|Politik und Gesellschaft
International Politics and Society 3/1999
Vorläufige Fassung / Preliminary version
JOHN EATWELL AND LANCE TAYLOR
The fundamental objective of all financial policy is to ensure the best possible outcome in the real economy. In this respect the simplistic complaint that the financial sector produces nothing by itself contains an element of truth. But it is only a small element. In a complex economy, with widespread division of labor through products, space and time, a sophisticated financial sector is necessary for the organization of production and distribution. An international financial system is necessary to sustain world trade and investment.
An economy without money markets would not work at all. The mobilization of large quantities of capital, and the allocation of that capital to profitable investments is the device that has transformed standards of living throughout the world in the past 200 years. Financial institutions must therefore be judged by the contribution they make to that process and hence to growth and employment. There is no point in having a financial sector that is in some sense "efficient" in its own terms if the result is a less efficient real economy.
Over the past year the persistent economic crisis in Asia has called into question much of the received wisdom that liberalization has enhanced the economic contribution of international capital markets. The Asian crisis is but the most recent example of other similar episodes: the financial crises in Latin America in the early 1980s, the European exchange rate crises of 1992, and the Mexican bond crisis of 1994. The explanations offered for these severe disruptions are various; indeed each crisis has a set of local explanatory factors. But they also have a common element - the impact of highly liquid international capital markets. These recurring episodes, most of which involve severe costs in terms of unemployment, loss of real income, and even stagnation, pose important questions for policy-makers:
The succession of financial crises in the past 20 years, the scale of what is happening now in Asia, and the reverberations of the Asian problems throughout the world, suggest that there is an urgent demand for answers to these questions. Increasingly, financial crises are not "local". They have worldwide systemic implications. Satisfactory answers will require a clear and convincing theoretical and empirical characterization of the relationship between financial liberalization and economic performance. For without such a widely shared characterization it will be almost impossible to formulate an internationally acceptable policy stance, even at the most general level. It is the objective of this Report to present the skeleton of such a characterization, and to draw from the argument a number of specific policy recommendations. These are necessarily tentative. If there is anything economists should have learned from the experience of the past two years, it is humility! Nonetheless, in distinctly un-humble manner, we believe the arguments presented in this Report do provide an intellectual framework that might guide practical and successful reform.
The argument in brief
International capital market liberalization began in the late 1950s when American and British banking authorities permitted external Eurocurrency credit markets to emerge, beyond their regulatory control. However, the crucial change came in the early 1970s with the collapse of the Bretton Woods system of fixed exchange rates buttressed by capital controls of varying effectiveness. With that collapse, foreign exchange risk, previously borne by the public sector, was privatized.
The assumption of forex risk by the private sector required the dismantling of exchange controls to permit the hedging of risk, and so precipitated the development of the plethora of new financial instruments and the explosion of trading which characterize present day financial markets. Together with increased private sector risk went increased opportunity for profit: from the provision of risk-bearing services, from the potential for speculative profit inherent in fluctuating exchange rates, and, of course, from the extensive new opportunities for profitable arbitrage. Combined with domestic pressures for the removal of financial controls, the collapse of Bretton Woods was a significant factor driving the worldwide deregulation of financial systems. Exchange controls were abolished. Domestic restrictions on cross-market access for financial institutions were scrapped. Quantitative controls on the growth of credit were eliminated, and monetary policy was now conducted predominantly through the management of short-term interest rates. A highly geared global market in monetary instruments was created. Today the scale of activity in this market dwarfs payments associated with foreign trade. Daily flows approach 10% of the world's annual GDP. In stark contrast to most domestic financial markets, it is largely unregulated.
Financial liberalization and the massive increase in financial flows have undoubtedly brought some benefits to some countries at some times. Flows of investment toward emerging markets were seen, in the early 1990s, as a welcome replacement for official development financing. The relaxation of external capital constraints led to increases in growth and reductions in inflation. However, the overall economic record of the post-liberalization period, 1970 to the present, is less satisfactory. There has been the series of severe financial crises. But as well as these shocks and the associated losses in real income, trend growth rates have slowed throughout the world. In every G7 economy trend growth in the 1980s and 1990s has slowed to around two-thirds of the rate in the 1960s. In developing countries taken as a whole the average rate of growth has also slowed, to roughly the same extent. Even prior to the current crisis in East and Southeast Asia, trend growth per capita slowed in four out of seven of the region's major economies.
The fundamental point at issue is what might be the connection between international financial liberalization and this widespread deterioration in performance. It has become the conventional wisdom that trend performance is determined by "the structure of the real economy". From this perspective, financial factors may result in severe shocks and significant deviations from trend, but will not alter the underlying performance of the economy. Financial factors will not change the fundamentals. The only qualification of this separation of real and monetary phenomena is that liberalization, by removing financial imperfections, should improve trend performance.
An alternative view is that financial institutions do indeed affect the medium- to long-term trend performance of the economy. Liberalization not only increases the likelihood of shocks, it also alters the fundamentals. Hence financial factors can effect the medium-term characteristics of the economy. They could be the factors behind the poor trend performance observed in many economies, as well as periodic crises.
Three factors have forged a link between liberalization and low growth: volatility, contagion, and changes in public and private sector behavior.
That there has been a significant change in public sector behavior is incontestable, and that change is typically attributed to the "discipline" imposed on governments by the international financial markets. In contrast to the 1950s and 1960s when public sector objectives were typically expressed in terms of employment and growth, objectives are now defined in terms of financial and monetary targets, typically summarized as "macroeconomic discipline". It is clearly true that lack of macroeconomic discipline is no way to secure sustainable growth. But what is most striking about the superior economic performance of the 1960s, when objectives were customarily defined in terms of growth and employment, is that fiscal balances typically displayed lower deficits than has been the case since liberalization, and, indeed, fiscal surpluses were not uncommon (Matthews, 1968). The reason for this outcome was, of course, the interdependence between public sector and private sector balances. High levels of investment by the private sector, encouraged by a public sector commitment to growth and employment, in turn resulted in healthy fiscal balances, a result reinforced by relatively small current account deficits.
Macroeconomic discipline is a necessary component of sustained economic growth. Burgeoning fiscal deficits and high and rising inflation will undermine any growth strategy. But discipline needs to associated with a public sector commitment to high levels of investment and employment. Small fiscal deficits, or even fiscal surpluses, may be more readily achieved when private sector investment is encouraged both by the financial environment and by public sector commitment to employment. If private sector investment is discouraged by an absence of public sector commitment to the high levels of employment and growth, fiscal prudence may be combined with recession.
Three elements link international financial liberalization to this change in public sector behavior: the potential threat posed to financial stability and the real economy by large capital flows, the belief that those flows are motivated by a particular view of "sound finance", and the additional belief that contagious financial crises may strike without warning. As the Bank for International Settlements (1995) has argued: "In the financial landscape which has been emerging over the past two decades, the likelihood of extreme price movements may well be greater and their consequences in all probability further reaching. ... At the macro level, the new landscape puts a premium on policies conducive to financial discipline. Strategically, a firm longer-term focus on price stability is the best safeguard, one which can only be achieved with the support of fiscal discipline". However, the BIS then warns, "yet such a safeguard is by no means always effective".
The identification of changed behavior in the private sector is more problematic. Ratios of investment to GDP have typically been lower in all countries since liberalization, suggesting a fall in private sector confidence. More specifically, defaults on US corporate bonds, which were at an all time low in the 1950s and 1960s, have increased significantly since the early 1970s. This finding may be explained by higher and more volatile real interest rates post-1970. Unsurprisingly, US business failures, which were also low in the 1950s and 1960s have been much higher since, and are correlated with high real interest rates and high debt-equity ratios. These patterns suggest, at very least, a less propitious climate for investment.
A decline in confidence in the private sector would also produce an increased desire for the opportunity of exit, further reinforcing the possibility of extreme swings in market sentiment which inflict both short-term and long-term damage.
These negative effects are reinforced by the emergence of pro-cyclical forces associated with liberalization. The ability of governments to moderate cyclical forces by monetary policy has been severely diminished both by international liberalization and by the shift in corporate finance from the banks to the securities market. The result is that all monetary policy is now focused on manipulating the demand for money via major swings in increasingly high short-term interest rates, damaging private sector investment.
In developing countries, the recent round of crises has been associated with clearly destabilizing behavior by the private sector. The tell-tale signs included rapidly rising ratios of foreign and domestic debt to GDP as a consequence of external deficits readily financed by capital inflows (at least for a time), together with maturity and currency imbalances in national balance sheets. Standard market practices pushed local financial sectors toward taking long positions in domestic assets and short positions in foreign holdings. A private sector build-up of foreign currency borrowing (without proper hedging, despite the alleged ability of international capital markets to provide such services) was an immediate precursor of both the Mexican and East Asian crises. It was abetted by pro-cyclical financial regulation.
Finally, the macroeconomic effects of liberalization can generate instability on a global scale. Industrialized economies can be destabilized by imbalances between flows and stocks induced by capital movements, although the time spans are likely to be longer and institutional responses more robust than those recently observed in Latin America, Eastern Europe, and Asia. In the case of the major economies there can be important feedbacks from national developments to the global system: Does the major borrower or lender, for example, behave in stabilizing or destabilizing fashion? What are its own weak points in terms of changes in stocks and flows? Such situations evolve over time. It seems likely that when imbalances emerge they are lagging indicators of the more fundamental processes which international financial liberalisation has set in train. It follows that the global system can be at substantial "market risk," in the phrase that regulators use for dangers transcending mere price fluctuations.
If international financial liberalization has indeed led to a change both in the environment for investment and in public and private sector attitudes toward investment, and has resulted in the mutually reinforcing hurt of severe swings in market sentiment and a general deterioration in medium-term confidence, then a deterioration in rates of growth and levels of employment is to be expected.
The policy challenge
The policy challenge is clear: Is it possible to secure the benefits of a flexible financial system, capable of mobilizing capital on a large scale, whilst at the same time ensuring that national economies and the wider world economy are protected from the systemic risks which financial liberalization brings in its wake? The basic components of a new international financial order may be gleaned from the above analytical sketch:
The history of the modern world economy teaches us that the disadvantages of the spread of liberal financial markets can be offset by sensible public intervention. After all the 25 years after World War II were characterized by strategic liberalization within a controlled international environment, and by the enjoyment of the highest rates of growth and employment in modern times. But in recent years indiscriminate deregulation has dominated domestic and international economic policy, and re-regulation has been in political disfavor.
The Asian crisis should have changed all that. Some commentators continue to seek explanations of the crisis in the peculiar characteristics of the Asian economies - the same characteristics which a year or two ago were typically lauded for their contribution to the Asian miracle. But increasingly, economic policy-makers are recognizing the global risks inherent in international liberalization. The political equation will certainly change if western markets crash or global macro performance deteriorates significantly. It would be better to revise the system to avoid such misfortunes before they happen.
The reforms proposed in this Report are not supposed to be definitive. Rather they are proposed in order to illustrate the practical argument of the Report, and provide a starting point for subsequent debate and development. These reforms would, we believe, substantially improve real economic performance, reduce systemic risk, and significantly diminish the likelihood of collapse.
The overall objective of these proposals is to arrive at a pragmatic consideration of the relationship between capital market liberalization and economic performance, and to create an institutional framework that can put such a pragmatic consideration into effect. If liberal financial markets are not to be perceived as imposing unacceptable costs on national economic performance, then markets must be regulated. If necessary restrictions must be placed on capital flows, national governments must have the opportunity to exercise control over the opening of their own capital markets. Nothing brings liberal financial structures into disrepute so much as the spectacle of national economies being forced into recession by "contagion" effects that bear no relation to their real economic circumstances. The success of Chilean and Chinese restrictions on short-term capital movements in limiting the damaging impact of contagion has been a salutary lesson.
The creation of an international body within which national policies on market openness can be debated and co-ordinated provides a route, perhaps the best route, to maintaining the benefits of liberal financial markets whilst minimizing the costs. The international body would also have the responsibility, in co-operation with national authorities, for directing and maintaining international regulatory structures.
It was the Bank for International Settlements (BIS) which pioneered international financial regulation with the formation of the Committee on Bank Supervision and Regulation in 1975. It was that Committee which formulated the capital adequacy requirements for banks in the 1980s to which all 13 then BIS members agreed to adhere and use as a tool to keep foreign banks not adhering out of their markets. The result was that countries voluntarily signed on to BIS requirements in order to achieve market credibility. The BIS has also sponsored a tripartite committee of banking, securities and insurance regulators to propose regulatory standards for financial conglomerates.
The International Organization of Securities Commissions (IOSCO) is the forum within which national regulators are developing common standards, and developing techniques of cross-border regulation. But IOSCO is essentially a co-operative organisation. This is not enough. An executive authority with surveillance capabilities is required. The World Trade Organization (WTO) illustrates that it is possible to establish an international executive authority with enforcement powers. The key task will be to devise a set of arrangements geared to the maintenance of national and international financial stability, and supportive of high levels of growth and employment.
A World Financial Authority
It would be the task of the WFA both to develop rules which would ensure the adoption of best regulatory practice and effective risk management procedures, and to oversee the development of a credible guarantor and lender of last resort function. It will therefore need to build on the achievements of IOSCO to develop a framework for international financial regulation (including risk management procedures) and to ensure, via the powers ceded to it, that those rules are implemented.
But the WFA should not simply be a body that develops and imposes regulatory procedures. It should also be a forum within which the rules of international financial co-operation are developed and implemented. Many of the goals of an efficient international financial policy can be achieved by effective co-ordination of the activities of national monetary authorities. The problem is that the means of achieving that co-ordination are, at the moment, very limited. The WFA will fill that gap. It will also be the responsibility of the WFA to ensure that once national polices have been agreed by the WFA, states support each other's national policies. It is that mutual support which is the key to success.
The WFA should also be given the responsibility of ensuring transparency and accountability on the part of international financial institutions such as the IMF and the World Bank. There is at present no systematic evaluation of the activities of the Bretton Woods institutions, and this lacuna may well have contributed to the damaging criticism that the IMF in particular is imposing an essentially political program in the guise of technical conditionality. Martin Feldstein, for example, has argued that the IMF "should not use the opportunity to impose other economic changes that, however helpful they may be, are not necessary to deal with the balance of payments problem and are the proper responsibility of the country's own political system". Making the Bretton Woods institutions accountable to the WFA would introduce a "safety valve" of evaluation and accountability that would make the IMF more effective.
Finally, the WFA should provide the necessary regulatory framework within which the IMF can develop as an effective lender of last resort. In many countries the WFA would simply certify that domestic regulatory procedures are effective. In those countries in which financial regulation is unsatisfactory, and which would therefore not have access to the IMF in a financial crisis, the WFA would assist with regulatory reform.
It is clear that there is no appetite today (especially in Washington) for the creation of a new international bureaucracy. Fortunately, the infrastructure for the WFA already exists in the form of the BIS and the co-operative cross-border regulatory framework already developed by IOSCO. With the backing of international agreement, adequate resources, and surveillance "teeth", these institutions could be developed into the needed world authority.
A reorganized IMF
A refocused World Bank
The role of national authorities
The goals of the development of a new financial framework are to give the authorities leverage over both the supply and demand sides of credit markets, and to prevent imbalances in which national financial systems have long internal and short external net positions or blatant stock-flow disequilibrium positions. The former task will take some of the pressure off short-term interest rates and limit the pro-cyclical consequences of a monetary policy that is directed only at the demand side. The latter task will reduce systemic risk by focusing more attention than at present to system-wide implications of individual agents' attempts to take profits as well as hedge and insure their portfolios.
The management of capital movements
National governments, after appropriate consultations with the WFA, should be empowered to impose restrictions on external capital movements as they see fit. Effective controls, particularly on short-term capital inflows may well be necessary if free trade in goods and services is to be sustained. Yet there is a significant difference between limiting short-capital flows into a country, and closing markets to foreign goods. In the latter case a country may attempt to acquire a beggar-my-neighbor advantage. The same argument does not apply to the former case. So the usual requirement of regulatory capital and reserve ratios imposed on firms may be supplemented with quantitative or tax-based obstacles to cross-border flows of funds. Whilst there should be a presumption in favor of national policies, the form, scale and duration of such restrictions (which may, if necessary, be deemed permanent) should, however, be determined in consultations with the WFA. Once particular conditions for the management of capital movement have been agreed then member states of the WFA should be required to provide assistance to fellow members in their operation.
Papers prepared for the International Capital Markets and the Future of Economic Policy project (most are available on the website: www.newschool.edu/cepa).
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© Friedrich Ebert Stiftung | technical support | net edition julia gudelius | Juni 1999