OPINION:Obama will not attend, but the summit is likely to yield a new approach to US involvement, writes Patrick Honohan
DURING THE election campaign, the financial crisis impinged on Barack Obama's team primarily in its domestic US aspects, but its effects continue to ooze around the globe. The grand summit of G20 leaders on the international financial crisis being hosted by the outgoing US administration in Washington DC this week, comes at a time when international co-operation is badly needed - and when the risk of a descent into "beggar thy neighbour" is clearly present.
Optimistically branded "Bretton Woods 2" - in reference to the 1944 conference in the New Hampshire town of the same name, which set up the IMF and the World Bank and helped put postwar international finance on a solid basis - Saturday's hastily-convened and underprepared summit will surely not achieve anything so complete. But, although Obama will not attend the meeting, it is likely to set in motion a new approach to US involvement in international economic co-operation.
The fact that half of the participants in the summit come from emerging economies such as China, India, Brazil and South Africa is already an indication of the shifting locus of economic power and a new approach to the governance of international finance. These countries are increasingly affected by the widening financial crisis; they must also be part of the solution.
For, although the most acute phase of the crisis might seem to be behind us, a lot of damage has been done. The fallout will be felt increasingly in employment and company failures all around the world in the months ahead.
The problems did start in the United States, but they were quickly transmitted to Europe's biggest banks because of their willingness, based on a shared approach to risk assessment and risk management, to invest in what proved to be toxic assets originating in the US.
The shock, not only of discovering just how much they had lost, but of realising how little they had understood the risks of their business, has made financiers all over the world highly cautious. They have been pulling back their investments, cashing in anything deemed risky or peripheral to their main activities, and placing the proceeds in the safest forms of investment, such as US treasury bills.
Anyone who has been relying heavily on borrowing has been vulnerable in this environment. That goes for Irish banks, which, in order to finance the property boom, ran up huge foreign borrowings from 2003 on.
It also goes for countries like Pakistan, Hungary and Ukraine to whom foreign lending has suddenly dried up. The position of tiny Iceland is more extreme still, but similar in character. In each case there are certainly underlying reasons for the lenders to be concerned. Lenders have reassessed these risks; furthermore their appetite for risk has diminished. The sudden stop to the flow of foreign funds is thus not arbitrary, but its abruptness is potentially disastrous.
Official international action to replace the withdrawn foreign funds and prevent acute distress in the countries worst affected is already swinging into effect under the leadership of the IMF. It has already promised huge loans to Hungary and Ukraine, and the queue of other stressed middle- and low-income economies seeking the IMF's assistance is growing. It will not have enough money to meet all the calls that are being made on its resources. Therefore, one urgent topic for international agreement is additional lending powers for the IMF, or some alternative funding channel.
Giving the IMF more money is problematic for many summitteers - and not just because IMF policy conditions have tended to be tough and unpopular. The dominance of the US, and to a lesser extent Europe, in the governance of both the IMF and the World Bank is an even bigger bone of contention. The United States has a veto on major issues, and the top job in each institution is always stitched up by Europe and the US. Such dominance of the rich countries is increasingly out of line with economic and political realities, as well as being ethically distasteful. The new US administration has to face up to drastic reforms here to give developing countries a more significant role in decisionmaking - as does Europe.
Apart from emergency lending, leaders are looking to international organisations to develop better early warning systems for systemic crises and better regulation of international banks. As far as early warning is concerned, it is regrettable that the United States, source of the crisis, refused to allow the IMF to conduct the kind of assessment of its financial sector that most other countries have undergone.
Up to now, bank regulation has been a national responsibility, with limited cross-border collaboration between regulators. There is some merit in having a global regulator for the world's top 50 banks, but much less agreement on what needs to be changed in regulatory practice. Actually, the failure of regulation in the current crisis comes down to the fact that professional regulators all over the world shared the mindset of the big banks and assessed risks in much the same way. As long as the banks were comfortable, the regulators were comfortable too, because they were using the same rose-tinted spectacles.
The elaborate new international standard for bank regulation, known as Basel 2, and just now being brought into effect, was constructed by a committee of the most experienced regulators in the world. Yet it would not have prevented the crisis. It relies heavily, for example, on credit-rating agencies, whose advice has proved woefully inadequate and whose opinions have often been absurdly optimistic in the past few years. Basel 2 is not something that was imposed by free-market US regulators against the better judgment of interventionist Europeans: if anything, the US regulators have tended to impose tougher limits on their own banks. Anyway, the regulatory system worldwide is now largely discredited and must be rethought from scratch on an international level. One part is easy: bank lending needs to be backed by much higher levels of shareholder capital. But the search must continue for an effective way of reducing the skewed reward structure for financiers: heads I win, tails you lose. Over-complex and opaque dealings must be effectively outlawed. There is much work to be done to devise a workable approach to bank regulation that will both prevent a recurrence of this system-wide failure, and ensure the flow of credit needed to support growth and employment.
Even as the wounded financial system is gradually nursed back to health, the pessimism and risk-aversion that has spread across the whole world is likely to build cumulatively on itself unless checked by international policy action. Why invest or hire workers when demand for your product is uncertain and falling? Lower interest rates can help boost investment spending; but lowering official interest rates as has been done in the US, and belatedly in Europe, is of limited use when no one wants to lend. Generations of students have learned the Keynesian policy prescription for this condition: more government spending, even running deficits. Here too international co-ordination is needed, since some of the benefits of deficit spending spill over to other countries. Some countries, like China, are better placed to expand spending than others, like the United States. Following two terms of China-bashing by the Bush administration we can expect Obama to be more constructive.
Perhaps that explains why this week China has announced what sounds like a very big expansion in government spending. Though details remain vague, this is the sort of initiative that can help sustain global demand, and which could help encourage comparable action by other large countries. Germany, for example, has so far declined to make any significant commitments. Admittedly, there are limits to this kind of action, but the world is far from such limits at present.
Policy through international co-ordination was not a hallmark of the Bush administration. If the G20 summit does mark the beginning of a new era in which the US becomes again an active and constructive participant in international policy collaboration going well beyond the financial sphere, it may temper Obama's apparent inclination, mentioned yesterday by Pat Cox, to adopt protectionist measures to insulate US firms most vulnerable to foreign competition. Such measures could, as in the 1930s, have a devastating knock-on effect on the global economy, aggravating the recession in the rich countries and slowing the escape from poverty of millions in the emerging economies.
Some commentators have suggested that the summit should explicitly turn its back on protectionism by reviving the stalled Doha trade round and settling, with generous concessions on all sides, the few key obstacles that stand in the way of its conclusion. Now that would be a result.
• Patrick Honohan is professor of international financial economics and development at the Institute for International Integration Studies, Trinity College Dublin
Tomorrow: Trina Vargo on the future of Irish-US relations under the Obama presidency