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Money, politics and a future for the international financial system

  • Klein, Michael

In developing the architecture for a financial system, the challenge is to combine deregulation and safety nets against systemic failure with effective prudential regulation and oversight. The author analyzes three approaches to choosing an adequate regulatory framework for a financial system. a) Those most worried about panic and herd behavior tend to favor relatively extensive controls on financial institutions'activities, including controls on interest rates and on the volume and direction of lending. b) Those most concerned about moral hazard advocate abolishing controls and safety nets, seeing the solution is stronger market discipline and reduced powers and discretion for regulators. c) Mainstream opinion advocates a mix of measures, to both strengthen market discipline and improve regulatory oversight. The approach a county opts for depends on 1) which monetary and exchange rate regime it chooses, 2) whether it is more concerned about moral hazard or about panic and herd behavior, and 3) how the politics of reform shape its solutions. The author suggests a scenario for development of the global financial system over the next two or three decades that assumes that the final outcome will resemble the market solution - not because that is the optimal policy choice but because of how political weakness will interact with advances in settlement technology. In the author's scenario, the world moves toward a monetary system in which fixed exchange rate systems or de facto currency competition limit the power of central banks. This limits options for discretionary and open-ended liquidity support to help deal with systemic financial crises. The costs of inflexible exchange rates are moderated by new types of wage contracts, using units of account that are correlated with the shocks a particular industry or kind of contract faces -- thus maintaining the positive aspects of monetary systems with flexible nominal exchange rates. Mistrust in monetary authorities and the emergence of private settlements lead to a return of asset-backed money as the means of payment. The disciplines on financial systems come to resemble somewhat those of historical"free banking"systems, with financial institutions requiring high levels of equity and payments systems protected only by limited, fully funded safety nets.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2226.

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Date of creation: 30 Nov 1999
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Handle: RePEc:wbk:wbrwps:2226
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  1. Stanley Fischer, 1999. "On the Need for an International Lender of Last Resort," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 85-104, Fall.
  2. Ross Levine & Norman Loayza & Thorsten Beck, 2002. "Financial Intermediation and Growth: Causality and Causes," Central Banking, Analysis, and Economic Policies Book Series, in: Leonardo Hernández & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Banking, Financial Integration, and International Crises, edition 1, volume 3, chapter 2, pages 031-084 Central Bank of Chile.
  3. Montiel, Peter J., 1993. "Capital mobility in developing countries : some measurement issues and empirical estimates," Policy Research Working Paper Series 1103, The World Bank.
  4. White, Eugene, 1995. "Deposit insurance," Policy Research Working Paper Series 1541, The World Bank.
  5. Paul R. Milgrom & Douglass C. North & Barry R. Weingast, 1990. "The Role Of Institutions In The Revival Of Trade: The Law Merchant, Private Judges, And The Champagne Fairs," Economics and Politics, Wiley Blackwell, vol. 2(1), pages 1-23, 03.
  6. anonymous, 1998. "Financial intermediation and growth," Economics Update, Federal Reserve Bank of Atlanta, issue Jan, pages 4.
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