Outside Shot September 17, 2009, 5:00PM EST

The Case for a Global Central Bank

With world finance increasingly intertwined, we'll need one sooner or later

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When the finance ministers and central bankers of the world's 20 largest economies gather in Pittsburgh on Sept. 24, they can congratulate themselves for averting a 1930s-type meltdown. But nothing the G-20 has done, or is likely to do, will prevent or substantially moderate the next global crisis. That will require deep-seated, global financial reforms. And for such change to take root, something else will be needed: the establishment of a global central bank.

I can hear the howls of critics. World Government! A Conspiracy of Bankers! In the U.S. Congress the aversion to such an institution would make the dogfight over health care look like a genteel dinner party. So right now there is zero chance that the U.S.—and other countries, such as China, that zealously guard their sovereignty—would support the idea. But if critics could suspend the hyperventilating for a few minutes, they'd realize a global central bank is becoming a necessity in today's complex, interconnected world economy.

Why? Think about the responses to previous financial meltdowns—the Latin American debt crisis of the 1980s, the Asian financial crisis and the collapse of Long-Term Capital Management in the 1990s, the Internet stock implosion early in this decade. Following each crisis, governments promised to create new rules and institutions—a fresh "financial architecture," in the parlance of pundits. But little was done. As a result, each successive crisis has been worse than the last. Each has involved more countries and asset classes. Each has been more globally synchronized. Each has more clearly shown that private financial institutions compete too fiercely for markets and profits to regulate themselves. Bottom line: The cost of failing to implement a global structural response—the lost economic growth, the lives destroyed—has escalated dramatically.

At the heart of this reality is a simple fact: Governmental oversight remains national, while financial institutions are more globally intertwined. No top official denies this dichotomy. Jean Claude Trichet, president of the European Central Bank, recently bemoaned the lack of international coordination needed to manage the "deeply integrated global economy." U.S. Treasury Secretary Timothy Geithner warned that "we need a common global solution to these markets, not separate regional solutions."

As the current credit crisis has shown, the degree of global interconnectedness in finance is astounding. According to McKinsey, annual cross-border capital flows increased to $11.2 trillion in 2007, more than 20% of global gross domestic product. That's up from $1.1 trillion, or 5.2% of global GDP, in 1990. Far-flung investors own one in three of the world's government bonds, one in four stocks, one in five corporate bonds. And some $450 trillion worth of impossible-to-value derivatives is sloshing around the globe.

The G-20's agenda correctly identifies many of the problems. But executing and sustaining oversight, especially as the recovery reduces the pressure to take painful steps, is what counts. And the record shows that the reaction of governments working together, even in good faith, is too slow, diffuse, and compromised by national political pressures to result in anything but actions that are too little, too late.

How would a global central bank do better? Here are some of the ways:

First, the bank would be the focal point for bringing together the different regulatory approaches of the U.S., the EU, and China in such areas as the oversight of banks and hedge funds, the quantity and quality of reserves, and the relationship of risk management to executive pay. We're a long way from resolution on these issues.

A global central bank would also oversee any major financial institution—a bank, securities firm, insurer, hedge fund, private equity firm, or sovereign or commodity fund—whose failure could bring down the system. (About two dozen of these exist today.) It would be responsible for restructuring these institutions, if necessary, or safely winding them down.