Off Balance

by Paul Blustein

  Unusual though the Suez episode was, it was by no means the only case in which the United States was able to use its clout at the IMF and World Bank to bolster its diplomatic objectives. Throughout the Cold War, US administrations made sure that these multilateral lenders gave loans to regimes that Washington deemed of strategic importance — one particularly odious case being Zaire, where the country’s kleptocratic leader Mobutu Sese Seko helped the CIA fight communism in Africa. As convenient as these foreign policy benefits were, however, the economic gains the United States reaped from the Bretton Woods system were even more important.

  “Exorbitant privilege” was the term resentful French officials used in the mid-1960s. When most countries, including France, ran trade deficits, they were compelled to undergo painful adjustments to bring their balance of payments into line. They had to constrain demand, thereby curbing imports, so they could ensure that their central banks’ coffers held sufficient reserves of dollars to defend their currencies; the alternative was a traumatic devaluation. The United States had no such worries about where the dollars would come from for its consumers to buy imported goods or for its companies to purchase foreign businesses. Dollar creation was at the whim of the Federal Reserve. If the United States ran trade deficits, it could do so “without tears,” as the saying went.

  Hegemony entailed encumbrances as well, of course. Aside from providing giant loans and aid that contributed substantially to recovery in Western Europe and Japan, the United States footed the lion’s share for collective defence against Communism, and US markets were opened to imports in many major sectors even though America’s allies didn’t lower their trade barriers nearly as much. But the Bretton Woods system, while hardly trouble free, generated mutual prosperity, as the founders of the system had envisioned. The combination of expanding trade and investment — and relative financial stability — fostered dynamic growth during much of the 1950s and 1960s. Much of the credit belonged to the General Agreement on Tariffs and Trade (GATT), the third multilateral body overseeing economic issues that was established in the postwar years along with the IMF and World Bank. Under the GATT, scores of participating countries struck a series of deals binding themselves to reduce their duties and other restrictions on foreign goods.

  Only after a quarter of a century did the Bretton Woods system break down, because it was perceived as no longer working in the US interest. At that point, the US trade balance was swinging into deficit, inflation was edging upward, the federal government’s budget was sinking deeper into the red and a worldwide glut of dollars was weighing on foreigners — all of which combined to undermine confidence in the US pledge to exchange gold for dollars at US$35 an ounce. A drain on the Treasury’s gold was accelerating, and if the United States had been an ordinary country, it would have been obliged to defend the dollar by imposing budgetary austerity or raising interest rates to quell inflation. But President Richard Nixon viewed such a course as untenable, especially with an election looming, and in a historic televised speech about the economy on August 15, 1971, he broke the dollar’s link with gold. Soon thereafter began the era in which major countries’ exchange rates fluctuated according to the forces of supply and demand, with greater or lesser efforts to manage the ups and downs depending on the country and the circumstances. Instead of exchange rates being periodically raised or lowered to fixed levels by government fiat, the market was supposed to do the job of keeping trade flows more or less in balance — by generating upward pressure on the currencies of countries with trade surpluses, and downward pressure on the currencies of countries with trade deficits.

  One thing didn’t change: the dollar remained far and away the most important currency for international transactions, even in deals in which US companies weren’t involved. This enabled Washington to continue enjoying exorbitant privilege — a state of affairs that, to a large extent, persists today. Because the dollar is so widely used, investors the world over regard US securities markets as a uniquely convenient and even essential place to put their money. The interest rate that foreigners require to hold dollars is correspondingly less — and that, in turn, has given the United States greater flexibility to run trade deficits, budget deficits and low interest rate policies without having to worry as much about a market implosion. Not that the United States can conduct economic policy with total disregard for investor sentiment; far from it. Occasionally, market pressures have forced US officials to change tack, one famous case being President Jimmy Carter revamping his budget in 1980 in response to a plunge in the dollar. But Washington has been able to push the limits further, and for longer periods of time, so Americans could consume more than they produce with greater impunity than any other country on the planet.

  The IMF, too, stayed in business, despite no longer having a fixed-rate system to oversee. The Fund’s articles and rules were changed to give member countries wide latitude in choosing their exchange rate regimes, and the institution was still responsible for “exercis[ing] firm surveillance over the exchange rate policies of members,” which included a duty to prevent beggar-thy-neighbour policies. As the articles stated: “Each member shall…avoid manipulating exchange rates or the international monetary system in order to…gain unfair competitive advantage over other members.”4 The Fund’s ability to compel compliance with that edict was questionable, as the institution no longer had the enforcement power it had held during the fixed-rate system, under which it could cut off support to countries that were letting their currencies fluctuate too much. But with its trove of dollars and other “hard” currencies (for example, the British pound sterling and the West German Deutschmark) that were needed for international commerce, the Fund soon reinvented itself as a crisis lender to developing countries.

  4 IMF (2011), Articles of Agreement, available at: www.imf.org/external/pubs/ft/aa/#a4s3.

  In other respects, the collapse of the Bretton Woods system led to shifts of seismic dimensions in the world of finance, obliging regulators in major financial centres to consider the necessity of working jointly in ways that Keynes and White could scarcely have imagined.

  The Internationalization of Banking and the Basel Committee

  Most central bank governors who belonged to the Group of Ten (G10) — a group akin to the College of Cardinals in monetary policy circles — relished their monthly dinners at the BIS, where single malt Scotch was the preferred aperitif, followed during the meal by a selection of wines from the bank’s lavishly stocked cellars, topped off after dessert with brandy and cigars. To enhance candour, the soirees excluded even the top central bank staffers who had accompanied their bosses to Basel; the only interlopers were special invited guests such as the IMF managing director. With no formal agenda, conversations usually centred on whatever international financial issue was au courant, although once inebriation had passed a certain level, talk often drifted to complaints about the appalling judgment and behaviour of finance ministries.

  One demurrer to the enthusiasm for these evenings was Paul Volcker, who during his tenure as Federal Reserve chairman (1979 to 1987) tended to avoid going to the BIS and usually sent another Fed governor in his stead. This was partly because of the travel required, partly because Volcker was too ascetic to indulge much and partly because he found the meetings to be of little use. But Volcker attended when he had something important to say, and March 11, 1984 was one of those occasions. Over dinner that evening, the Fed chief informed his foreign counterparts that he wanted to raise a “major concern.” He knew that what he was about to propose would be met with skepticism, if not utter incredulity; as he later recalled in a brief conversation with me, “the Basel people told me there was no way it could be made to work.”5

  5 For much of the history in this section, see Ethan Kapstein (1994), Governing the Global Economy: International Finance and the State, Cambridge, MA: Harvard University Press, chapters 1–5; Howard Davies and David Green (2008), Global Financial Regulation: The Essential Guide, Cambridge,
UK: Polity Press, chapter 2; Steven Solomon (1995), The Confidence Game: How Unelected Central Bankers Are Governing the Changed World Economy, New York: Simon & Schuster, chapter 22; and Charles Goodhart (2011), The Basel Committee on Banking Supervision: A History of the Early Years 1974–1997, New York: Cambridge University Press.

  The quixotic idea Volcker was pushing was to establish an international standard that commercial banks would have to meet for their capital — that is, the difference between assets and liabilities, which affords a cushion to absorb losses. His purpose was to both improve the safety of the global system and to create a level playing field for the banks of various countries in the competition for international business.

  These had been non-issues during the period up to the early 1970s. When currencies were not freely convertible and capital movements restricted, banks had scant reason to engage in cross-border operations. Overseas bank branches or subsidiaries were relatively rare.

  As currencies gyrated and exchange controls eased along with the end of Bretton Woods, however, the flow of money across borders swelled from a trickle to a torrent, taking a variety of major forms including eurodollars (US dollar deposits in banks outside the United States) and petrodollars (US dollars received in payment for oil and deposited in European or American banks). Whereas Keynes and White had inveighed against free movements of private capital, a new orthodoxy prevailed, buttressed by the pro-market regimes of Ronald Reagan and Margaret Thatcher: capital should be invested wherever in the world it could be put to work most productively, thereby maximizing efficiency for both investors and recipients of funds — and theoretically, enhancing the welfare of their countries’ economies in the process. By the early 1980s, international bank lending was surging, and more than 800 banks had established overseas branches, compared with less than one-eighth that number in the 1950s. Accompanying all this internationalization was a dizzying amount of innovation, as financiers began inventing and using with greater frequency many of the products and practices that would later be implicated in the recent financial crisis — among them securitized loans, derivatives and reliance by banks on “wholesale” funding instead of ordinary deposits. Beneficial though all this was in terms of lower-interest costs and the tailoring of funding to borrowers’ specific needs, it meant that serious problems for banks in one country might have domino-like repercussions elsewhere around the globe. The potential for contagion to spread across borders, when banks have all sorts of activities and operations overseas, presented a novel set of challenges — the most fundamental being how to ensure that those overseas arms are properly supervised and how to apportion the responsibility for providing a safety net when crisis strikes.

  At the time of Volcker’s visit to Basel, officials had been wrestling with such issues for nearly 10 years. The failure in June 1974 of Bankhaus Herstatt, a Cologne-based bank crippled by losses in foreign exchange, and the insolvency a few months later of Franklin National Bank, America’s twentieth-largest bank, prompted the G10 central bank governors to establish a group whose purpose was to reach understandings on some of the conflicts that were bound to arise. Thus, the Basel Committee on Banking Supervision was born, which included one central banker and one regulator from each of a dozen countries (the majority of them European, plus the United States, Canada and Japan). Operating in near-total secrecy — it waited until 1981 to disclose any of its work — the Basel Committee had no formal power; its decisions depended upon national governments enacting the necessary legislation and regulations. One of the key principles that it adopted early on was “home country control,” meaning that the country where a bank’s headquarters is located is primarily responsible for regulating it, rather than the “host countries” of its overseas branches — and with that power came the burden of providing emergency loans if necessary. British officials were especially adamant about this, because hundreds of foreign banks had established branches in London, and the UK government was unwilling to provide a safety net for them. Home country control suited other countries’ officials as well; they shared the desire of their British colleagues to avoid being accused of bailing out foreign banks. Bank executives were happy too, because they would otherwise have to abide by too many different countries’ regulations.

  In the mid-1980s, a new problem was coming to the fore — differences among countries over their requirements regarding the amount of capital banks had to have. US banks were reeling from the effects of a severe recession, as well as successive debt crises in Latin America, where they had gone on a lending spree during the previous decade, and as Volcker repeatedly reminded them, they needed to shore up their capital to ensure that they would retain a sufficient cushion between assets and liabilities.

  But banks dislike being required to boost their capital. They complain it will reduce their profit ratios, and quite possibly their stock prices, if they have to obtain the extra capital by selling more shares to investors or by retaining more earnings (that is, cutting dividends). And US banks argued that a government-mandated increase in capital would worsen their plight in another key respect — their competitiveness in international markets. Foreign banks were grabbing a rapidly growing share of deals from their American rivals, none more formidably so than the Japanese, who appeared on a trajectory of total global financial conquest. Of the top 10 banks in the world, as ranked by assets, Japanese banks would account for nine in 1987, up from just two only five years earlier. Their success clearly stemmed, in part, from the much thinner capital bases on which Tokyo allowed them to operate.

  This was why Volcker was seeking a deal that would lead to convergence on capital standards. The chief obstacle was the vast disparity in the way financial systems work from one country to the next. Whereas Anglo-Saxon nations, including the United States, maintained strict separation between banks and other types of firms, the same did not apply in continental Europe or Asia. Germany’s “universal” banks, which combined commercial banking with other financial services such as securities brokerage and investment banking, might own equity stakes in a number of the country’s big industrial conglomerates, and would provide financing to those businesses on a preferential basis. In Japan, families of companies called keiretsu — Mitsubishi, Mitsui and Sumitomo being the best known — included “main banks” that were expected to ensure a steady stream of funding, in good times and bad, for their corporate kinfolk, whose shares the banks typically held in large quantities.

  Understandably, therefore, chances for reaching an agreement looked slim to Basel veterans. After the Basel Committee met with Volcker and agreed to begin considering how to implement his idea, Peter Cooke, the panel’s British chairman, wrote in a report of the meeting: “I expressed the hope that undue expectations would not be raised by giving publicity to the mandate or to the timetable set.”6

  6 See Goodhart, The Basel Committee on Banking Supervision, chapter 6.

  In those days, US banks had to abide by a simple, crude rule: for every US$100 in loans or other assets, they had to maintain US$5.50 in capital, regardless of whether they were buying a US Treasury bond or lending money to a corner grocery store. European regulation was generally more complex, and often “risk-weighted”; authorities in a number of countries allowed banks to vary the amount of capital they had depending on borrowers’ creditworthiness. Japanese banks, with their giant portfolios of stock in keiretsu companies, were deemed by their regulators to be in fine fettle, given that the surging Tokyo stock market was lifting the value of the banks’ holdings well above the original purchase prices.

  A stalemate ensued for more than two years, because the Basel Committee operates by consensus, and each country’s representatives wanted to protect their national financial system’s interests. Frustrated, and under severe pressure from members of Congress who were upset about the unlevel field on which US banks were playing, Volcker flew to London on September 2, 1986, in the hope of persuading the Bank of England to join the Fed in striking a bilatera
l accord. The gambit worked; four months later, members of the Basel Committee were shocked to learn that their American and British colleagues had secretly agreed on the terms of a deal. Although the pact was by no means binding on other countries, the two countries that were party to it controlled the world’s two biggest financial centres. This raised the prospect — especially discomfiting to the Japanese — that foreign banks might be restricted or even barred from operating in those two giant markets if their home countries’ capital rules differed substantially from the requirements specified in the Anglo-American pact.

  The upshot was an agreement, finalized in July 1988, which “the Basel people” had once thought inconceivable. Its most important feature was a figure — eight percent — for the amount of capital a bank was supposed to maintain as a fraction of its assets. The figure “had no rigorous objective basis, but was judged to be the kind of level that would allow well run banks to stay out of trouble most of the time,” as British financial authorities Howard Davies and David Green later put it.7 Not all loans and investments were subject to the eight percent rule; the accord used a risk-weighting system allowing banks to maintain less capital when they put their money into certain categories of relatively safe instruments, such as long-term bonds, and there was no capital requirement at all for investments in short-term securities of advanced-country governments.

  7 See Davies and Green, Global Financial Regulation, chapter 2.