Editor’s Note: This essay is adapted from a three-part lecture series presented at the Johns Hopkins School of Advanced International Studies in May 2006. Finance is the heart of capitalism. When it works, it provides a uniquely effective way to shift resources from those who own but cannot use them to those who do not own but can use them. When finance fails, however, it can generate huge losses, with human and material costs that endure for years.
What is true at neighborhood and national levels is also true at the international and global levels. The tighter integration of the world’s economic activities, almost universally referred to by the shorthand label “globalization”, has brought improvements in the living conditions of millions of people. But the global economic crises of the last quarter century have also had large adverse consequences for whole countries and regions. They have brought debilitating global economic shocks, reawakened mercantilism and undermined the legitimacy of globalization. And at the heart of those crises have been failures of the global financial system.
Since the emerging-market financial crises of 1997 and 1998, the world has not suffered another worldwide financial crisis. But this seeming stability rests on an unprecedented and worrisome new pattern of global capital flows. An accelerating flood of capital is moving “upstream” from the world’s poor countries to its richest, in particular to the United States, which has become the superpower of borrowing. Underneath what is, in important respects, only an illusion of stability is a dramatic, rapidly widening and almost certainly unsustainable “imbalance” in the global balance of payments. How that imbalance is handled may determine whether globalization continues, or whether, as in a previous globalizing age, that before World War I, the progress toward economic integration is derailed. Moreover, even if the pattern of capital flows continues, it is evidently undesirable. It makes little sense for a globalized financial system to push capital from poor countries that need it to the world’s richest consumers.
The mistake that led to the financial crises of the 1980s and 1990s was the failure to appreciate the fragility of the financial system taking shape around us. We did not understand how the dramatically enlarged scale of financial transactions would magnify risk. The institutional framework of global finance at that time, starting with the International Monetary Fund and including the World Bank and related institutions, not only did not help national governments cope with unappreciated fragility and risk, but in some respects made things worse. We must do better in the future.
The Origins of “Twin Crises”
A financial system that works well is a highly desirable economic asset: Companies grow faster the better their access to finance, and the economy as a whole uses resources more efficiently. It is no accident that the country with the world’s most developed financial system—the United States—appears to have an endless capacity for sustained productivity growth.
It is therefore good news that globalization itself appears to strengthen financial development not only in advanced countries but, potentially at least, in every country. It does so by bringing greater competition, institutional reform, adoption of best practices and increased liquidity, all of which spur economic activity. So what is the problem with financial liberalization at the international level? Why do things occasionally go so wrong?
A financial system is an institutional arrangement that enables trades in promises. These systems work when these promises are reasonably trustworthy, whether we are talking about millions, billions or trillions of dollars worth of promises. Trust is always incomplete, however, because purchasers of promises know that those who sell them have incentives to cheat or, as economists put it, “information is asymmetrical.” What is the value today of a promise to pay $1,000 ten years from now? That will depend on whether one expects the person making the promise to be able—or even want—to keep his word. The temptation not to do so when the time comes is evident. Most of the time, any unkept promises are safely absorbed by the system through the legal enforcement of contracts, bankruptcy law and the like. But because of the inherent uncertainties in any financial marketplace, big swings in mood can occur, and the resulting panics can generate a collapse of trust. Money can then move abruptly in ways that undermine efficiency and reduce economic activity.
Global liberalization of finance exacerbates the danger of such troubles. Even in mature and well-institutionalized economies, mood swings can occur, as was shown after the bursting of the U.S. stock market bubble in 2000. But today’s system of global finance is still immature by many measures: Trust is weak, knowledge is limited and institutions are fragile. As former U.S. Treasury Secretary Larry Summers put it, “Global capital markets pose the same kind of problems that jet planes do. They are faster, more comfortable, and they get you where you are going better. But the crashes are much more spectacular.”
Liberalizing emerging market economies face additional difficulties. Their lack of transparency, widespread corruption, poor regulations and inadequate legal systems produce relatively greater risks, and so a bigger likelihood of financial crises in the very economies that can least afford them. Emerging market countries are also vulnerable to the linked macroeconomic dangers of fiscal indiscipline, inflation and an excessive reliance on borrowing in foreign currency.
These latter factors have made the financial systems of the vast majority of emerging market economies exceedingly fragile. One study counted 95 financial and currency crises in emerging market economies between 1983 and 1997.1 Not all currency crises are financial crises, of course, and not all financial crises are also currency crises. But the most damaging events occur when currency and financial crises come together, which happened in 21 of those 95 cases. These “twin crises” represent the interaction of the microeconomics of finance with the macroeconomics of exchange rate regimes and monetary and fiscal policies.
Such twin crises have been very costly. By some estimates, about a third entailed an immediate jump in public debt, to bail out the banking system, of more than 10 percent of GDP. In some cases (Indonesia in 1997 and Argentina in the early 1980s, for example) the cost exceeded 50 percent of GDP. That is the equivalent of having the U.S. public debt rise by $6 trillion dollars overnight—more than twice the Federal budget.
How did this staggering number of crises come about, and why were they so devastating? We can answer this question if we retrace the road that led to these crises. As Frederic Mishkin of Columbia University argues, this road has four stages.2
In the first stage, national authorities liberalize a banking system that has never had to compete in an efficient and properly regulated market. They do this because they believe that this will raise the efficiency of the economy and improve its access to international finance. Whatever the hopes for a liberalized banking system, there comes an explosion of credit overseen by bankers and regulators who have little experience in managing risk. Not surprisingly, banks quickly find that they have made too many bad loans, losses mount, banks start failing, and the contagion spreads to healthy banks. An important additional aspect of liberalization is large-scale borrowing in foreign currencies. Relatively low interest rates on such borrowing are an important stimulus, particularly if the exchange rate is expected to be stable. As a result of such borrowing, currency mismatches emerge in the domestic economy and, most dangerously, in the financial system.
In the second stage of the journey, there is a run-up to a currency crisis usually caused by higher interest rates abroad. The origin of this stage is innocent enough: For one reason or another, the U.S. Federal Reserve decides to raise interest rates. Other central banks typically follow suit. A rise in rates results in a decline in cash flow as higher interest rates start eating into profits. To keep going, companies in emerging market economies need to borrow more, but now borrowing has become more expensive. Companies start failing, and declining asset prices start to wipe out the financial system’s collateral.
Then we come to the third stage: the currency crisis itself. People start realizing how big problems are. They start to sell the local currency, and this leads lenders to pull out short-term credit. Foreign banks in particular start panicking. Governments find themselves facing an impossible choice: If they try to support the currency by raising interest rates, they undermine corporate solvency and worsen the crisis; if they do not raise interest rates, the currency collapses, wiping out companies with large net liabilities in foreign currencies.
Finally, in the fourth stage, the currency collapse triggers a financial crisis. Particularly in countries with histories of inflation and default, loans tend to be short-term and denominated in foreign currency. So when the local currency starts falling, debt obligations soar in value, sending whole sectors into bankruptcy. These countries usually have inadequate bankruptcy procedures, so dead companies stay dead, their remaining assets rendered unusable to others. Domestic credit seizes up. Inflation often surges as the currency falls, and there is a deep recession. And if the crisis is bad enough, creditors start to worry about neighboring countries. Contagion then begins spreading to the rest of the region.
It is stunning to recognize what some countries went through in the twin crises of the late 1990s. In 1997 Indonesia’s currency lost 80 percent of its value, a staggering collapse for a country with no serious inflation. The resulting bank defaults, fiscal losses and mass bankruptcies wiped out 15 percent of GDP in the following year. The Indonesian economy regained its pre-crisis level of GDP only in 2003, six years after the crisis began. Even in 2005, GDP was only 16 percent above its 1997 level.
From Crises to Imbalances
What lasting effect did these crises have on emerging market economies, and on the global financial system as a whole? Among the benefits has been a better understanding of risk, stronger financial systems and better regulation. But the most structurally important consequence—and certainly the most malign one for the global financial system—is the widespread fear of current account deficits in emerging market countries. Capital markets have been trying hard to place capital in emerging market economies for the past several years. But governments have been determined to recycle them in the form of foreign currency reserves—especially by investing in the paper of “the world’s largest hedge fund”: the United States. In this way the weaknesses of the global financial system in the 1980s and 1990s have had long-term consequences for the world economy: They have left us with a global financial system whose seeming stability rests on an unsustainable imbalance in the global balance of payments.
An extraordinary number of countries have converted the excess savings of their citizens and corporations, together with the capital inflow from abroad, into official holdings of foreign exchange. At the end of 2005, the world’s stock of foreign currency reserves was worth about $4.1 trillion, of which more than half had been accumulated since 2000. Most of the economically important regions of the world are running current account surpluses. Meanwhile, a single country, the United States, is absorbing 75 percent of these excess funds.
The massive surpluses of savings over investment in emerging economies (which is what a current account surplus means) have three principal causes: the impact of past financial crises, which depressed investment and so led to the surpluses of savings over investment that are the underlying cause of current account surpluses; the recent jumps in oil prices, which have created surpluses of savings over investment in oil exporting countries; and deliberate attempts to maintain export competitiveness by intervening in foreign currency markets.
This last idea needs elaboration. When one says that a country has a deliberate policy of exchange rate undervaluation, what does one mean and how does such a policy work? The simple answer is that the currency is kept below its market-clearing level by foreign currency intervention. As a result of intervention, exports are initially bigger and imports smaller than they would otherwise be. To maintain these surpluses, the government has to find ways to stop some of the income earned by exporters from being spent. If it fails to do so, there will be excess demand and so inflation. Higher inflation will, in turn, undermine competitiveness, so defeating its purpose. Thus, a policy of exchange-rate intervention designed to preserve the competitiveness of exports and import-competing sectors needs to be complemented by policies that suppress excess demand. The normal choices are tighter fiscal policies, credit controls and sterilization of the domestic monetary impact of foreign currency intervention.
If a great many countries are intervening in foreign currency markets to keep their exchange rates down and their trade surpluses up, some other country or countries must be running the counterpart deficits. The dominant counterpart country is the United States. Since most of the intervention is against the U.S. dollar, that is the inevitable result. Consider a world in which many countries are keeping their currencies down, in real terms, against the U.S. dollar. That means U.S. imports are cheap and its exports relatively uncompetitive. At levels of domestic demand that generate the highest level of employment consistent with full employment and stable and low inflation, there is excess demand for tradable goods and services or a current account deficit. That deficit is the counterpart of the surpluses generated in the countries intervening to keep their exchange rates down and their external sectors competitive. It turns out that the level of demand needed to generate full employment in the United States at recent levels of the dollar and energy prices is now roughly 7 percent higher than the country’s gross output. The difference is the current account deficit.
U.S. policymakers strive for the most output they can get before inflation becomes a serious problem—in other words, for whatever mix of monetary and fiscal policy will produce something close to full employment. And they are in serious trouble if they fail to deliver. They have certain advantages, however. As issuer of the world’s key currency, the United States can accommodate whatever the rest of the world throws at it. It suffers from no foreign-exchange constraint. In effect, the Federal Reserve balances the world economy by balancing that of the United States. And it has to do this because the currency for which it is responsible is the object of the targeting by other governments.
Despite U.S. advantages in dealing with these massive global financial flows, it suffers from a problem. At the real exchange rate given by the behavior of the rest of the world, including the foreign currency interventions, U.S. imports tend to grow faster than exports whenever the economy is growing in line with its potential. So U.S. net flows of liabilities to the rest of the world will grow faster than the U.S. gross domestic product and so will its stock of net liabilities. To put the point more bluntly, the United States as a whole is forced to go ever more deeply into debt (where debt also includes other claims, such as equity investment). The chart on the next page shows the prospects for U.S. external liabilities under a variety of scenarios. In the brightest of them, net external liabilities level off at around 45 percent of GDP. But if current trends were to continue, net liabilities would reach 100 percent of GDP within eight years. This would be extremely high even for a developing country. At that point, U.S. authorities would also need to sustain a current account deficit of 17 percent of GDP, which is not going to happen. The real exchange rate will have to depreciate first.
So far, many foreign governments are pleased with present arrangements because they are enjoying a stable period of fast export growth. Unfortunately, a part of that export growth entails the accumulation of claims on which the United States will default, one way or another—most likely through a significant currency depreciation. In short, most foreign governments, especially those bent on export-led growth, are living in the present and heavily discounting the future. That’s their privilege, but it does not mean that they are wise for the long run. U.S. authorities will not—cannot—continue to tolerate current trends forever.
The American Dilemma
The United States is remarkably well suited to being the world’s borrower and spender of last resort. It is the world’s biggest and richest economy, comprising nearly a third of the global economy at market prices. It has the world’s deepest financial markets. Its size is a great comfort to foreign creditors. Nobody thinks their claims on U.S. assets are going to be seized or wiped out or endure any of the other miseries that happen in many other debtor countries.
In a world of floating exchange rates, it also makes sense for the issuer of the world’s most important currency to be its largest debtor. Incurring a large net liability position in someone else’s currency is precarious, as we have seen, but there are advantages to doing so in your own. John Maynard Keynes once said, “If you owe your bank a hundred pounds, you have a problem. If you owe a million, it has.” This is especially true if the debt is denominated in your own currency because, when your creditor wants his money back, depreciation offers a simple way to reduce your obligations without a formal default. Creditors will certainly be disappointed to lose a fraction of their equity investments, but not as disappointed as when they watch their debtors plunged into bankruptcy, thus losing nearly all of their investment.
For the United States, however, there are also significant long-run disadvantages from running large current account deficits, even if they are financed by borrowing in U.S. dollars. As noted, a sustained high real exchange rate that squeezes industries which produce tradeable goods and services will almost always generate protectionist pressures. Just as problematic, where is all this accumulating debt to go? American corporations do not want it. They are doing well these days: Their profits are sufficient to finance their investments. So to avoid a deep recession, the government and household sector must do the spending and issue the liabilities. Households in particular are pushed—or rather, powerfully enticed by cheap goods and low interest rates—deeper into debt. For most of the past half century, the American household sector has tended to run a financial surplus—its income has exceeded its aggregate spending. But ever since the household account went into deficit in the 1990s, the household financial deficit has grown dramatically. Aggregate household spending now exceeds its income by 7 percent of GDP every year, which is astonishing—and there appears no end in sight.
Another disadvantage: Foreigners hold U.S. liabilities mostly in Treasuries, which are going to roll over and, with rising interest rates, become more expensive. So the U.S. debt is likely to rise sharply, because the cost of financing it seems certain to jump. If there were a sudden change in mood in the markets, there might be a dollar crisis—which would produce a severe economic shock. We got a hint of that in mid-June, when stock markets across the globe plunged for a few days over fears of inflation and rising interest rates. Markets are always prone to volatility as expectations alter. When foreign governments stop supporting the dollar, its plunge might not just be deep, which is necessary, but swift, which would be disruptive.
There is a geopolitical side to this, as well. In the past, some governments have used net creditor positions in a not particularly friendly manner. During the Suez Crisis of 1956, the U.S. government told its British and French counterparts that it would dump pounds and francs if they did not withdraw their forces—and they withdrew. Some of today’s creditors may incline to be even less friendly to the United States than the United States was to Britain and France almost exactly fifty years ago—although by dumping dollars under current circumstances, a country like China would arguably harm its own position more than the American one.
What about the creditors’ position? There are obvious advantages, some of them already noted. One is that if one does not borrow, there is no need to worry about the sort of disaster in which banking and currency crises interact to produce devastating losses. For Asian emerging market economies, in particular, there are several other advantages. If Asian governments all target the dollar, a de facto Asian monetary region comes into being without the difficulty of persuading the Japanese and Chinese to agree publicly about anything. By targeting the dollar, Asian governments ensure that their currencies move relatively little against one another. This stability encourages the growth of internal trade within the region: About half of Asia’s trade is with itself. Meanwhile stability against the dollar preserves competitiveness in U.S. markets, which remain the most important source of final demand. Thus the combination of liberal trade with stable and highly competitive exchange rates is helping to create a rapidly growing, export-oriented industrial sector that is generating millions of jobs.
Moreover, these governments are securing the value of their domestic excess savings by holding them in U.S. liabilities. This approach enables them to avoid the many obstacles to generating a more efficient, market-oriented and flexible financial system. Instead of getting their own financial systems to work well, which may be politically “too hard” for many governments at the present time, they use the United States as a great big bank. Finally, loaning money to the United States is not a bad way to make a valuable friend.
There are also disadvantages for creditors, however. Since central banks create the money with which they buy foreign currency, this is a huge money-printing operation. Then central banks must find ways to sterilize or offset the impact of the money they have printed, to prevent it from leading to excess credit growth, economic overheating and ultimately inflation. They can do this by selling longer-dated securities to the public or banks, by imposing higher reserve requirements on banks, by direct controls on expansion of bank lending or by some combination of these methods. China must sterilize an expansion in base money of about 10 percent of GDP every year. That is a big job, particularly in a country that has an undeveloped long-term bond market. The heavy reliance on direct control on lending, in turn, makes reforming the financial system next to impossible because controls systematically distort the exercise of judgment by banks and the flow of information about markets.
Another disadvantage to creditors is that their returns on investments in safe securities are low. Ultimately they are likely to suffer large losses, in the hundreds of billions of dollars or more, via the dollar’s depreciation. Meanwhile, this is money that is not being invested in their domestic economies. Subsidizing exports through an undervalued exchange rate, sustained by unhedged lending in foreign currencies invested in low-return assets, is both risky and ultimately expensive.
Clearly, then, there are advantages and disadvantages for everyone in the current position. But the disadvantages—in terms of what is happening to debt accumulations within the American economy, to net U.S. external liabilities, to protectionist pressures and to the potential losses of creditors—will inevitably become bigger over time. And then there is what some might consider a purely normative question: Is it not perverse that about an eighth of the rest of the world’s gross savings is going to the world’s richest country? And that money is not in the main being invested in the United States; it is, instead, supporting household consumption. In a world with so many needs, there must be a better use for the world’s savings.
Leaving to the side the desirability of the current arrangement, there is another question: Is it sustainable? Can the net liability position of the United States ultimately reach 200 percent of GDP, as current trends would suggest? Simply put, that is not going to happen. At some point, there will be an adjustment.
Some economists, notably, Richard Cooper at Harvard University and Ricardo Caballero of MIT, argue that with the advent of globalization structural surplus countries and, correspondingly, natural debtors have emerged. According to their view, the United States can sustain its debtor position as long as surplus countries maintain their surpluses. The problem with this argument is that the U.S. current account deficit is not steady—it is exploding. Moreover, a net liability position greater than GDP is historically rare. The United States should indeed be running a deficit, but one this large and growing this fast looks unsustainable.
With respect to China in particular, other economists, such as Michael Dooley of the University of California, Santa Cruz, argue that the current arrangement is encouraging the same sort of growth as occurred in postwar Germany and Japan, and that it will continue until China’s labor surplus (of 800 million people) is fully absorbed some 15 to twenty years from now. The problem with this argument has to do with what we might call, somewhat playfully, diseconomies of scale. China is too big: If it stays on its current course, Chinese foreign currency reserves could well exceed $3 trillion by 2015. Besides having an expensive export subsidy policy, China risks a huge protectionist backlash in the United States. Moreover, at such surplus levels a currency adjustment is inevitable, and if China has anything like $3 trillion in reserves when that finally happens, it might lose 50 percent of its current GDP off the domestic value of the reserves.
For all these reasons, an adjustment in the current global financial imbalance is both desirable and inevitable. But it is likely to come in the form of a financial crisis unless effective policies first begin to shift the system onto more solid footing. What mix of policies will be needed to accomplish that?
First, the U.S. current account deficit needs to shrink, but not to zero. In today’s global economy, in which the United States is indeed a natural debtor, a current account deficit at 3–4 percent of GDP should prove quite manageable. But if the U.S. deficit is to shrink, demand in the rest of the world has to grow faster than potential output—and that poses a significant macroeconomic and financial challenge. Which countries can manage a swing from surplus to deficit large enough to offset the U.S. adjustment?
The natural countries to run deficits are fast-growing countries with large reserves and huge inflows of foreign direct investment (FDI), because FDI is a risk-free way of financing a current account deficit. With enormous reserve cushions, these countries could pursue policies that allow for current account deficits relatively safely. Only Asia provides that mix, particularly China and to a lesser extent India. China is the big decision-maker in this regard, because its actions will influence everything else that happens in Asia. China could—and should—let its surplus shrink; but its government has not worked out how large a current account surplus and foreign currency reserve it can afford to create. It seems, instead, to be content to let the current situation run its course.
The right policy mix is therefore straightforward: higher savings, including a fiscal tightening, in the United States on the one hand, and a combination of expansionary policy and structural reform in Asia on the other. The priorities should be an end to such export-dependent growth, which in turn will require a more sensible macroeconomic regime, a reformed financial sector and better functioning global institutions.
None of this will be easy, however. Part of the problem in convincing successful emerging markets to abandon mercantilist growth strategies is that these have proven the most successful route to development in the past half century, from postwar Japan and Germany to South Korea and now China. The mercantilist approach has usually entailed low consumption, high investment, and even higher savings and current account surpluses. But China will be unable to pursue this strategy to a successful conclusion because it is too big. If it continues in this mercantilist way, it will ultimately prove globally destabilizing.
In an interesting recent paper, two IMF economists argue that China should focus instead on making its economy resilient to large shocks, on ensuring the sustainability of its growth, and on translating this growth into more widely shared benefits for its citizens.3 In order to do this, they insist, China will need comprehensive reforms in its financial sector and legal system, along with a move to inflation targeting, a floating exchange rate, central bank autonomy and more public spending on social capital. One may add to this list that China must be willing to run a current account deficit. But the question that obviously emerges from the experience of crises past is how big a current account deficit can they risk running?
In China’s case, a deficit equal to long-term inflow of FDI, about $50 billion, is essentially risk free. If China were to run a deficit of that size, it would generate a massive shift in its current account of about $200 billion, from the last year’s surplus of over $150 billion. India is already running a deficit, which is helpful, but as FDI to India increases rapidly in coming years, it could run larger deficits. Along with fiscal tightening in the United States, Chinese and Indian actions alone would serve to put the global balance of payments on a better footing. But reductions in surpluses in oil countries would also help, as would stronger demand—and a move into aggregate current account deficit—by continental Europe.
In order to give emerging market countries the confidence that they can safely shift away from mercantilism, they must erect more sensible macroeconomic regimes. This means exchange rate flexibility for most countries, the continued abandonment of exchange controls, autonomous central banks that focus on inflation targeting, and governments that keep their finances in order.
One good thing that emerged from the financial crises of the past two decades is that the era of pegged exchange rates is over. That does not mean we have genuinely freely floating rates instead. Most economies with floating currencies intervene to manage their rates. But as Argentina’s experience shows, the choice is not whether to float, but how to float: either on one’s own, or pegged to some other floating currency, in that case the U.S. dollar. And the latter policy only makes sense when both countries are natural trading partners or are subject to similar economic conditions.
Another exchange-rate lesson of crises past is that the safest way to borrow in an adjustable-currency world is in one’s own currency. That way, currency risk is borne by those best able to diversify those risks, namely, the international creditors. Some think that foreigners will always avoid assets or liabilities denominated in emerging market currencies, but there is no compelling reason why this should be so. The challenge for emerging markets is to persuade their own citizens to lend domestically. Once there is a deep and stable market in domestic-currency-denominated bonds, foreigners will enter. Of course, the ability to borrow in one’s own currency demands the creation of a sound currency, which depends upon the other reforms discussed here. But that is the only viable future for large-scale international borrowing in the current era of globalization.
As to exchange controls, things are already moving in the right direction. Developing countries have been abandoning exchange controls for decades. That is good news, because exchange controls, often thought of as protective, create a host of problems, especially corruption, that developing countries are particularly ill-equipped to handle.
Third on the macroeconomic list of priorities is an independent central bank that focuses on inflation targeting. This is indispensable. One cannot operate an economy on the basis of a managed float with no exchange controls unless one has a monetary regime that gives people confidence in the currency.
In the area of fiscal policy, a country has to ensure solvency in the long run and flexibility in the short run. It sounds simple but in practice can be difficult to achieve. Yet it must be achieved. If it is not, monetary stability is impossible and international demand for borrowing in the domestic currency will not materialize.
What is required to make a national financial system work tolerably well is evident from the experience of the high-income countries. There needs to be a system that limits the moral hazard generated by deposit guarantees while giving enough of a guarantee to prevent runs. There needs to be a well-functioning property-rights regime, effective bankruptcy procedures and transparent accounts. No international lender will lend without being able to tell what shape borrowers are in, or how much collateral is really worth. Financial institutions need to be adequately capitalized and operating under independent regulators. Financial-sector reforms are particularly difficult in emerging market countries because the obstacles often go far beyond the merely economic. Endemic corruption in countries with entrenched business interests closely connected to political power is, for example, a huge obstacle to financial sector reform in many cases.
The Institutional Dimension
Fixing global finance predominantly involves a set of domestic challenges, but global institutions have roles to play, as well. There are four central tasks for such institutions: technical assistance, surveillance, coordination and crisis lending. And with these tasks come associated questions of institutional reform and representation.
Just to indicate how complicated all of this has become, the following bodies have been actively engaged in technical assistance: the IMF, the World Bank and regional development banks, the BIS (Basel Committee on Banking Supervision) and the Financial Stability Forum, the International Organization of Securities Commissions, the International Association of Insurance Supervisors, the International Accounting Standards Board and the International Federation of Accountants. I presume and hope that all of this has done much good, because they have been very busy. Reading their reports is an exercise in unrelieved tedium, but they do illustrate an immense amount of improvement. And that ought to be the case, because the experiences of the 1980s and 1990s were so painful that nobody would rationally want to repeat them. On paper, a lot has happened to improve the strength of the systems in many countries in the world.
The IMF is the body principally responsible for surveillance, but in order to serve that function, it needs to be more professionally independent, and it needs a leader of the highest caliber chosen by the membership as a whole. Exchange rates are by definition a topic that affects more than one country. They are, therefore, an obvious candidate for international coordination, or at least frank and open discussion. But with the dominant role of the Fund’s Executive Board, that is not what is happening now.
Then there is the question of crisis lending. At present, the IMF is essentially out of the lending business. It has only one large borrower: Turkey. There does remain, nevertheless, a strong case for reserve pooling and lending in the case of a liquidity crisis. It is crazy for countries to invest in $4 trillion of reserves when we could have the reserve-pooling function of an institution like the IMF instead. That means that the Fund should be able to lend freely in crises. But at present, the fund has only $300 billion at its disposal, and that is not enough to deal with major systemic crises.
Above all, the IMF needs more legitimacy. We cannot continue with the present situation in which the high-income countries, which never use the IMF’s resources, continue to dominate the institution so completely. In light of the controversial role the IMF played in the financial crises of the late 1990s and the consequent reluctance of emerging market economies to become dependent on its good offices, one has to wonder whether the IMF will ever again play a central role in the world economy.
What the world needs is a financial and global macroeconomic regime that allows all generally well-run countries to import capital reasonably safely; ends the world’s excessive reliance on the United States as borrower and spender of last resort, while preventing a return to the cycle of massive financial crises that preceded the U.S. deficits; and works on the basis of good domestic policies and global discussion of topics of obvious mutual interest.
It is perfectly feasible to do all these things if we learn the big lessons of the past: Do not borrow huge quantities in foreign currency; encourage inward FDI; do not open up rotten financial systems before they have been reformed; do not make exchange rate commitments that cannot be kept; do international finance, but do it carefully; and do not rely on a mercantilist growth strategy forever, particularly if you are the world’s most populous country!
The most important challenge is to understand the system of global finance we have today and fix its problems quickly. The huge current account deficit of the United States is in large part a consequence of the past failures in transferring resources to developing countries. But it is only a temporary solution and one that depends on a perverse flow of capital from many of the world’s poor savers to its richest consumers. This needs to change. But it will do so only with large reforms. If we move in the right direction, we should be able to see the tide of globalization flowing in ever broader and more inclusive waves across the world. If we do not, it will go out again, as it did in the early 20th century.
1Barry J. Eichengreen and Michael D. Bordo, “Crises Now and Then: What Lessons from the Last Era of Financial Globalization?” NBER Working Papers (January 2002).
2Mishkin, “Is Financial Globalization Beneficial?” NBER Working Papers (December 2005).
3Eswar S. Prasad and Raghuram G. Rajan, “Modernizing China’s Growth Paradigm”, IMF Policy Discussion Papers (March 2006).