Ian Goldin is Director, 21st Century School, University of Oxford. Any views expressed are his own.

As the global economy staggers from one crisis to another, states are desperately pouring more funds into their economies to keep them from collapsing. However, the weakness of the global policy response is even more alarming than the shortage of credit. There is widespread agreement on the need for reform in financial management, but the ideas currently being mooted are too modest to halt a continuing spiral of crises. Four global policy issues need to be addressed if we are to escape the current crisis and guard against future systemic shocks to the financial system.

First, G7 countries must make credible commitments to reducing global financial imbalances in the medium term. The USA, UK and parts of Europe are living beyond their means, funded by savings accumulated in emerging economies, especially in Asia and the Gulf region. In response to their stalling economies, G7 leaders have driven up fiscal deficits.  These will lead to further deteriorations in European and US indebtedness – the very sources of global instability that has produced the current crisis. Not allowing government dissaving in the short term to mitigate the massive swing in the private sector financial balance would dramatically deepen output losses. In the medium term, however, these spending strategies will dangerously exacerbate global financial imbalances.

Second, global institutions need fundamental reform to become legitimate and effective, which includes greater representation of the interests of emerging markets. The G7 has called for ‘international cooperation’ to compel emerging markets to appreciate their currencies and increase their demand for US and European goods and services. This proposal has little chance of success until systems of global cooperation are radically reformed to give emerging markets more power in decision making.

Emerging markets see the demand for ‘international cooperation’ as a poorly disguised attempt by G7 countries to export the burden of their policy mistakes. Given the history of the G7’s past insistence – through the World Bank and IMF – on the need for prudence to overcome the crises of the past, the current reversal of formulas is regarded as particularly ironic and illegitimate. While emerging markets benefited from the growth of consumption demand – and they will increasingly suffer from a collapse in the West – they have been largely excluded from the G7 discussions on what should be done. Including key emerging markets in genuine dialogue is vital if future agreements are to restore stability by drawing on the potential strength of interdependency in global markets.

Third, we need to design effective controls that mitigate systemic risk without destroying the potential value released by the global distribution of capital and risk.

Financial innovation has made many rules and regulations irrelevant to the management of a growing share of global capital flows. The banking regulations of the 1988 Basel Accord failed to capture the wave of derivatives which these regulations spawned, and successive agreements have not caught up with the constant financial innovation. New instruments slice and dice credit and risk for global distribution using algorithms devised by maths graduates, whose bonuses multiply when they find new channels around arcane rules.

Given that a key driver of financial innovation is regulatory arbitrage, one may expect that the creation of another set of rules will give rise to ever more complex instruments. It hardly surprising that even the credit and risk committees of the banks cannot understand the  financial products cooked in their kitchens. It is even more unrealistic to expect civil servants, politicians, or economists in international financial institutions to keep pace with the inventiveness of the financial frontier. National regulators and global financial institutions require modernisation, with competencies and tools that keep pace with financial innovation and enable them to match the ingenuity and global spread of financial markets.

Fourth, accelerated globalisation has brought greater interdependence and complexity that requires new forms of global governance in the areas of regulation and risk management. To capture new opportunities released by globalization, the USA and UK have competed in opening their capital markets and reducing regulatory burdens to enhance competitiveness. They have been joined by the international financial institutions in calling for light touch regulation and accelerated capital movements, even though their core mission is to save the world from systemic financial crises. These institutions – such as the IMF, the Bank for International Settlements and the Financial Stability Forum – did not signal that a crisis was coming, were unable to contain it when it erupted, and are now marginal to the resolution of the current crisis.

While the development of global markets offers enormous benefits, it also implies growing interdependence, complexity, and fragility. Capital and banking systems have become truly global and evolving financial instruments transcend borders. While markets have become global, regulatory structures remain primarily national. The national and international institutions tasked with financial management do not have the skills, tools or mandates to keep up with rapidly evolving trans-national financial flows. Greater attention to the fragility of increasingly complex systems is required. The nature of globalisation and interdependence means that systemic shocks will necessarily become more frequent, even as their origin becomes more diverse – both in terms of geography and source.

The existing set of national regulations and global institutions are no longer adequate to formulate a coherent global policy response to current or future financial crises. A 21st Century response is required for the first 21st Century systemic crisis.