A Modest Proposal for the G20

Soon the G20 group will meet again to continue its discussion of changes in the rules governing the international economy and the global, financial system. A danger is that, as time passes and as the world moves further away from the deepest point of the recent financial crisis, inertia will set in, lobbies will reacquire their past influence on legislators and other policymakers, and national interests will again prevail over global interests. These developments will inevitably affect the countries’ willingness to establish clear and widely shared rules to guide future financial operations and operators.

Many issues continue to characterize the ongoing debate. Among these, the following are significant ones:
(a) Should the focus be on micro, institution‐specific risks or on macro‐prudential risks? Depending on the focus, different policy tools would be needed.
(b) Should the regulators and the regulations remain nationally based? Or should they become more global character?
(c) If they remain national, how much harmonization of the rules is necessary among the countries for a financial market that is global in scope and that can thus exploit regulatory arbitrage?
(d) If the rules and the regulators remain national, how much exchange of information would be necessary among the regulators?
(e) What should be the reporting requirements for those who operate in the market? And to whom should they report?
(f) Which financial operations should be registered and/or would be required to use transparent and monitored channels?
(g) What should be the capital requirements for loan‐making institutions, or for those that, through their operations, acquire large, potential, financial liabilities? How to make these capital requirements not contributors to cycles?

These and other questions need to be addressed in the development of new rules that would hopefully reduce the probability of financial crises in future years. An old issue that will inevitably arise in the discussions is whether countries that participate in the G20 meetings should try to agree on precise rules. Or, whether it would not be preferable to focus on the development of broader principles that could provide an umbrella for determining proper behavior in the financial market. Obviously, the existence of principles would not eliminate the need to develop (within specific countries) more detailed rules that could complement the principles. As an example, the principle that states that those who drive cars have the responsibility to drive carefully does not eliminate the need to have speed limits (rules) that could be different from place to place.

With some generalization it can be argued that Americans and generally those from Anglo‐Saxon countries have preferred to have specific rules for what is called a ‘rule‐based society”. In these societies lawyers have acquired great importance because they are those who often make the rules and determine whether the legal rules are followed. The main argument in favor of a rule‐based society is that precise, agreed rules reduce political and administrative discretion. This is a strong and important argument. I recall that during the 1997‐98 financial crisis, that hit several of the countries of Southeast Asia, high level representatives of the US Treasury kept repeating ad nauseam that the crisis had occurred because of the absence of specific rules in the affected countries. If those countries had had American‐style rules, they would not have had the crisis.

Continental European countries have relied a bit less on precise rules and a bit more on broader principles to guide behavior in the financial market and in other activities, including driving. An important argument for this preference, and one that has acquired more weight due to the recent financial crisis, is that, just as happened with the famous Maginot Line, before World War One, precise rules tend to deal with the situations of the past (past wars or past crises) and not with the reality of the present and future. In a fast developing world, in which technology and other relevant areas are changing rapidly, thus continually creating new situations, new institutions, new relations, and new financial instruments, existing and precise rules tend to become inadequate in dealing with new situations, because they were developed with the needs of the past. In a rule‐based world, rules tend to follow, rather than anticipate, real world changes. Another argument, stressed by pronouncements from the Vatican, is that unethical behavior, as distinguished from illegal behavior, is difficult to be dealt with by precise rules.

The recent financial crisis has driven home the fact that some financial operations considered unethical by most observers may not have violated any existing rules. Thus, the perpetrators could not be penalized and they could keep their gains. There have been many examples of this problem.

The criticism of some of Goldman Sachs’ operations, of rating agencies, and of other operators was clearly the result of this divergence between what the rules allowed and what was considered ethically correct behavior by much of the population. If the existing rules had been complemented by some relevant, broad principles, there might have been fewer problems.

Perhaps, an example from India may help clarify the point made above. In a strict, rule‐based society, there is a sharp distinction between “tax evasion” and “tax avoidance”. Tax evasion occurs when one breaks a clearly identifiable norm or rule. That behavior is punishable by law. Tax avoidance occurs when a taxpayer uses some potential ambiguities in the fiscal norms to reduce the tax payment or to avoid paying taxes. Tax avoidance is generally not considered a violation of the law. In the USA and in several other countries, it is not legally punishable. At best the Internal Revenue Service or equivalent agencies bring (ex post) changes to the regulations or to the legislation to reduce future tax avoidance. However, in India this sharp distinction, between tax evasion and tax avoidance, is not legally accepted. The principle is that, if a special tax court decides that the intention of the taxpayer was to defraud the government of tax revenue, tax avoidance is treated as tax evasion.

Returning to the G20, it is not realistic to expect that a group of 20 heterogeneous countries, with different national interests and traditions, would be able to agree, at the next or at future meetings, on precise “rules governing the international economy and financial system”. However they might be more successful if they concentrated on developing a set of general but relevant principles, a kind of constitution, that could in turn influence the precise rules that the specific countries might want to follow. The rules might differ between countries, but the more they would follow the general principles, the greater global harmonization would take place. Obviously the principles should not be so general as to become meaningless. Calling for equality, fraternity and liberty would be an example of a useless principle. Calling for full transparency in all financial transactions would be a more useful principle.

The G20 could also agree on an institution ‐‐‐‐the IMF?‐‐‐‐ that might exercise some kind of surveillance function over countries to determine whether the ongoing behavior in their part of the financial market is consistent with the agreed principles.

This would clearly be a second‐ best option. However, this might be realistically the best that could be achieved.