Global Financial Crisis
Lessons and Opportunities for International Political Economy
This is a preprint of an article whose final and definitive form has been published in International Interactions © 2009 copyright Taylor & Francis; International Interactions is available online at: informaworld. The complete article can be found in International Interactions, Volume 35, Issue 4.
The global financial crisis that began in 2007 is a once-in-a-lifetime event with wide-ranging consequences for government policymaking. The crisis has prompted much soul-searching among economists and financial experts who failed to anticipate it, or whose warnings were not taken seriously by regulators and investors. Scholars of international political economy (IPE), however, are generally not in the business of predicting financial crises or recessions, and so the field is unlikely to see the crisis as a manifestation of scholarly failure. Yet the crisis may have an appreciable impact on the trajectory of IPE, just as the downfall of the Soviet Union shaped subsequent scholarship on international relations and great-power conflict and prompted a movement away from grand, and toward mid-range, theories.
This article discusses three categories of inquiry—or puzzles within the realm of global finance—that have received relatively little attention within the field of IPE, but which should receive greater scrutiny as a result of the crisis: the determinants of cross-national variation in financial regulation; patterns of cooperation and discord within global regulatory bodies and the involvement of emerging-market countries in these bodies; and the interplay between individual firms-as-political-actors and public policy outcomes.
Domestic Financial Regulation
David A. Singer is assistant professor of political science at MIT. Singer co-authored the article with Layna Mosley, associate professor of political science at the University of North Carolina.
There is considerable cross-national and temporal variation in the manner in which national governments regulate their financial sectors. Some aspects of this variation are particularly striking. Government ownership of banks is still prevalent in certain OECD countries, including Greece, Italy, Portugal, and Switzerland, and is relatively common in the developing world. The dynamics of regulation in these countries—in particular, the relationships between regulators and regulated firms—almost certainly differ from countries in which there is a clear public-private divide. Regulators themselves also differ across countries, in their ties to other government bureaucrats and elected leaders. Some regulators are relatively independent from political pressures and from the entities they regulate, while others are highly susceptible to partisan pressures or regulatory capture. In some nations, central banks are responsible for bank supervision, while other countries have separate—and sometimes multiple—agencies for bank supervision (Copelovitch and Singer 2008). Perhaps most importantly, there are substantial cross-national differences in the content of regulation, including capital requirements, financial transparency, holding company supervision, and portfolio limitations. These regulatory differences are of interest for scholars of comparative politics as well as international relations, because disparate national policy requirements are potential drivers of international systemic risk. Given the diversity of national regulatory structures, multinational firms’ incentives for forum shopping and regulatory arbitrage are significant. And given contemporary global financial interdependence, the system as a whole is vulnerable to financial instability within any individual country.
To date, the study of domestic financial regulation has received relatively little attention from political scientists in the international relations subfield. Existing studies often focus on individual countries or regions rather than taking a broader cross-national approach.1 The field of IPE has generally not appreciated the fact that cross-national differences in domestic financial regulation can have international repercussions. While the open-economy implications of domestic policy areas such as central banking, taxation, and even welfare spending have garnered substantial attention, the political economy of domestic financial regulation has remained curiously outside the traditional confines of the IPE field.2
Today’s financial crisis highlights the international salience of domestic regulation. Countries with relatively lax banking supervision, such as Belgium and the U.K., were more vulnerable to the contagious effects of the bursting of the housing bubble in the U.S. than were countries with more conservative banking restrictions, such as Australia and Spain. To be sure, assessing the effects of regulatory laxity or stringency is no easy matter. Canada, for example, employs a principles-based approach to regulation, which is ostensibly less stringent than the rigid rules-based (or "checklist") approach of U.S. regulators. However, the Canadian banking sector has been remarkably resilient during this financial crisis, whereas U.S. banks are faltering as a result of imprudent decisions—such as shifting risky investments off their balance sheets—that were technically in compliance with regulators’ dictates. Future empirical analyses of domestic regulatory variation, then, would need to consider not only the formal procedures in place, but their application in practice (e.g., Quillin 2008).
Will scholars of IPE take an interest in domestic financial regulation? The macroeconomic developments of the 1970s and 1980s provide a clue. After the fall of the Bretton Woods monetary system, scholars began to pay more attention to the inflation that wreaked havoc on the industrial world, from the first oil shocks and into the 1980s. Economists noted the importance, in a rational expectations setting, of institutional mechanisms that addressed policymakers’ time-inconsistency problems. Empirically, they began to assess the political independence of central banks and the relationship between these institutional structures and inflation outcomes. At the same time, political scientists began to explore the range of reforms that countries undertook to manage their economies in the absence of a dollar- and gold-based currency standard. Over time, the field of IPE came to embrace the study of exchange rate regimes, the politics of currency crises, the structures and mandates of central banks, and the liberalization of capital controls.
The incorporation of these topics into IPE scholarship offers a clue as to the trajectory of future scholarship. The global financial crisis has laid bare the international consequences of domestic regulatory policies. Several areas are ripe for exploration, including the determinants of domestic financial regulation, the measurement of the political independence of regulatory agencies, and more generally, the relative impact of domestic and international influences on national regulatory outcomes. However, barriers to entry for IPE scholars are relatively high. Graduate students often perceive financial regulation as a topic too arcane to understand, especially in the context of also needing to master a variety of methodological tools and existing theoretical literatures. While this may be an unfair stereotype, financial regulation is indeed a complex phenomenon.
There are early signs that the crisis has prompted the greater inclusion of emerging-market countries in global financial governance. Whereas the G7 was the common negotiating forum for macroeconomic policy as well as for global efforts at financial standards and codes throughout the 1990s, the G20 has emerged as the locus of international cooperation in the aftermath of today’s financial crisis.
The increasing prominence of the G20—and of emerging-market countries in general—could signal a move away from a Bretton Woods-era distribution of global financial power, in which sizeable economies such as Brazil’s and India’s have been given short shrift in international governing bodies. Of particular importance is China, whose previous exclusion from the international bargaining table was particularly striking in light of its enormous economy—currently behind only the European Union and the U.S – and its substantial holdings of dollar-denominated reserve assets. China was an active participant in the G20 summits and even pushed (unsuccessfully) its own agenda of supplanting the dollar with an alternative global currency, possibly based on the IMF’s SDRs or some other construction.3 An expanded role for major emerging market countries may suggest that, within the context of individual institutions, scholars will need to consider the extent to which shifts in formal governance structures (including IMF quotas) generate changes in institutional behavior.
Beyond the participation of China, though, the efforts to expand the number and type of countries involved in global governance may fall short. The marked public pressure for inclusion suggests that the G20 indeed will be the locus of many future discussions of regulation and governance. But the sheer size of the group, as well as its diversity of interests, domestic political environments, and development levels, will render agreements difficult. Relying on the G20 could alter the distributional nature of negotiated outcomes (leading to different locations along the Pareto frontier), but it also makes such outcomes harder to achieve (so that reaching the Pareto frontier becomes less likely). This may, however, be perfectly acceptable to some current G7 members, particularly the US: given the ambivalence of the US toward past global regulatory efforts, the US government may correctly anticipate that the G20 forum will lead to gridlock. And indeed, the ostensible success of the first two G20 meetings might reflect the consonance of the group’s proposals with the reform agenda of the Financial Stability Forum, rather than a significant shift beyond the G7’s preferred outcomes (Helleiner and Pagliari 2008).
The financial crisis, then, poses a test not only of the efficacy of existing global governance institutions, but also of existing theories of international cooperation. A breakdown in negotiations within the G20 could open a window of opportunity for national and regional governance initiatives—such as the creation of an Asian banking standard, or the development of disparate national regulatory standards—as well as bilateral discussions between key players such as the U.S. and China (in a so-called G2 forum). If the complex labyrinth of transgovernmental regulatory networks fails to promote international cooperation in the midst of a truly global crisis, then scholars of IPE will have to reevaluate whether the structures of global financial governance have an independent impact on state behavior (e.g., Slaughter 2004). Scholars also will need to consider whether a proliferation of trans- and intergovernmental institutions leads to higher levels of cooperation, or to increased opportunities for "forum shopping," especially by powerful countries. More research is required to understand the conditions under which the multiplication of institutions, including the various "G" groupings, the Basel Committee, the International Organization of Securities Commissions, and a host of others, fosters regulatory convergence, and the circumstances under which this proliferation generates centrifugal pressures that lead to regulatory fragmentation.
A third way in which the current crisis may alter the face of IPE scholarship concerns the treatment of private actors, particularly financial firms, as key players in the policymaking process. In the wake of the Asian financial crisis, efforts to govern global finance – to improve the transparency of economic policymaking, or to standardize accounting rules – often were located in the private sector. In some cases, public-sector initiatives were backed by private-sector enforcement, with the hopes that such private market pressures would improve compliance. In other cases, private actors sat alongside finance ministry officials and central bank personnel, helping to craft new rules. And in still other circumstances, industry self-regulation was the norm (see Mosley 2009). Although the rise of private actors as direct regulators occurred in some realms of finance as well as in areas such as human and labor rights (Bartley 2005; Vogel 1995), scholars paid very little attention to this phenomenon.4 Thus far, relatively little research has explored the conditions under which delegation to the private sector occurs or the extent to which it is effective.
In the area of finance, the current crisis has cast an ominous shadow over the concept of industry self-regulation and the involvement of private firms in shaping their own regulatory environments. Willem Buiter (2009) recently quipped that "self-regulation stands to regulation as self-importance stands to importance." Legislators have accused financial regulators of being too cozy with the firms under their jurisdictions, and the regulators themselves are now scrambling for new authority to supervise previously unregulated firms such as hedge funds and some financial holding companies. The backlash against industry involvement in regulation could be a double-edged sword. The crisis might prompt regulators to expand their jurisdictions to non-bank financial institutions and complex financial instruments like derivatives, and to shift toward a more adversarial relationship with their regulated constituents. On the other hand, the lack of buy-in from regulated firms could hinder the implementation phase of new regulations (e.g., Mosley 2003) and foster new forms of regulatory arbitrage – revealing again the importance of domestic regulatory structures for global financial stability.
From the point of view of IPE scholarship, direct and indirect firm participation in the making and enforcement of regulations highlights the empirical and theoretical importance of micro-level (or firm-level) analyses. While many theories of IPE are based on firm-level behaviors—for instance, on the preference of import-competing firms for protection, or on the desire of multinational corporations to invest in locales with stable property rights—very few empirical analyses occur at the firm level.5 Rather, much scholarship employs aggregate national (or sectoral) data to test firm-level propositions. While such analyses allow for relatively large samples in the context of limited (sub-national) data availability, they also obscure much of the variation within sectors and countries. As such, they may fail to illuminate the precise causal mechanisms by which firms influence public policy outcomes. What are the sources of firm preferences over public policies? Under what conditions do firms pressure governments for regulatory changes? And what determines governments’ responsiveness to such demands, beyond select firms’ perceived status—as we might think about in the recent cases of AIG, Citigroup or even General Motors—as "too big to fail"? Analyzing the policy preferences and political activities of firms in a range of sectors and countries should be of considerable interest to scholars of international political economy, particularly in light of the current crisis.
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1 Notable examples of national or regional treatments of financial regulation by political scientists include Amyx (2004), Huang, Saich and Steinfeld (2005), Moran (1991), Rosas (2006), Rosenbluth (1989), Underhill (1997), and Vogel (1996). Braithwaite and Drahos (2006) and Rosenbluth and Schaap (2003) take a cross-national approach. See Kapstein (1994) and Wood (2005) on international banking regulation and Singer (2004, 2007) on the domestic origins of international financial regulation.
2 Recent work by economists highlights the cross-national variation in bank supervision and analyzes its effect on macroeconomic outcomes. See, for example, Barth, Caprio and Levine (2006).
3 Market size alone is an imperfect indicator of regulatory influence; see Bach and Newman (2007).
4 Exceptions include Büthe and Mattli (2005), Cutler (2003), Haufler (2000), and Mattli and Woods (2009).
5 Notable exceptions include Bauer, Pool and Dexter (1963), Jensen (2007), Mares (2003), Martin and Swank (2001), Milner (1988) and Murphy (2004).