The Brookings Institution hosted a less-than-entirely pessimistic discussion today of how to cope with the global financial crisis.   

Treasurer Wayne Swan of Australia pointed out that few countries had reformed their financial systems in response to lessons learned from the 1998 Asian financial crisis, but Australia had reformed and so has thus far escaped the full brunt of the new crisis.  He argued that coordinated action should be taken, not by the G7 or some new organization but by the G20, which would include 85% of the world economy and could work with the IMF on execution.  Otherwise there would be insufficient political backing to ensure that appropriate immediate measures and critical long-term reforms were implemented.

Australia is calling for the establishment of global best practices for regulation, capital requirements, and accounting principles; and these should be countercyclical, he said.

Brad Setser of Brookings noted that a fall in American consumption will reduce the imbalances that have grown up over time between the United States and East Asia.  Parallel to this, the ironic appreciation of the U.S. dollar will  help to correct the imbalance between China and the EU.  Also, the decline of the price of oil will reduce or eliminate the current account surplus of Middle Eastern countries.

According to Setser, Chinese purchases of U.S. Treasury bonds had freed up American funds to flow excessively to borrowers, leading to growing household deficits, so long-term trade and financial imbalances indirectly contributed to the current financial crisis.

Eswar Prasad of Brookings argued that, although the crisis will lessen demand from rich countries for the products and services of emerging economies, the crisis has not had a great impact on India and other emerging economies, in part because the banking sector is not so important there.  The high reserves of the central bank in China should keep the Chinese financial system from suffering unduly.

Even though regulation is on the agenda in rich countries, Prasad remarked, Indians and others in emerging markets cannot stop their moves toward deregulation.  They have no choice but to learn to handle risk.  Financial institutions in emerging markets do such a poor job of providing services to the people, he thought, that the current global financial turmoil provides even more reason for strengthening financial systems in India, China, and other emerging markets.

Mauricio Cardenas of Brookings said that Latin America was faring relatively well in the crisis.  Forecasted growth would decline from 4 1/2% in 2008 to 3% in 2009, but thus far there is no sign of further economic trouble.  Latin America has proved resilient, he claimed, because current account deficits have been reduced, inflation has dropped to single digits, and fiscal situations have improved.  These trends make Latin America less dependent on capital flows from abroad.

In the current situation, only the U.S. dollar, U.S. treasuries, and gold are credible assets, Cardenas asserted.  So one of these three must work to establish credibility for a return to normal financial activity.  Latin America is waiting to see what happens.  The Central American economies remain the most vulnerable.

Asked whether the current crisis validated the Asian policy of building up reserves, Setser commented that the Asians had drawn this conclusion from the 1998 crisis.  Now all countries will do this, he said.  There is a flight to the safest and most liquid reserve assets–U.S. treasuries.  So we are experiencing a suboptimal outcome:  American consumers will stop buying Asian products, and Asians (with the possible exception of the Chinese) will not purchase even moderately risky US assets.  Sovereign wealth funds have lost money in the United States and so are focusing on investing at home.

Responding to a question about whether the world should create an international “toxic waste disposal” institution to get rid of bad debts, Setser remarked that the various schemes for broadening the G7 assumed that China would be willing to join.  But the Chinese would impose conditions and not wish to accept the conditions others sought to impose on them–in particular, to permit the renminbi to appreciate.  So it is very possible that the Chinese will not join in an institutional framework to resolve the crisis.

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