Trade Deals Must Allow for Regulating Finance

World leaders who are gathering for the APEC summit in Indonesia next week had hoped to be signing the Trans-Pacific Partnership Agreement (TPP). The pact would bring together key Pacific Rim countries into a trading bloc that the United States hopes could counter China’s growing influence in the region.

But talks remain stalled. Among other sticking points, the United States is insisting that its TPP trading partners dismantle regulations for cross-border finance. Many TPP nations will have none of it — and for good reason.

Not only does the United States stand on the wrong side of experience and economic theory. It is also is pursuing a policy that runs counter to the guidelines issued by the International Monetary Fund.

That is especially noteworthy, as the IMF used to be considered the handmaiden of the U.S. government in such matters for quite a few decades. Unfortunately, its newfound independence and insight has not yet rubbed off on the U.S. government.

That surprising development aside, the U.S. government could learn a few lessons from the TPP countries when it comes to overseeing cross-border finance.

Proven need for regulation

As shown in a new report that I co-authored with Katherine Soverel, Ricardo French-Davis and Mah-Hui Lim, TPP nations such as Chile and Malaysia — one in the Americas, one in Asia — successfully regulated cross-border finance in the 1990s to prevent and mitigate severe financial crises.

Their experience proved critical in the wake of the 2008 financial crisis, when a global rethink got underway urgently regarding the extent to which cross-border financial flows should be regulated. Many nations, including Brazil and South Korea, have built on the example of Chile and Malaysia and have re-regulated cross-border finance through instruments such as taxes on short-term debt and foreign exchange derivative regulations.

It is only prudent that, after the global financial disaster of 2008, emerging market nations now want to avail themselves of as many tools as possible to protect themselves from future crises.

New research in economic theory justifies this. Economists at the Peterson Institute for International Economics and Johns Hopkins University have demonstrated how cross-border financial flows generate problems because investors and borrowers do not know (or ignore) the effects their financial decisions have on the financial stability of a particular nation.

In particular, foreign investors may well tip a nation into financial difficulties — and even a crisis. Given that constant source of risk, regulating cross-border finance can correct for this market failure and also make markets work more efficiently.

This is a key reason why the IMF completely rethought its earlier position on the crucial issue of capital flows. The IMF now recognizes that capital flows bring risk — particularly in the form of capital inflow surges and sudden stops — that can cause a great deal of financial instability. Under such conditions, the IMF will now recommend the use of cross-border financial regulations to avoid such instability.

United States is the odd one out

I observed this entire process up close when I led a Boston University task force that examined the risks of capital flows between developed and developing nations. Our main focus was on examining the extent to which the regulation of cross-border finance was compatible with many of the trade and investment treaties across the globe.

Our task force consisted of former and current central bank officials, IMF and WTO staff, members of the Chinese Academy of Social Sciences, scholars and other members of civil society. In a report published this year, we found that U.S. trade and investment treaties were the ones least compatible with new thinking and policy on regulating global finance.

U.S. treaties, however, still mandate that all forms of finance move across borders freely and without delay, even though that was a key component in triggering the last big crisis.

And it gets worse. Deals such as the TPP also would allow private investors to directly file claims against governments that regulate them. This is a significant departure from a WTO-like system where nation-states (i.e., the regulators) decide whether claims are brought.

Therefore, under the so-called investor-state dispute settlement procedure, a few financial firms would have the power to sue others for the costs of financial instability to the broader public which these firms were instrumental in creating in the first place.

Can there be a more pernicious way to deal with these issues? It seems like a repeat of the classic mantra “Heads, I win; tails, you lose.”

U.S. proposals heading in wrong direction

Such provisions also fly in the face of recommendations on investment from a group of more than 250 U.S. and globally renowned economists in 2011. In 2012, the IMF decided to embrace this new thinking, saying, “These agreements in many cases do not provide appropriate safeguards or proper sequencing of liberalization, and could thus benefit from reform to include these protections.”

If even a traditionally conservative institution like the IMF can get its head around these new realities, why can’t the U.S. government do the same?

Until Washington sees more clearly the connection between the problems carelessly created by financial firms that are often headquartered in the United States and what their actions mean for the economic and social fate of hundreds of millions of people, there can be only one logical consequence. Emerging market countries should refrain from taking on new trade and investment commitments unless they properly safeguard the use of cross-border financial regulations.

Leaked text of the TPP (from the highly secretive negotiations) reveals that Chile and other nations have proposed language that could provide such safeguards.

If U.S. government really intends to establish a trans-Pacific partnership (sic!), then it should work with those two nations to devise an approach that gives all of the potential TPP member nations the tools they need to prevent and mitigate financial crises.

The author is a grantee of the Ford Foundation’s Reforming Global Financial Governance project.