By Velibor Jakovleski
Head of Research, Global Governance Centre,
Graduate Institute of International and Development Studies
Ten years after the 2008 global financial crisis, and we are no closer to really understanding its causes. Nor are we any closer to preventing a future crisis. It seems to be more a question of when rather than if.
Those were my main takeaways from a double-header of events on Monday 5 November at the Graduate Institute, Geneva. Prof. Timothy Sinclair, a leading scholar of credit rating agencies, shared his insights during a colloquium and public lecture organized by the Global Governance Centre.
Why has relatively little changed in the global financial system since 2008? Part of the reason, according to Sinclair, is the complexity of financial markets. There was no “smoking gun”, and without understanding the underlying causes it’s difficult to have effective solutions. The cyclical nature of boom and bust phases that characterize capitalist systems also complicates matters. So the post-2008 response has been largely limited to regulative rules.
But what we should focus on for more effective financial governance, according to Sinclair, are the constitutive rules.
Getting the rules right
Regulative rules are regulations – in the form of proscriptions, prescriptions, or permissions – that aim to shape behaviour. Examples include the establishment of the Office of Credit Ratings and the Consumer Financial Protection Bureau in the US. They were set up under the Dodd-Frank Act, the major response to the financial crisis by the Obama administration (some of which has already been rolled back).
Constitutive rules, on the other hand, are more fundamental. They create actors as social entities and determine their roles and capabilities for action. An often-cited distinction between regulative and constitutive rules (which some scholars have debated) is found in John Searle’s The Construction of Social Reality.
If we take chess as an example, the rule that the player using the white pieces moves first is a regulative rule. The rule can be broken if the player using the black pieces starts the game. But the two players would still be playing chess. A constitutive rule is that a pawn can only move one square at a time and only in a forward direction. If the pawn were to move otherwise the players would not be playing chess as commonly understood and practiced. In short, the rules of chess constitute the game by creating the conditions to play.
Rethel & Sinclair have argued for a change in constitutive rules in their book The Problem with Banks (2012). In a nutshell, they tell us that the existence of banks and the way they operate is not a given. Governments can, and do, regulate banks. But they also create (or constitute) what we understand as banks, and what banks do. Over time, Sincair & Rethel argue, banks have become unrecognizable. In the chess example, it would be as if a pawn was moving like a bishop.
Banks are increasingly engaging in “innovative” financing to ensure their survival. They have shifted their business model, from the traditional “retail” banking focused on individuals, to “wholesale” banking based on riskier transactions with corporations and other financial institutions. The latter was proliferating in the lead up to the 2008 crisis. The wholesale banking industry was also subject of tighter regulations after the crisis, and it has shown some signs of contraction thereafter.
The behaviours of today’s banks might also go against the public interest. Yet, their actions ultimately benefited from a publicly-financed bailout after the crisis. US Senator Bernie Sanders referred to this predicament as “a clear case of socialism for the rich.”
According to Sinclair, we must change what the core nature and functions of banks are, rather than simply regulating banks after crises. The argument is well taken. But changing the constitutive rules of baking doesn’t capture the full landscape of rules needed to govern global finance. For a more complete picture, it’s important to look more closely at configurations of rules and at what levels they operate, akin to what Elinor Ostrom advised in a 1986 essay on how to study the effects of rules.
The often overlooked role of the US Federal Reserve System (the Fed) at the start of the financial crisis can help illustrate this point. Financial historian Adam Tooze provides excellent insights on the matter in The Forgotten History of the Financial Crisis (2018). It was not just that the Fed stepped in that was fascinating, but also how it did so.
The world needs a stabilizer, one stabilizer
The Fed’s actions in the build-up to the crisis were largely out of the public eye. It seems that the US Congress was also in the dark (more on that later). What really happened was only brought to light in 2011 in a meticulous investigation by the US Government Accountability Office (GAO).
It started in 2007, and for complex reasons related to the global financial system’s heavy reliance on US dollars, the Fed acted promptly to inject much needed liquidity into the system. Two main schemes are of note here: Term Auction Facility (TAF) and swap lines.
The TAF is a temporary program used by the Fed to deal with issues in funding markets by auctioning short term (1 or 3 month) discount window loans. According to the GAO, the largest borrower under the TAF scheme was a US entity, the Bank of America ($280 billion). But in a close second and third were the UK-based banks Barclays ($232 billion) and the Royal Bank of Scotland Group ($212 billion). Many others in the list of top-25 borrowers were also noticeably not American (see figure below).
The use of swap lines is even more intriguing. Swap lines are used to address disruptions in foreign dollar funding markets by exchanging dollars for foreign currency with foreign central banks. In effect, that allows foreign central banks to use dollars to make dollar-denominated loans to institutions within their respective countries.
The global lack of dollar liquidity in 2007 led many major foreign central banks to rely on a swap lines scheme with the Fed. The European Central Bank in particular was heavily drawing on US dollars through swap lines, accounting for about 80% of total dollars drawn (see figure below).
Swap lines have been used periodically in the past. But their use during the financial crisis was a marked change in the way they are used. During the 1960s under the Bretton Woods system, they were used to provide central banks with cover for currency imbalances and prevent gold losses. From 2007 on, swap lines were being used to finance foreign operations in US dollars, effectively making the Fed the global (instead of the national) lender of last resort.
The role played by the Fed echoes with the tenets of Hegemonic Stability Theory (HST). Boiled down, HST states that a well-functioning global order is characterized by a distribution of power where a single dominant actor carries the brunt of order provision. As Charles Kindelberger summed it up: “For the world economy to be stabilized, there has to be a stabilizer, one stabilizer.”
In the liberal variant of HST, a hegemon provides collective goods (which are usually under-provided due to the free-rider problem) to ensure the smooth operation and openness of the global order. The Fed providing short-term liquidity to stabilize the world economy during a financial crisis is a case in point.
From that angle, Bernie Sanders was not entirely wrong with his “socialism of the rich” accusations. Banks across the world did free-ride, and they were bailed out. But so did other (less capable) governments, and the Fed helped bail them out too. What was perceived as bad for the American taxpayer in the short term was deemed to be good for the global order down the line.
But part of the Fed’s motivation was surely to also prevent the US economy from imploding. As Adam Tooze explains, international banks were failing to pay their dollar debts and there were credible fears of widespread dollar sell offs. So the Fed’s actions were also necessary to reaffirm the status of the US dollar as the world’s reserve currency.
We can save talk about the US dollar’s “exorbitant privilege” and associated benefits for another time. Suffice it to say that the bailouts can also be viewed through the realist lens of HST. It holds that the main concern of the hegemon is to secure its own interests first and foremost. Benefits can accrue to other actors, yes, but that’s not the primary motivation.
Back to the rules
The tenets of HST, in either its liberal or realist variants, can be understood as a set of constitutive rules which define the international system. Stretching the earlier chess analogy a bit, we might see the US as the queen. It has the broadest authority of action on the global chessboard. It is able to – and sometimes must – make certain moves to maintain the global order (e.g. providing global public goods). And its moves would be perceived as legitimate by other players.
What does all this have to do with the debate about rules? Sinclair rightly points out that we must reconstitute banking for more effective financial governance. Presumably that would mean reverting to something like the more traditional nature and function of banks. Even so, that revised set of rules would not operate in isolation. Change in what constitutes a bank would not necessarily change what constitutes a hegemon.
For example, the existence of a willing and capable global lender of last resort can encourage more free-riding by other actors down the road. This might (re)incentivize risky behaviour by states and banks (however constituted), anticipating that the US (or just the Fed) has an interest in maintaining the status quo.
This logic can contribute to a crisis down the road as it did in 2007. Playing by the rules of the international hegemonic order, the US could counterintuitively shape the behaviour of other players such that their actions could occasionally threaten the stability of that very order.
The Fed examples bring forth other important elemements about rule configurations and constitutive change. The Fed – like other central banks – was originally constituted as a national lender of last resort, to ensure liquidity in the US market when borrowing would be otherwise difficult.
As the TAF and swap lines examples above show, the Fed was reconstituted as a global lender of last resort. Under the umbrella of an international hegemonic order, the constitutive rules of national central banking effectively became globalized (at least temporarily), augmenting their boundary and authority.
Interestingly, it was not the hegemon as a united entity that was stabilizing the system. In this case it was the Fed, essentially acting unilaterally. This raises important constitutional questions. Should a government agency (the Fed), be able to bail out its foreign counterparts (European Central Bank) or foreign private entities (Credit Suisse) without approval by the domestic legislature (Congress) or executive (White House)?
When contemplating rule change, we must keep in mind the complex ways different sets of rules are configured and how their interactions affect the outcome of any given situation. Under what conditions can rules be reconstituted? To what actors do the rules apply? How are they interrelated? Is there a hierarchy of rule sets? That should give us a more complete picture of causes and solutions.
What about the next crisis?
If finance has an inherent tendency toward crisis, hegemony has an inherent tendency toward stability. That, of course, hinges on there being a global hegemon. Much has been recently said about the decline of US hegemony, and it would appear that we are well on the way to multipolarity. On the way, perhaps, but not fully there.
As far as global reserve currency status is concerned, the US dollar remains on top with about 62% of the global share. It is incentivized to retain that status. In the short run we might well expect the US (or the Fed) to again act as the global lender of last resort. With a gradually declining preponderance of power, this will likely be according to the realist strand of HST. It won’t be exactly Trump’s version of “America First” but it won’t be too far off either. Especially if the next financial crisis happens beyond the West (read: China).
What happens when the global order is no longer steered by a willing and capable hegemon, like during the interwar years? Antonio Gramsci perhaps summed that scenario best: “The old is dying and the new cannot be born; in this interregnum a great variety of morbid symptoms appear.”
During hegemonic decline power becomes diffused to other actors. Among them would be international and (more probably) regional organizations, both formal and informal, rising powers (like China), but also private actors (like banks). Under those conditions, getting the constitutive rules of banking and global order right will no doubt be important.
The G20, for example, grew in prominence since the 2008 financial crisis. Despite the benefits of its informality and flexibility, the G20 is arguably too embedded within the existing hegemonic order. Its representative legitimacy has also been questioned. At times, so has its unity. These are notable, but not necessarily insurmountable, obstacles to becoming a widely accepted alternative to deal with future global financial problems, among others.
Its recent progress and promotion of alternatives to the American hegemonic order (like the Asian Infrastructure Investment Bank) notwithstanding, China becoming a willing and capable leader remains an open question. The Fed’s former Chairman Ben Bernanke seems to agree. His view is reflected, in part, by the renminbi’s minor (1.4%) global share of currency reserves.
In the near term, the symptoms Gramsci anticipated are likely to be greater uncertainly and institutional flux. Neither bode well for financial stability. But perhaps it’s equally likely that a pragmatic form of multilateralism will emerge among strange bedfellows with common vested interests in global stability.