DERIVATIVES STUDY CENTER
www.financialpolicy.org 1600 L Street, NW, Suite 1200
New Rules for Global Finance
Director, Directives Study Center
Department of Economics, American University
Very little has changed since the East Asian financial crisis nearly derailed the world economy several years ago. Trillions of dollars continue to flow through global financial markets, with little or no regulation, almost as if nothing had happened. So it is welcome news that President Bush has appointed new economic advisors who want to refocus attention on the need for “new global financial architecture.”
Senior U.S. officials like Treasury Secretary Paul O’Neill and chief presidential economic adviser, Lawrence Lindsey, have joined the growing international circle of policy analysts and street protestors who have been demanding the reform of international financial institutions, particularly the International Monetary Fund (IMF). Unfortunately, the Bush team's definition of the problem is too narrow and its single solution impractical.
According to the Bush team, the financial crises in developing countries were caused by "moral hazard"--a situation in which investors, who expect to be bailed-out by governments or international financial institutions, take greater risks than they would otherwise. The Bush solution is to announce that, henceforth, there will be no bailouts. For developing countries feeling the heat of a financial meltdown, this approach gives new meaning to the term benign neglect. More likely, however, this is an empty threat. Most economists believe that the Bush Administration, faced with the likelihood of serious harm to U.S. interests, would take whatever rescue measures were necessary.
The financial markets, understanding this, will not act more responsibly.
This is a textbook case of how faulty analysis leads to bad policy. Almost all observers now agree that the financial crises of the past decade were caused by a combination of problems including over-valued fixed exchange rates, large trade deficits, "hot money" flowing into the small emerging capital markets, poorly regulated financial markets and various forms of local corruption or "cronyism." Developing country financial crises were not caused by any one factor and will not be prevented by any single policy change.
Benign neglect will not fix these problems. And unfortunately a lack of preventive measures is exactly what got us where we are today. No real changes were made after the Mexican peso crisis in December of 1994, or the East Asia crisis in the summer of 1997. The Russian and Brazilian crises followed in 1998. And although the IMF and World Bank have created new departments--the World Bank promises to focus more on poverty and the IMF to conduct better market surveillance--still there is no major change.
Although the critical posture of the Bush team is appropriate, its passivity is not. New and more severe crises cannot be prevented or mitigated unless new measures are adopted to reduce the disruptive shifts of financial flows. The Bush team should start by insisting that the IMF stop pressuring developing countries to deregulate their financial markets. Many ardent free traders now observe—after near meltdowns in Mexico, Thailand and Turkey—that financial “liberalization” often precedes financial crashes, and fails to deliver the promised higher rates of economic growth. Some have even embraced an idea first suggested three decades ago by Nobel Laureate economist James Tobin: slow down the rate at which “hot money” moves in and out of countries by levying a modest financial transaction tax.
The Administration should then discourage some of the riskiest activities, the ones that have financial panic written all over them: establish and enforce adequate capital and collateral requirements for all investors so that their losses do not undermine the financial system; eliminate off-shore money laundering and the use of tax havens that assist the evasion of national financial market regulations; and rein in hedge funds which pool the money of wealthy investors for high stakes betting on the direction of currency fluctuations.
The Bush Administration wasted no time establishing its “get tough” foreign policy bona fides, but on the most pressing international financial problems it is pointing an empty gun at the wrong target.