How Will World Leaders Fix the Financial Mess?

Editors' Note: This piece has been corrected.

This week, the leaders of the world's 20 largest economies will gather in Pittsburgh with an ambitious agenda: strengthening international financial regulation, coordinating economic recovery, and financing the most vulnerable developing countries. Given the history of ineffective economic coordination among world leaders, from the Basel II Accord in 2004 to the current trade negotiations of the Doha Development Round, it's no wonder that expectations for this summit are low. The G-20, however, has already brought about unprecedented levels of cooperation among its members to fight the global recession through large-scale fiscal expansion and resources committed to the International Monetary Fund. The group is now poised to take center stage for guiding global financial reform.

Harvard professor Ken Rogoff, former chief economist of the IMF, talked to the Prospect about the underlying issues dividing the leading economies of the world. An edited transcript follows.

Economists and pundits alike seem very skeptical of the G-20 Summit. Will the world leaders be able to coordinate the international standards and regulations they aspire to?

Ken Rogoff: The short answer is no. It is hopelessly complicated and difficult, but perhaps over five to 10 years they will be able to figure something out. The trouble is that U.S. and European banks live in totally different accounting and regulatory worlds where "capital" has a different meaning. The United States has a very expansive interpretation of what a bank's capital is, while in Europe, it's just much stricter.

Also, the undercurrent is the United States makes a lot of money off of international finance. It's a big profit center -- we are the winners, and we want to keep the system. The rest of the world says, "But you're generating risk." We have a very different agenda from, say, Germany or France. They will have much less to lose by strengthening regulation because they have much stronger regulation to start with.

Despite the U.S. being a winner in the current system, stricter regulations are in our interest in the long term, right?

Yes, we should have stricter regulations. We should turn our financial-regulation system upside down. I'm very worried that we're just going to see minor fixes and not serious reform. The fundamental issue is to force financial institutions, especially big banks, to hold much more capital against the debts that they're taking, and especially when they're borrowing short term. Financial innovation is very important to growth, but not at the scale that we've seen. [Treasury] Secretary [Timothy] Geithner's proposal is to bring banks' leveraging down to 15 to 20 times their net worth, down from 30 times. That's not enough. We don't need them to be rolling over five to 10 times their net worth every month.

One result of April's G-20 meeting in London was an agreement to ensure that emerging market countries receive adequate support from developed nations to sustain their economies. What can we expect to see on this front after this week's summit?

Casting this huge safety net over emerging markets was in many ways the biggest move they made in April. But we're not going to see much change because they set out a very long-term timetable for awarding that support -- as long as five years. This creates a real problem because the economies of Ukraine, Latvia, and other Eastern European countries will just fall off. Consequently, the IMF will be holding a lot of the debt, and it will just be a mess. But they prefer to have a bigger mess in emerging markets later than to have to deal with it while the rich countries are in crisis.

The main focus of this meeting regarding emerging markets is pressing Asia to expand its consumer demand. For the last 25 years, the U.S. consumer was the engine of the bubble, but nobody thinks the U.S. consumer is coming back the same way, even after the recovery. Somebody's got to step in. The Chinese consumer has to be a piece of it.

How will the world leaders press Asia to increase consumer demand, and how quickly can it happen?

At this juncture, the Chinese authorities really have the same goals as us because they are not keen on doubling their U.S. dollars from $2 trillion to $4 trillion. The core problem is not easily solved overnight because most Chinese have to pay for their own education, retirement, and medical care; there's very little social safety net. So they save. Meanwhile, they get very low interest rates on their savings because of the recession, and so they have to save even more. It won't change overnight, but I think they are definitely going to press China to do it fast. And if China can solve the problem over five to 10 years, that would be enough.

Brazil, Russia, India and China [the BRIC countries], as well as South Africa, are expected to demand a rebalancing of distribution quotas and more voting power in the IMF. What will the response be from Western countries?

My sense is that they've cut a deal. I think Europe's going to give as much as 5 percent to the BRIC countries. Europe is absurdly overrepresented at the IMF and is standing in the way of reform.

In truth, the BRIC countries should get a lot more than 5 percent, but this is a start. It's not in anybody's interest to have China, Brazil, India, and Russia so underrepresented at the IMF because the IMF is supposed to help deal with issues like global trade imbalances, and you can't work with just half the equation. The current distribution of balance is absurd.

The EU will be coming to the G-20 Summit hoping to limit executive pay, an issue that's expected to be contentious in Pittsburgh -- will there be agreement?

Something will come out of it, but there's no one-size-fits-all solution. It's hard not to be sympathetic to that, and clearly we've shown that a lot of the financial firms are effectively public entities with trillions of dollars of cash at their disposal. On the other hand, it's sobering to note that the European banks, by and large, did not have these huge, American-size payouts. Yet they managed to get themselves into just as much trouble. The short-term borrowing is the real problem.

Correction: The following line was missing "don't" in the original version: "We don't need them to be rolling over five to 10 times their net worth every month."