by John Gault:

Thank you for inviting me to address this conference commemorating the 175^th anniversary of the law firm Des Gouttes & Associés.

The focus of today’s proceedings is cross-border and offshore banking. Nevertheless, our meeting takes place in the midst of a broad global financial and economic crisis. I propose we step back for a moment to examine how the issues we are discussing today fit into this larger context.

I am an economist, so I will focus on the forces that drive the economy. Rules and regulations at the local, national and international level are important drivers affecting commercial behavior. Depending upon how such rules are designed and enforced, they can enhance or damage economic welfare.

We have lived through several decades of market deregulation, propelled by a prevailing but oversimplified belief that competitive market forces are self-regulating and provide the greatest possible human welfare. The current global economic downturn has cast doubt on this simple faith in markets.

We are now at an important turning point. An urgent effort is underway to revive and strengthen old rules, or develop new ones, to meet current and future challenges. Attempts to standardize and enforce rules on cross-border and offshore banking are only one example of this broad trend.

I have organized my comments into three brief sections:

1.How did we get here?
2.Where are we?
3.Where are we headed?

How did we get here?

The period since WWII saw global economic expansion on an unprecedented scale. Market liberalization made this growth possible. A series of negotiating rounds under the General Agreement on Tariffs and Trade (GATT), culminating in the Uruguay Round, facilitated this rapid global economic expansion.

Regionally, Europe tore down internal trade barriers and expanded to a single market of nearly 500 million customers. In North America, NAFTA entered into force in 1994, removing most barriers to cross-border trade and investment among the United States, Canada and Mexico. The AFTA agreement in Asia had a similar purpose.

But not everyone benefited from this rapid expansion. In the United States, for example, real wages1 were lower in 2004 than they were in 1964. Income gaps widened. In 1980, Chief Executives of US companies, on average, received an income 42 times larger than the average hourly worker; by 2005, this had risen to 262 times larger.

Although many countries adopted flexible exchange rates, especially after 1971, trade imbalances expanded and persisted. Normally, one would expect exchange rates to move in such a way as to reduce trade imbalances, but the world’s willingness to absorb and hold dollars, thus effectively financing US consumer debt, perpetuated the imbalance.

Numerous warning signs appeared, including:

The US savings and loan crisis in the late 1980s;
The stock market plunge in October 1987;
The Asian financial crisis in 1997-1998;
The collapse of the Long-Term Capital Management (LTCM) hedge fund in 1999-2000;
The collapse of the Dot-com bubble in 2001;
The bankruptcy of Enron, also in 2001; and
The bankruptcies of Worldcom and Adelphia in 2002.

Looking back on this period, one cannot escape a comparison with the Tour de France – not the bicycle race per se, but the race between the developers of performance-enhancing drugs and the authorities trying to detect and prohibit their use.

On the one hand, one recalls the relentless removal of prior regulations, such as the repeal of the Glass-Steagel Act in 1999, and the fervent defense of unregulated sectors, such as the “Enron loophole” for electronic energy trades. On the other hand, one notes the tightening of the Basel rules on bank capital adequacy in 1988 and 1996, and the Sarbanes-Oxley legislation enhancing the responsibilities of corporate directors in 2002.

To use an alternative metaphor: some leaders were stepping on the accelerator, while others were trying to put on the brakes, or at least develop crash-prevention technologies.

This long period that preceded the present global economic recession was accompanied by a divergence between American, or perhaps Anglo-Saxon, world views and those held on the European Continent. This divergence was well summarized in a famous article on foreign policies by Robert Kagan in 20022. The United States, he said, saw the world as a Hobbsian jungle where rules are unreliable and true security requires the possession and use of force. Europe, in Kagan’s view, saw the world as governable through laws and rules and negotiation, a Kantian vision of how to establish “Permanent Peace.”


Where are we?

There is wide agreement that the present crisis originated in the US housing market, where a long period of easy credit and low interest rates contributed to a speculative bubble. Sub-prime mortgages, along with other loan instruments, were packaged into Collateralized Debt Obligations (CDOs) purchased by banks both inside and outside the United States. When the housing bubble burst, mortgage holders defaulted. So-called “monoline” insurers and sellers of Credit Default Swaps (CDSs) collapsed. Credit markets dried up. The real economy, dependent on the financial economy, subsequently foundered.

Those were the immediate causes. The broader cause, however, was the inadequate attention paid to systemic risk over a long period, in spite of numerous warnings. No one has suggested that cross-border or offshore banking (the subjects of this conference) caused the present crisis, or that their reform will, ipso facto, reverse the economic downturn.

Today, we are all watching for signs of the beginning of economic recovery. To date, such signs are tentative at best. The upswing in stock markets and commodity prices following the mid-March announcement that the US Fed would purchase $1 trillion of debt can hardly be taken as a leading indicator of recovery. Some leading indicators, such as new housing starts, or orders for durable goods, remain very weak. On the other hand, recent up-ticks in US consumer confidence, home sales and construction spending represent glimmers of hope.

Projections by the International Monetary Fund (IMF) that a sluggish recovery may be anticipated next year would be more encouraging if the IMF had not consistently underestimated the depth of the recession. Even the IMF’s gloomy projections rely on an assumption that governments will continue to provide fiscal stimuli well into next year. The IMF admits that the risks are “weighted to the downside”.

Stepping back, however, we can see some longer-term positive developments. Most encouraging are the examples of international collaboration on both the size and timing of responses. Central banks have coordinated their interventions. The G20 leaders, in their April communiqué, took some collective actions – such as adding resources to the IMF – and promised others. Perhaps most importantly, the new US government has indicated that it intends to follow a more collaborative approach on a wide variety of economic and foreign policy issues.

The speed with which the present downturn spread globally, and the synchronized nature of the recession, indicate that only global collective action can bring recovery and prevent a repeat of the crisis. Yet on a number of critical challenges where international collaboration is essential, progress has been slow:

Various protectionist measures have been adopted, and could become more widespread as the recession lingers;
The Doha Round remains in limbo;
Many countries have failed to meet their Kyoto Protocol undertakings;
It is far from certain that we will arrive at an agreement in Copenhagen to succeed the Kyoto Protocol; and
We are failing to meet Millennium Development Goals, especially in the areas of child nourishment, sanitation, gender equality and foreign aid.


Where are we going?

However diverse may be our visions of the role of government, we can perhaps agree on certain fundamental values. Based on a broad understanding of how we arrived at our present predicament, two conclusions in particular might be part of a new consensus:

We must reinforce our commitment to the rule of law; and
As markets are liberalized, they require enhanced regulation, especially to deal with significant externalities or systemic risks.

Based on such principles, any number of proposals for tighter regulation of the financial sector have been advanced, such as:

Bringing large private equity and hedge funds under regulation;
Further standardizing international accounting practices and improving transparency;
Raising capital adequacy ratios, particularly on banks’ trading books, and ensuring the capital coverage is appropriately related to risk;
Bringing over-the-counter trades of commodities, derivatives and swaps under the regulatory umbrella;
Linking executive bonuses to long-term measures of profitability; and
Ensuring the independence and objectivity of credit rating agencies.

It has been relatively easy for leaders to score points with electorates during this crisis by bringing pressure on alleged tax havens, but reforms like those listed above will undoubtedly prove more important in the long run.

It should be obvious that none of the above regulatory reforms will make much sense if carried out only by some countries. In our globalized world, financial institutions can easily relocate to less regulated jurisdictions. We therefore have little choice but to pursue reforms in a coordinated, collaborative manner.

Stepping back one last time, I would suggest that we will achieve the necessary financial reforms only if, simultaneously, we make an even broader commitment to reforming global governance.

Governments will more easily impose and enforce tighter regulations in the financial and economic sphere if they demonstrate that the rule of law can be equitable and fair with regard to wider issues as well. Governmental authorities, too, must be answerable to the law.

This means, for example:

Strengthening the role of the United Nations and other multilateral institutions in intergovernmental dispute resolution;
Achieving universal adherence to the International Criminal Court; and
Enhancing respect for the Geneva Conventions, treating violations thereof as requiring urgent international response.

If governments set the example by themselves adhering to and abiding by a universal rule of law, they will earn greater respect when it comes to regulating financial markets and global economic welfare.

Crises breed opportunities for reform, so perhaps we can seize this moment to achieve some of our greatest ambitions.

[This article was originally presented at the Des Gouttes & Associés 175th Anniversary Commemoration Conference “Cross-border and offshore banking”, Geneva, May 2009]

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