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J. Bradford DeLong
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Back in the 1890s and 1900s international capital flows were of great benefit to the world. Flows of money and investment from the center to the periphery of the world economy allowed investors in the capital-rich core to earn higher rates of return than they would have otherwise, and allowed workers in the resource-rich periphery access to the fixed and working capital they needed to multiply their productivity--and hence their wages.
In the 1920s and 1930s international capital flows--interacting with attempts to restore the pre-World War I monetary order--did great harm to the world economy. Rational and less-than-rational fears of heightened taxation, of devaluation, and of depression caused country after country to suffer large-scale capital flight. Central bank and finance ministry beliefs that long-run growth required holding on to the gold standard led them to induce recessions in order to defend the gold standard. In the end defense of the gold standard proved incredible: the political will to continue the defense drained away as unemployment deepened in the Great Depression, and all that the combination of international capital flows and government commitment to the gold standard did was to make the Great Depression much greater than it would otherwise have been.
The architects of the Bretton Woods system that governed international monetary arrangements in the 1950s and 1960s had lived through the 1920s and 1930s. They were eager to embrace controls on international capital flows, which they saw as bringing little more than trouble: destabilizing speculation, irrational capital flight, and the potential for chains of contagious panic like that that had brought on the Great Depression. Stable exchange rates (so that world trade could develop and expand) and governments committed to preventing serious depressions at home seemed much more important than encouraging the free flow of international capital.
But with the breakdown of the Bretton Woods fixed exchange-rate system in the 1970s, the political retreat from social democracy in the 1980s, and the fading of the memory of the Great Depression, the pendulum swung back once again. The first generation of post-World War II economists would have said "yes." The second and third generations of post-World War II economists regretted the fact that capital controls kept people with money to lend in industrial countries away from people who could make good use of the money to expand economic growth in developing economies, and noted that capital controls were not working effectively anyway as ingenious investors found more and more ways around them. The balance of opinion shifted to the view that the world economy was sacrificing too much in the way of economic growth to be worth whatever reduction in instability capital controls produced.
So now we have all the benefits of free flows of international capital. These benefits are mammoth: the ability to borrow abroad kept the Reagan deficits from crushing U.S. economic growth like an egg, and the ability to borrow from abroad has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge to the industrial core.
But the free flow of financial capital is also giving us one major international financial crisis every two years.
If you read your newspapers the flood of capital out of East Asia is blamed on a lack of democracy, on crony capitalism, official corruption, over-extended banks, and an absence of honest and trustworthy corporate and government accounts. But a lack of democracy, high-level corruption, banks making loans to the politically well-connected, the absence of trustworthy accounts, crony capitalism--all these were as salient and as troubling back when East Asia was the darlings of the international capital market, the place to be for anyone who wanted to be surfing the leading edge of the wave of financial opportunity.
The root cause of the crises is a sudden change of state in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996, and then they turned around and are all going the opposite way today. Economists will dispute which movement was less rational: Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business, or is the stampede of captal out of emerging markets today an irrational panic? The correct answer is probably "yes"--the market was manic, it is now panicked, and the sudden change in opinion reflects not a cool judgment of changing fundamentals but instead a sudden psychological victory of fear over greed.
So what is to be done?
Countries that seek to take advantage of the large benefits (and they are large benefits) of global capital flows need to make sure that they do not destroy their own ability to handle crises. In the current international monetary system it is assumed that one reaction to a crisis will be a devaluation: since the world economy has signalled that it is no longer willing to pay as much for a country's capital or goods as before, a devaluation is a way of reducing the price of a whole nation's goods, the analogue to a firm cutting its prices in response to falling demand. But devaluation does little good if the value of the debts owed by a country in crisis rise as the currency falls in value: if the banks and firms in a country in crisis have borrowed not in their local currency, but in dollars, pounds, yen, or marks.
If the depreciation and the hard-currency debts are large enough, the consequence is general bankruptcy and financial collapse, and general bankruptcy and financial collapse are the stuff of which Great Depressions are made.
A government may, as part of an inflation-control program, have promised that it would not let its exchange rate depreciate. The commitment that one's currency is fixed in terms of the dollar or the deutschmark or the pound or the yen is an important tool often used to convince people that the government is committed to an anti-inflation policy. So depreciate your currency and you may wind up with a sudden burst of inflation.
But avoiding depreciation is no solution either. Because everyone notices that demand for your products and assets has fallen, everyone concludes that your exchange rate is highly likely to fall. So everyone requires enormous interest rates in order to keep their money invested in your country. And enormously high interest rates make investment unprofitable and worsen the balance sheet of all financial institutions that have loaned long-term and borrowed short-term. Once again the consequence is general bankruptcy and financial collapse--the stuff of which Great Depressions are made.
Hence here enters the International Monetary Fund. As its role has evolved over the past generation, the IMF exists to make "structural adjustment" loans to countries that have--either because of bad and unsustainable policies pursued by their governments or because of bad luck in terms of the shocks inflicted on them by the world economy--gotten into this kind of financial trouble. The IMF makes the process of adjustment easier by lending hard currency to countries to allow them to take steps to turn their economy around gradually. But the IMF expects to get its money back: so the IMF requires that countries that borrow from it adopt economic policies that make it confident that it will indeed be repaid.
I happen to believe that the IMF got it just about right in East Asia, in Thailand, Indonesia and South Korea. Others disagree. There are many critics of the IMF: those who think it loaned too little with too many conditions, those who think it loaned too much with too few conditions, those who dislike the IMF because they think it could have avoided recessions in East Asia but didn't, those who dislike the IMF because they think it did significantly alleviate recessions in East Asia but think that higher unemployment in East Asia is a good thing because it will teach East Asians who deserve to suffer not to borrow so much, those who dislike the IMF because they think it did significantly alleviate recessions in East Asia but think that higher unemployment in East Asia is a good thing because it will teach financiers in New York who deserve to suffer not to lend so much, those who think that IMF lending helps the unworthy and creates "moral hazard" that will cause future crises, those who think that IMF lending is insufficient and does not provide an adequate level of insurance against less-than-rational speculative attacks, et cetera, et cetera. But they disagree with one another much more than they disagree with the Fund, and they advise the Fund to change its policies in radically different and contradictory ways.
So if the IMF got it right, why is there still a crisis? We are now nineteen months into this particular financial crisis. Nineteen months after the start of the EMS crisis in 1992, or the Mexican crisis in 1994, the crisis was over--economies were growing rapidly again, and the fear and panic of the crisis months were fading memories.
There is still a crisis because the East Asian economies have been hit by another shock--the worsening Japanese recession. There is a worldwide crisis because the East Asian crisis in 1997 was followed by an--independently caused--crisis in 1998: the Russian default.
But the Russian default, coming so soon after the East Asian crisis, made investors all around the world believe that the world was a much more risky place than they had thought. Hence "contagion" and a "flight to quality" as all over the world people try to shift their wealth out of leveraged emerging-market equity, out of risky investments, and into safe investments in strong currencies like the government bonds of major financial-center countries. Over the course of the summer and fall the worldwide structure of asset prices has rotated: anything less risky than the U.S. stock market has risen sharply in price--U.S. government bonds, for example, on which the Federal Reserve has cut interest rates--and anything more risky has fallen in price. The result has been one spectacular hedge-fund bankruptcy--LTCM--an increase in capital flight from emerging markets like Brazil, and a general feeling that financial markets are still highly vulnerable to downward shocks.
The size of this flight to quality has been surprisingly large. The IMF blames "...technical factors... Highly leveraged investors [who] had to realise assets to meet margin calls... [selling] in the most liquid markets to raise cash." And it calls for financial regulators in all countries to take steps to change their systems to increase investor confidence that assets and companies widely thought to be sound are in fact sound: "greater transparency of positions being taken by investors... controls on excessive leverage... differential reserve requirements against loans to different countries depending on their banking standards." And perhaps the IMF will call for Chilean-style, market-based measures to regulate inflows of short-term capital.
What Is To Be Done?
So what is to be done?
In the short term, first, the central banks of the industrial core should make sure that there are enough less-risky, "quality" securities to meet demand as investors flee to less-risky, "quality" securities: buy back people's bonds for cash, and lend freely to institutions and market participants that are not insolvent but merely illiquid. This policy is being carried out. Thus the three lowerings of short-term interest rates by the U.S. Federal Reserve over the course of this fall. And the declaration by European central bankers that after the January 1, 1999 launch of European monetary union that Europe-wide interest rates should be at the low levels currently seen in France and Germany.
Second, deal with Japan's recession. Rapid action to recapitalize its banks, and further fiscal stimulus, would go a long way to help Japan and the rest of Asia recover. This policy is not being carried out, or is not being carried out well.
Third, keep the smoldering embers of the crisis from bursting into flame through a large-scale epsiode of depreciation and capital flight in Brazil. Some of this needs to be done by President Cardoso and the rest of the Brazilian government: Brazil needs to balance its budget so that investors do not worry that the Brazilian government will start printing money to pay its bills and that high inflation will return. But the rest of this needs to be done by the rest of the world: enough financial support to allow Brazil to withstand speculative attacks, and lower interest rates in the world as a whole to make it more costly for Brazilians to bet on a large forthcoming depreciation.
It is not clear whether or not the Brazilian government will accomplish its tasks.
In the longer run, it is less clear what needs to be done. If sudden changes of opinion by international investors cause so much trouble, shouldn't we keep such sudden changes of opinion from having destructive effects? Shouldn't we use capital controls and other devices to keep international flows of investment small, manageable, and firmly corralled? The first generation of post-World War II economists would have said "yes." The second and third generations of post-World War II economists regretted the fact that capital controls kept people with money to lend in industrial countries away from people who could make good use of the money to expand economic growth in developing economies, and noted that capital controls were not working effectively anyway as ingenious investors found more and more ways around them. The balance of opinion shifted to the view that the world economy was sacrificing too much in the way of economic growth to be worth whatever reduction in instability capital controls produced.
So now we have all the benefits of free flows of international capital. These benefits are mammoth: the ability to borrow abroad kept the Reagan deficits from crushing U.S. economic growth like an egg, and the ability to borrow from abroad has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge to the industrial core.
But the free flow of financial capital is also giving us one major international financial crisis every two years.
So what is to be done?
The answer is probably that we should try to have the benefits of free capital mobility while also setting up institutions to strictly limit how much damage is done by international financial crises. But how to do so is not clear. We do not have a perfect international economic system. We do not know how to build a better one. So we need to make sure that we manage this one that we have as carefully and prudently as possible.
Professor
of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/
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