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«&(3$ Center for Economic Policy Analysis International Capital Markets and the Future of Economic Policy John Eatwell (University of Cambridge) and ...»

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Center for Economic Policy Analysis

International Capital Markets and the Future of Economic Policy

John Eatwell (University of Cambridge) and

Lance Taylor (Center for Economic Policy Analysis)

CEPA Working Paper Series III

International Capital Markets and the Future of Economic Policy

A Project Funded by the Ford Foundation

Working Paper No. 9

August 1998 (Revised September 1998)

Center for Economic Policy Analysis

New School for Social Research

80 Fifth Avenue, Fifth Floor, New York, NY 10011-8002 Tel. 212.229.5901 ì Fax 212.229.5903 http://www.newschool.edu/cepa International Capital Markets and the Future of Economic Policy “A global financial system, of course, is not an end in itself. It is the institutional structure that has been developed over the centuries to facilitate the production of goods and services.” (Alan Greenspan, October 14, 1997) This Report reviews the current behavior and structure of international capital markets and suggests institutional and policy changes to improve their impact on the performance of real economies, or the production of useful goods and services.

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:

Given that every crisis has its own specific characteristics, what do their common factors suggest about particular strategies in international financial policy?

Should the ubiquitous policy stance of the past three decades in favor of international financial liberalization be qualified in the light of experience? If so, how?

Is any consistent policy toward financial markets, other than liberalization, practically

–  –  –

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 analysis in this Report draws heavily on papers written by participants in a project on International Capital Markets and the Future of Economic Policy, organized by the Center for Economic Policy Analysis at the New School for Social Research and supported by the Ford Foundation.

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.

Deteriorating performance of the real economy 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.

Volatility Liberalization has undoubtedly resulted in financial markets becoming more volatile, whether measured by short term swings in exchange rates and interest rates, or the longer swings such as that in the real value of the dollar from an index of 100 in 1980, to 135 in 1985, down to 94 in 1990, and up again to 134 in 1998. Volatile financial markets generate economic inefficiencies.

Volatility creates financial risk, and even if facilities exist for hedging that risk, the cost of capital formation is raised. The impact of financial market volatility is felt not only in Latin America and East Asia. In the face of higher and more volatile real interest rates, US corporate defaults have increased enormously since the early 1970s.

Contagion And the damage done by financial volatility is not confined to countries with real economic imbalances - volatility is contagious. The Mexican bond crisis of 1994 propagated the “tequila effect” throughout Latin America. The Asia financial crisis has spread throughout emerging markets, including Eastern Europe, Latin America, and South Africa. The stock market crash of 1987 spread rapidly from New York to all financial markets. A recent study of the 1992 ERM crisis (Buiter, Corsetti and Pesenti, 1998) has concluded that systemic contagion makes the link between domestic macroeconomic conditions and the size of currency devaluations, let alone the likelihood of a crisis, “tenuous”. Indeed, the link may even have the “wrong” sign, with the financially virtuous suffering the greater punishment!

Changed behavior in both public and private sectors It will be argued in this Report that the volatility, contagion, and hence uncertainty associated with liberal financial markets have not only imposed short-term shocks on the real economy of affected countries and regions, but have in fact led to changes in trend performance by inducing changes in behavior in both public and private sectors.

Public sector 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

–  –  –

However, the BIS then warns, "yet such a safeguard is by no means always effective”.

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