U.S. financial regulation demand a big hurdle to Trans-Pacific Partnership

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Many world leaders who gathered for this month's Asia-Pacific Economic Co-operation (APEC) meetings in Bali, Indonesia, had hoped to sign the Trans-Pacific Partnership (TPP) agreement. The pact would have brought together key Pacific Rim countries into a trading bloc that the United States hopes could counter China's growing influence in the region.

But the talks remain stalled. Among the sticking points is the U.S. insistence on TPP trading partners dismantling regulations for cross-border finance. Many TPP countries will have none of it, and for good reason.

Not only does the U.S. stand on the wrong side of experience and economic theory, it is also pursuing a policy that runs counter to International Monetary Fund guidelines. This is especially noteworthy, because the IMF was considered the handmaiden of the U.S. government in such matters until recent years. Unfortunately, the IMF's new-found independence and insight have not yet rubbed off on the U.S. government.

The U.S. could learn a few lessons from other TPP countries when it comes to overseeing cross-border finance. As shown in a new report that I co-authored with Katherine Soverel of Boston University, Chilean economist Ricardo French-Davis and Malaysian economist Mah-Hui Lim, TPP countries such as Chile and Malaysia regulated cross-border finance in the 1990s to prevent and mitigate severe financial crises.

Their experience proved critical after the 2008 global financial crisis, when a global rethink started to find the extent to which cross-border financial flows should be regulated. Many countries, including Brazil and South Korea, have built on the examples of Chile and Malaysia and re-regulated cross-border finance, through instruments such as a tax on short-term debts and foreign exchange derivative regulations.

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 given country. Foreign investors may well push a country into financial difficulties – even a crisis. Given that constant source of risk, regulating cross-border finance can correct this market failure and also make markets function more efficiently.

This is a key reason why the IMF changed its position on the crucial issue of capital flows; it now recognizes that they create risks – particularly waves of capital inflows followed by sudden stops – that can cause devastating financial instability. To avoid such instability, the IMF now recommends the use of cross-border financial regulations.

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 countries. Our main focus was on the extent to which the regulation of cross-border finance was compatible with many of the trade and investment treaties around the globe. The task force consisted of former and current central bank officials, IMF and World Trade Organization (WTO) functionaries, members of the Chinese Academy of Social Sciences, scholars, and representatives of civil society.

We found that U.S. trade and investment treaties were the ones least compatible with new thinking and policy on regulating global finance. The report was published earlier this year.

U.S. treaties still mandate that all forms of finance move across borders freely and without delay – even though that was a key component in triggering the global financial crisis. Deals such as the TPP would only make it worse, because they would allow private investors to directly file claims against governments that regulate them. This would be a significant departure from a WTO-like system where nation-states (that is, the regulators) decide whether claims can be filed.

Under the so-called investor-state dispute settlement procedure, a few financial companies would have the power to sue others for the cost of financial instability to the public that the companies themselves were instrumental in creating. Can there be a more pernicious way to deal with these issues?

Such provisions also fly in the face of recommendations on investment by a group of 250-odd U.S. and globally renowned economists in 2011. The IMF decided to embrace this new thinking in 2012, 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?

Until Washington sees more clearly the connection between the problems carelessly created by financial companies, which are often headquartered in the U.S., 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 economies should refrain from taking on new trade and investment commitments unless they have in place proper cross-border financial regulations.

Leaked text from a TPP document reveals that Chile and other countries have given suggestions that could provide such safeguards. If the U.S. really intends to establish a Trans-Pacific Partnership, it should work with Chile and Malaysia to devise an approach that gives all of the potential TPP countries the tools they need to prevent and mitigate financial crises.

Kevin Gallagher is an associate professor of international relations at Boston University, and is part of the Ford Foundation's project Reforming Global Financial Governance. A version of this article originally appeared on The Globalist (www.theglobalist.com). Copyright The Globalist.