Professor Jane D’Arista’s broad and deep expertise spans monetary policy and regulation. Rick Rowden asked her some large-scale questions about the global economy for The Mint.
The Mint: What are your most significant concerns about today’s global economy?
D’Arista: I’m constantly outraged about the fact that nobody is really thinking about what is needed in terms of large-scale structural reforms to the global financial architecture. Such thinking is today out of fashion and people are not looking at structural change. The political climate has certainly not been there for it, and while this may be changing, it has not changed enough yet for structural reforms to be seriously considered. There are other very important issues that keep people occupied, but if we have another financial crisis, it’s not going to be pretty and we’re not going to come out of it well.
The Mint: What are some of the large-scale structural reforms that you think are most needed today?
D’Arista: Well, one is the need to do something about the fragility of the global system, as some countries seek to build up large trade surpluses while many others build up large trade deficits. Today’s system, which was designed at the Bretton Woods conference in 1944 that led to the establishment of the International Monetary Fund (IMF) and the World Bank, tends to only punish the countries who run up large trade deficits and forces them to cut wages, reduce the value of their currencies and take other measures to reduce their imports, while doing nothing to punish or dissuade countries like China and Germany from running up large trade surpluses. Such imbalances in the global system can build up over time and create financial fragilities that many economists believe were contributing factors to the global financial crisis in 2008.
The Mint: What could be done to prevent such imbalances from building up?
D’Arista: At the Bretton Woods conference, British economist John Maynard Keynes introduced a proposal to create an International Clearing Union (ICU) that was aimed at correcting such imbalances by forcing the trade-surplus countries to automatically finance those in the trade-deficit countries to help the latter reduce their deficits. The basic idea was that all international trade would be denominated in a special ICU unit of account, the proposed bancor, which was to have had a fixed exchange rate with national currencies. All countries could use their national currencies for imports by exchanging them for bancors. Any exported goods would add bancors to a country’s ICU account, while any imported goods would subtract them. But critically, the proposed ICU would have also created disincentives for trade-surplus countries to maintain large surpluses: in the case of an excessively positive bancor balance, part of a country’s surplus would automatically be taken and applied to the ICU’s Reserve Fund. In the case of an excessively negative bancor balance, a deficit country’s currency’s exchange rate would be lowered, making imports more expensive and exports cheaper. In this way, nations would be encouraged to buy other nations’ products and could help prevent trade deficits from mounting. However, because the US was the major trade-surplus country in 1944, it did not like the idea of being penalised and being forced to put its surplus into the ICU’s Reserve Fund and so it did not support the establishment of an ICU in 1944. So even though there was, and still is, a great need for such a global institution, we’ve long been stuck with a lopsided system that rewards surpluses and punishes deficits, which results in significant imbalances building up over time, creating global financial fragilities.
The Mint: Are there any chances for ever getting something like the Keynes proposed ICU established today?
D’Arista: There were some serious discussions about the need for this following the global 2008 financial crisis, but it lacked any significant political support and was soon forgotten. There is a saying that you should never let a financial crisis go to waste, but in this case we wasted our opportunity. Today, very few are calling for this problem to be addressed, even as global trade imbalances continue to grow.
The Mint: What are other large-scale structural reforms that you think are most needed today?
D’Arista: Another is about the need to find a much more effective way of getting “patient” investment capital into the small and medium-sized enterprises in the world’s majority of developing countries, which is absolutely essential for their successful long-term national economic development and poverty reduction.
The Mint: What do you mean by “patient” capital?
D’Arista: It means investment and credit which is longer-term in its duration and available at lower interest rates than what is typically available today. The origins of today’s international finance system were designed at the Bretton Woods conference. And with financial liberalisation taking off around the world in the 1980s, there are many problems with the way the international financial system has evolved. Mostly, it’s that the financial sectors in most countries around the world primarily serve the short-term speculative interests of international capital, much more than they provide the critical long-term investment capital needed by companies in the real sectors.
The Mint: What is the “real sector”?
D’Arista: The “real sector” is the part of the economy that includes companies that produce real goods and services. The financial sector is supposed to serve the real sector; it is supposed to bring together savers and borrowers so that investment capital can be made available to companies in the real sector. But with extensive financial sector deregulation in the last 40 years, it’s become a problem that too much investment capital is today seeking higher returns on more speculative investments in the financial sector and less investment capital is available for companies in the real sector, which are trying to expand production and employment. Today, the balance has become too lopsided. If you keep opening the financial sector wider like a big casino, of course more of the limited pool of investment capital is going to go there, not to investments in the real sector.
The Mint: Why are so many small and medium-sized enterprises in developing countries unable to access “patient” capital?
D’Arista: Partly, it’s because their domestic financial sectors are too small; and partly it’s because too many financial sectors have allowed the entry of foreign investment that is disproportionately speculative in nature. It’s there to make quick money on the local stock exchanges and real estate markets, through quick merges and acquisitions, to exploit the opportunities in currency exchange rate fluctuations and interest rate differentials, and then to pull profits quickly back out. Most is not there to provide long-term investment in local companies in the real sectors. Many of the traditional restrictions and incentives and disincentives to steer investment capital into the real sector have been done away with under financial deregulation in recent decades. And where you do have financial institutions still providing commercial lending to real sector companies, it’s often in hard currencies and at high-interest rates which frequently involve currency or duration mismatches – which means if everything stays the same, the financing might work out, but if exchange rates or interest rates fluctuate too much one way or the other, commercial borrowers can suddenly become saddled with much larger debts.
The Mint: Why has the international financial system been unable to address this?
D’Arista: One major reason has been the dominance of a single currency of one major economy which has long served as the major reserve asset in the global system. It had been the British Pound before the US Dollar took on this role. It has also been a major problem that developing countries cannot use their own national currencies to pay for their imports, but must instead export goods in return for hard currencies (like the Dollar, Pound, Euro, Swiss Francs or Japanese Yen) and then use these to pay for their imports. This system represents huge structural constraints for developing countries. The lack of a truly global currency, and the continued reliance on one country’s currency as the global reserve asset, has meant a few important things. It has meant that all other countries around the world want to earn and hold onto US Dollars in their central banks – so they have to constantly export more goods in order to get US Dollars. In turn, this has also meant that the United States has to always run a trade deficit so that other countries can get enough US Dollars to use for their reserves.
The Mint: Why do developing countries need to hold high levels of US dollars among the reserves at their central banks?
D’Arista: They do it as insurance, in case they experience macroeconomic imbalances or a financial crisis, and currency traders start dumping their currency on international currency exchanges. If that happens, they can shore up their currency by using their Dollars to buy their currency on international exchanges. But storing US Dollars (US Treasury bonds) in their central banks has significant opportunity costs – US Treasury bonds pay out very little interest and developing countries could arguably be using their scarce resources for far more productive long-term investments in their own economies. This amounts to another major structural constraint faced by developing countries.
The Mint: What is your proposal to address this concern?
D’Arista: One arrangement I have proposed is the establishment of a closed-international Investment Fund under the Bretton Woods umbrella. The Investment Fund would issue its own liabilities in various national currencies and use the proceeds to invest in private and public assets in emerging and developing countries. These investments would provide funds for infrastructure and other projects that require long-term financing. Selling shares in the proposed fund to private institutional investors, such as mutual and pension funds in both developed and emerging economies, would help provide developing countries with a buffer against the volatility of current channels for private cross-border flows. Shares in the fund would also provide assets for the investment of reserves by central banks and governments in emerging and developing economies. Given the multilateral guarantee by the fund, backed by its Bretton Woods member countries, this channel for reserve investment would redirect export surpluses back into the countries that own them, rather than into the financial markets of strong-currency countries.
The Mint: What is your opinion of the financial sector reforms adopted in the US after the 2008 global financial crisis known as the Dodd-Frank reforms, named after the legislators who drafted the reforms?
D’Arista: The Dodd-Frank reforms largely affirmed the role of higher levels of capital reserves for banks as the primary safeguard for the financial system. The procyclical fault in such a solution (given that private investment available to capitalise banks expands in a boom and implodes in a downturn) was not questioned and no effort has been made since to design a counter-cyclical asset comparable to the reserves created by the central bank before deregulation erased reserve requirements as its primary channel of influence. But Dodd-Frank also failed to recognise the diminished role of banks in the system and left untouched the need to provide safeguards for the expanding role of nonbank financial institutions, such as the shadow banking sector, asset managers and others, and to provide adequate oversight of their highly leveraged activities. Central banks and regulators can no longer assess systemic risk or prevent systemic insolvency. What is needed to provide an effective safeguard is a publicly created asset that does not lose face value to replace private capital on the balance sheets of all financial institutions.
The Mint: What are other major structural issues that are of concern?
D’Arista: One of the major missing pieces in both the domestic and international financial systems is a safe global reserve asset that is stable, or in other words, that does not change value regardless of what happens in the market. Concern about this goes back to the 1940s, when Keynes asked how could we create a global reserve asset that is not going to fluctuate so much. The goal was, and still is, to avoid the situation we had in the 1930s, when the value of reserve assets imploded. This will most likely have to be a public asset of some type.
The Mint: Are you referring to the need for a global currency that could replace the US Dollar as the global reserve asset?
D’Arista: Yes. Many people believe the IMF’s internal reserve unit, the Special Drawing Rights (SDRs), could one day evolve into playing the role of a truly global reserve asset. Keynes’ bancor was proposed as a public non-national fiat currency and I have followed his lead on that. It is imperative that more people should be working on this and trying to figure it out, because it is really needed if we are to ever build a more stable and egalitarian global financial system.
The Mint: Are you happy that the Biden Administration is backing the issuance of new SDRs at the IMF to help developing countries weather the Covid-related economic fallout?
D’Arista: Yes, it will provide some small degree of help, but it doesn’t at all address any of these larger structural problems.
The Mint: There are also proposals to set up a mechanism by which rich countries who don’t need their new SDRs can give some away to developing countries at the IMF. What do you think of this?
D’Arista: Yes, it would be helpful, but only marginally. It wouldn’t resolve any of these larger structural issues.
The Mint: Where do you think things stand now?
D’Arista: The problem is basically a political one. The political will does currently not exist among the major economies to take steps to address these missing pieces in the global financial architecture. Very few economists, even progressive ones, are focusing on them. Sadly, it may take another global crisis before there is sufficient will. As for now, the ability of the state to re-regulate the financial sector has been weakened. For example, one part of the Dodd-Frank reforms included limits on lending that altered the definition of a “loan” in order to limit the exposure of one institution to another. The financial industry objected vociferously, saying this would, in effect, reduce the size of the market. Well, that’s right. The financial industry thinks it has become an end in itself and has forgotten its purpose is to serve the real sector. Its oversized growth relative to the real sector has become a problem, and it needs to be shrunk and reigned in. That is precisely what needs to happen. But we’ve got a long way to still go towards making that happen.