Crises of uncertainty

PRINCETON — A relatively small-scale banking crisis has been sufficient to demonstrate the fragility of multilateralism today. Bank failures in the United States and Europe have upended expectations, because governments did not even pretend to be following any shared rulebook in handling the fallout. While the world’s banking system is in better shape than it was just before the 2008 financial crisis, the mechanisms established over the past 15 years to cope with financial strain have proved insufficient.

The latest crisis has broader implications for how the world can and should address collective problems. After all, multilateralism had already fallen on hard times. Though world leaders insisted repeatedly after the 2008 crisis that there must be no return to protectionism, the World Trade Organisation has been rendered powerless, incapable of concluding new agreements or even arbitrating conflicts on the basis of the existing ones. All the major economies, the US, China and the European Union, have adopted various forms of protectionism.

This trend can be understood as a combination of financial protectionism and arbitrary government action. A crucial lesson of the 2008 crisis was that fragmented regulatory systems are problematic, and that clear rules are needed in the event of a sudden shock or collapse. The failure of Silicon Valley Bank, however, was handled partly by the US Federal Reserve and partly by a California state regulator, which made the decision to close the bank in the middle of a trading day, precipitating a much wider run on smaller banks.

After a weekend of chaos, the US Department of the Treasury coordinated an announcement guaranteeing all deposits at SVB, not just the insured deposits up to $250,000. But this response immediately raised more questions. Were US financial authorities in fact guaranteeing all US bank deposits? The Treasury said no, but it needed depositors to interpret its response as meaning yes.

Another lesson from 2008 was that systemically important financial institutions should be subject to well-prepared resolution mechanisms. But endless rounds of regulatory discussions and negotiations proved completely irrelevant when the new regime was finally tested. The moment of truth arrived when Credit Suisse’s biggest investor, Saudi National Bank, declined to provide it with any more liquidity. Faced with the need to move fast, the Swiss regulator, the Swiss government, and the Swiss National Bank devised their own ad hoc response, organising a controversial buyout by UBS. All the internationally negotiated plans remained in the drawer.

While Credit Suisse shareholders were paid in UBS shares, holders of Additional Tier One bonds worth $17 billion were wiped out. To many observers, not to mention those holding the AT1 bonds, this felt like a shocking violation of the implicit understanding about the hierarchy of claims. And yet the decision was entirely defensible, given the fine print of the bond contracts, and given the need for Swiss regulators to be able to set the terms of a restructuring.

Wherever one looks in the current crisis, one finds governments insisting that there is no systemic threat, even as they redefine their own responses to what is clearly a systemic threat. This contradiction, together with the constantly changing response, has become a major source of uncertainty. Everything, the safety of bank deposits, the seniority of credit claims, and the likelihood of new runs, seems to be up in the air.

Now that “neoliberalism” has fallen out of favour, it is worth remembering the emphasis it once placed on economic governance according to clear, predictable, generally applicable rules, without which there will always be uncertainty and a potential for panic. Moreover, in a world without rules, the strong always win at the expense of the weak.

Recall the 2008 bailouts. Among other things, they showed that large countries like the US (or China, for that matter) could always step in to rescue their banking systems, whereas smaller countries had no such option. While Iceland and Ireland took this lesson to heart, Switzerland is not out of the woods yet. Having narrowly escaped a meltdown by creating a new superbank with assets twice as large as Swiss GDP, it is creating even more systemic risk.

The realisation that some countries play by different rules than others is a profound threat to multilateralism. Following a disastrous pandemic and Russia’s war on Ukraine, with all its adverse global effects, is there any alternative to cumbersome international negotiations in pursuit of common frameworks and rules?

One area where the standard multilateral approach might be improved is the response to climate change. For many years, economists and policymakers worked on mechanisms for carbon pricing or emissions trading, and the Europeans sought to lead the way by developing domestic carbon markets. But the US effectively abandoned this approach with the 2022 Inflation Reduction Act. Instead of negotiating with any other government, it simply enacted its own massive investment program to support domestic production and renewable energy.

Though the IRA has been decried as protectionist, it could radically reduce the production costs of non-carbon energy, both in the US and globally. However, one does it, non-carbon fuels need to be cheaper than carbon fuels if the price signal is going to drive the transition to a net-zero economy. If that outcome cannot be achieved by negotiating fees or taxes on emissions, progress can still be made by reducing the costs of rival fuels.

Still, it isn’t clear that a beneficial race to the top is better than traditional multilateralism. Uncertainty and unclear signals lead to destructive behaviour, because they orient everyone towards the short term and sow the seeds of disillusion. Effective longer-term strategies require predictability and transparency based on simple, clear rules. A rules-based system that needs continual reinvention ultimately is unsustainable. Can banking be made less complex, less vulnerable to runs, and less in need of constant regulatory readjustments? Answering that question will be a test for governance across many issues beyond banking.

Harold James, professor of History and International Affairs at Princeton University, is the author of “The War of Words: A Glossary of Globalisation” (Yale University Press, 2021). Copyright: Project Syndicate, 2023. 

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