Power within the global economy has shifted. The change is epitomised in the importance of the G20, comprising the leading advanced and emerging national economies, which met in London last week. The financial crisis has put the G20 at the centre of global policymaking. Economic diplomacy is no longer the preserve of rich countries. The crisis originated in the advanced industrial economies. Much of the remedy lies with the developing world.
The G20 summit managed to avoid, for now, some bad ideas for banking reform. It concentrated instead on stemming the economic damage inflicted by a dysfunctional financial system. That is the path the G20 should stick to. The longer-term action it must take is to help to correct the global financial imbalances that allowed American (and British) households to live off an unsustainable credit boom.
By the bureaucratic expedient of referring the issue to a future meeting, the summit resisted pressure from the governments of France and Germany to impose a cap on bankers’ pay. That proposal has powerful populist appeal and minimal economic logic. Governments can reduce income inequalities through the tax system, if that is what voters want. But they have no insight into what a particular job in the marketplace is worth and whether it is “socially useful”.
It makes sense for banks to tie employees’ pay to risk-adjusted measures of profitability, and to be able to claw back bonuses from traders who take risks that turn sour. Banks are unlike other businesses. Bad commercial decisions by banks risk contaminating the whole economy.
Regulators should reward banks that operate deferred compensation schemes. They can recognise that these institutions pose less systemic risk and therefore can legitimately operate with lower capital requirements. But statutory caps on bankers’ pay give a message that only underachievers need apply. The G20 has so far maintained the right balance.
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The G20 summit was deliberately cautious in judging how far governments’ expansionary policies are working. Some influential economists, such as Jim O’Neill of Goldman Sachs, expect a vigorous return to growth in 2010. Gordon Brown, however, has a practised technique of insinuating that policymakers of earlier epochs were handicapped by not possessing the farsightedness of today’s Labour Party. He warned the G20 that premature tightening of policy had prolonged the Great Depression (in reality, it was the maintenance of the Gold Standard that did the damage). In Mr Brown’s view, governments should continue with fiscal expansion.
There is a respectable intellectual case for deficit spending in a recession, but there will be a reckoning. The build-up of public debt in the UK will need to be offset by tax rises and cuts in public spending once the economy recovers. Mr Brown has resisted this unpalatable conclusion by tendentiously presenting the economic debate in the UK as “investment versus cuts”.
The structural weakness of the UK and US economies is that households have too much debt. They need to save more. The credit explosion of recent years was generated by low interest rates, which in turn were made possible by an inflow of overseas (especially Chinese) savings. Even if growth now picks up, credit conditions will remain tight.
The principal task for policymakers after the crisis is to face these constraints and tell the truth. Higher savings in the West and stronger domestic demand in Asia would help to stabilise the global economy. Correcting these global imbalances will not compensate for the hardship caused in this crisis, but it would help to mitigate the effects of the next one.