Distinguished Speaker Seminar: Peter A. Petri- Governing the Global Economy: Problems and Solutions

Peter A. Petri, Carl J. Shapiro Professor of International Finance at the Brandeis International Business School, Massachusetts , and a senior fellow of the East-West Center, Hawaii delivered a lecture on "International Economic Governance: Problems and Solutions" at a distinguished speaker seminar on 10 April 2009 in Tokyo.

Professor Petri discussed one of the most topical issues of the current economic crisis—reform of international economic institutions (IEIs). He explored built-in structural limitations of existing IEIs that hinder their effectiveness, and used the analytical framework in public economics, called "club theory" in his search for solutions toward more flexible and responsive institutions, as well as to shed light on the difficulty of reforming them. He discussed other applications of proposed decentralized solutions on macroeconomic management, lending through development banks, and trade cooperation.

Professor Petri, stated that the current economic crisis has been the biggest since the 1930s. Yet, despite the global scope of the crisis, IEIs were surprisingly absent in the first year of action, particularly the International Monetary Fund (IMF), which was only resuscitated at the G20 Summit in London in April 2009. One year earlier, the IMF lent to just one client, had a fourth of its staff take early retirement, and expected to sell a substantial part of its gold reserves to stay operational. Suddenly, the IMF is now in a position to play a key role in boosting global liquidity. Resource commitments made at the Summit beefed up the IMF's coffers from US$250 billion to US$750 billion. Countries agreed to create US$250 billion of Special Drawing Rights (SDR) , with the remaining half of the extra US$500 billion largely pledged by Japan and Europe. Much of the G20 Communiqué was related to the IMF's work.

A sense of cooperation was visible at the Summit, as leaders promised to do whatever was necessary to solve the crisis. Although countries differed on specific national "firefighting" policies, an agreement was reached on entrusting international institutions with greater resources and more responsibility. The Summit also created a new Financial Stability Board based on the Financial Stability Forum which would deal with regulatory issues that arise in the financial sector.

All this has raised expectations for the work of international institutions. For example, the IMF is expected to undertake governance reforms, and to deepen its capacity for crisis prevention and management. Specifically, the IMF is expected to provide close surveillance of systemically important countries with ample financial capacity to perform its functions fully.

Professor Petri examined whether international institutions are likely to be able to meet these challenges using the framework of "club theory". He said international institutions are clubs, in the sense that countries get together to set them up to deliver impure public goods which cannot be produced by markets. Unlike a pure public good which is wholly non-rivalrous and non-excludable, club goods are only partially non-rivalrous. This means that the consumption of a club good by one country does not preclude the consumption of the same good by another, although there may be some congestion costs. An example he provided is the orderly and safe trading system facilitated by the World Trade Organization (WTO) which benefited all its member countries.

According to theory of public goods, clubs can produce public goods efficiently provided clubs members agree on what public goods to produce. However, unlike market institutions that remain generally efficient while adapting to changing market demands, over time, clubs still produce goods that serve their members and will not necessarily adapt to the needs of a changing world economy. Private clubs often ensure control and continuity by admitting only applicants sharing the club's mentality. However, in the world of international organizations, there is great pressure to allow membership to become universal. The initial commonality of purpose and optimal production of services are compromised as members increase. Clubs widen the scope of their mission as they respond to each member. Resources become spread out across various missions lessening the club's effectiveness. Ultimately, tensions and gridlock in the management arise, resulting in the emergence of new clubs.

Professor Petri used the case of the IMF to illustrate club membership and control. Although the IMF's membership has grown six-fold to 185 countries since its inception, only nine are needed to get a majority of the votes, up from three in 1945. Moreover, 85% of the votes are required to pass important decisions, and this gives the United States a veto power owing to its 16.77% share. The IMF's quota allocation system means that tripling its resources will not necessarily translate into additional reserves for countries that need them most, as allocation is based on existing IMF quotas dominated by rich countries. The IMF can only hope that countries in no need of their new SDR allocation will lend them out.

For Professor Petri, the "governance trilemma"—the difficulty of achieving universal, democratic, and decisive institutions—summarized the fate of IEIs. All three characteristics are important, but it appears impossible to have them simultaneously in IEIs. For instance, while the G7 can be decisive and can reflect the voices of its members in a democratic fashion, it is not universal as it leaves out roughly 195 sovereign states in the world.

Two solutions can be offered in the "club theory" framework: (1) Tiebout or "voting with your feet" solution, and (2) decentralized decisions. The first solution entails the creation of many competing clubs giving countries more choices in addressing which ones to use to address their needs. But such a large range of clubs is not likely to be available internationally. The second solution allows subgroups within an institution to craft policies that not all members subscribe to. Linking various independent institutions to make decisions together is also another way. He recommends an extensive study of these two solutions.

To solve the IMF's governance trilemma, Professor Petri suggested giving greater voice to emerging countries to solve the democracy deficit. Currently, the five emerging economy members of the IMF —People's Republic of China, India, Republic of Korea, Brazil, and Mexico— have roughly the same IMF votes as with the five advanced European countries—Italy, Netherlands, Belgium, Sweden, Switzerland—but the former have over 40% of the world's population while the latter have less than 2%. International reserves of the latter are only a tenth of the former group. But Professor Petri remains optimistic that the IMF's quota system can be changed, albeit very sluggishly.

But there are also signs that the IMF is reforming its decision making structure. One is the condition-free short-term liquidity facility for debtors with prudent macroeconomic records, recently availed of by Mexico. Another is allowing main creditor countries to participate in loan negotiations as was done in the recent lending to three severely crisis-hit European countries—Ukraine, Hungary, and Iceland.

Professor Petri then extended the applications of these decentralized structures for international governments. In terms of development lending, parallel regional institutions exist along with the World Bank. This set up may permit a degree of specialization. The World Bank could concentrate on global problems, such as the achievement of the millennium development goals, and environmental issues. Regional banks on the other hand, can add regional priorities to their agenda, such as infrastructure financing. Similarly in terms of trade, the WTO could provide a framework that would make regional free trade areas more effective and coherent with global agreements. In terms of macroeconomic cooperation, the IMF could be substantially enhanced by regional programs, for example, Asia's Chiang Mai Initiative. The challenge is to ensure that the regional or sub-global pieces become "building blocks" of the global pieces.

Finally, Professor Petri offered his ideas on how to achieve this delicate balance between flexibility of global IEIs and coherence among sub-global IEIs. These include sharing of infrastructure and staff between the global and regional IEIs; and conducting joint operations. However, ultimately, he believed that resources, be it finance or people, would need to be used as incentives to make a decentralized system work. Global resources should partly serve as incentives to align regional initiatives with global objectives by way of co-funding regional projects to strengthen the coherence of regional IEIs with the global system.