, and there will be some fundamental differences about the role of regulation, size of stimulus and IMF participation.

I also disagree with your assessment of the IMF over the years. Check out the hundreds of countries what have borrowed from the IMF and taken their advice on how to straighten out their economies. I think once you are more familiar with the facts of the situation, you will draw a different conclusion.

Everyone of good will wants the situation to get better. I have no particular biases that cannot be broken if it would help. I am not sure you understand the seriousness of the crisis we face. The wheels have come of the world's economies. Major stuff is needed to put them back on. Clinging to ignorance and prejudice will not do the job.

Also, to assign to Keynes the problems the UK has had since WWII is rather simplistic and, simply, wrong. He was a private economist and currency trader. The British Empire was at the end of it life because of a host of factors, none of which were under the power of J.M Keynes.

Best wishes,

Ray

2008 Nov 14 08:07 PM

[Obama is Bu...:]

I have studied Bretton Woods conference. The United States was in a position to pretty much impose its will on the rest of the world; every other major economy was literally in ruins. Keynes made quite a few suggestions that international authorities (IMF and World Bank) should be much more powerful - but the US authorities stated clearly that they had no interest in giving up sovereignty. They said so in as many words. Anecdotally, many other countries "expressed reservations" about losing sovereignty, which is diplomatic speak for "that's a dumb idea".

Keynes did not bring down the UK by himself, but his bone-headed theories on central economic planning certainly contributed.

Keynesian economics stays in economic textbooks mostly because college professors have a well documented socialist leaning. The country usually votes somewhere close to 50/50 Democrat/Republican -- even after Bush's bumblings, the country voted about 55/45 Obama/McCain. The country is somewhat centrist, as one would expect. College professors have done research on their peers and found that professors vote closer to 98/2 Dem/Rep. You are entitled to your opinion -- but the thinking of you and your colleagues is rather incestuous and not representative of the country as a whole.

The problems with Keynesian economic theories led to the rise of monetarists, neo-classical macro theorists, and a reincarnation of Austrian theories-- just to name a few. Prominent market theorists like George Soros completely reject the whole idea of markets finding any equilibrium. If Keynes' theories were as widely accepted as you claim, there would not have been a need for all these other schools of thought. You might emphasize Keynesian theories in your classroom, but that doesn't make the theories mainstream. Outside your classroom, you cannot threaten people with a bad grade if we don't agree with you.

Any analysis of the experience of Japan (and the US in the last couple years) thoroughly refutes the argument of a "liquidity trap". The Bank of Japan threw so much money at their "liquidity trap" that their govt debt is now over 300% of GDP -- and they have nothing to show for it. Bernanke has slashed interest rates and doubled the Fed's balance sheet -- and after all that Lehman failed while Merrill and Wachovia were days away from collapse.

A liquidity issue happens when banks won't lend to solvent borrowers. When people won't lend to insolvent borrowers, that is called common sense. Everyone -- from consumers to hedge funds to corporations to the government -- have more debt than they are able to service. Everyone needs to de-lever. No amount of extraordinary lending on the part of the Fed is going to change that.

Home prices got way too high as a multiple of income-- several standard deviations higher than the "norm" that existed before Keynes and several decades after Keynes. People do not have the income level to support home prices; making a loan (providing liquidity) to someone who cannot service the debt makes no sense.

An economy with too much debt already cannot be stimulated with more debt. There is no liquidity trap -- the whole idea is simply a shameless way for socialists to justify shifting more power to central economic planners like the Fed and Treasury. While Bernanke has issued some limited mea culpas, he hasn't had the courage to just come out and admit that Greenspan's policies were a major contributing factor to the bubbles and collapses of the last couple decades-- including housing.

2008 Nov 15 05:36 PM