The April 2009 London summit of the G20 is widely regarded as having been a great success.  The world’s largest economies agreed on an immediate coordinated approach to the global financial crisis then raging and promised to work together on banking reforms that would support growth.  At the time, President Obama got high marks for his constructive engagement.

The G20 heads of government have met twice a year since London and in Cannes this week they meet again (November 3-4).  Could this summit also help stabilize the world economy?  And can President Obama again play a leading role?  The answer to both questions is likely the same: No.

In 2009, the primary problem was slumping economies in the United States and Western Europe.  It was in the perceived individual interest of those economies to engage in some fiscal stimulus – and they were happy to present this as a joint approach.  China was also willing to stimulate its economy, as its policymakers feared slowing global trade would lower Chinese exports.  President Obama’s appeal for fiscal stimulus around the world was pushing on an open door.

Now the issue is quite different.  We have a sovereign debt crisis within the eurozone, in which countries that have borrowed heavily are facing the prospect of restructuring their debts.  The eurozone summit last week established that Greek debt will fall by about half (relative to face value), although this does not clearly put Greece onto a sustainable debt path.  The surprise referendum in Greece, announced this week, could build political support for the needed reforms.  Or it could lead Greece to exit the euro and to default on its debts in a “disorderly” manner – meaning without any kind of international framework or outside financial support.

But the real issue is Italy, as it has been at least since the summer. The Europeans are only beginning to get to grips with the centrality of Italy in the European debt web – glance at Bill Marsh’s recent graphic to get the point.  Italy has over 1.9 trillion euros in debt outstanding; this is the third largest bond market in the world.  In the aftermath of the Greek referendum announcement, the yield on Italian debt rose above 6.1 percent – the standard view is that if this reaches 6.5 percent, Italy will need to seek assistance in the form of a back-stop fund, to guarantee that there will be no default.

But the International Monetary Fund does not have enough resources available and the existing European Financial Stability Facility is also likely too small.  Informed observers talk of the need for more than 2 trillion euros in a “stabilization fund” and while there is a lot of fuzzy math involved in contemporary international financial rescues, the IMF and EFSF combined would be hard pressed to provide more than a third of that.

This might seem like a good time for a summit – so the hat can be passed around world leaders.  And some people do hope that China could provide an enormous loan, either directly or working with the IMF.  China, after all, has more than 2 trillion euros worth of reserves (not all in euros, of course; much of this is in dollars).

But it’s not clear China wants to take the credit risk of lending directly – the Europeans might not pay back, after all.  And the US is not keen to have China funnel such a large amount through the IMF; this would undermine the traditional US predominance there.  In today’s budgetary environment, there is no way that the US can come up with anything like matching funding at a level that would make a difference – would you like to ask the House of Representatives for $100 billion right now, to help keep Mr. Berlusconi in power?

And the heart of the problem is really European, not global.  Specifically, the eurozone needs to address its underlying fiscal structure, which has become severely dysfunctional.  They need a proper fiscal union, with the right to tax and to issue debt – backed ultimately by the European Central Bank.  And the ability of member governments to issue new debt must be severely curtailed.

The US faced a similar problem, long ago.  The original Articles of Confederation proved inadequate, largely because there was no centralized fiscal authority.  The Constitutional Convention convened in 1787 in large part because the US had defaulted on its debts – incurred during the war of independence – and there was no way forward without a new agreement among the original 13 states and greater fiscal powers (and more) for the federal government.

Europe needs the equivalent of a constitutional convention.  But today’s financial markets move so much faster than 200 years ago and the delay to date in Europe has already been excessive.  The Europeans need to move fast.  Will the Cannes summit speed them up?

An edited version of this post appeared on the NYT.com Economix blog today; it is used here with permission. If you would like to reproduce the entire post, please contact New York Times.

Early Friday I went through the G20 communique for the Wall Street Journal; a marked up copy is available on-line.

It is hard to imagine how the summit could have gone any worse for the US Treasury and the president.  The spin machine is now working overtime – and you’ll see big efforts to get more positive stories over the coming week – but on all fronts the outcome is very bad.

1. There was no substantive progress on anything to do with exchange rates.  The “indicative guidelines” to be agreed next year are just a way to kick the can down the road.  The Chinese are digging in hard on their exchange rate; this is headed towards a mutually destructive trade war.
2. There was less disagreement at the summit regarding the ”regulation” of global megabanks – but only because this had been gutted so effectively by the bankers’ lobby and officials who bought their specious arguments.  There is nothing here that will prevent or limit the impact of another major worldwide financial crisis.
3. On IMF governance, over which there was substantial fanfare in advance, it turns out there has been a major step backwards.  The Europeans have apparently signaled they are no longer willing to give up the job of Managing Director – they have always controlled this job and this is a major reason why IMF legitimacy remains weak.  Unless and until an emerging market person gets this position, no one (outside of Europe) will want to rely on the IMF in an emergency.  As a result all countries will want to “manage” their exchange rates – to the extent they can – along Chinese lines, aiming for a significant current account surplus (so as to build up foreign exchange reserves).  See point #1 above for the likely consequences of that.

The Group of 20 summit for heads of government this weekend will apparently “hail bank reform,” particularly as manifest in the Basel III process that has resulted in higher capital requirements for banks. According to leading authorities on the issue, however, the Basel process is closer to a disaster than a success.

Bank capital can be best thought of as the amount of financing of a bank’s operations (lending and investment) that is covered by equity and not by debt obligations. In other words, it describes how much of the assets of the bank are subject not to the “hard claim” of debt but rather to a residual or equity claim, which would not lead to distress or insolvency when the value of the asset goes down. For global megabanks, equity capital is thus a key element in preventing the failure of an individual institution (or a couple of banks) from bringing down the financial system.

The framing of the Basel “success,” according to officials, is that the big banks wanted to keep capital standards down — and this is definitely true — but that governments pushed for requirements that are as high as makes sense. The officials implicitly conceded the banks’ main intellectual point, that higher capital requirements would be contractionary for the economy.

But according to top academic experts on this issue — people who know more about banks and bank capital than anyone else on the planet — the banks have misrepresented and the officials have misunderstood reality.

In a letter published in The Financial Times this week, Professor Anat Admati (Stanford University) and her colleagues — a Who’s Who of finance — make three main points.

First, the basic economics behind official thinking is wrong.

“Some claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs,” thus lowering economic growth, the professors write. “This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs.”

They go on to say: “High leverage encourages risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk-taking at the expense of creditors or governments.”

Second, the Basel process uses dysfunctional methods to adjust capital requirements to reflect the risk of various kinds of assets.

“The Basel accords determine required equity levels through a system of risk weights,” they write. “This system encourages ‘innovations’ to economize on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities [around U.S. housing loans] before the crisis is an example.”

Third, capital requirements should be simplified and greatly increased — relative to what the Group of 20 leaders will congratulate themselves on.

“Lending decisions would be improved by higher and more appropriate equity requirements,” they say.

And they are also completely on target with regard to the political economy problem here: “Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.”

This is not extraordinary language per se — you can see the same sentiments, for example, echoed throughout the new movie “Inside Job” (which I highly recommend, as does the reviewer for The New York Times; disclosure, one sound bite from me appears in the movie). And I have advanced similar views on this blog over the past 18 months (e.g., see this post).

But to have the intellectual leaders of the finance profession weigh in so heavily and with such language is huge. Officials claim that they are the custodians of best practice in economics. If you criticize them on this or any other issue, they will roll their eyes — implying you do not understand reality or the insights of the truly deep thinkers.

So here are the deepest thinkers — founders and mainstays of the entire field of finance — finally standing up and saying: Enough of this nonsense. You may wish to pretend that keeping capital requirements low is a good idea, but you should understand that this is pretense and bad science, pure and simple.

Remember that most productive firms in our economy are financed with equity — shareholding is at the heart of the American economic model. Bankers make it sound as if something is wrong with being equity-financed, but all these big banks are publicly traded in any case. They just need to raise more equity and rely less on debt. This would not be difficult — and definitely not disruptive to the nonfinancial “real” part of the economy.

There is no intellectual case for the Basel process on its current basis or for the outcome that will be discussed this weekend. The Group of 20 leaders are kidding no one but themselves when they endorse this approach.

The Group of 20 has completely failed to do what is necessary to rein in global megabanks — and to make them safer.

Listen to the leading minds of the finance profession and take corrective action now, before it is too late.

An edited version of this post appeared today on the NYT.com’s Economix; it is used here with permission.  If you wish to reproduce the entire post, please contact the New York Times.

Most accounts of the ministerial meeting last weekend of the Group of 20 — 19 nations plus the European Union that represent the world’s wealthiest economies —implied that it continued to perform sterling service – heading off currency wars, keeping explicit protectionism under control and deftly managing the process of reforming governance at the International Monetary Fund.

Post-financial crisis, middle-income countries continue to rise in economic importance, and the recent shift in global leadership from the Group of 7 (the United States, Canada, Britain, Italy, France, Germany and Japan) to the G-20 is commonly supposed to accommodate the growing claims of “emerging markets” on the world stage.

This interpretation is correct as far as it goes, but it also misses the main story, which is that emerging markets have two primary goals that are increasingly at odds with each other. These goals – to hold large stocks of American dollars and to stave off a flow of capital from abroad – add up to wanting to retain the emerging markets’ recently achieved status of collective net creditors (i.e., being owed more than they owe). Unfortunately, this contributes to the serious vulnerability of the world economy as we head into the next credit cycle.

Emerging markets want to hold onto – or increase further – the vast stock of foreign exchange reserves that they have recently accumulated through current-account surpluses. In part these assets are a buffer against future shocks, but the countries now hold much more than they would need for purely precautionary purposes – China alone acknowledges holding around $2.5 trillion, much of which is presumably in American dollars.

Increasingly, emerging markets think about using the value of these reserves (or what they could buy with them) in a broader manner. They enjoy the status and power that comes with being a net creditor to the system – rather than a net debtor, as in the past (which involved periodic crises, loans with unpleasant conditions from the International Monetary Fund and having to be deferential to the United States when times were tough and so on).

They even begin to think about forming the basis for a new monetary arrangement that is less dependent on the dollar – since the 2008 financial crisis, both the Russians and Chinese have spoken in public about this objective, and it is shared in private by most policy-makers outside Europe and the United States.

The “reserve currency” status of the dollar means just that – private and public sector investors around the world hold their rainy-day funds in dollars. Traditionally, at least, this arrangement has been seen as a major economic advantage and source of political power for the United States.

Emerging markets want to discuss moving reserves into a basket of currencies, presumably involving some Chinese renminbi, Indian rupees, Russian rubles and Brazilian reals (the four Rs), among other currencies.

But this is where tension with the second goal enters the picture. Most emerging markets – including those with the four Rs – do not want to allow their currencies to appreciate, and they are also unwilling to take other measures (like cutting fiscal spending) that would be likely to hold back appreciation in some instances (Brazil, in particular, takes this stance). Instead they are imposing capital controls to prevent inflows.

The controls are unlikely to prove fully effective, but they do slow the appreciation for now – and they also send a very clear signal: Foreign investors will be treated at a differential disadvantage when the chips are down.

Ask an Indian executive whether she is thinking about investing in Brazil and the answer is an unequivocal yes. But ask whether she or her policy-making colleague would like to hold reserves in reals and the answer is also quite frank: no, thank you.

Emerging markets will continue to save for a very rainy day (or a bright unspecified future) – in dollars. They intervene to keep their exchange rates relatively depreciated and will try to run current-account surpluses for as long as they can. This behavior pushes down long-term interest rates in the United States, relative to what those would be otherwise.

And – here’s the kicker – very low interest rates in the United States contrast sharply in the minds of yield- and risk-seeking investors with the situation in Brazil, where you are now offered 11 percent interest rates.

In other words, the global credit machine in this part of its cycle takes savings from emerging markets, runs them through the United States, and – at the margin — plows them back into emerging markets. Dollars are bought up through central bank intervention and – you guessed it – funneled back into the United States. The Institute for International Finance, which represents global banks, just revised upward its estimate of capital flows into emerging markets this year.

This is exactly the kind of issue – inherently cross-border and very political – for which a structure like the G-20 is needed. But it will do nothing about these flows for three reasons:

1. The emerging markets want to save in this fashion, thinking they can dodge the consequences.
2. The United States needs to borrow, big time. Our politicians refuse even to think about the first-order causes of our recent fiscal disaster; they would rather just continue to borrow (at least as long as interest rates remain low).
3. The big banks like this approach. Their influence is in no way diminishing, and there is nothing about their recent track record that has diminished their appeal in the eyes of policy-makers (just this week, for example, the I.M.F. appointed a senior Goldman Sachs executive to head its high-profile European Department).

Accommodating emerging markets in global governance structures is appealing; their aspirations are legitimate, and the G7 looks outmoded. The profound instability of global financial structures and the broader “doom cycle” today is not the fault of emerging markets – the blame lies squarely with the United States and Western Europe, which have consistently failed to rein in their global megabanks.  (For an 8-minute primer on the “doom cycle,” if you are not familiar with the concept, try this video.)

The argument that the global savings glut, largely from emerging markets, was a major driver of the 2008-9 crisis is tenuous at best. But there is no question of a dissonance within the current policy goals of emerging markets – and this is not helpful to financial stability moving forward.   Most likely it helps feed – or otherwise becomes central to – the next financial frenzy.  And there is nothing the G-20 can or will do about it.

An edited version of this post appeared this morning on the NYT’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

The G20 communiqué, released after the Toronto summit on Sunday, made it quite clear that most industrialized countries now have budget deficit reduction fever (see this version, with line-by-line comments by me, Marc Chandler and Arvind Subramanian).  The US resisted the pressure to cut government spending and/or raise taxes in a precipitate manner, but the sense of the meeting was clear – cut now to some extent and cut more tomorrow.

This makes some sense if you think that the global economy is in robust health and likely to grow at a rapid clip – say close to 5 percent per annum – for the foreseeable future.  With high global growth, it will matter less that governments are cutting back and unemployment will come down regardless.  Taking this into account, the IMF is actually predicting (as cited prominently by the G20) that budget “consolidation” actually raise growth over a five-year horizon.

There is no question that some weaker European countries, such as Greece, Portugal, and Ireland, had budget deficits that were out of control.  Particularly if they are to pay back all their foreign borrowing – a controversial idea that remains the conventional wisdom – these countries need some austerity.  But what about those larger countries, which remain creditworthy, such as Germany, France, the UK, and the US?  If these economies all decide to reduce their budget deficits, what will drive global growth?The answer in Toronto was obvious: China.  China is only about 6 percent of the world economy, measured using prevailing exchange rates, but it has a disproportionate influence on other emerging markets due to its seemingly insatiable demand for commodities.  It also has a relatively health fiscal balance – and its fiscal stimulus, working mostly through infrastructure investment, did a great job in terms of buffering the real economy in the face of declining world trade in 2008-09.

Now, however, the Chinese government is trying to slow the economy down – there is fear of “overheating”, which could mean inflation or rising real wages (depending on who you talk to).  Chinese economic statistics are notoriously unreliable, so reading the tea leaves is harder than for some other economies, but most of the leading indicators suggest that some sort of slowdown is now underway.

The G20 knows this, so the bet is that China will pull off a “soft-landing”, with growth staying in the region of 8-9 percent.  China’s recent exchange rate appreciation against the dollar does not help in this regard, and this is one reason why pressure for further appreciation from other governments is likely to remain muted.  Even the United States, above all, wants a robust China.

Talking to Chinese experts – I was in Beijing over the weekend – there are three major worries.

1)      There is already a great deal of wasteful investment in infrastructure.  At some level, there is a desire to clean this up and make it more sensible.  This implies slower growth.

2)      There is much discussion of “overcapacity” in the state sector.  Again, there is interest in addressing this – although it is not an easy problem.  In any case, this further lowers the incentive for state investment both directly and through various forms of subsidies to government-backed enterprises.

3)      The incentives for local government officials have been heavily weighted towards boosting GDP growth; they move up (and presumably down) the government and party hierarchy based on how they do in this dimension.  There is now a great deal of thinking that it would be better to also include other objectives, such as impact on the environment.  This makes sense – air and water quality are hot issues – but it would also imply slower growth.

China’s reported GDP numbers are likely remain robust – the reported statistics are very much part of the broader government management process.  But the economy could still slowdown in ways that would impact commodity prices – these are the key variables to watch, including for energy and metals used in industrial production (e.g., for the link to Latin America, see the NYT today).

The irony, of course, is that China is also a leading candidate to be at the epicenter of the next boom.  In a sense this is what the G20 would like, unless the boom becomes debt-based and unsustainable, as in emerging markets during the 1970s or Japan in the late 1980s.

The G20 is betting that China can keep its growth high enough to sustain the global economy while also not getting drawn into some sort of bubble – particularly one that would involve big Western banks.  Given the nature of China and the volatility of global capital flows – international investors love you without limit, until the moment they leave you – this is quite a bet.

We should also not overestimate the ability of the Chinese government to fine tune its economy.  To be sure, the authorities have done well both in terms of high average growth and in terms of managing the impact of regional and global cycles over the past 20 years.  Can they really do so well indefinitely?

An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission.  If you would like to reproduce the entire article, please contact the New York Times.

The underlying idea is that if you talk long enough about the US current account deficit and the Chinese surplus, stuff happens and the imbalances will take care of themselves – or move on to take another form.

Warren Buffett seems to agree.

Buffett’s big investment in railroads looks like a shrewd way to bet on growth in emerging markets – which is where most incremental demand for US raw materials and grain comes from.  It’s also a polite way to bet against the dollar or, even more politely, on an appreciation of the renminbi. 

When China finally gives way to market pressure and appreciates 20-30 percent, their commodity purchases will go through the roof.   You can add more land, improve yields, or change the crop mix of choice (as relative prices move), but it all has to run through Mr. Buffett’s railroad.

Of course, Buffett is nicely hedged against dollar inflation – this would likely feed into higher inflation around the world, and commodities will also become more appealing. 

And Mr. Buffett is really betting against the more technology intensive, labor intensive, and industrial based part of our economy.  If that were to do well, the dollar would strengthen and resources would be pulled out of the commodity sector – the more “modern” part of our production is not now commodity-intensive.

The G20 will stand pat, waiting for the recovery and hoping for the best; “peer review” will turn out to be meaningless.  But this raises three dangers.

1. China will overheat, with capital inflows fuelling a giant credit boom.  Books with titles like “China as Number One” and “The China That Can Say No” will appear.  The boom-bust cycle will resemble that of Japan in the 1980s – you don’t need a current account deficit in order to experience a costly asset price bubble.  Other emerging markets may follow a similar pattern (think India, Brazil, Russia.)
2. US and European banks will be drawn into lending to China and other emerging markets, directly or indirectly.  In a sense this would be a re-run of the build-up of debt in Latin America and Eastern Europe in the 1970s, leading to the debt crisis of 1982 (remember Poland, Chile, Mexico).  Banks with implicit government guarantees will lead the way.
3. We hollow out the middle of the global economy – with a few people doing ever better and most people struggling to raise their living standards.  Increasing commodity prices hit hard at poorer people everywhere (recall the effects of the relatively mild run-up in food and energy prices in the first half of 2008).  Global volatility of this nature helps big business but at the cost of undermining the middle class.

By betting on commodities, Mr. Buffett is essentially taking an “oligarch-proof” stance.  Powerful groups may rise to greater power around the world, fighting for control of raw materials and driving up their prices further.  As long as there is growth somewhere in emerging markets, on some basis, Mr. Buffett will do fine.

As for the G20, they are already a long way behind the curve.

By Simon Johnson

But who elected the G20?  The answer is: No one.  And, in case you were wondering, there is no application form to join the G20 (although you can crash the party if you have the right friends, e.g., Spain).  The G20 has appointed themselves as the world’s “economic governing council” (to quote Gordon Brown).

Is this a good idea?

Not really – it would be much better to have a structure in which all countries were represented, probably with some weighting according to their economic and financial importance in the world.

The problem is that we have what is supposed to be exactly that structure, at the International Monetary Fund, and it doesn’t work very well.  The IMF has 186 members, represented by 24 executive board members, who live in Washington DC and work every day (almost) at the Fund. 

The IMF’s resident executive board members are often not very senior, meaning they are long way below the real decision makers in their respective bureaucratic structures; this is cumbersome.  But twice a year, finance ministers representing the 24 board seats meet as the International Monetary and Financial Committee (IMFC) to oversee the work of the Fund – with the next meeting in Istanbul, October 6-7.

You might think that Istanbul will advance the G20 agenda – because the people meeting as the IMFC are almost the same people who will meet in November as the G20 ministers of finance.  But they are not the same and many other people will be in the room at Istanbul.  This is all very awkward and will further slow down whatever progress there is at the global financial reform level.  In fact, the G20 suggested that the next productive meeting would be of its finance ministers in November, i.e., implying that Istanbul is a waste of time.

The relationship of the G20 to the IMF is extremely delicate – smaller countries are already beginning to complain, and with some reason.  If the goal is to rebuild the legitimacy of the IMF and to encourage countries to trust it to lend fairly in a crisis, this is not going very well.  The rules around who will be supported and on what basis are becoming increasingly murky and not rules-based - e.g., Eastern Europe is almost certainly getting deals that would never have been offered to troubled countries in Asia.

It would be better for emerging markets to form their own Fund (let’s call that the EMF).  They have plenty of “hard” currency in hand to do so and no shortage of economic expertise; $1 trillion of paid up capital would be more than enough to get it started (and this would also take the pressure off China with regard to its “excess” reserves). 

The EMF can cooperate with the IMF but also operate independently – and just as much (vaguely) under the auspices of the G20.  This would go a long way towards restoring emerging market and developing country confidence in the international financial system – and towards assuring they will get timely and appropriate help in the event of another world crisis.

By Simon Johnson

Perhaps just having emerging markets at the table will bring the world closer to stability and more inclined towards inclusive growth, but that seems unlikely.  Should we just move on – back to our respective domestic policy struggles?

That’s tempting, but consider for a moment the key way in which the G20 summit has worsened our predicament.

There is broad agreement that capital requirements need to be increased and a growing consensus that very large banks in particular should be required to hold bigger equity cushions.  This is a pressing national priority – if our financial system is to become safer – and reasonable people are starting to put numbers on the table, ever so quietly: Joe Nocera is hearing 8%, but Lehman had 11.6% tier one capital on the day before it failed and the US banking system used to carry much more capital – back in the days when it really was bailout free (think 20-30% in modern equivalent terms (see slide 40 here).

Obviously, raising capital standards in the US is going to be a long and drawn out fight.  The G20 could help, if it set high international expectations, but the opposite is more likely.  As Nocera suggests this morning, the inclination of the Europeans – largely because of their funky “hybrid” capital, but also because they have some very weak banks – will be to drag their feet.

Why should we care?  This administration seems to think that we need to bring others with us, if we are to strengthen capital requirements.  Our progress will be slowed by this thinking, the glacial nature of international economic diplomacy, and the self-interest of the Europeans.

Instead, the US should use its power as the leading potential place for productive investments to make this point: If you want to play in the US market, you need a lot of capital.  If you would rather move your reckless high risk activities overseas, that is fine.

It’s time to get past the thinking that our economic prosperity is tied to the “competitiveness” of the financial sector, when that means doing whatever finance wants and keeping capital standards low.

As we discovered over the past 12 months, undercapitalized finance is not a good thing – it is profoundly dangerous and expensive.  Other countries should be encouraged to raise capital standards also, but if they can’t or won’t, then their financial institutions will (a) not be allowed to operate in the United States, and (b) be allowed to interact in any way with a US bank only to the degree that the US entity carries an extra (big) cushion of capital in those transactions.  Any US entity found circumventing these rules will be punished and its executives subject to criminal penalties.

Of course, this process needs to be WTO-compliant and the G20 is as good a place as any to manage the high politics of that.  But stop worrying about what other countries might or might not do.  Establish high capital requirements in the US, and make this a beacon for safe and productive finance.

And prepare for the crises that will sweep undercapitalized parts of the world financial system in the years to come.

By Simon Johnson

The last time this group met – in London at the beginning of April – they had one of the most productive summits in living memory, agreeing to triple the resources of the International Monetary Fund (IMF) so that it could help troubled countries, while also projecting an image of determination to “do whatever it takes” to avoid a Second Great Depression.

There could still be dramatic moments at or around the summit.  There will be some street protests, mavericks could rock the boat (President Sarkozy of France is always threatening to do this), and there is always scope for mini-drama and quirky photos when so many heads of government rub shoulders.

But in terms of the economic agenda – and this meeting is supposed to be about the global economy – the likely deliverables look thin. Three issues are up for discussion.

First, whether the countries can agree on “rebalancing” global growth, which means – in its current iteration — that the US would commit to save more and China would commit to save less.  But “commit” will not mean that the countries agree to any penalties if they fail to comply.  The US may well save more as it struggles along the road to recovery – after all, households have been saving very little for over a decade – but this won’t be much or at all affected by any agreement at Pittsburgh.

Second, whether lower income countries can have more representation at the International Monetary Fund.  This is a long-standing issue, which should eventually help the IMF rebuild the legitimacy that was sorely damaged by its handling of the Asian Financial Crisis in the late 1990s.  Unfortunately, real progress on this issue is blocked by some rich West European countries, who are overrepresented at the IMF for historical reasons and who would lose out in any reshuffle; they will not be in Pittsburgh and there is no sign of any new concessions from this side.

Third, to what degree and precisely how financial regulation will be tightened around the world.  Here there is scope for a deal, with the US pushing for higher capital requirements for banks, while the Europeans (and Mr. Sarkozy in particular) are demanding changes in how bankers are compensated.  These are crucial question, but here we face our greatest potential disappointment.

The open secret is that even the US is not pushing for significantly higher capital requirements – the US Treasury view is that our largest banks currently “have enough capital,” even though Citi and JP Morgan have roughly only about as much of an equity cushion against losses as did Lehman Brothers the day before it failed.  So the US proposal is largely meaningless – which does not prevent the continental Europeans from opposing it; many of their banks are very thinly capitalized but their governments don’t want to draw attention to this fact.

The Europeans want, instead, to focus on how bankers are paid.  Compensation systems in big banks encourage reckless risk-taking, but more this is more of a symptom than a cause.  Unless the underlying causes are tackled – the excessive size of our biggest banks, their thin level of capital, and the revolving door that has top Wall Street people running bailout strategy in Washington – changing compensation rules would just increase the effort that smart lawyers and accountants put into figuring out new ways to pay people.

If the G20 fails to deliver, is it really possible that we are doomed to repeat the same mistakes with regard to building up vulnerabilities in our financial system?  Amazingly, the answer is: a definite yes.  How can this happen, with so many smart people in government?  Unfortunately, it is not about having clever individuals on the job; it is about their incentives, their world view, and whether or not they really face pressure for change. 

During World War I on the Western Front, well-educated British generals with great practical experience insisted on repeating the same mistakes again and again, at great cost.  Democratic oversight, in that context, was worth little.  If you delegate to “experts” and they fall into dangerous groupthink – and are allowed to construct sophisticated sequential cover-ups – expect the worst.

By Simon Johnson

This is a slightly edited version of a post that first appeared on the NYT’s Economix.  If you would like to reproduce the entire post, please contact the NYT for permission.

This is appealing to the G20 leaders because their call to “rebalance” global growth will involve no immediate action and no changes in policy – other than in the “medium run” (watch for this phrase in the communiqué).

When exactly is the medium run?

That’s an easy one: it’s always just around the corner.  Not today, of course; that would be short run.  And not in 20 years; that’s the long run.

The medium run is perhaps in 3 years or perhaps in 5 years.  It feels close enough not to be meaningless at the press conference, but it’s not close enough to be meaningful.

And – here’s the key – whatever you agree on for the medium-term, you know that the world will change, quite dramatically, 2 or 3 times before you get there.  At that point you can say, quite reasonably: But the conditions today are quite different from what they were when we made this medium-term commitment, so we really need to rethink it.

Of course, having the IMF report back every year on progress towards these medium-term goals is equally pointless.  This is what the IMF has been doing since 2006 and what it was preparing diligently to do just as the global crisis broke out.

Expectations for the G20 summit are low.  But unless and until the leaders take any steps to address our pressing financial sector vulnerabilities, the summit is not worth its carbon footprint.

Remember what the financial experts said at the previous summit (April) and the one before that (November): we can’t fix the financial system in the height of the crisis.  True enough, although the opportunity to break the power of the largest players was squandered in both the US and Europe.

So, now the crisis is over – as the G20 heads of government will affirm – where are their efforts to fix the financial system?  Please don’t tell me, “that’s what we’re doing, in the medium-term.”

By Simon Johnson

Long documents have been produced and official websites have become more organized.  Statements of principle have been made.  And the melodrama of rival reform proposals has reared its head: continental Europeans for controlling pay vs. the US for raising capital vs. the UK not really wanting to do anything.  But what does all of this add up to, and what should we expect from the forthcoming summit sequence?

Nothing meaningful.

This is a sophisticated delaying action and you are seeing masters of economic policy spin at work.  When something goes wrong on a colossal, global scale, here’s the playbook (e.g., as applied to capital requirements).

1. Agree that there is a problem, but be very vague about it.  “It’s complicated” is a good watch phrase.
2. State some completely bland principles to which no can object.
3. By all means, have a spat with the French or Germans.  But then patch it up amicably at the big summit; agree to do a bit of everything, in principle.  People are wowed by your leadership.
4. Send the job of formulating technical details to a committee of experts, asking them to report at the end of 2009 – and then make adjustments through the end of 2010.
5. Rely on the experts to produce a report of mind-numbing detail, which few really understand.  The experts know their job and will deliver.
6. Provide leaks of this work and your “true feelings” to sympathetic reporters.  They will help declare victory against great, albeit vaguely specified, odds.
7. At this point, it’s 2011 and either (a) new people are in power, or (b) other things have gone sufficiently well that everyone has forgotten about the financial fiasco of 2008-09.

The brilliance of this approach is that you can say, whenever someone objects that capital requirements are not being increased as much: “we are doing that, but the details are not yet fully settled,” or “but we agree with that principle; of course the details are complicated.”

And, in this context, the point of a G20 or IMF meeting is to have the world’s economic policymakers show mutual support.  After all, our opinion leaders reckon, if everyone is on board, then this must be the right way to go.

There will be some minor changes, and these will be much trumpeted.  But what will really change in or around the power structure of global finance – as it plays out in the United States, Western Europe, or anywhere else? 

Nothing – and you know this because otherwise the CEOs of all our top financial institutions would be mounting massive PR campaigns against the proposals, with op eds, Internet ads, innumerable cable appearances, and a virtually constant presence at Treasury. Just think back to how active they were earlier this year, when FDIC-type resolution for big banks was on the table.

Unless and until our biggest financial players are brought to heel, we are destined to repeat versions of the same boom-bust-bailout cycle.  If you find a government willing to state this problem clearly and really take action to confront the relevant powerful people, let me know.

By Simon Johnson

President Obama had just the right tone yesterday.  Admittedly, he was helped by the fact that we no longer have anything to be arrogant about, but still the way he reached out to other countries – while also pointing out that they made big mistakes and are currently in trouble – conveyed exactly the right message.  The US will do much better if it lets emerging markets and developing countries have a serious and permanent place at the big table. 

Among other things, this will fundamentally change the way the IMF operates.  As a symbol and for its potential impact on the international economy moving forward, yesterday’s final loss of European control over the IMF really matters.

By Simon Johnson

These are all reasonable questions.  And the answer is simple: in terms of the obvious major issues of the day, this summit is unlikely to achieve much.

But every global economic recovery has to start somewhere and it probably has to begin small.  And there are some slight glimmers of hope because (a) President Obama is taking a global leadership role, (b) he is doing this in a creative way that might seem surprising, but which should reduce the chance of a further global meltdown.

To be clear, President Obama’s team tried to turn this into a constructive meeting that would contribute in a major fashion to a global recovery.  They pushed hard for further fiscal stimulus around the world, but were rebuffed by the Europeans (for some of whom – e.g., those who speak German – fear of inflation trumps all other sensible considerations).  There is no real summit-related progress on that front – just the usual kind of official window dressing.  But it was worth a try and the topic can be reopened in future discussions.

Obama’s team didn’t push quite as hard for expansionary monetary policy elsewhere in the world, to match what Ben Bernanke and the Fed are now doing in the US, partly because there is an unfortunate anachronistic notion that central banks are “independent” and should not be discussed by heads of government.  This leaves the European Central Bank with a deflationary policy stance (in large part, again because it is dominated by the Germanic anti-inflation obsession); this is dangerous for that whole continent and – given they comprise around a quarter of the world economy – for all of us.

No one made much progress with financial regulation.  None of the G20 governments really seem to have got to grips yet with the implications of having created large financial institutions that are too big to fail – and which derive great economic benefit and, in some cases, political power from this status.  At least the US is beginning to think harder about how to regulate the system, but the positive signs along this dimension are quite limited and nothing to do with the G20.

If the summit will make essentially no progress on the big three topics of fiscal, monetary and regulatory policy, how exactly is President Obama showing leadership and making a difference?  Here’s the creative surprise – it’s by raising a great deal of money for the IMF and proposing fundamental changes in the way that organization operates.

The IMF currently has about $250bn to lend; this is not enough to really make a difference in a world of trillion dollar problems.  The Europeans proposed to raise this to $500bn, which seems still low – particularly as it’s mostly European countries that have a pressing need to borrow; you guessed it, the Germans don’t want to put up more.  The Obama Administration is pushing for closer to $1trn in total IMF funding and, after a lot of hard work, seem likely to get close to this target.

In essence, this is a clever way to force the Europeans to help themselves.  The Europeans won’t do it with fiscal or monetary policy, and their regulatory changes – even if meaningful – won’t help the recovery.  So the US has persuaded other countries to stuff the IMF full of cash and line it up as the lender of last resort to European economies that now find their property markets collapsing, their currencies under pressure, and their budget deficits increasingly hard to fund.

But that’s not all.  The masterstroke is simple and also brilliant.  The US is pushing for – and likely to get – the Managing Director (known as the MD) of the IMF to be selected through an open, competitive and merit-based selection process.

Why is this a big deal?  Governance of the IMF has been for too long dominated by Europeans – by convention, every MD has been European since the founding of the organization; the results have been questionable.  The MD has enormous power and great discretion on almost all questions – the IMF is subject only to its own rules and its executive board is dominated by… Europeans.  This combination wore thin with much of the rest of the world a long time ago.

Deeper governance reform and de-Europeanization of the Fund (e.g., Europe is massively overrepresented in terms of board seats) is long overdue, but the Europeans have been strong enough to slow down the process in the past.  As a result, middle income and poorer countries rightly question if the IMF really works for them or just for the Europeans (and, it must be said, for the United States.)

By forcing open the leadership selection process of all International Financial Institutions (e.g., so this means no more guaranteed job for an American as President of the World Bank), the Obama team has jumped over major roadblocks around IMF governance.  It has also formed a natural alliance with large emerging markets (Mexico, Brazil, India, China, South Korea, South Africa, etc), who are also members of the G20; the natural next step would be to support a new MD from one of these countries.  Emerging markets lending to struggling Europe, through the IMF, is something we should all get used to thinking about.

Arising directly from the G20 process and this summit therefore, the IMF gets a large amount of cash and the real opportunity to establish broader legitimacy – this should help convince countries that loans from the IMF will come on reasonable terms in the future, and this in turn should serve as a buffer against further downturn. 

How much difference will this make?  We don’t know, but it’s a sensible step.  Global leadership pushing hard in the right direction is surely much better than what the world experienced before Barack Obama became President.

Almost all the important issues are kept off the table by anachronistic diplomatic niceties: monetary policy around the world, Europe’s impending crisis, and how to escape the overweening power of major banks in almost all industrial countries.  The G20 summit has substantially failed even before it begins.

There is, however, one topic worthy of debate that is still on the agenda - the IMF.  We need the IMF to have enough resources to help out when small and not-so-small countries get into trouble.  Feel free to imagine IMF-less futures, but when the chips are down – as in Europe right now – to whom else can countries turn for money, advice, and the keys to international support?  When they go to the EU, the Germans, the Swedes, or any other regional power, they are told bluntly: bring in the Fund.

The G20 therefore has to address the current low level of funding at the Fund – as the world economy and financial flows grew, no one bothered to increase the resources available under global financial emergency conditions.  And here there is great tension – as I discuss in a piece at the New Republic online, the Europeans are lowballing (for no good reason), the emerging markets are standing idly by, and only President Obama could potentially rise to the occasion.  But with so much else going on in the US financial sector and around the world, can he focus his persuasive powers sufficiently to win the day – particularly on and around a topic as dry as the IMF? 

Or will the key issues get punted down to the G7/IMF spring meetings at the end of April?  In international economic diplomacy, there is always another summit and another crack at meaningless communique drafting just around the corner.

By Simon Johnson

In fall 1997, a key issue for Indonesia’s IMF program was whether the government could close the banking operations belonging to one of President Suharto’s sons.  There was an epic and fascinating struggle and, in the end, the government did not have sufficient political will or power.  The subsequent loss of US support, and further currency and economic collapse is (messy and painful for many) history.

It is striking that Ben Bernanke now asks whether the United States today has sufficient political will.

How did we get to the point where the U.S., with a strong balance sheet relative to the size of problem banks, is regarded – by the markets and more broadly – as less likely to resolve the problems in its financial system than say the British (with big banks relative to a weak fiscal position) or the Germans (who talk all the time about how they are not going to bail anyone out)?

You can point the finger at Congress.  The parliamentary system in Britain and Germany means that the government can implement and innovate a bailout policy without worrying about being able to legislate enough financial support.  The Obama Administration has much to worry about in this regard.

The problem surely goes deeper – at least back to the bailouts of the fall.  Poor communication, particularly by Hank Paulson, undermined popular and congressional support.  And the lack of a consistent strategy exacerbated initially negative perceptions.

But the underlying issues are deeper still and laid bare by this week’s latest round with AIG.  We have moved far beyond financial policy and into the kind of scandal that really gets taxpayers’ backs up.  The greed of bankers slaps you in the face while the hubris of their leadership remains unchecked. 

There is no sense of responsibility, no feeling of shame, no acknowledgment of any kind of mistake: read Lloyd Blankfein’s FT article again – or print it out and tape it to your wall.  Because we now know, from the newly disclosed AIG counterparties list, that the wealth of Goldman Sachs insiders remains high solely because we saved their sorry bank, their failed risk management strategy, and their pretence of wisdom with our cash in mid-September.

This resentment against bankers pervades Congress, and even the Administration begins to get the message – being called “asinine” yesterday by Richard Kovacevich, the Chairman of Wells Fargo, may have helped underline to Treasury how deeply the bankers appreciate the help they have received.  There can be no resolution and no moving on until there has been a proper congressional investigation, with full subpoena powers, into exactly what did and did not happen around AIG.  This will take months and may well slow down the economy (Jamie Dimon’s clever point: if you vilify us, you will lose), but it is now inescapable.  And, if channeled productively, this kind of hearing may lead to a better regulatory system (and smaller big banks) than the current anemic proposals on the table - as last weekend indicated, the G20 process is currently worse than useless on this issue.

Ben Bernanke knows all this, at the same time as he sees our economy worsening and global storm clouds still gathering.  So where will he take us, starting with the Federal Open Market Committee meeting this week?  The British experiment with quantitative easing is pushing down the yield on long government debt.  It’s risky - inflation, once started, is not so easy to control.  And it may not work so well in the US (where the dollar tends to appreciate as the world becomes more scary) as in the UK (where they can successfully push for depreciation, particularly vis-a-vis the hidebound eurozone). 

Inflation breaks the political and social logjam around banking.  With some luck, it helps growth – at least in the short-term.  And of course the surviving bankers win big.