Markets Can’t Rule Themselves

What should this new set of global financial rules encompass? For starters, it should ensure that managerial incentive schemes are transparent and do not provide perverse encouragement for bad accounting, myopic behavior and excessive risk taking. Compensation should be based on returns not from a single year but over a longer time period. At the very least, we should require greater transparency in stock options, including making sure that they receive appropriate accounting treatment. And we need to restrict the scope for conflicts of interest—whether among rating agencies being paid by those they are rating, or mortgage companies owning the companies that appraise the properties on which they issue mortgages. We need to restrict excessive leverage, and other very risky behavior. Standardization of financial products would enhance transparency. And financial-product safety and stability commissions could help decide which products were safe for institutions to use, and for what purposes. We have seen what happens if we rely on bankers to regulate banking.

Beyond better global coordination of macroeconomic policy and regulation, there are at least two other actions governments should take. First, we need a reform of the global reserve system. More than 75 years ago, John Maynard Keynes, the greatest economist of his generation, wrote that a global reserve system was necessary for financial stability and prosperity; since then the need has become much more dire.

Keynes's hope was that the International Monetary Fund would create a new global reserve currency that countries would hold instead of sterling (the reserve of the time). Today, such a currency could be used to replace the dollar as the de facto reserve currency. Because it would not depend on the fortunes of any one country, it would be more stable. Supply could be increased on a regular basis, ensuring that reserves kept up with countries' needs. Issuance could be done on the basis of simple rules—including punishment for countries that caused global weaknesses by having persistent surpluses. This is an idea whose time may have finally come.

The other major reform should be a new system of handling cross-border bankruptcies (including debt defaults by sovereign states). Today, when a bank or firm in one country defaults, it can have global ramifications. With various national legal systems involved, the tangle may take years to unwind. For example, the problems arising from Argentina's 2001 default are still not resolved, and bankruptcy complications plagued South Korea and Indonesia during their crises a decade ago, slowing down the process of recovery. The world may soon be littered with defaults, and we need a better way of handling them than we have had in the past.

This crisis has highlighted not only the extent of our interdependencies but the deficiencies in existing institutions. The IMF, for instance, has done little but talk about global imbalances. And as the world has focused on problems of governance as an impediment to development, deficiencies in the IMF's own governance meant its lectures had little credibility. Its advice, especially that encouraging deregulation, seems particularly hollow today. Many critics in Asia and the Middle East, where pools of liquid capital dwarf the IMF's own, are wondering why they should turn over their money to an institution in which the United States, the source of the problem, still has veto power, and in which they have so little voting power.

This is a Bretton Woods moment—a time for dramatic reforms of existing institutions or, as was done at the end of World War II, the creation of new ones.

Until now, Washington has consistently blocked efforts to create a multilateral global financial system that is stable and fair. It exported the deregulatory philosophy that has proved so costly, both to itself and to the world. President Obama has an opportunity to change all this. Much depends—now and for decades to come—on his response.

Stiglitz is a Nobel laureate in economics and a professor at Columbia University.

© 2008