What Should Bretton Woods II Look Like?

NEW YORK – For those of us who have long claimed that the world’s international financial architecture needed deep reform, the call for a “Bretton Woods II” is welcome. Of course, similar calls were made after the Asian and Russian crises of 1997-1998, but were not taken seriously by the rich industrial countries. Now that these countries are at the center of the storm, perhaps they will now be serious.

Two fundamental problems exist with the call for reform. First, it lacks content: it is unclear what any eventual Bretton Woods II discussions will be about. Second, the process started the wrong way, by excluding most countries from the talks. It is obviously good for the G-7 or a subset of G-7 members to show leadership, but no fundamental reform can occur without an inclusive process that gives both industrial and developing countries, and both large and small countries an adequate voice. Global institutions, not ad hoc groups of countries, must be at the center of the reform effort.

The clearest issue right now is correcting the deficit of regulations that characterizes global financial markets. Discussion must start by agreeing on regulatory principles . An obvious one is that regulations must be comprehensive, to avoid the massive loopholes that led to the current turmoil.

Regulations should also have a strong counter-cyclical focus, preventing excessive accumulation of leverage and increasing capital and provisions (reserves) during booms, as well as preventing asset price bubbles from feeding into credit expansion. Reliance on financial institutions’ internal models, the major focus of the Basel II agreement on banking regulation, should be discarded. That strategy has now been exposed as perilous, and the use by financial institutions of similar risk models can lead to greater instability.