New Rules. But What Rules? Filomeno S. Sta. Ana III Action for Economic Reforms

Regulation-lite takes a retreat. But what will replace it? Doing diagnostics is the first step. There is agreement on many factors that contributed to the crisis. To cite the major ones: a) failure of regulation; b) monetary policy that encouraged irresponsible lending, resulting in highly leveraged banks; c) capital account liberalization, d) misaligned incentives, oriented towards short term; e) moral hazard problems; f) poor corporate governance; g) global imbalances; h) conflict of interests (e.g. rating agencies).

Prescriptions require a new mindset. Not enough to say improved and better regulation, which is motherhood and apple pie. Improved and better regulation requires discarding the old ways of thinking. This means discarding an ideology that worships rational behavior, efficient markets, and self-regulation; an ideology that belittles government intervention, systemic risks, transparency and accountability.

Identification of problems leads to a long list of prescriptions. Stricter regulation and supervision of banks and investment houses; stronger mechanisms for disclosure. Breaking up big banks; separation of commercial banking from high-risk investments like securitization and derivatives. Insolvency rules to curb bailouts that only harden moral hazard problems. Having monetary policy that targets asset bubbles.

List of Prescriptions Improved transparency and information disclosure to address problems of information asymmetry. Removing incentives that are biased for short-term gains, including parameters on executive compensation. Putting in place speed bumps, reintroducing controls on capital. New arrangements for bank and finance surveillance (independent, accountable and with proper incentives) Discouraging currency manipulation to smoothen global imbalances.

Prescriptions Introducing a new global reserve system. Global coordination, involving political leaders. Rethinking Basel 2. Reform of the international financial institutions. Rethinking Central Bank mandate and policies--especially in developing countries, balancing development and growth goals on one hand and inflation targeting on the other. Monetary policy should be constrained by broader development goals.

Problems to Watch Out The proposed measures all make sense. At the same time we don’t want a repeat of having a laundry list of reforms (a la Washington Consensus), but in the process losing track of the key ones. Global rules need to be strengthened but should not constrict institutional/policy space for regional and especially national development. Proper to ask: How thick should be the global rules?

Policy and Institutional Space Let’s look at the xxample of global imbalances: To address this, currency manipulation (undervaluation of local currencies) will be curbed. However, evidence shows that undervaluation has been the main instrument used by developing countries to boost and sustain growth. (see D. Rodrik.) The exchange rate has been used as some kind of industrial (or protection) policy by the developing countries with good economic performance.

Sensitivity of global rules to national development When undervaluation is discouraged to address the problem of global imbalances, the global rules must allow developing countries to find other options or instruments to achieve growth and development (Rodrik). In other words, the use of industrial policy, that has been demonized, must be respected and revived. This will imply that global rules on trade and investments have to be constrained to allow industrial policy to take effect as replacement to exchange rate policy that aggravates global imbalances.