Financial Crises, Global Capital Flows and
the International Financial Architecture
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Written: May 1999
The upheavals in the world financial markets during the latter part of the 1990s were quelled by the immediate intervention of both international financial institutions (IFIs) such as the IMF and of domestic ones in the developed countries, such as the Federal Reserve in the USA. The danger seemed to have passed. But, subsequent tremors in South Korea, Brazil and Taiwan and mounting imbalances inside the USA (the "twin deficits") and in the international exchange rates system do not augur well. We may face yet another crisis of the same or a larger magnitude.
What are the lessons that we can derive from the last crisis to avoid the next?
The first lesson, it would seem, is that short term and long term capital flows are two disparate phenomena with not much in common. The former is speculative and technical in nature and has very little to do with fundamental realities. The latter is investment oriented and committed to the increasing of the welfare and wealth of its new domicile.
It is, therefore, wrong to talk about "global capital flows". There are investments (including even long term portfolio investments and venture capital) – and there is speculative, "hot" money. While "hot money" is very useful as a lubricant on the wheels of liquid capital markets in rich countries – it can be destructive in less liquid, immature economies or in economies in transition.
The two phenomena should be accorded a different treatment. While long term capital flows should be completely liberalized, encouraged and welcomed – the short term, "hot money" type should be controlled and even discouraged. The introduction of fiscally-oriented capital controls (as Chile has implemented) is one possibility.
The less attractive Malaysian model springs to mind. It is less attractive because it penalizes both the short term and the long term financial players. But it is clear that an important and integral part of the new International Financial Architecture must be the control of speculative money in pursuit of ever higher yields. There is nothing inherently wrong with high yields – but some capital markets provide yields connected to economic depression and to price collapses through the mechanism of short selling and through the usage of certain derivatives. This aspect of things must be neutered or at least countered.
The second lesson is the important role that central banks and other financial authorities play in the precipitation of financial crises – or in their prolongation. Financial bubbles and asset price inflation are the result of euphoric and irrational exuberance – said the Chairman of the Federal Reserve Bank of the United States, the legendary Mr. Greenspan and who can dispute this?
But the question that had hitherto been delicately side-stepped was: who is responsible for financial bubbles? Expansive monetary policies, well timed signals in the interest rates markets, liquidity injections, currency interventions, international salvage operations – are all coordinated by central banks and by other central or international institutions.
Official inaction is as conducive to the inflation of financial bubbles as is official action. By refusing to restructure the banking system, to regulate and transparently trade derivatives and other complex financial instruments, to introduce appropriate bankruptcy procedures, corporate transparency and good corporate governance, by engaging in protectionism and isolationism, by avoiding the implementation of anti competition legislation – many countries have fostered the vacuum within which financial crises erupt.
The third lesson is that international financial institutions can be of some help – when not driven by political or geopolitical considerations and when not married to a dogma. Unfortunately, these are the rare cases. Most IFIs – notably the IMF and, to a lesser extent, the World Bank – are both politicized and doctrinaire.
It is only lately and following the recent mega-crisis in Asia, that IFIs began to "reinvent" themselves, their doctrines and their recipes. This added conceptual and theoretical flexibility led to improved results. It is always better to tailor a solution to the needs of the client. Perhaps this should be the biggest evolutionary step:
That IFIs will cease to regard the countries and governments within their remit as inefficient and corrupt beggars, in constant need of financial infusions. Rather they should regard these countries as clients, customers in need of service. After all, this, exactly, is the essence of the free market – and it is from IFIs that such countries should learn its ways.
In broad outline, there are two types of emerging solutions. One type is market oriented – and the other, interventionist. The first type calls for free markets, specially designed financial instruments (see the example of the Brady bonds) and a global "laissez faire" environment to solve the issue of financial crises. The second approach regards the free markets as the source of the problem, rather than its solution. It calls for domestic and where necessary international intervention and assistance in resolving financial crises.
Both approaches have their merits and both should be applied in varying combinations on a case by case basis.
Indeed, this is the greatest lesson of all:
There are no magic bullets, perfect solutions, right ways and only recipes. This is a a trial and error process and in war one should not limit one's arsenal. Let us employ all the weapons at our disposal to achieve the best results for everyone involved.
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