WATCHDOGS NEED NOT BARK TOGETHER / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Watchdogs need not bark together

By Joseph Stiglitz

Published: February 9 2010 22:19

In the years before the crisis, there was a race to the bottom, with countries competing on the “lightness” of regulation. Iceland may have been the winner of that race, but its citizens were the losers. As the consequences of these failures continue to manifest themselves and discussions of the new regulatory regime proceed, the problem of global co-ordination has moved centre stage.

Banks within any jurisdiction threaten to take their business elsewhere if tough regulations are imposed (or even if they are asked to pay for a fraction of the costs they have imposed on others). Modern finance is a footloose industry, so the threat seems at least partially credible. If regulations are different in different jurisdictions, there is a real risk of regulatory arbitrage. With finance moving to the least well regulated jurisdiction, there is a danger that the problems that marked the global financial system before the crisis will persist.

These are among the reasons that there is a consensus on the need for global co-ordination. But progress in creating an effective global regulatory regime has been remarkably slow. The Financial Stability Forum, created for that purpose after the last global financial crisis, did little – obviously too little to prevent an even worse meltdown a decade later. This body has now been entrusted with guiding the international community towards a new regulatory regime. The Group of 20 leading economies may hope that changing the name to the Financial Stability Board, and adding a few new members, will make all the difference; but I wouldn’t count on it. Perhaps those who believed in the liberalisation mantra that was responsible for the crisis and its rapid spread have learnt the lessons; but mindsets are often not so easily changed.

There are other reasons for pessimism about quickly achieving effective global co-ordination. Priorities have seemed to differ: France and the UK have emphasised incentive structures; the US the dangers of proprietary trading. While Mervyn King, governor of the Bank of England, and most academics warned of the dangers of institutions that were too big to fail, too intertwined to fail or too correlated to fail, no government in the G20 wanted to annoy its big bankers by raising these issues, at least until President Barack Obama finally proposed doing something in the US, a year after taking office. There are still no effective proposals for dealing with the over-the-counter non-transparent and complex derivatives.

Moreover, each country looks at each proposal and assesses how it affects the competitiveness of its financial system; the objective too often is to find a regulatory regime that crimps competitors more than one’s own companies. As the saying goes, all politics is local, and, at least in the US and many other jurisdictions, finance is a big political player. This, combined with deep philosophical differences – as remarkable as it may now seem, there are some that still believe in unfettered markets – mean the only agreements that are easy to come by are those involving the least common denominator, or small countries not at the table; and even these victories are often hard fought, as evidenced by the struggle to deal with tax havens.

Given the difficulties in achieving global co-ordination, insisting on such co-ordination may be a recipe for paralysis – just what the bankers who don’t want regulations want. It is perhaps no surprise that they have become among the most vocal advocates of the need for global action.

But each country is responsible for ensuring the safety and stability of its financial system and economy, and for protecting its citizens. It is dawning on leaders – in some cases egged on by rightly impatient voters – that we cannot wait for co-ordination. It is far better to have strong action now and then harmonise the regulatory structures later. It may be “second best” – but far better than the third-best alternative of delayed and ineffective regulation. There is even a possibility of a “race to the top”. US voters can see for themselves the much tougher crack-down on bonuses in Europe.

Even if we were to achieve co-ordination on the regulatory regime, Iceland should have taught governments that they cannot rely on regulators in other countries to protect their citizens and their financial markets.

Moreover, one of the arguments used for bailing out shareholders and bondholders was that to do otherwise would have risked global financial meltdown. Because of this threat, American taxpayers were asked to pick up bills that should have been borne by others. To prevent this from happening again, we must undo some of the intertwining – it is a matter of self-protection that each country will have to deal with on its own.

Countries that proceed on this track will face threats of the kind already received – a rapid departure offshore. But the parts of the financial system critical to the real economy – those, for example, that lend to businesses – are not so footloose. Any cost-benefit analysis of the loss of the gambling casinos offshore would surely conclude that if some other government wants to risk economic instability and big bills for bail-outs to its taxpayers, so be it – our task is simply to prevent contagion from these under-regulated jurisdictions. No country can fully insulate itself, but the best protection is a good regulatory structure at home. The continuing instability in global financial markets should have made it clear that we need that now.

The writer is University Professor at Columbia University. His book ‘Freefall’ was published last month

Copyright The Financial Times Limited 2010.