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So, with policy makers and pundits railing against sustained oversized trade imbalances, we need to recognise the real problems are rooted in excessive concentrations of debt. If G-20 governments asked themselves how to channel a much larger share of the imbalances into equity-like instruments, the global financial system that emerged just might be a lot more robust than the crisis-prone system that we have now.
Unfortunately, we are very far from the idealised world in which financial markets efficiently share risk. Of the $200 trillion in global financial assets today, three-quarters are in some kind of debt instrument.
Certainly, there are some good economic reasons why lenders have such an insatiable appetite for debt. Imperfect information and difficulties in monitoring firms pose significant obstacles to idealised risk-sharing instruments. But policy-induced distortions also play an enormous role. Many countries' tax systems hugely favour debt over equity. The housing boom in the US might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction.
Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at both the corporate and the individual level.
Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does. But it is not just rich, well-connected bondholders who get bailed out. Many small savers place their savings in so-called money-market funds that pay a premium over ordinary federally insured deposits.
Shouldn't they expect to face risk? Yet a critical moment in the crisis came when, shortly after the mid-September 2008 collapse of Lehman Brothers, a money-market fund "broke the buck" and couldn't pay 100 cents on the dollar. Of course, it was bailed out along with all the other money-market funds.
Unfortunately, overcoming the deeply ingrained debt bias in rich-world financial systems will not be easy. In the US, for example, no politician is anxious to say that home-mortgage deductions should be eliminated. Likewise, developing countries should accelerate the pace of economic reform, and equity markets in too many emerging economies are like the Wild West, with unclear rules and lax enforcement.
Worse still, even as the G-20 talks about finding a "fix" for global imbalances, some of the policy changes that its members have adopted are arguably exacerbating them. For example, we now have a super-size International Monetary Fund, whose lending capacity has been tripled, to roughly $750 billion. Europe has similarly expanded its regional bailout facility. These funds may help in the short-term, but over the long run, they might fuel moral-hazard problems, and potentially plant the seeds of deeper crises in the future.
A better approach would be to create a mechanism for orchestrating orderly sovereign default, both to minimise damage when crises occur, and to discourage lenders from assuming that taxpayers' money will solve all major problems. The IMF proposed such a mechanism in 2001, and a similar idea has been discussed more recently for the eurozone. Unfortunately, ideas for debt-restructuring mechanisms remain just that: purely theoretical constructs.
In the meantime, the IMF and the G-20 can help by finding better ways to assess the vulnerability of each country's financial structure — no easy task, given governments' immense cleverness when it comes to cooking their books. Policymakers can also help find ways to reduce barriers to the development of stockmarkets, and to advance ideas for new kinds of state-contingent bonds.
Even if the composition of international capital flows can be changed, there are still many good reasons to try to reduce global imbalances. An asset diet rich in equities and direct investment and low in debt cannot substitute for other elements of fiscal and financial health. But our current unwholesome asset diet is an important component of risk, one that has received far too little attention in the policy debate.
The author is professor of economics and public policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2011
(This story was published in Businessworld Issue Dated 14-03-2011)