Formal and Informal Institutions and the Regulation of Flows of Money
Summary and Keywords
When academics explore the politics of international monetary regulation, they tend to focus on three more specific policy challenges, each with attendant tradeoffs. Explaining how the global system has addressed these tradeoffs across time and space is at the core of the political science literature on the regulation of international monetary flows. Many political scientists are interested in the politics of macroeconomic imbalances. Some countries operate current account surpluses, while others operate deficits, placing downward pressure on their currency. One of the key questions examined by the political science literature on this subject is that of who adjusts. Moreover, some works discuss how domestic politics constrains and informs the positions of leaders. Other works discuss the role of international summits and organizations in facilitating cooperation. Others, in turn, explore how ideas shape our understanding of adverse events, and thus, which actors adjust to crises. Other political scientists are interested in regulatory matters. Some argue that in a world where capital mobility is high, the ability for states to regulate their financial systems may be constrained, fostering a race to the bottom. At the same time, much of the literature explores how issues of hegemonic interests, domestic politics, and ideational contestation enable the creation and implementation of some forms of global, though not others. Finally, many works explore how the system responds to currency crises.
Each year, vast amounts of money flow between states throughout the world. The maintenance of a global payments system is vital to facilitate the high levels of trade and investment that characterize the contemporary international monetary system. The purpose of this article is to review the literature on how international monetary institutions emerge and function. Political scientists have explored the difficulties in achieving the interstate cooperation necessary to establish a successful international monetary system. Different camps of scholars emphasize different potential obstacles and amplifiers of cooperation. These include the presence of a global hegemon, contending national interests, international institutions, and ideas and norms.
The structure of international monetary institutions, as well as the way those institutions react to external events, have varied considerably across time and space. When academics explore the politics of international monetary regulation, they tend to focus on three more specific policy challenges, each with attendant trade-offs. Explaining how the global system has addressed these trade-offs across time and space lies at the core of the political science research literature on the regulation of international monetary flows.
Many political scientists are interested in the politics of macroeconomic imbalances. Some countries operate current account surpluses, while others operate deficits, placing downward pressure on their currency. One of the key questions for political scientists is that of who adjusts. Do the costs of adjustment fall mainly on deficit countries, often with a high risk of disruption? Or do central banks and governments in surplus countries, assisted by organizations like the Bank for International Settlements (BIS) and the Group of Seven (G-7) coordinate to ease the pain of adjustment? Some studies discuss how domestic politics constrains and informs the positions of leaders. Others examine the role of international summits and organizations like the BIS in facilitating cooperation. Still others, in turn, explore how ideas shape our understanding of adverse events, and thus, which actors adjust to crises.
Other political scientists are interested in regulatory matters. Some argue that in a world where capital mobility is high, the ability for states to regulate their financial systems may be constrained, fostering a race to the bottom. Thus, although the free flow of capital across states may be beneficial for both host and source countries, it also may present risks. Global regulations represent an opportunity for states to impose standards collectively, overcoming race-to-the-bottom pressure. At the same time, much of the literature explores how issues of hegemonic interests, domestic politics, and ideational contestation enable the creation and implementation of some forms of global regulation (such as the Basel Capital Accord), but not others.
Finally, many works look at how the system responds to currency crises. In an interdependent global economy, there may be advantages to bailing out countries facing a crisis, so as to avoid crisis contagion. On the other hand, easy bailouts may generate moral hazard for recipients. Many works examine how lender-of-last-resort institutions, particularly the International Monetary Fund (IMF), balance these two trade-offs. Whereas some researchers say that the IMF is largely a technocratic institution, imposing conditions that reflect best practices and encourage catalytic investment booms, others argue that conditions flow from the interests of the IMF’s powerful principals, financial firms, or neoliberal ideas about economic governance.
In the next section of this review, I discuss some of the economic background needed to understand the research concerning the three questions explored in this paper. Next, I examine the foundational literature exploring variations in interstate cooperation in international monetary relations. Next, I summarize the theoretical works attempting to answer each of the more specific questions mentioned previously: Who adjusts to macroeconomic imbalances? What determines the regulation of capital flows? How do lenders of last resort balance liquidity and moral hazard? A final section suggests some directions for further research.
Considerable study has been made of three distinct challenges for global monetary governance. First, persistent macroeconomic imbalances are unsustainable in the long run for most countries. However, adjustments between countries are costly and difficult to negotiate. Second, while some stress that global capital flows can stimulate growth, others focus on the risk of speculation, capital flight, and contagion. Regulations may be able to inhibit some of these risks, but they also could impede growth. Finally, should imbalances persist and regulations prove unable to prevent a crisis, external actors may choose to bail out ailing economies, lest crises spread abroad. Rescue operations must often balance the benefits of providing liquidity to end a crisis with minimizing moral hazard.
For each state, it is possible to calculate a balance of payments, consisting of both a current account (exports minus imports) and a capital account (inflows of foreign direct investment, portfolio investment, and reserves minus outflows). Typically, current account deficits result in downward pressure on the value of a country’s exchange rate, while surpluses tend to drive currency appreciation. Large imbalances can be problematic in a few cases. If countries maintain fixed exchange rates, they have committed to keep their exchange rate at a certain level. Sustained downward pressure challenges that commitment, potentially forcing devaluation. In some cases, panicked investors may flee the currency in question, resulting in a currency crisis. Imbalances within a currency union make it hard for central banks to design a monetary policy that works for surplus countries and deficit countries (Mundell, 1961, 1962, 1963). Even when countries maintain floating exchange rates, however, imbalances can be problematic. Large imbalances provide cheap credit, which may encourage undue risk-taking and systemic financial crises (Obstfeld & Rogoff, 2009). Reinhart and Rogoff (2009), for instance, found that large current account deficits are a strong predictor of crises.
While there might be benefits to reducing imbalances, any such move raises the question of who adjusts. Deficit countries can adjust, adopting deflationary policies and limiting private and public spending or devaluing. And surplus countries can adjust as well, adopting inflationary policies, increasing government consumption and stimulating private consumption, or allowing their currency to appreciate. Often, states must choose between internal and external adjustments. As per the trilemma, states cannot simultaneously have free capital flows, fixed exchange rates, and the ability to use central bank policy to respond to recessions (Cohen, 1977). If central banks respond to a recession by cutting interest rates, this will place downward pressure on the currency, as portfolio investors seek higher safe returns elsewhere, threatening the fixed exchange rate. Sometimes it may be desirable to coordinate macroeconomic adjustment among a large number of states, reducing the adjustment costs for any one state. Many works suggest that political factors play a significant role in determining when adjustment is likely to fall on deficit countries, fall on surplus countries, or be coordinated among multiple actors.
Capital market regulation represents a second channel through which governments might reduce the risk of crises. States can generally regulate their own domestic financial systems without any coordination with other states. Here, they may be constricted by trade-offs between, for instance, the stability of their financial system and growth or innovation (Ramey & Ramey, 1995; Loayza & Ranciere, 2006). Alternatively, states might coordinate around particular regulatory standards, or even impose regulations at the global level. Even absent an enforcer, states might promote standards that, in turn, could reduce risk-taking behavior by financial institutions. The most significant of these in the contemporary system are Basel Capital Adequacy Ratios. These ratios stipulate that banks must hold a certain amount of capital relative to the risk-adjusted value of their assets. Thus, for instance, a bank whose assets consisted of a billion dollars in U.S. government bonds would need to hold less capital than one with a billion dollars in construction loans. The idea is that well-capitalized institutions should be less likely to experience the precipitous collapse we see during panics.
Whereas reducing macroeconomic imbalances and regulating global capital flows can reduce the risk of financial crises, lender-of-last-resort operations serve a different role. Bailouts for ailing states can give them the foreign exchange reserves necessary to stave off a currency crisis, while also preventing crises from spreading. The problem with such rescue operations is that if actors (including both countries running current account deficits and investors) know that they will be bailed out, they may be more likely to take risks that lead to crises.
Bagehot (1873) proposed the classic solution to the moral hazard problem: rescue bankrupt entities to diffuse the crisis, but apply penalty rates so that the rescued parties pay a price for their malfeasance. Nonetheless, overly strict penalty rates may undermine recovery. Thus, for lender-of-last-resort institutions like the IMF, the trade-off between providing liquidity and preventing moral hazard is significant. In practice, IMF conditionality may serve a penalty rate function for rescued parties, while the fund also may negotiate haircuts for lenders. Much of the political science work on global lender-of-last-resort operations focuses on the precise balance between providing liquidity and inhibiting moral hazard for countries and investors.
Origins of Monetary Cooperation
Before examining more specialized research on international monetary regulation, it is instructive to look at studies investigating which conditions are most conducive to monetary cooperation in general. Broadly following the international relations paradigms of realism, liberalism, and constructivism, these works highlight power, institutions, and ideas, respectively, as drivers of cooperation and conflict in monetary relations. That said, many works discuss cross-pollination between these factors, with Sterling-Folker (2002) even arguing that a realist-constructivist model can best explain monetary cooperation after Bretton-Woods. In addition, they present taxonomies of many of the key concepts addressed by midlevel theory.
One explanation for variation in global monetary cooperation is offered by hegemonic stability theory. Olson (1965) famously argued that the provision of public goods is difficult because many of the beneficiaries prefer to free-ride on the contributions of others. Cooperation is likely only when one has a privileged group that is likely to capture most of the benefits of the public good. Kindleberger (1973) sought to extend this argument to the international system writ large. He argued that hegemons are the ultimate privileged group—a single actor with such a large stake in the global economy that it might provide the functions necessary to ensure smooth operation, including macroeconomic coordination, a stable medium of exchange, and lender-of-last-resort operations. Gilpin (1987) assessed hegemonic stability from a historical perspective, arguing that the historical pattern fit this theory, with strong public goods provision during the Pax Brittanica and the height of American relative power (immediately after World War II), and weak public goods provision in the interwar period and the period of American decline beginning in the 1970s.
Others challenge hegemonic stability arguments. For instance, Snidal (1985) and Lake (1993) contended that public goods could be provided in adequate levels by multiple actors. Some subsequent works theorized on the nature of a system characterized by collective hegemony, with multiple states leading the global system (Volgy & Bailin, 2003, pp. 79–101).
Bargaining and National Interests
Although a consensus never emerged behind hegemonic stability theory, and the debate itself turned more toward whether hegemony promoted trade openness or engaged in strategic trade (McKeown, 1983; Coneybeare, 1984; Gowa & Mansfield, 1993; Lake, 1993), many researchers argue that considerations of state power influence international monetary relations absent public goods considerations. Cohen (1998, 2004), for instance, argued that holders of top currencies (e.g., the American dollar, euro, and yen) that are held by other countries as foreign exchange reserves are distinct because they have an incentive to maintain the use of their currency abroad. So long as others use their currency for foreign exchange reserves, reserve currency countries can run current account deficits without facing downward pressure on their currency. Because the interest rates on bonds of the reserve currency country are lower than the returns on long-term investment, reserve currency countries can borrow short and invest long, a benefit described as exorbitant privilege (Eichengreen, 2011). Some economists estimate that the United States earns an additional 3% return on investment as a result (Gourinchas & Rey, 2007).
Other works are less sanguine about the benefits of owning a reserve currency. Triffin (1960) viewed monetary leadership as more burden than boon because the reserve currency would have to run current account deficits to provide liquidity to the global economy. This responsibility might conflict with short-term domestic objectives.
Additional works attend to the task of defining what power means in international monetary relations. Strange (1971a, 1971b) investigated the question of why some currencies are used by other states. She contrasted between top currencies (employed by the leading economic powers), negotiated currencies (where states use carrots to encourage broader use of their currency), and master currencies (where states use coercion to promote use of its currency). Kirshner (1995) described various ways in which a country’s currency can be employed as a weapon. States can directly intervene in the exchange markets of others, create currency blocs and threaten members with expulsion from those blocs, or threaten to disrupt a monetary system.
Regimes and International Institutions
In contrast with perspectives emphasizing the role of power and national interests behind international monetary cooperation, other works stressed the power of international institutions and regimes to improve the scope for cooperation. Krasner (1983, p. 2) defined regimes as “institutions possessing norms, decision rules, and procedures which facilitate a convergence of expectations.” Drawing from game theory (Axelrod, 1984), neoliberal institutionalist theories agree with realists that cooperation is difficult in an international system characterized by anarchy (Keohane, 1984). Many interstate interactions resemble prisoner’s dilemma situations, where mutual defection is the rational choice for both actors. However, international institutions can encourage cooperation by providing information and facilitating ongoing communication, extend the shadow of the future, and alter the incentives and expectations for actors.
Ideas and Norms
Finally, another group of works emphasizes the role of ideas and norms in shaping monetary cooperation. Ideational approaches vary, however, in terms of the precise ways that ideas influence policy. Comparatively few works in monetary relations follow Wendt’s (1999) notion of a system comprised of “ideas all the way down.” Some stress that ideas are shaped by events like crises. Blyth (2002) argued that financial crises create Knightian uncertainty—a form of uncertainty wherein one cannot even gauge the probability of some outcome—about the state of the economy. Ideas not only reduce this uncertainty, but may also create a focal point around which coalition-building can form. At the same time, crises themselves may be constructed by actors (Widmaier, Blyth, & Seabrooke, 2007). Understandings of how a crisis was resolved can also be of lasting importance. McNamara (1997), for instance, argued that the apparent success of German monetary policy in the 1970s helped forge a monetarist policy consensus, aiding the operation of the European Monetary System even where its precursor, the so-called “snake in the tunnel” had failed.
Other ideational understandings of monetary cooperation view ideas as being intermediated by institutions. Hall (1989), for instance, looked at how the rise of Keynesian ideas in the 1930s was either aided or undermined by different civil service structures across countries. Other works examined how epistemic communities create and spread ideas (e.g., Adler & Haas, 1992).
Finally, some ideational accounts discussed how certain concepts can frame state goals or affect which actors are able to influence policy. Seabrooke (2007) examined the role of legitimacy as motivating the construction of finance in 19th-century Britain and the contemporary United States. Alternatively, Barnett and Finnemore (2004) emphasized the role of expertise in allowing some actors to influence others, garnering a larger role in policymaking.
Who Adjusts to Macroeconomic Imbalances?
Macroeconomic adjustments between states are not coordinated formally; rather, multiple institutions attempt to facilitate coordination to control imbalances. At present, the leaders of the world’s major economies meet regularly at summits (most notably the G-7 and G-20), where coordination is debated and agreed upon. In addition, the BIS acts both as a clearinghouse and a forum where central bankers can meet and coordinate policy.
The Domestic Politics of Adjustment
A number of studies have investigated the question of when states are likely to coordinate in the resolution of imbalances and when they are not, from a domestic political perspective. This literature includes many works examining the political economy of exchange rates. However, these perspectives are also useful for understanding the political trade-offs facing leaders as they consider the implications of macroeconomic adjustments. Scholars investigating these questions variously offer electoral, partisan, or sectoral explanations for why states might be more or less willing to adjust to imbalances, and whether they opt for internal or external adjustment. For exemplary reviews of this literature, consult Broz and Frieden (2001).
Some works in this vein argued that electoral motivations influence the tendency of leaders to adjust. Often, works draw from the economic voting model, which assumes that voters tend to vote for incumbents during good economic times and for challengers in bad economic times (Lewis-Beck, 1990). Gowa (1983), for instance, argued that domestic politics were an important factor behind U.S. president Richard Nixon’s 1971 decision to abandon the gold standard in the face of current account deficits. She contended that Nixon feared entering the 1972 election with high unemployment, whereas devaluation would free up the central bank to use monetary policy to secure his reelection. Other works, however, argued that in general, devaluation may be unpopular. For instance, Stein and Streb (2004) told a story about the timing of external adjustment. Governments seeking reelection do not want to reduce the purchasing power of their constituents in the run-up to an election. As a result, such governments tend to defend their currency aggressively before elections, devaluing significantly in the aftermath.
The literature on the domestic politics of macroeconomic adjustment also includes works stressing partisan explanations for adjustments. Many of these works draw from the analysis presented in Hibbs (1977), applying the Phillips curve to explain left-right political differences. Under the Phillips curve, there is a trade-off between inflation and unemployment. Because parties on the left draw more support from the working class (which he suggested is disproportionately harmed by unemployment), he argued that they are more likely to support policies that favor low unemployment. For parties on the right, which attract more support from upscale (and inflation-averse) voters, he argues that inflation is more likely to be of concern. Simmons (1994) made an argument with a similar emphasis in her investigation of how governments responded to imbalances during the interwar Gold Standard era. She stated that partisan distinctions were important—that is, conservatives were more willing to accept the internal adjustments and tariffs necessary to uphold the gold standard, while parties on the left preferred to devalue their currencies to the benefit of labor.
Other distinctions besides those between left and right have received attention in the literature. Henning (1994) for instance, argued that lobbying firms adversely affected by a strong dollar helped lead to global efforts to reduce imbalances in the 1980s. Frieden (1991, 2002, 2015) argued that preferences toward trade are important in determining both preferences for fixed versus floating exchange rates and preferences for a strong versus a weak exchange rate. He suggested that export-oriented sectors are likely to favor a weak, fixed exchange rate in order to keep their goods competitively priced and to reduce transaction costs and promote trade. In contrast, import-competing sectors might prefer a weak, floating exchange rate, both to protect against imported goods and because they are more likely to benefit from the freedom afforded to the central bank by a floating rate.
Other sectors may have more complex attitudes toward exchange rates. A nontradable sector that imports inputs from abroad, for instance, might prefer a strong, floating exchange rate. Alternatively, Walter (2013) examined the politics of adjustment from the vantage point of the individual voter rather than the firm. She argued that financial liberalization has altered the distributional effects of internal and external adjustment. Voters can be more vulnerable to either decision in different circumstances. She stressed, then, that for governments, choices of internal over external adjustment, or assumptions that voters will respond negatively to devaluation due to reductions in purchasing power, may not always be correct.
Some works have argued that the domestic politics of major economies within a monetary system can create either complementarities or obstacles to macroeconomic coordination. For instance, Broz (1997) argued that the relative stability of the 19th-century gold standard rested on the compatibility of sectoral interests in Britain, France, and Germany. Whereas the prominence of the investor class in British politics gave Britain strong credibility in its commitment to gold, domestic interests in France and Germany were seen as less credible. As a result, Britain could run small current account deficits without downward pressure on the pound, while France and Germany had to maintain extensive gold reserves. In times of British duress, the central banks of France and Germany would have plenty of reserves to lend to Britain. Schwartz (2009) also discussed domestic complementarity, suggesting conflict between American and Chinese interests in the early 2000s. While China’s development model hinges on low domestic consumption and large surpluses, U.S. consumers have a massive appetite for credit. He suggests that Chinese surpluses flooded the United States, fueling a bubble in the housing market.
In addition to works suggesting ways in which domestic politics might produce policies that that amplify current account imbalances, other works explored how national interests can prevent easy adjustments. Some historical accounts of Anglo-American interactions in the 1920s, for instance, emphasized strategic rivalry between London and New York as a motivating factor behind the British decision to return to the gold standard at its overvalued prewar parity (Costigliola, 1977). Some more recent research suggests a similar dynamic of competition between different reserve currencies taking place in the current global environment (Katada, 2008; McNamara, 2008; Chinn & Frankel, 2008). Other studies, however, suggest that currency competition is weaker than the conventional wisdom might presume, drawing on the historical experience of large monetary blocs during the interwar period for support (Eichengreen, 2005).
Other works argued that the nature of macroeconomic adjustment and coordination hinges on ideational factors. Widmaier (2003) challenged the idea that monetary crises are materially identifiable events. Rather, he argued that the very notion of a crisis can be socially constructed. He contrasted between two understandings of crises: “New Classical” constructs of crises view a crisis as stemming from state failure, limiting the need for cooperation, whereas “New Keynesian” constructs emphasize market failure, expanding the scope for cooperation. He argued that the understanding of the crises of the 1980s tended to undermine cooperation, while those of the 1990s strengthened it.
Institutions and Summit Diplomacy
Since the 19th century, states have held international conferences aimed at stabilizing the international monetary system. Many works have examined the features of these conferences and summits, with varying conclusions regarding their impact on the scope and nature of macroeconomic adjustment. Some economic historians argue that central bank cooperation is essential to global monetary stability. Eichengreen (1995), for instance, argued that cooperation among central banks was essential for resolving imbalances during the classical gold standard era. He argued that central bankers would pool reserves during hard times instead of competing for gold by altering interest rates. Other researchers are more skeptical, with Flandreau (1997) arguing that central banks rescued one another for largely selfish motives. Rather, he suggested that the smooth operation of the system hinged on the complementarity of interests among different actors. Gallarotti (1995) explored efforts at monetary cooperation during the classical gold standard era, with monetary conferences in 1867, 1873, 1881, and 1892. According to Gallarotti, although the conferences failed, the gold standard system was able to remain intact so long as states retained a strong ideological attachment to the gold standard.
Adherence was comparably better in core countries dominated by liberal groups, however, than in peripheral states dominated by agriculture. Gourevitch (1996), in a review of Simmons (1994) and Eichengreen (1995), similarly argued that while cooperation can hypothetically allow states to improve outcomes, domestic politics often underlies both the decision to cooperate and the decision not to.
States may not be the sole actors capable of coordinating to reduce current account imbalances. Central bankers are often granted considerable independence from governments, and some works have explored the role that international institutions like the BIS play in facilitating coordination. The history of the BIS (until 1973), as presented extensively in Toniolo (2005), is fairly eclectic in its offerings, but it does highlight the role of national and bureaucratic jealousies. He suggested that interwar efforts at coordination tended to fail because American involvement was undermined by rivalry between the national and New York branches of the Federal Reserve. After the war, however, the United States was able to use its hegemonic power to encourage cooperation among the European states engaged with the BIS.
Other works explored how specific rules of counting reserves can help foster cooperation. For instance, Oye (1986) examined the gold-exchange standard of the 1920s and 1930s, identifying a prisoner’s dilemma between holders of reserves and reserve currency countries. To uphold the system, reserve holders had to abstain from converting reserves to gold, despite doubts about the future value of the currency. Reserve currency countries, in turn, had a strong incentive to shut down gold convertibility or depreciate early. Oye contrasted the failure of the gold-exchange standard with the relative success of cooperation following the 1936 Tripartite Agreement among Britain, France, and the United States. By agreeing to settle balances in gold on a daily basis, potential gains from devaluation were limited, and the number of “plays” in the prisoner’s dilemma game increased. Despite being a weak agreement, cooperation prevailed.
Other works examined more recent efforts at obtaining cooperation. Funabashi (1989) interviewed policymakers between the 1985 Plaza and 1987 Louvre accords, finding divergence in the interests of central bankers, politicians, and bureaucrats across countries. He argued that it matters as to which actors are present, and what role they have within a summit. Similarly, Putnam and Bayne (1987), a study on the G-7, contrasted between a “library group” approach, favoring informal, direct meetings between heads of state, and a “trilateralist” approach with formalized meetings. They argue that the latter approach increased specialization, creating a role for “sherpas” (i.e., emissaries who lay the groundwork for summits themselves) to influence outcomes. Putnam (1988) argued further that summit agreements expand the scope for leaders to enact otherwise unpopular policies that ease imbalances for other states by giving leaders political cover.
Other accounts examine the G-7 as an institution upholding a particular vision of economic governance, rather than merely one that alters the scope for policy behavior. Gill (1995) portrayed the G-7 as part of a larger nexus of institutions promoting a vision of disciplinary neoliberalism. The goals of the G-7 are limited more by intragroup differences (Japan and Germany being less inclined toward markets). Other states and actors are castigated for violating the market norms of the system. Similarly, Baker (2000, 2006) argued, rather, that the G-7 acts as a caucus pressure group promoting open markets across states. In that way, it works as a global ginger group, spreading a set of ideas abroad.
In contrast, Bailin (2005) offered a materialist vision of the G-7. She contended that the G-7 represents a form of collective hegemony, aimed at allowing collaboration within the core, while excluding the periphery. Collectively wielding enormous power, she suggested that the G-7 can act as a powerful stabilizer. Moreover, the institutional design of the organization helps facilitate cooperation within the G-7 by creating a group identity (amplified by the small number of actors), the promotion of interaction, and documentation, as well as holding regular meetings that extend the shadow of the future.
Other analyses emphasized the inability of the G-7 to overcome differences in the interests of members. Henning and Bergsten (1996) argued that in the 1990s, the G-7 moved toward a consensus for inaction, even as trade imbalances mounted. They argued that European states became increasingly preoccupied with the creation of the euro, exacerbating existing differences over the proper balance between growth and price stability. In addition, they stressed that increases in the size of global capital flows make it more difficult for the G-7 to coordinate as it had in the Plaza and Louvre accords.
Some scholars also explore the implications of the G-20 for global economic governance, both as an alternative and a complement to the G-7. Beeson and Bell (2009) argued that the transition from G-7 to G-20 governance may involve two different forms of policy coordination. One reflects hegemonic incorporation—that is, the most powerful states may wish to develop a neoliberal consensus, which they might then impose on the rest of the world. In this world, the G-20 may simply be a place to legitimate G-7 policies.
On the other hand, the G-20 may reflect collectivist inclusion, wherein powerful states genuinely include others in decision-making so as to enhance the effectiveness of policy coordination. Beeson and Bell (2009) stressed that there are elements of both in the G-20: the policy prescriptions that the organization unites around tend to be broadly neoliberal, although not exactly the same as the “Washington Consensus.” At the same time, they agreed with Porter (2003) that informality, consensus decision-making, and the technical nature of the subjects under discussion may expand the influence of non-G-7 members.
What Determines the Regulation of Capital Markets?
Macroeconomic imbalances are not the only risk to the global monetary system. When financial actors make risky investments or overleverage themselves, this too can create difficulties. In a highly interconnected system, financial crises in one country can spread to others. The regulation of financial firms, then, represents another channel through which risks to the system can be reduced.
The Race to the Bottom
Individual states can regulate their financial systems unilaterally. However, some works suggest that in a world of highly mobile capital, stringent regulations place a state at a disadvantage. Many works in the 1990s, for instance, suggested the presence of a race to the bottom (Andrews, 1994; Cerny, 1995; Strange, 1998). Financial firms fit many of the criteria most conducive to a race to the bottom as well—they are highly sensitive to regulatory change and have low sunk costs. At the same time, others are skeptical about the presence of a race to the bottom, arguing that states retain considerable agency over policy decisions (Oatley, 1999; Mosley, 2000; Bearce, 2007).
International Institutions and the Basel Capital Accords
Some works have suggested that international institutions can expand the ability of states to regulate the global monetary system, even in the face of capital mobility and competitive pressures. Mosley (2010), however, argued that there are limits to this approach. Lacking enforcement power, international institutions tend to propose standards rather than laws. The Basel Capital Adequacy Ratios, monitored by the BIS, represent the most ambitious of these standards. The BIS measures the capital adequacy ratio for banks. Enforcement of the accord, however, falls to individual governments.
Many works seek to explain the adoption and implementation of the Basel Capital Accords. Kapstein (1989, 1992, 1994) described a confluence of factors as leading to global capital adequacy standards. Market forces, in the form of financial globalization, brought increased volatility in bank earnings, creating an impetus for rules that might reduce fluctuation in global markets. Ongoing studies of the causes of volatility beginning with the Cooke commission, a British-led global group formed to study ways to combat financial instability, produced consensual knowledge—a body of beliefs that are accepted as true by the relevant actors (in this case, regulators). The group ultimately converged on capital adequacy and a preference for international standards over competitive deregulation. While consensual knowledge brought regulators together, state power was necessary to foster cooperation. When agreement proved elusive initially, Britain and the United States proposed a bilateral accord, frightening other states into joining the accord.
Hegemony and National Interests
Simmons (2001) argued that hegemonic financial centers (like the United States in the current system) play an outsized role in regulation. Innovations by such actors can create incentives for harmonization, divergence, or no effect abroad. The reaction of other states to hegemonic regulatory change can either create negative externalities or insignificant ones. Simmons (2001) suggested that where the negative externalities of global response are high, the hegemon is likely to apply pressure through multilateral institutions. Where other states have strong incentives to emulate the hegemon, this pressure might involve information, technical assistance, or broad-based membership. Where states have divergent incentives, she suggested that pressure is likely to be more coercive, including both carrots and sticks.
In contrast, where negative externalities are low, the scope for multilateralism is limited, and coordination tends to emerge only where incentives to emulate the hegemon are high. Processes like focal points or market forces tend to play a stronger role in this case. In the case of global capital market regulations, which feature high negative externalities and strong incentives for states to emulate financial leaders, Britain and the United States were able to push for the Basel Capital Adequacy Standards. Many countries adopted the standards, while the BIS and IMF help facilitate and monitor their implementation. But Simmons (2001) argued that global securities regulation features lower incentives to emulate the United States and fewer negative externalities for the hegemon. Multilateralism and harmonization, accordingly, has been weaker.
Other works stress domestic considerations in driving the push for standards and the success of the Basel Capital Accords generally. Oatley and Nabors (1998) argued that regulators push for international agreements as a way to redistribute income from abroad, so as to accomplish domestic goals. They contended that Britain and the United States faced intense competitive pressure from a rising Japan in the 1980s. Using financial market power, however, British and American policymakers could effectively redistribute rents from Japan to their own economies. Because Japanese banks were less well capitalized, international standards would increase the competitive advantage of British and American financial institutions. In other words, regulations did not respond to market failure, but rather the interests of powerful states within the system. Singer (2004, 2007) offered a similar account, arguing that regulators only turn to international standards when it serves their domestic needs. He contrasted policy convergence on banking regulation with divergence over securities and insurance regulation.
Other works stressed the importance of domestic politics and lobbying in explaining adherence to the Basel standards. Quillin (2008) investigated the degree of adherence to capital adequacy rules, finding wide variance across countries. Walter (2008) examined the specific case of East Asian countries, arguing that compliance to global standards in East Asia hinged largely on the cost of implementation for private actors.
Signatories to the Basel Capital Accord may not be the only actors able to influence implementation. Ozgercin (2012) argued that the clublike institutional design of the BIS excludes many actors from infiltrating the organization, while its normative outlook inhibits its application of regulations. Moreover, he contended that rules are employed largely to benefit the largest banks in the system. Young (2012) offered a contrasting approach. While agreeing with the notion that financial firms extensively lobby the Basel Committee on Banking Supervision, he stressed that lobbying does not necessarily equate to influence. In some instances, he argued that lobbying increased regulatory stringency, in contrast with a regulatory capture depiction.
Liquidity Versus Moral Hazard for Lenders of Last Resort
Many works have defended the utility of a lender of last resort as a means to avert a severe crisis (Minsky, 1992). Countries with a balance of payments problem may not necessarily be insolvent. The IMF, designed to fulfill this role within the international system, remains controversial, however. Among many criticisms, some argue that IMF conditionality represents austerity amidst crises, worsening the problem (e.g., Stiglitz, 2002). Others have defended IMF conditions as reflecting sound economic management and the application of penalty rates to diffuse moral hazard problems (Rogoff, 2003). Empirical analyses of IMF effectiveness reach differing conclusions (Stone, 2002; Dreher & Walter, 2010), yielding fertile grounds for political scientists to attempt to explore what drives IMF policy.
Some works have argued that the IMF’s insistence on strict conditionality is rooted in good policy. Stone (2002) presented a sanguine view of IMF policy, arguing that conditionality assists recovery. An IMF loan may signal credibility on the part of the recipient, triggering a catalytic effect as investors and possibly other states jump on board. Morris and Shin (2006) similarly emphasize the power of catalytic effects, although they stress that strategic complementarities may amplify these effects. They suggest that where countries face problems that are serious, but fixable, catalytic effects are likely to be highest. Others are more skeptical that such an effect will hold in the current global environment. Copelovitch (2010a) argued that a shift in the pattern of debt-holding weakens catalytic investment in the contemporary economic environment. Whereas most sovereign borrowing was financed by commercial banks in the 1980s, borrowing today tends to be private-private and dominated by bondholders. He suggested that this increases the number of actors, creating collective action problems among bondholders and handicapping the ability of conditionality to affect the mostly private actors that drive current account deficits.
Other works have suggested that IMF policy may reflect hegemonic interests. This approach would suggest that rather than assisting economies in duress, IMF assistance is a Trojan horse that can be used to push policies on states that benefit the United States. Various commentators have termed the collection of policies promoted by the IMF as the Washington Consensus (Williamson, 1994; Stiglitz, 2002; Oatley & Yackee, 2004). As the world’s largest capital exporter, the United States would stand to gain the most from opening markets abroad. Similarly, Stone (2010) discussed how decision-making rules within the IMF favor the United States. Not only does the United States have the largest share of votes, it is the only state with more than 15% of the vote, allowing it to veto decisions requiring an 85% majority. As a result, he argued that the United States wields an inordinate amount of influence over IMF policy, despite having only 17% of the vote.
Copelovitch (2010b) agreed that IMF policy is driven by national interests, but he also believed that power may be shared more broadly among a “collective principal” (p. 3). He stressed, for instance, that while the United States can veto structural changes, it cannot unilaterally prevent countries from receiving loans. However, just five countries—the United States, Japan, Germany, France, and the United Kingdom—collectively wield nearly 40% of the votes, giving them an outsized role in IMF policy. Copelovitch argued that principals favor strict conditionality when a large proportion of a country’s debt is owed to a lender in G-5 countries.
Should G-5 countries possess heterogeneous preferences over a loan, their jockeying could produce either logrolling or distributional conflict (Copelovitch, 2010a, 2010b). At other times, however, G-5 interest may be limited. In this environment, Copelovitch suggested that IMF policies are likely to follow the bureaucratic interests of the IMF itself. He also stated that the IMF has an interest in large loans with strict conditionality, which can help the IMF expand its mission.
Barnett and Finnemore (2004) argued that IMF policy is rooted in bureaucratic interests. They suggested that the primary source of IMF power lies in expertise. Because IMF experts have the ability to frame policy decisions, the IMF gains slack vis-à-vis others, even its principals. However, the development of expertise alters the interests of the IMF. As the IMF obtain experts on a given topic, these experts seek to be relevant to IMF policymaking by insisting on conditions pertaining to their specialty. Expansions of expertise, then, drive burgeoning numbers of conditions. Thus, not only may the IMF insist on conditions not justified on policy grounds, but also the number of IMF conditions is likely to increase over time.
Some perspectives on the trade-off between liquidity and moral hazard stress the role of interest group politics. Oatley and Yackee (2004) and Copelovitch (2010a) suggested that the financial sector in the United States and the G-5, respectively, may play an outsized role in driving IMF policy. Financial actors should be highly interested in IMF decisions, and thus motivated to lobby their home governments to push for favorable policies (e.g., strict conditions to ensure repayment of debt or capital market liberalization to open up opportunities for profit). Gould (2006) argued even more purely for an interest group understanding, suggesting that the IMF directly crafts policy reflecting the preferences of private finance.
Other works have discussed the political role of the IMF from a partisan perspective. Vreeland (2003) argued that some governments borrow from the IMF without facing a balance of payments crisis, while others avoid IMF assistance despite facing a crisis. Right-leaning governments might seek IMF aid, because conditionality will impose policies upon them that they could not otherwise implement. Further, they can blame negative fallout on external actors. Conversely, left-leaning leaders may avoid seeking aid, in spite of a crisis, because they fear the imposition of policies that they abhor.
Chwieroth (2010) emphasized the role of neoliberal ideas as a driver of IMF policy. He was primarily interested in the puzzle of why the IMF often imposes capital account liberalization, while the economic evidence for such a policy is mixed. Examining the biographies of economic advisors across the developing world, he found evidence that greater numbers of neoliberal advisors yielded a greater probability of capital account liberalization. Nelson (2014) also painted a picture of the IMF as an organization with ideational leanings. He found that neoliberal leaders tend to receive weaker conditionality than left-leaning ones. Thus, the IMF also may take into account the ideational framework that guides recipients, fearing lesser compliance from Keynesian leaders.
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