The G20 Finance Ministers and Central Bank governors are meeting today in St. Andrews, talking about the data they will need to look at in order to monitor each other’s economic performance and sustain growth (seriously).

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

Strong advocates of our new G20 process are convinced that it will bring legitimacy to international economic policy discussions, rule-making, and crisis interventions.  Certainly, it’s better than the G7/G8 pretending to run things – after all, who elected them?

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

It is easy to dismiss the G20 communique and all the associated spin as empty waffle.  Ask people in a month what was accomplished in Pittsburgh and you’ll get the same blank stare that follows when you now ask: What was achieved at the G8 summit in Italy this year?

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

On Thursday evening and all day Friday, heads of government from countries belonging to the G20 will meet in Pittsburgh.  On paper, this looks important – 90 percent of world economic output and 67 percent of world population will be at the table: the G7 (US, Canada, Japan, UK, Germany, France, and Italy), plus the European Union, the largest emerging market countries (including China, India, Brazil, Mexico, and South Africa) and a few others.  And unlike the G7, which is really a club for rich industrialized countries, every continent and almost all income levels are represented in the G20.

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.

It looks like the G20 on Friday will emphasize its new “framework” for curing macroeconomic imbalances, rather than any substantive measures to regulate banks, derivatives, or any other primary cause of the 2008-2009 financial crisis.

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

As we wade through a long line of international economic meetings – G20 ministers of finance last week, G20 heads of government in Pittsburgh coming up, IMF-World Bank governors meeting in Istanbul early October (and all the associated “deputies” meetings, where the real work goes on) – it seems fair to ask: where is regulatory reform of our financial system heading?

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

The big news at the G20 was obviously about the IMF, with the Americans pulling out an impressive deal on funding (compare with our predictions…). But the money is not the biggest achivement. The big move was in terms of who will run the IMF in the near future – as I explain my NYT.com column this morning, there is an implicit and almost immediate shift towards emerging markets.

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

With our myriad banking problems, rapidly rising unemployment, looming political battles over the budget and much more on the pressing domestic agenda, is the G20 summit in London (dinner Wednesday and meeting Thursday) really worth all the time and effort that the President and his team have devoted to it?  And, granted that President Obama has to attend this heads of government meeting for protocol reasons, is there much that this summit can realistically achieve – i.e., are there actions that will be taken as a result of the summit that would not otherwise have happened and that can really make a difference to the parlous state of our economy?

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.

We know already much of what the G20 will produce: a communique that looks very much like the last one (dubious reassurances about the great progress being made along vague dimensions), no progress on fiscal stimulus (as we have been projecting for some time), and promises to clamp down on regulation for hedge funds and the like (fine, but how relevant is this to either what caused the crisis or what can sustain a recovery?)

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

Stabilization programs in emerging markets often come down to this: the government needs to do something unpopular, e.g., reduce some subsidies, privatize an industry, or eliminate the crazy credit that goes to oligarchs – no one likes oligarchs, but their factories employ a lot of people.  There is naturally resistance - pushback from legislators, riots in the streets, or oligarchs calling their friends in the US foreign policy establishment.  The question becomes: does the government have the ”political will” to get the job done?

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.

A fundamental principle that we all hold dear is: in industrialized countries, with relatively high income levels, the government can’t be completely out to lunch.  After all, we reason, there are democratic processes, watchdogs of various kinds, and we can safely delegate monitoring of government official actions to others (e.g., the media). 

This principle is, of course, now appropriately called into question both for government officials directly and increasingly for the media’s scrutiny of what the government (and business) is doing.  As a result, the level of public attention to various domestic policies - bailouts and the like - is surely at or close to all-time highs; the current reaction time and seriousness in public discussions of various initiatives for banks must set some sort of record.

Yet there remains at least one completely murky and unaccountable area of government action: international economic diplomacy.

The G20 summit, broadly, is a leading example (as is the G20 process since the fall).  No one can believe that this really achieved nothing because that would be, well, dumb.  And we know our rulers are not stupid.

But smart people frequently produce unfortunate or even idiotic outcomes – it all depends on the incentives and the process.  And, of course, of their ability to keep things covered up until they have moved on to another job.  Check with your local subprime mortgage lender for details.

As a leading example of what you can get away with in the international economic diplomacy space, I would emphasize how key European governments (France and Germany, also the UK to a large degree; the EU and others tag along) are currently viewing the issue of resources for the IMF – and I would link this to how they and the previous U.S. Administration treated the IMF’s staff and capability more generally.  From my op ed in The New Republic on-line this morning (I’ll post the link below when it goes live),

The only slight ray of hope [from the G20 process at present] is the American idea to increase funding dramatically for the International Monetary Fund. In addition to enabling the Fund to help emerging markets as they increasingly fall into the danger zone, it should provide a backstop for the eurozone–in case France and Germany fail to provide it themselves.

Yet even on this dimension, the news on Saturday was bad. Secretary Tim Geithner this week proposed an additional $500 billion for the IMF–this would constitute a bold and long overdue tripling of its loanable resources. But the West Europeans are, inexplicably, digging in around the idea that there should be only another $250 billion for the Fund (and they haven’t actually offered to pay anything themselves). Providing these resources has no budgetary implications and no other financial costs for the countries that choose to hold their reserves partly as a line of credit to the IMF. Without significant money for the IMF from European countries with deep pockets, though, there is no hope of attracting large-scale resources from emerging markets. And if the IMF is short of funds, it has no alternative but to negotiate tougher lending programs with countries that need external financial assistance. To you and me, the implications are simple and stark: a longer recession and a more difficult recovery. So why not do it?

It is, pure and simple, the kind of short-sighted and deluded European financial policy that prompted leading countries to demand that the IMF cut 20 percent of its most skilled and experienced personnel in early 2008–at the same time as Bear Stearns collapsed and major banks in almost all industrial countries started to unravel. It is hardly believable–but nevertheless true–that the G7 and now the G20 have refused to undo the IMF cuts and replace essential staff.

Yes, European leaders and the Bush Administration pushed hard for the IMF to cut back on skilled and experienced staff just as the global crisis broke – and as the IMF was emphasizing, politely in public and pointedly in private, that this was a major crisis likely affecting all countries.  In fact, given that this emphasis was not welcome by governments, this apparently hardened the resolve of key players to push through senseless, unnecessary, and irresponsible cuts.

Egregious stupidity and borderline malpractice goes unnoticed in the international economic diplomacy space, or at least not picked up on by leading news sources or in the general public discussion.  Why?  To some (the media), it doesn’t quite meet the threshold for newsworthy – it’s a little too far from the interests of readers and a bit too hard to explain in a news program; nobody cares as much about international issues as they do about domestic bailout scandals - for which there is a much higher tolerance for compelling details.  To others (much of the public), it seems too technical and surely something best left to experts.  And – remarkably and mistakenly – those who follow the IMF closely (e.g., in the development community) think that this downsizing somehow fits with what they have been trying to achieve; they were completely snowed.

European policy towards the IMF is a masterpiece of misdirection and disinformation.  The proportions and audacity should take your breath away.  And of course the same principle applies to government officials dealing with international economic policy as it does to CEOs of failing banks: never admit responsibility and definitely never suggest there was the slightest mistake in the past (because that might actually be newsworthy to the mainstream or, even more scary, draw Jon Stewart’s attention).

Rearranging the deck chairs on the Titanic looks productive by comparison.  The actions of the G7 with regard to the IMF in 2008 – and the attitudes of the Europeans still today – are more like burning lifeboats and throwing skilled pilots overboard.  In this context, what are the odds that the upcoming G20 heads of government summit on April 2nd will truly be productive?

I’m continually amazed by how easy it is for government officials to hoodwink most of the news media.  All it takes is for a couple of leading finance ministers to get on roughly the same page, and we’re reading/hearing about “substantial progress” or “major steps forward.”  If someone provides an articulate background briefing to a leading newspaper on the supposed debate within a group of countries, this becomes the dominant news story.

Saturday’s G20 meeting of finance ministers and central bank governors is a leading example.  It was a disaster - we face what officials readily concede is the biggest financial and economic crisis since the 1930s, yet this conclave agreed precisely nothing that will make any difference.  If the G20 heads of government summit on April 2nd is a similar failure, we will be staring at the real possibility of a global catastrophe.  Yet the spinning storytellers of the G7 have still managed to get much of the press peering in entirely the wrong direction.

For more on what would the right direction, take a look at my piece in Britain’s Sunday Telegraph.

The global crisis approaches another major twist in its downward spiral.  A key barometer of financial and fiscal pressure – the credit default swap (CDS) spread – has widened sharply for Irish government debt over the past few days; the markets think that the risk of a sovereign default is rising sharply.  Immediate action is needed to forestall a dramatic deterioration of growth prospects across Europe and around the world.

The G7 ministers of finance and central bank governors met today in Rome.  It was a great opportunity for this group of leading industrial countries to reassert its leadership in the global economy, taking strong preemptive action to prevent a recurrence of the calamitous days and near total financial collapse of September/October 2008.

Instead, all we received officially is a communique that blandly restates what these documents always say: we are opposed to instability and we are working on it, honestly.  When an official has nothing to say, he or she talks about “principles” – and this was a pure principles communique (e.g., see their 3rd and 6th paragraphs).  Nothing new or even vaguely reassuring.

Unofficially, it appears the situation is even worse.  The G7 is signalling a lack of support for various key countries that are in the line of financial market fire.  This is irresponsible, short-sighted, and bound to lead us all into great danger. 

G7 effectiveness is at a low point.  Why?  The Europeans are in denial, particularly regarding the way their banks and their broader economic and political elite contributed to the global financial fiasco.  The Americans are distracted, to put it mildly, while they search for a policies that make sense.  There is a great deal of unproductive finger pointing within the G7.

But the real issue is that no one is yet ready to take on the deeper underlying problem – the political power structure of modern finance.  While this structure is a particular problem – and particularly obvious right now – in the US, all industrialized countries today share some version of the same problem.  We supersized our banking systems, allowed them to load up on risk that could threaten the macroeconomy, and gave them a mindboggling put option – in other words, the taxpayer is on the hook for a vast amount of downside.  Across the industrialized (and coming soon to the industrializing world), the message from bankers is the same: give us the bailout money, or your economy will suffer.

Coming to terms with this reality and doing something about it will take leadership – the skills, popularity, and vision needed to really take on bankers (and preferably, win).  That leadership is unlikely to come from Europe, Japan, or Canada.  It’s also unlikely to come from the G20 (which is basically the G7 plus large emerging markets), whose next heads of government meeting is on April 2nd.

Everyone and everything, in some sense, waits for the US and for President Obama.  How long will it be before he is able to fully and personally take charge of sorting out banking at home – and help those trying to do the same abroad?

If you see any other – even slight – glimmer of hope in this situation, post it as a comment here.

The big annual economic meeting at Davos opens next week (Jan 28-Feb 1 are the official dates), and the discussion there – in both formal and informal interactions – is worth scouring for indications of the current situation around the world and where we all may be heading.

Given the likely composition of the main players this year – world corporate leaders and the non-US policy elite (with the new US policymakers stuck at home, doing real work; update: this is now confirmed by Bloomberg for Summers and Bair) – I would suggest viewers at home and on the ground keep watch for answers to the following.

1. Are we on the same planet? It is not unheard of for Davos participants to appear as if they are living in their own bubble.  Watch for opulent parties and excessive consumption, particularly if the people involved have nominated themselves for any kind of government handout.  If you meet someone from Merrill, ask if their attendance fees came out of 4th quarter earnings – or if there is still more bad news to come.
2. Who doesn’t have their hand out?  It would be nice to see a corporate leader or, ideally, more than one, stand up and make a categorical statement along the lines of, “we don’t need a bailout of any kind, nor will we seek any kind of additional government assistance however clandestine, and the idea of pseudo-protectionism to goose profits and jack up my bonus is quite repellent.”  Remember that the slippery slope to global trade wars is not the product of irresponsible politicians alone – they get a lot of assistance from business and lobbyists of many stripes.
3. Are they really in trouble or do they just want to fire us because it’s in fashion?  More than a sneaking suspicion is arising that many of the firings, layoffs, and pay reductions around the world are not actually necessary.  Somehow corporate leaders have formed the idea that this is what they must do, rather the investing more in their people, looking for ways to innovate our way out of the crisis, or generally doing things that are hard work for executives and pay off only over time.  No doubt someone will do very well by bucking this trend.  But who?
4. Who didn’t overspend in the good times?  Some self-appointed intellectual and financial leaders – including universities, venture capital, and private equity – previously prided themselves on having deep pockets, a long-time horizon, and recession-proof strategies.  Now we find that they overcommitted to things they couldn’t really afford, just as if they were No Income No Documentation borrowers.  And if you actually hear someone admit personal responsibility for anything at all – however small – in the boom or the crash, write me at once.
5. Is the G20 at all relevant?  The G20 grouping of leading industrialized and emerging market countries has a great opportunity to establish itself as the preeminent forum for addressing the world’s problems, pushing aside the G7, IMF, etc, and rising to the top of the global alphabet soup.  The current chair is Gordon Brown and he will be in full voice.  But what exactly is the agenda? Some of his re-regulation points make sense and will help preempt problems in the future, but we need more.  Where is the recovery strategy, how are really poor people going to be helped, and what – if anything – does global cooperation offer that you can’t do with a smart unilateral approach? 

You may have thought that denial, arrogance of power, and profound irresponsibility left the world stage around noon on Tuesday.  If so, Davos will likely prove you wrong.

Update: WSJ’s preview of Davos gives details of fee structure, attendees, and attitudes.  Only Valerie Jarrett will attend on behalf of the Obama Administration.

The US has the opportunity – and perhaps the responsibility – to immediately retake a leadership role in global economic policy thinking, with the pressing priority of preventing the world’s recession from becoming something more serious.  But what should be Mr Obama’s priorities in this regard, for example in the run-up to the G20 summit in early April – which, given the timetable for these things, will have an unofficial dry run of sorts at the Davos meetings next week?

The obvious message could be: a large US fiscal stimulus is coming, but the rest of the world needs to do more.  In this option, Mr Obama could devote considerable effort to encouraging others to expand their government spending and/or cut taxes.

While worldwide cooperation of this form may have been a constructive thought last year at Davos, when the idea was first broached publicly by the IMF, a joint global fiscal stimulus is a glorious idea whose time has for now passed.

Much of Europe is facing impending fiscal pressures that mount by the day.  The issue there is not fiscal stimulus but “fiscal capacity,” meaning the ability of governments to take banks’ (bad) assets onto the public balance sheet, and the danger is that not all European governments will feel able to even let their “automatic stabilizers” work fully (i.e., government spending goes up and tax revenue goes down in recession, without any discretionary change in fiscal policy.)  There is currently hot debate on and around this issue at the European Commission.

Most emerging markets are similarly facing the prospect of difficulties in rolling over their sovereign debt – at least that part which is not placed directly with the domestic banking system.  And the global social safety net that wants to give them some general reassurance and specific fiscal encouragement in this situation – the IMF – looks sorely frayed.  Governments in middle income countries sensibly feel it is wiser to keep their fiscal powder dry.  If you think they are overly worried, look at the latest data from Singapore today – 16.9% decline in GDP (a subscription link, but the summary data are in the free part) at an annualized rate in the 4th quarter of 2008 compared with the 3rd quarter; think of Singapore as a bellweather for international trade in goods and services at this time.

The exception of course is China, where there is long-standing scope for a stimulus. But the Chinese economy is only about 6% of world GDP and their effective additional stimulus per year is likely to be around 3% of GDP.  3% of 6% is essentially the rounding error in measuring the world’s economy, and you are unlikely to notice the effects of China’s stimulus globally – although it might just keep oil prices higher than they would be otherwise.

So what should Mr Obama emphasize?  Given the latest economic and financial developments, three potential priorities stand out:

First, a world system-wide plan for recapitalizing banks and removing any toxic assets.  This has to be implemented country-by-country and of course plans should vary according to circumstances, but the cross-border nature of banking calls out for a more coordinated approach.  The US has always been a taste-setter in terms of what constitutes responsible economic policy, and Mr Obama should help persuade other leaders to adopt plans that broadly mirror his.  And if they don’t follow suit, their domestic financial situations may well become more complicated.

Second, in the global bank clean up, some countries will find themselves short of cash, particularly foreign currency.  Rather than risking more Iceland-type situations, the US should help arrange financial assistance where appropriate. This could be through the IMF but if there are historical objections (e.g., from Asia), alternatives can be arranged.  The use of regional arrangements – including in Asia – should be encouraged, rather than discouraged; this would be a major departure for US policy.

Third, the world needs to avoid deflation.  Moving the US to an explicit inflation target would help, particularly if the announcement is strongly supported (and explained) by the White House at the same time as there is dramatic further monetary easing among leading central banks.  The point would be to demonstrate that the US can and will keep its inflation rate above zero without depreciating the dollar – and thus without exacerbating the difficulties of our trading partners.  Remember that if countries do not want to cooperate with this approach, they risk appreciation of their currencies – this fear should concentrate minds in the eurozone.

This constitutes a major agenda with many difficult tasks.  President Obama not only can do it, but he should.  The alternative is a much deeper global recession with greater risks of further sovereign collapse – and many more American job losses.