Excessive liquidity and the wholescale mismanagement of financial institutions were the key triggers behind the current global financial crisis, leading economist Dr William Overholt has said.
And one clear solution to avoid a repeat of the problems would be the establishment of a "global central bank" – with the IMF and World Bank being unable to prevent the financial meltdown.
Overholt, a senior research fellow at Harvard's Kennedy School, was in the UAE to speak at Dubai School of Government on 'The Global Financial Crisis: The Real Causes and the Political Obstacles to Real Solutions'.
He has previously held the Asia Policy Distinguished Research Chair at the think-tank Rand Institute in California and was director of the centre. He is also a visiting professor at Shanghai Jiatoung University and Principal of AsiaStrat, where he advises on investment strategies and direct investments in Asia. He has authored six books including Asia, America and the Transformation of Geopolitics.
Following his lecture at Dubai School of Government, he shared his views with Emirates Business:
EXCESSIVE GLOBAL LIQUIDITY
This is the single most important cause of the current crisis – excessive global liquidity; too much money at excessively low interest rates caused asset bubbles and too much speculation.
The other fundamental source of today's crisis is a failure of corporate governance. Salaries and bonuses are based on short-term performance. Investment bank analysts make their recommendations based on quarterly or annual profits. Investors mostly invest based on such recommendations.
This creates overwhelming incentives for management to maximise short-term earnings, often at the expense of taking excessive longer-term risks.
GLOBAL CENTRAL BANK
To avoid another crisis, we need an ability to manage global liquidity. Theoretically that could be achieved through some kind of global central bank, or through the creation of a global currency, or through global acceptance of a set of rules with sanctions and a dispute settlement mechanism.
Some companies have begun basing bonuses on multiple-year performance. Some companies are demanding that executives who earned huge bonuses at the cost of jeopardising their companies' long-term futures refund those bonuses. But so far the reforms are relatively superficial. I believe that, following the crisis, governments, pension funds, insurance companies and mutual funds could successfully demand a change of behaviour so that taking excessive risks in order to maximise short-term performance becomes unacceptable. Boards must be held accountable for creating compensation systems that incentivise long-term performance. Analysts and investors have to look beyond quarterly and annual earnings. These are not inherently difficult reforms and they are in the interest of all important participants.
The third set of necessary reforms would require all-important financial institutions to be brought under prudential regulations analogous to (but not necessarily identical to) the ones that apply to banks.
The regulatory system for banks created after the crisis of the 1930s brought us generations of financial stability. But new financial institutions have put a high proportion of financial transactions outside the regulatory system. We need to update the rules.
Existing institutions are ineffective not because international institutions are inherently ineffective but rather because they were not created to deal with this problem.
When the IMF was created, more than half a century ago, today's level of financial globalisation was not contemplated.
The UN deals with political disputes, not with global financial management. The WTO deals with trade and investment globalisation, but not with the more important phenomenon of financial globalisation.
Those institutions were created because leaders realised that the world's economic growth and stability required participation, contributions, and some sacrifice of sovereignty. The question we face today is whether our current leaders will be as far-sighted and decisive as their post-World War II predecessors.
My recommendations are not idealistic, they just state the minimum requirements for avoiding a cycle of crises that get worse and worse. The needed changes are far smaller than the reforms of the 1930s and 1940s. But they require the kind of visionary leadership that typically arises only in periods of crisis.
A FAILURE OF CAPITALISM
The crisis of the capitalist world does not mean that socialism is a more attractive alternative. All modern experience shows that government-owned banking and industrial systems are more prone to inefficiency and crisis than market-based systems. Nonetheless, in a crisis, governments have to intervene and this often means taking ownership positions in troubled institutions. If owners of banks mismanage the banks, they should lose ownership, as they would if the government did not intervene. If governments spend vast amounts of money rescuing banks, they should get ownership positions so that taxpayers can be repaid when the banks recover. But such ownership should be temporary; after the crisis, the government's equity should be sold, with taxpayers benefiting.
Having said that, if governments do not agree on systemic reforms, the next crisis will be far worse and historians will write about a crisis of the capitalist system. You cannot have globalised financial flows and wholly nation-based financial regulation. Agreed standards for banks are necessary but not sufficient. We must have tools for managing global liquidity.