Only a New Global System Can Handle a World of Explosive Risk

03/18/2010 05:12 am ET | Updated May 25, 2011

The recent financial crisis is the first systemic crisis of the 21st Century. By learning its lessons we cannot only avoid a destabilizing cycle of more acute future financial crises, but also equip the world to handle other looming catastrophes such as climate change, global pandemics and bio-terrorism.

One lesson in particular is inescapable -- that the world's governing bodies, from the UN to the World Bank, from the G20 to the IMF, can no longer cope with systemic risks of these kinds. A radical reform of the national and global system is required to ensure that the constantly evolving catastrophic 'weapons of mass destruction' are identified before they explode. Otherwise the next decade will see new problems thrown at old and outdated institutions.

These institutions have not kept pace with the complexity, innovation and interdependence of the globalized 21st Century world.

Unprecedented economic, political and technological changes have come together to create this tidal wave of globalization. Between 1980 and 2005, global foreign investment inflow increased 18 times, real world gross domestic product (GDP) has grown by over a third, and world trade increased sevenfold.

The seismic policy shifts of recent decades and pace of innovation has brought wide ranging benefits and is unlikely to be reversed. However, there is an underbelly to integration, which is interdependence and growing systemic risk. Global systemic shocks, such as the recent financial crisis, will become an endemic feature of the next decade.

In financial markets between 1998 and 2007, the 'Golden Decade', the combination of global integration and computing power saw an explosive growth of sophisticated financial instruments. In the course of a decade, the value of derivative trades grew from being marginal to over $600,000 billion in 2007, ten times global GDP. Integration and new networks greatly increased the robustness of the finance system, but interdependence, complexity and the growing gulf between oversight and market innovators simultaneously made global finance more brittle and fragile.

Integration and financial innovation in a deregulated environment created a financial network vulnerable to systemic risk. Governance gaps at all levels of the financial system allowed regulatory arbitrage, bonus gouging, and other corporate governance failures to spiral out of control. These failures are symptomatic of a deeper malaise, which is systemic instability resulting from increased integration and innovation.

As the global financial network grew in scale and reach, it also became more interconnected. These increases in connectivity contributed to robustness of the network by spreading risk through securitization, but also rendered the system fragile, raising the potential for risk amplification and contagion. A key feature of the financial crisis, which has lessons for other systemic risks, is that the underlying innovation, integration and interdependency of the network created new and unforeseen systemic vulnerabilities.

The failure of financial regulators to appreciate the systemic nature of the risks was exacerbated and informed by a complacent new economic orthodoxy, which saw the markets as rational. While macroeconomists rightly worried about the systemic implications of 'global imbalances', there was virtually no focus on the nature of banking or the risks born of economic deregulation.

Strict rules are required to reduce systemic risk since there is a 'tragedy of the commons' where traders lack the incentive or regulatory framework needed to limit their risk-taking. The national and global regulators had neither the incentive nor the technical capacity to understand the complex underlying systemic risks festering under the rapidly evolving financial instruments. The system was overwhelmed by innovation that sidestepped underwhelming regulation.

The double tragedy of the financial 'commons', is that over 20,000 global regulators are devoted to managing it. Employed by central banks and supervisory authorities, as well as by the IMF, they failed to see the looming disaster and subsequently could not agree how to avert the meltdown. It took the G20, which has no administrative or executive capacity, to agree a short-term remedy. Although appropriate, the coordinated fiscal stimulus and focus on corporate bonuses have failed to get to the roots of the crisis and distracted attention away from a deeper and more lasting resolution.

Fundamental reforms are nowhere in sight and no international supervisory body has made more than vague statements about the radical structural changes needed. The tightening of existing regulations is widely favored, but is unlikely to address the underlying problem.

The key questions are whether and how integration and innovation should be managed. Both provide short-term gains, but if the longer-term costs, in terms of systemic failures undermine these gains, and are particularly devastating for the poorer members of society, then there may well be reasons to limit the pace and form of integration and use of new financial instruments.

The failure of the best-equipped global governance system, finance, has highlighted the scale and urgency of the challenge of systemic risk. It may be that without the well-established institutional architecture of international economic regimes, other challenges are even more susceptible to systemic risks than that of global finance. This is because in comparison to global finance, global institutions understand much less about other complex, interdependent and emerging systemic risks facing the 21st Century.

Many of the greatest challenges of the 21st Century are not new. These include the elimination of poverty and disease, the avoidance of conflict and nuclear threats and bio-terrorism, and the loss of biodiversity and natural resources. What is new is the emergence of an interdependent but systemically fragile world. Harvesting the benefits of integration while minimizing the associated risks is likely to be the biggest challenge of the coming decade.

The arguments above draw on an article co-authored with Tiffany Vogel in the inaugural issue of the journal Global Policy, which is published on 10 January 2010.