What the World's Leaders Did on their Winter Vacation: Nothing
The big idea behind the World Economic Forum in Davos is that many of the world's most important problems, such as reforming the financial sector and curtailing greenhouse gases, cannot be resolved without cooperation on a global scale. The forum that just ended was a great opportunity for government officials, central bankers, representatives of the financial industry, and members of the business community to signal that they are strongly committed to working together to prevent another global financial crisis. In my view, they blew it.
The most important regulatory changes that are needed to reform the financial sector are limits on leverage ratios and increased capital requirements (which generally amount to the same thing). These changes must be international so that firms can't use foreign subsidiaries to get around domestic regulations. They've done it in the past. For example, AIG's London division "took advantage of light-touch British regulation to rake in profits" in the words of this Forbes article. The profits didn't last, however, and the division lacked capital reserves when losses began to mount. U.S. taxpayers were left holding a $182 billion bag..
And there are more changes that are needed within the financial sector. The world needs a procedure for liquidating large, international banks that get into trouble, and increased transparency, liquidity provisions, and common accounting standards.
Reform of the financial sector was one of the issues on the agenda at Davos. During this year's Forum, there was a closed-door meeting of government regulators, finance ministers, central bankers from the United States and Europe, and bank executives to discuss some of these issues. But while there were some positive notes that came out of the meeting, there were also signs of disagreement in important areas.
On the positive side, there was general agreement on the need to establish a resolution fund that can be used to wind down systemically important banks that are in trouble, and there was some progress on establishing capital and liquidity requirements.
But there was disagreement about how to pay for the resolution fund and, importantly, about the general direction that reform should take, with the U.S., as you might expect, pushing for a more market-based approach to regulation. In addition, while Europe acknowledges the need for a global approach to regulation, "participants were skeptical of any cross-border body that would impinge on national sovereignty," according to this Reuters article.
You can see why the Europeans feel that way. The sovereign debt problems that the PIIG countries (Portugal, Ireland, Italy, Greece, Spain) are currently experiencing illustrate the very concerns expressed at Davos about cross-border regulation.
The PIIGS desperately need a currency devaluation to help with their problems, but that is not what is needed in most of the other countries in the European Union. But with a common currency, the European Union can only have a single, unified monetary policy. These tensions are putting the European Union under considerable pressure, the most since its inception. I think the EU and the Euro will survive, since there are clear benefits from avoiding the transactions costs and uncertainties involved with multiple currencies, differing tax rates, etc., particularly when economic conditions are strong. But there is obviously dissatisfaction now with the current structure.
The annual World Economic Forum at Davos bills itself as "committed to improving the state of the world by engaging leaders in partnerships," but the problems the EU is having now will make such partnerships much harder to bring about. European leaders will be very hesitant to commit to the one-size-fits-all type of regulatory policies that emerge from coordinated policy actions. Davos was an excellent opportunity to demonstrate unity and commitment to reforming the financial sector and reducing the chance of another crisis. Instead, however, participants at Davos failed to do any of this and simply revealed the growing divisions among nations.
The financial system remains vulnerable to another collapse, so there is no choice but to push forward on financial regulation. The key will be finding a way to impose tough international regulations while still allowing individual countries enough flexibility to address domestic issues. This is a very difficult problem, but it can be solved with hard work and a commitment to a cooperative solution. Unfortunately, the movers and shakers at Davos this year failed to make use of an important opportunity to make progress on this issue.