Financial diplomacy and the credit crunch: the rise of central banks.

• Author: Bayne, Nicholas
• Position: GLOBAL FINANCE AND THE STATE

Economic diplomacy can be defined as the method by which states conduct their external economic relations. It embraces how they make decisions domestically, how they negotiate internationally and how the two processes interact. Economic diplomacy has been transformed in the last two decades with the end of the Cold War and the advance of globalization. Its subject matter has become much wider and more varied and it has penetrated more deeply into domestic politics--no longer being limited to measures imposed at the border. Internationally, it engages a far larger range of countries, including new rising powers like China, India and Brazil. Yet the relative power and resources of governments have been shrinking, so that they often seem to be trying to do more with less. (1)

Governments have adopted four broad strategies to meet the new demands made on its economic diplomacy. They involve ministers--i.e, cabinet-rank politicians--far more alongside bureaucrats. They try to get non-state actors, like private firms or civil society bodies, to share its burdens. They encourage greater transparency to widen understanding and support. They use international institutions to advance domestic as well as external aims and to make the system more inclusive. In many areas of economic diplomacy, notably international trade and the global environment, these strategies yielded major advances in the 1990s. The World Trade Organization (WTO)--in operation since 1995--embraced all trade, including agriculture, services and intellectual property, engaged virtually all countries and went deeply into domestic policy, as well as introducing judicial settlement of trade disputes. In 1992, the United Nations Conference on Environment and Development launched a series of binding treaties on issues like climate change and biodiversity with global institutions in support. This would have been inconceivable during the Cold War.

Financial diplomacy--a subset of economic diplomacy--changed more slowly. The International Monetary Fund (IMF) and World Bank, while not achieving universal membership, remained the dominant institutions. A major upheaval came with the Asian financial crises that began in 1997 in Thailand, Indonesia and South Korea and proved highly contagious, spreading far beyond East Asia. Previous financial crises, up to the Mexican Financial Crisis of 1994, had been caused by the imprudence of governments. This time, the crisis was provoked by the private sector. The three Asian countries in question were pursuing sound fiscal policies and their main mistake was to fix their currencies to the U.S. dollar, which was falling. This encouraged irresponsible financial behaviour by local borrowers and Western lenders, which became a disaster when the dollar began to strengthen. (2)

Resolution of this last financial crisis of the 20th century followed the usual pattern. The finance ministers of the Group of Seven (G-7) countries, led by the United States, encouraged the IMF to mount rescue packages linked to policy reforms. (3) The G-7 then worked out proposals for "new international financial architecture" to be adopted by the IMF and the World Bank and to prevent the recurrence of similar problems. The process was interrupted in 1998 by Russia's default and capital flight from Brazil, but the new architecture was finally agreed upon by the IMF and the World Bank in 1999. (4) Many of the agreed policy measures fell short of their promise, but the institutional changes were valuable. The IMF's ministerial committee was formalized as the International Monetary and Financial Committee (IMFC). The Financial Stability Forum (FSF) was created to provide multilateral surveillance of financial regulators. A new grouping of finance ministers, the Group of Twenty (G-20), successfully associated the emerging powers like Brazil, China, India and South Africa with the original G-7. (5)

After the advances of the 1990s, however, the 2000s have been disappointing for trade and environmental diplomacy. Multilateral negotiations have struggled. The WTO's Doha Development Agenda, launched in 2001, has still not concluded--the last attempt to do so failed in July 2008. Emerging countries are more engaged than in the past, but this has not made it any easier to reach consensus. Bilateral and regional trade agreements are proliferating, so that the system risks fragmentation. In the environment, especially climate change, transatlantic differences have inhibited progress. In Europe, policy has been driven by consumers and lobby groups that favor limits on greenhouse gas emissions. In the United States, policy has been driven by producer interests, mainly in the energy sector, which oppose controls. The Bush Administration, therefore, rejected the Kyoto Protocol of 1997, which would have required the United States to reduce emissions. The Kyoto Protocol does not bind emerging countries like China and India--which are becoming the largest emitters--and they will not move unless the United States does. The position should improve with President Bush's successor but--meanwhile--a decade has been lost.

The financial scene was calmer at first. In 2001, the collapse of Argentina and the shock of September 11 were easily contained. Thereafter, the world economy enjoyed buoyant growth with low inflation sustained over several years and embracing all regions--not only China and other dynamic Asian economies, but even sub-Saharan Africa, which had fallen far behind. In G-7 countries and the European Union (EU), this successful performance was attributed in part to the growing independence of central banks in determining monetary policy, beginning with the creation of the European Central Bank (ECB) in 1998.

Paradoxically, these were unfavourable conditions for advances in financial diplomacy. Financial diplomacy makes the most progress in times of trouble; when things are going well, there is less appetite for reform. The United States, the usual source of initiative, was inactive. President Bush's first two Treasury secretaries took little interest in international financial diplomacy, and Henry "Hank" Paulson, Jr, who took office in 2006, concentrated on bilateral relations with China. The Europeans, despite their success in creating the Eurozone, were unable to unite at the international level. The IMF carried out a modest reorganization of its quotas to give more weight to rising powers like China, but demand for the IMF's lending programs shrank, and its new regime of multilateral surveillance of macroeconomic policies lacked teeth.

This calm was abruptly shattered by a financial crisis--the credit crunch--that began in August 2007. This article looks at how the instruments of financial diplomacy, both domestic and international, have responded to the credit crunch from August 2007 to August 2008 and what that signifies for economic diplomacy more widely. Its main findings are that, over the first year of the crisis, central banks emerged as the leading players. Domestically, they have gained authority at the expense of both governments and other regulators. Internationally, the action migrated away from the IMF, where finance ministers lead, to the Bank for International Settlements (BIS) and its committees, where central bankers are in charge. Central banks have many merits: precise objectives, technical expertise, instinctive prudence and the ability to make hard decisions. On the other hand, their predominance turns the usual strategies of economic diplomacy on their head. Financial diplomacy becomes less politically sensitive, transparent and inclusive, and more vulnerable to the errors of the private sector.

This ascendancy of the central banks is proving to be short-lived, however. Despite their efforts, the credit crunch got worse after August 2008. The international economy is being shaken by wider forces boosting inflation and threatening recession. Addressing these problems puts governments back in the lead and requires central banks and governments to work together again. They will need institutions that engage all international players, which should give a new lease on life to the IMF. The distinct financial diplomacy of the credit crunch could therefore prove a brief episode, not a new trend.

THE FIRST FINANCIAL CRISIS OF THE 21ST CENTURY

In industrial countries, the strong growth in the beginning of the 21st century was encouraged by the rapid expansion of credit due to imaginative financial innovation. Traditionally, banks kept their loans on their own balance sheets and relied on increased deposits to back higher lending. However, the practice of "securitization" enabled banks to package up their debts and sell them as securities on the worldwide markets. Loans for house purchases, backed by mortgages, were especially popular because they generated asset-backed securities, which looked like a sound risk. Banks used mortgages to underpin a cascade of complex, non-transparent instruments, often creating vehicles outside their balance sheets to hold them. Rating agencies graded such instruments highly, compared to other forms of lending. Regulators regarded them as benign since...