If an ounce of optimism exists in the market meltdown, it is this: Europe and the US have agreed to make the world safe again for capitalism by rethinking global rules for the financial system. One thing is for sure: The old rules, largely set in 1944, are as good as a rusted-out speed-limit sign.
Too much of the new world of international finance, such as hedge funds, derivatives, and mortgage securities, now operates in the shadows. US credit-rating agencies badly underestimated the real risks of subprime mortgages. Big banks have become too big to fail. And most of all, when Wall Street crumbles, the rocks ricochet from Shanghai to Stockholm.
Reining in the excesses of this complex, 24/7 business won't be easy – even within each country. But hope for reform is strong after recent joint action by Europe and the US to prop up banks and grease money flows.
Round 1 in designing a new "architecture" for global finance starts Saturday when the current head of the European Union, French President Nicolas Sarkozy, meets with President Bush in Washington. He will bring with him a raft of reform ideas from the EU. "We need to found a new capitalism based on values that put finance at the service of companies and citizens and not the reverse," says Mr. Sarkozy.
Europe's finger, as might be expected, is already pointed at the US for this crisis, with the same finger wagging for more "discipline" in Wall Street. The EU's initial proposal is to set up a supervisor for the world's 30 largest financial institutions. Most of those, of course, are American.
Despite that one-sidedness, the lead thinker for reform, British Prime Minister Gordon Brown, offers a few better ideas. He would revamp the governing bodies and the voluntary rules set up near the end of World War II in an agreement known as Bretton Woods (named for a New Hampshire resort). The International Monetary Fund, for instance, would be allowed to act as an early warning system for excessive risks in the world economy.
Mr. Brown wants more transparency in accounting and more rewards for long-term investing. Banks must keep more capital to back up loans. And, says Brown, "We must ensure that all board members have the competence and expertise to manage the risks and so effectively supervise their institutions."
A summit to design a "Bretton Woods II" may take place in November. Plenty of differences need to be resolved for it to succeed. The US, for instance, is more historically inclined than Europe to let financial institutions fail, with the view that capitalism improves through the learning curve of mistakes. Britain disagrees with France about the dangers of hedge funds and offshore financial centers. And bringing India and China into a new global governance might mean more pressure to reduce US dominance.
In any agreement, the US needs to be careful not to diminish the role of the dollar, which is used for 60 percent of global currency transactions. But it may be time for the Federal Reserve, with its immense power to flood markets with credit, to act in tighter coordination with other central banks.
America remains the anchor country for trade and finance. But as in 1944, it needs again to bend its ways in order to create a global system that other nations will join. Therein lies mutual prosperity.