April 1999 EPI Book
TAMING GLOBAL FINANCE
A better architecture for growth and equity
by Robert A. Blecker
Encouraged by the United States and the International Monetary Fund (IMF), many developing countries launched a great experiment in opening their capital markets to free flows of short-term foreign investment in the early 1990s. For a few years, bank lending and portfolio investment in these “emerging markets” skyrocketed, but before long, beginning with the Mexican peso crisis of December 1994, the emerging market boom collapsed. By 1997, the financial panic broke out in Thailand, and it soon spread like a contagion to other countries in Asia, followed by Russia and Brazil. In each case, the financial crisis unleashed a general economic collapse, causing massive unemployment and cutting living standards. Although the U.S. economy has continued to grow, it has already felt the effects of the Asian crisis through a widening trade deficit and lost manufacturing jobs.
The IMF, closely following the dictates of the U.S. Treasury Department, tried to alleviate the financial distress by applying the traditional cures of currency devaluation, budget cutting, and high interest rates – while insisting that the countries maintain open capital markets. Essentially, the IMF and U.S. government continue to promote what have become known as “Washington Consensus” policies. Yet in the financial crises of the 1990s, this policy package has often only deepened the financial panic and failed to prevent the contagion from spreading to other countries. IMF bailouts have succeeded in shielding large multinational banks from the full consequences of their own risky lending practices, but they have failed to restore economic growth and to protect average citizens in the debtor countries.
As a result of these developments, the Washington Consensus has begun to break down. More and more economists are questioning the policies of fiscal austerity, monetary contraction, and financial liberalization that formerly commanded nearly universal support among leaders in the profession. At the same time, a wide-ranging debate has opened up about how to design a “new architecture” for the global financial system. This debate includes numerous proposals for regulating domestic financial markets, containing volatile capital flows, constructing new international institutions, stabilizing international currency values, and coordinating national macroeconomic policies.
This book surveys the emerging debate about the global financial system and evaluates the policy options for reforming it. The analysis consists of three parts: an assessment of the costs and benefits of capital market liberalization; a critical review of the theoretical models underlying the Washington Consensus on macroeconomic policies; and an examination of alternative policy proposals for constructing a new financial architecture. The analysis in this book is intended to inform a broad audience of policy makers, political activists, media professionals, college students, and concerned citizens about the state of the expert debate on global financial policy – and to enable them to participate more knowledgeably in that debate.
Proponents of liberalizing capital markets promised that it would bring three benefits: a more efficient allocation of global savings, thus stimulating growth; enhanced financial opportunities for international investors, especially the ability to diversify risks across countries; and greater discipline on national governments, forcing them to adopt sound economic policies. Critics, on the other hand, have charged that financial liberalization causes four types of costs: international investment based on inadequate information tends to be speculative and fails to enhance efficiency; capital mobility constrains governments from adopting autonomous monetary policies; the threat of capital flight leads to contractionary or deflationary macroeconomic policies; and the volatility of capital flows increases real economic instability.
On the whole, the costs of capital market liberalization have generally outweighed the benefits. Although more research is clearly needed, there are no empirical studies to date that demonstrate significant gains in either efficiency or growth from liberalized financial flows, while at least one study shows that capital market liberalization fosters higher real interest rates that can discourage productive investment. There is, moreover, overwhelming evidence that liberalized capital flows tend to be extremely volatile and have contributed to the spread of financial crises around the world. Although these crises have been most severe in countries with weak regulation and supervision of their domestic financial markets, a recent opening to external capital flows is a common feature in all the countries that have experienced financial crises in the 1990s.
Instead of delivering more sustainable, long-term economic growth, capital market liberalization has worsened economic instability in countries where booms were fueled by speculative capital inflows and then cut short by panic-stricken outflows. Rather than investing where the long-term prospects are greatest, investors seem to move their funds into and out of countries in herd-like fashion, causing self-fulfilling bubbles and panics based on limited information and fickle expectations. The end result is a global economy that is less stable without being more efficient.
The evidence reviewed here also shows that liberalized financial markets constrain national policy makers, but the constraints vary in their nature and severity in different countries at different times. The ways in which capital flows constrain macroeconomic policies depend on a country’s size and openness to trade, its exchange rate system (fixed or flexible), the magnitude and composition of its international debts, and its susceptibility to inflation. Generally, larger and more closed economies with flexible exchange rates, small foreign currency debts, and low inflation are less constrained than smaller and more open countries with fixed exchange rates, large foreign currency liabilities (especially with short maturities), and high inflation.
While international investors do indeed reward countries that prioritize low inflation in their macroeconomic policies, they do not always support policies that result in slow growth and high unemployment. On some occasions, international investment flows have actually pressured policy makers to lower their interest rates, such as in the United Kingdom in 1992 and the United States in 1998. Moreover, even when countries use high interest rates and fixed exchange rates to attract foreign investors, the resulting large capital inflows often lead to speculative bubbles in financial markets and exaggerated boom-bust cycles in productive activity. Far from disciplining policy makers, then, speculative capital flows can temporarily suspend ordinary limits on growth, only to cause a subsequent crash when investors suddenly perceive higher risks and head for the exits.
The fact that Washington Consensus policies have neither prevented nor cured financial crises suggests the need to reconsider the intellectual foundations of this approach. This book reviews the major strands in international financial modeling and shows how the theories have evolved away from the early models that implied easy cures for balance-of-payments crises, either through automatic market adjustments or simple policy correctives such as
currency devaluation, fiscal austerity, and monetary contraction. These policies are much less effective and more costly in practice than they appeared to be in theory, and yet they still underlie the policy prescriptions of the IMF and the U.S. government. In many recent cases, these policies have failed to restore investors’ confidence and have instead worsened financial panics.
Much contemporary policy analysis rests on models which assume that flexible exchange rates respond in predictable ways to changes in macroeconomic “fundamentals,” such as interest rates and fiscal policies. Yet empirical studies of the post-1973 period of floating exchange rates show that these models have a poor ability to predict short- and medium-run fluctuations. As a result, the traditional policy prescriptions that rely on such predictions are no longer credible. New theoretical models reveal that movements in exchange rates can become delinked from the underlying fundamentals, and instead follow various types of “self-fulfilling expectations,” such as speculative bubbles and panics. Fixed exchange rates can suffer speculative attacks, not only when the pegged rate is unsustainable but even if the peg might be sustainable in the absence of such an attack. When a crisis breaks out, self-fulfilling panics can force adjustments that are far in excess of what would be required to restore equilibrium (e.g., eliminate a balance-of-payments deficit) in the absence of the panic. These newer models are beginning to identify the causes and consequences of financial market instability, but as yet have had little influence on policy debates.
U.S. and IMF officials have recently shifted to promoting more “orderly” liberalization efforts in developing countries – thus tacitly admitting that capital market liberalization has been pushed too far in the past. The official U.S. and IMF proposals for a new financial architecture emphasize policies designed to make financial markets work more efficiently. These proposals stress the need for greater transparency on the part of banks, firms, and governments, as well as for improved regulation and supervision of banks and other financial institutions. Such proposals place most of the burden of reform on the debtor countries, requiring them to make fundamental changes in their domestic institutions in order to be better prepared to handle massive inflows of foreign funds.
Essentially, the official new architecture proposals seek to make the world a safer place for international investors. But no amount of transparency and supervision can eliminate the inherent information problems in international capital markets or prevent global financial flows from destabilizing domestic economies. In order to make international capital flows serve the broader public interest in a more stable, equitable, and prosperous global economy, further policy reforms are needed in four interrelated areas:
1. Regulating capital movements. A variety of measures such as capital controls, exchange controls, and transactions taxes (including a “Tobin tax” on foreign exchange transactions) can help to discourage short-term speculative capital flows, restore greater national policy autonomy, and encourage more stable, long-term investment. Different types and degrees of controls may be needed in different countries, depending on their specific situations and structures. Chilean-style reserve requirements on capital inflows may be adequate in some countries; Malaysian-style controls on foreign exchange may be needed elsewhere. The U.S. and other industrial countries should increase prudential regulations on capital outflows and reduce the incentives to be used as “safe havens” for capital fleeing other countries.
2. Reforming international institutions. The international financial system has become integrated to a point where the need for global regulation cannot be avoided. Simply abolishing the IMF and allowing markets to discipline errant countries would be a mistake because it would invite greater instability and harsher adjustments. While in the future it may be desirable to create new global institutions, such as a world central bank or international supervisory agency, most such proposals are politically unrealistic at present-although regional institutions such as an Asian Monetary Fund are more feasible in the short term. Today, the most immediate priority is to fundamentally reorient the governance and policies of the IMF by replacing its top leadership; instituting more democratic control and accountability; broadening its mission to emphasize global prosperity and distributional equity; tailoring its crisis intervention policies to better meet the needs of specific debtor countries; and shifting more of the adjustment burden in crisis situations onto creditors.
3. Managing exchange rates. Neither extreme of perfectly flexible or rigidly fixed exchange rates is generally desirable. The best way to reduce exchange rate volatility is to establish a compromise system of “target zones” among the major currencies (especially the dollar, euro, and yen), with wide enough “crawling bands” around the targets to allow moderate exchange rate fluctuations – and with regular, small adjustments in the targets and bands to keep them credible. To discourage speculative attacks, massive and automatic intervention should be conducted by central banks or a new international stabilization fund whenever rates threaten to go outside the bands. Other countries should be free to experiment with alternative exchange rate arrangements or to join the target zone system – and would benefit from greater stability among the major currencies anyway.
4. Coordinating macroeconomic policy. Supporting the exchange rate targets and promoting more rapid global growth with more balanced trade and full employment will require economic coordination among the G-7 countries. International coordination of monetary policy would permit reductions in interest rates without creating incentives for speculative capital flight. Countries that agree to coordinate their interest rates need to retain other policy levers for domestic adjustment, however, especially by using fiscal policy more flexibly for countercyclical purposes and by using prudential restrictions (e.g., reserve requirements) more actively for monetary control.
Even if full-fledged macroeconomic policy coordination at the global level is difficult to achieve, major countries like the United States and the members of the European Union are far from paralyzed. Such large countries or blocs have plenty of room for maneuver to embark on new policies that could help to restore global prosperity and avert the possibility of a global crash. With or without a formal coordination agreement, it is vital for the Europeans and the Japanese to pursue domestic expansionary policies and to reduce their trade surpluses in order to boost global demand. It is also vital that the U.S. lower its interest rates further in order to stop attracting so much capital out of other countries and allow the dollar to move to a lower level that is more consistent with balanced international trade.