Reform of the International Monetary and Financial System

Abstract

The financial crisis has imposed large costs on the global economy and revealed deficiencies in policy frameworks around the world. While the ongoing reforms to financial regulation aim to make the financial system more resilient, they cannot eliminate all the risks associated with large global capital flows. This paper argues that broader reforms to the International Monetary and Financial System (IMFS) are also required.

The paper sets out three objectives for a well-functioning IMFS: i) internal balance, ii) allocative efficiency and iii) financial stability. The IMFS has functioned under a number of different regimes over the past 150 years and each has placed different weights on these three objectives. Overall, the evidence is that today’s system has performed poorly against each of its three objectives, at least compared with the Bretton Woods System, with the key failure being the system’s inability to maintain financial stability and minimize the incidence of disruptive sudden changes in global capital flows.

There is little consensus in the academic literature, or among policymakers, on what are the underlying problems in the global economy which allow excessive imbalances to build in today’s IMFS and/or which impede the IMFS from adjusting smoothly to counteract these imbalances. This paper attempts to provide a framework for thinking about these underlying problems, and thus a means for discriminating among the reform solutions.

Finally, the paper proposes a number of reforms to today’s IMFS. Measures that countries could implement themselves to reduce the underlying frictions include greater flexibility in nominal exchange rates; reforms to make national balance sheets more resilient; and measures to improve financial market participants’ understanding of the risks on countries’ balance sheets. Policy initiatives that require some degree of international co-operation to be effective include improvements to global financial safety nets; international initiatives to close data gaps; co-ordination on financial regulatory reform; and possibly revisiting the application of WTO rules. But the paper also notes that it may be impossible to remove the frictions entirely, and so there may be a need for a more fundamental overhaul of the IMFS in which a rules-based system would prevail, to force countries to internalize the externalities that result from their policies.