How will the world look when the dust settles?

A couple of decades ago, there were serious banking difficulties, but the US was benefiting from increased price stability and strong growth. China was still in the ranks of emerging countries, not yet considered a major economic force. Our perspective today is quite different.

Powerful compensation practices and complex financial engineering have been introduced into our markets and institutions. Now it is evident that those changes have not protected us from a succession of bubbles and busts; rather, they appear to have contributed to them. Years of growing economic imbalances within and between nations have given way to the worst recession in living memory. Once-proud banks and investment banks have disappeared or found themselves reliant on government support. We look hopefully to the 'new' China, now economically powerful, as one of the few countries of growth in 2009.

So the questions multiply. What about the outlook for the US and the world economy? Are there not implications for the management of both the domestic and international systems? Can there be any question that the broken financial system needs extensive repair?

A healing process in financial markets seems to be under way, an expectation of some growth late this year and next year in the US seems reasonable. Prospects for a really strong recovery, typical of most recessions, seem unlikely; instead a long slog can be expected. Continuing high levels of unemployment seem to be in store. For most of the developed world, sources of strong spontaneous growth are hard to envisage. In the US, as elsewhere, even modest growth remains dependent on strong fiscal and monetary stimulus. The financial system, even if out of the emergency room, remains in intensive care.

Destabilising bubbles

There is an active and useful debate in the US and elsewhere about how and when the monetary authorities should respond to potentially destabilising 'bubbles' in financial or commercial markets. The challenge of restoring fiscal and monetary restraint will need to be front and centre as the economy recovers. There is also growing discomfort about whether the financial crisis and the spreading sense of 'too big to fail' may be leading to a degree of government intervention inconsistent with effective, competitive private markets. Put simply, the old concern about moral hazard looms even larger.

To me, the ultimate logic of a globalised financial system is a world currency. This is far from a reality in any formal sense. In its absence, the US dollar has provided a workable, pragmatic approach. Its widespread acceptability, the fluidity and breadth of its markets, and its relative stability in its massive domestic markets, has made it a common means of payment, an agreed unit of account for much of world trade and a widely used store of value.

At the same time, deep and ultimately destabilising imbalances have been prolonged, specifically the growing and seemingly irresistible current account imbalances between China (and much of the rest of Asia) and the US. All of that points to the need to deal effectively with the imbalances that underlie excessive growth of dollar balances.

The fact is that there are no practical alternatives today, or for many tomorrows, to the US dollar as an international currency. I think it should be clearly understood that the central responsibility of the US - in its own interest, in China's interest, and in the world's interest - is to maintain both the purchasing power of the dollar at home and in international markets, and a strong and open financial system.

Of more immediate concern is reform of the financial system. Key elements of the reformed system must be internally and internationally consistent - for example, capital and leverage requirements, accounting standards, clearance and settlement arrangements for over-the-counter derivatives, and practices with respect to disclosure and the sharing of information. Converting the substantial agreement in principle into the specifics of national legislation and administrative arrangements will be a big challenge.

In approaching reform more generally, there are potential risks extending beyond individual institutions. Some authority should be alert to identifying systemic excesses or weaknesses that might impair market performance and institutional stability. Also, there is a strong case for reviewing the application of so-called 'fair value' accounting standards to commercial banks, insurance companies and perhaps certain other regulated financial institutions.

The problem is not only the difficulty of measuring value in disturbed markets, but strict mark-to-market accounting appropriate for trading operations and investment banks may introduce a degree of volatility in reporting incompatibility with the basic and essential business model of banks which inherently intermediate maturity and credit risks.

Paul Volcker is the former chairman of the US Federal Reserve and chairman of President Barack Obama's economic recovery advisory board. This article is an extract from the keynote speech given at the Great Hall of the People in Beijing at the Institute of International Finance Spring Meeting on June 11, 2009.