Did global financial institutions survive the Great Recession?

Foreign opinion

The Great Recession that beset in 2008 and the ongoing European sovereign debt crisis pose serious challenges to global financial institutions. In this exclusive interview for the Russian Council Daniel W. Drezner, Professor of International Politics at Tufts University, assesses the effectiveness of global financial structures during the 2008 crisis and talks about the future of the global economic system.

Foreign opinion

The Great Recession that beset in 2008 and the ongoing European sovereign debt crisis pose serious challenges to global financial institutions. In this exclusive interview for the Russian Council Daniel W. Drezner, Professor of International Politics at Tufts University, assesses the effectiveness of global financial structures during the 2008 crisis and talks about the future of the global economic system.

Interviewee: Daniel W. Drezner, Professor of International Politics, Tufts University

Interviewer: Maria Porsviryakova, Russian International Affairs Council

Photo: Daniel W. Drezner, Professor of
International Politics, Tufts University

What parallels can be drawn between The Great Depression and The Great Recession in terms of impact on global economy and the response of financial institutions to both?

There are a few disturbing parallels and there are a few parallels that hopefully won’t be similar. The obvious disturbing parallel in both cases is that the crisis started in one of the advanced industrialized states: in 1929 - a major financial crisis in the United States stock market and in 2008 – a crisis in the U.S. subprime mortgage market.

The other disturbing parallel is that the crisis was taking place at a time when the most powerful country in the world seemed to be relatively on the decline; and there was another country that was on the rise but didn’t necessarily want to participate very much in contributing for global public good. Charles P. Kindleberger, an economic historian, very famously said that in 1929 Great Britain was willing but unable to do what was necessary; when the United States was able but unwilling. So, a lot of people argued that in 2008 it is in fact that the United States is willing but unable; when China is able but unwilling.

That said there have been some significant differences as well. If you take a look at things like trade levels and global economic output, you will see that this crisis hasn’t been nearly sever as the Great Depression was. The Great Depression eventually led the United States to pass this Smoot-Hawley Tariff, which raised the U.S. tariff levels to their highest levels in history. This triggered worldwide trade wars. Other countries responded by raising their tariffs, and also trying to devalue their currencies as quickly as possible. That hasn’t happened till nearly the same extent this time around.

There has been a little bit of what I often call “ticky-tacky protectionism”, which means you have made some steps to try to restrict trade, but on the whole it has actually been remarkable and modest.

How do u assess the response of international financial institutions to the financial crisis? Were the policies of international financial institutions effective? What could have been improved?

My take is that on the whole these institutions haven’t done that bad of a job. To be clear, probably, they could do a much better job. But I think the comparison to the Great Depression is quite apt, because it is really the only data point that you can talk about simultaneously - a crisis that was global in scope and that started in one of the developed countries.

If you are talking about the International Monetary Fund or the World Bank – one of the things that they have done is that they have seen their resources increased: the IMF’s reserves were tripled in 2009 and there was another $400+ billion added this year. The World Bank’s resources have also gone up. This has helped to prevent some of the peripheral countries in Europe from being insolvent. Countries like Hungary or Ukraine have being able to get loans that staved off the worst.

You can argue that these institutions have not done as much as they could with respect to Europe and European sovereign debt crisis. Even if these institutions had the exact right solution for how Europe could get out of its sovereign debt crisis, it is unlikely that Europe would have actually listened to them. Because in the end they would see it as a sovereignty issue. In fact these institutions can do very much when they are trying to push against the great power that is not going to listen to them.

Yet the European Union hasn’t been able to overcome the sovereign debt crisis on its own. So, if the IMF were to help, what it could suggest to end the crisis?

Probably, the best thing the IMF could do is to give a more unvarnished advice to the European political actors as well as to the European Central Bank. One of the problems here is serious distribution issues within the European Union: who is going to bear the cost of adjustment in terms of the fact that countries like Greece, Spain and Italy are now facing higher borrowing cost.

The IMF - as one of the three creditors (the European Commission and the ECB) providing the European Stability Mechanism - could potentially argue that the ECB should inject more liquidity into the banking system as a way to keep interest rates low. That would give some breathing room to countries like Spain and Italy to engage in structural reforms, which are necessary for long-term fiscal sustainability. But it is not going to be easy, because Europe is not going to listen to the IMF, unless it has no other choice.

The G20 supplanted the G8's diminishing power and relevancy. On one hand, this is an example of institutional flexibility and resilience during the financial crisis. On the other hand, the G20 faces serious disagreements among its members and lacks macroeconomic policy consensus. In 2013 Russia will chair the G20, what could be done to improve the coordination of actions on the global scale?

That is going to be a very significant challenge for Russia. The trick is that the G20 did actually do a lot in terms of policy coordination between 2008 and 2010. But after its Toronto summit 2010 there was a fundamental diversion of opinions among the G20 members about what had to be done for the global economy to continue to grow.

The United States and a few other countries argued that continued monetary and fiscal expansions were necessary to keep the global economy running. Whereas countries like China, Germany and Great Britain argued that there needed to be some degree of austerity within the developed world because these countries were borrowing so much.

There is also criticism against the United States for engaging in massive quantitative easing, which then led to currency depreciation in some of the developing countries.

I am modestly hopeful that the IMF latest global economic outlook - which is relatively pessimistic and points out the need for different countries in the G20 to do different things - could offer some opportunities for greater coordination. Russia should pick up on the recommendations of the IMF made to the United States, to Europe and to the advanced developing countries.

Because there is a way in which a deal could potentially be done there. If you improve the level of consultation among these countries prior to the actual summits, that could at least offer momentum towards macroeconomic policy coordination.

What are the prospects of the global financial governance?

I am moderately optimistic with how well the global financial governance has handled the 2008 financial crisis. It has done the things that it had to do in the wake of that crisis. Namely, injecting liquidity into the global system, there has been some effort to rewrite international banking rules in the (Basel III).

That said there is increasing level of paralysis in these institutions just because they have enlarged their membership. For example, we went from the G8 to the G20. And that is very good in terms of the representativeness, but with more heterogeneous members and just with more members’ period, it is much tougher to build consensus.

The one advantage that the system has is that the bias is still in favor of economic openness. The status quo policies pursued by the IMF, the World Bank, the Bank for International Settlements, the WTO and so forth are for relatively open global economy.

So, as long as these policies continue, even if there are no necessarily further pushes towards liberalization, the system should eventually repair itself.

Professor Drezner, thank you so much for this interview.