Newsweek International, February 1, 1999

The Crisis of Global Capitalism

In an excerpt from his new book, the billionaire financier assesses the current state of the world economy, describes how close we came to a collapse and offers some ways to prevent a real meltdown

Less than six months ago, the global financial system was teetering on the brink of collapse. Russia had defaulted on its treasury bills, financial institutions were extremely risk averse, and the price differentials between various classes of financial instruments were so out of kilter that a large hedge fund, Long-Term Capital Management, was nearly wiped out. Since major banks and investment banks were, like LTCM, massively speculating on those differentials, the system literally came within days of a meltdown. It was only the firm and timely intervention of the Federal Reserve that saved the day.

Since then, interest rates have been lowered repeatedly, and a number of good things have happened. Markets have recovered their poise. In the U.S., stock prices have made new highs; in Europe, the introduction of the euro has gone off without a hitch. The system has survived a severe testing, and if I want to talk about the global financial crisis, the first question I have to answer is, "What crisis?"

The fact is that economies at the periphery of the system have suffered tremendous declines, such as haven't been seen since the Great Depression. People in countries like Indonesia and Thailand have been plunged into misery. But these people are far away, and the economies at the center—Europe and the U.S.—have actually benefited from their troubles. Since we have learned to suffer other people's pain without flinching, it would be only too easy to dismiss the recent turmoil and carry on with business as usual. But we would do so at our peril. The events of the last 18 months have revealed certain fundamental flaws in the system. Unless we attend to them, the system is liable to disintegrate—and we too shall suffer the consequences.

We live in a global economy that is characterized not only by free trade in goods and services but even more by the free movement of capital. Interest rates, exchange rates and stock prices in various countries are intimately interrelated and global financial markets exert tremendous influence on economic conditions. Given the decisive role that international financial capital plays in the fortunes of individual countries, it is not inappropriate to speak of a global capitalist system.

The system is very favorable to financial capital, which is free to go where it is best rewarded. This has led to the rapid growth of global financial markets. The result is a giant circulatory system, sucking capital into the financial markets and institutions at the center and then pumping it out to the periphery either directly, as credits and portfolio investments, or indirectly through multinational corporations. As long as the circulatory system is vigorous, it overwhelms most other influences. Capital brings many benefits, not only an increase in productive capacity but also improvements in methods of production and other innovations; not only an increase in wealth but an increase in freedom.

Until the Thai crisis in 1997, the center was both sucking in and pumping out money vigorously, financial markets were growing in size and importance and countries at the periphery could obtain an ample supply of capital by opening up their capital markets. There was a global boom in which the emerging markets fared especially well. At one point in 1994 more than half the total inflow into U.S. mutual funds went into emerging-market funds.

The Asian crisis reversed the direction of the flow. Capital started fleeing the periphery. At first, the reversal benefited the financial markets at the center. The U.S. economy was just on the verge of overheating and the Federal Reserve was contemplating raising the discount rate. The Asian crisis rendered such a move inadvisable, and the stock market took heart. The economy enjoyed the best of all possible worlds, with cheap imports keeping domestic inflationary pressures in check, and the stock market made new highs. The buoyancy at the center raised hopes that the periphery might also recover, and between February and April of last year most Asian markets recovered roughly half their previous losses measured in local currencies. That was a classic bear-market rally.

There comes a point when distress at the periphery cannot be good for the center. That point was reached with the meltdown in Russia in August of last year. I have three main reasons for saying so. First, the Russian debacle has revealed certain flaws in the international banking system which had been previously disregarded. In addition to their exposure on their own balance sheets, banks engage in swaps, forward transactions and derivative trades among each other and with their clients. These transactions do not show up in the balance sheets of the banks. Swap, forward and derivative markets are very large and the margins razor thin; that is to say, the value of the underlying amounts is a manifold multiple of the capital employed in the business. The transactions form a daisy chain with many intermediaries, and each intermediary has an obligation to his counterparts without knowing who else is involved.

This sophisticated system received a bad jolt when the Russian banking system collapsed. Russian banks defaulted on their obligations, but the Western banks remained on the hook to their own clients. No way was found to offset the obligations of one bank against those of another. Many hedge funds and other speculative accounts sustained large enough losses that they had to be liquidated. Normal spreads were disrupted, and professionals who arbitrage between various derivatives, i.e., trade one derivative against another, also sustained large losses. The disruption culminated with the forced rescue of Long-Term Capital Management.

Second, the pain at the periphery has now become so intense that individual countries have begun to opt out of the global capitalist system or simply fall by the wayside. First Indonesia, then Russia, suffered a pretty complete breakdown. What happened in Malaysia and, to a lesser extent, in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia shut itself off from international capital markets deliberately. Its action has brought temporary relief to the Malaysian economy and allowed its rulers to maintain themselves in power, but, by reinforcing a general flight of capital from the periphery, it has put additional pressure on those countries that are trying to keep their markets open. If the capital flight makes Malaysia look good in comparison with its neighbors, the policy may easily find imitators.

The third major factor working for the disintegration of the global capitalist system was the evident inability of the international monetary authorities to hold it together. IMF programs did not seem to be working and the IMF nearly ran out of money. The response of the G-7 governments to the Russian crisis was woefully inadequate, and the loss of control was quite scary. Financial markets are rather peculiar in this respect: they resent any kind of government interference, but they hold a belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken.

The near-failure of LTCM served as a wake-up call to the financial authorities. The New York Fed brought the leading investment banks into the same room and persuaded them to inject additional equity into the hedge fund. The Federal Reserve lowered interest rates, Congress voted the long-delayed capital increase for the IMF and a $41 billion rescue package was put together for Brazil. Unfortunately, the package did not prevent a renewed crisis.

The response of the Federal Reserve to the crisis at the center stands in stark contrast to the response of the IMF to the crises at the periphery. The Fed lowered interest rates; the IMF insisted on raising them. The results show the difference. Wall Street has recovered in short order, while the economies at the periphery have been plunged into deep depression. There is an urgent need to rethink and reform the global capitalist system.

Today that global capitalist system still stands near the height of its powers. It is certainly endangered by the present global crisis, but its ideological supremacy knows no bounds. The Asian crisis has swept away the autocratic regimes that combined personal profits with Confucian ethics and replaced them with more democratic, reform-minded governments. But the crisis has also undermined the ability of the international financial authorities to prevent and resolve financial crises. How long before the crisis starts sweeping away reform-minded governments? I am afraid that the political developments triggered by the financial crisis may eventually sweep away the global capitalist system itself.

The role that financial markets play in the world ought to be radically reconsidered. In the case of the financial crisis that originated in Thailand, the financial markets behaved very differently from the way economic theory would suggest. Financial markets are supposed to swing like a pendulum: they may fluctuate wildly in response to exogenous shocks, but eventually they are supposed to come to rest at an equilibrium point. Instead, as I told Congress, financial markets behaved more like a wrecking ball, swinging from country to country, knocking over the weaker ones. It is difficult to escape the conclusion that the international financial system itself is the main culprit in the meltdown process.

It would be regrettable if Americans remained complacent because most of the trouble is occurring beyond their borders. The U.S. economy has actually benefited from lower raw-material prices and cheaper imports from countries that have been plunged into depression. But with one-third of the world in depression, not only exports but also investments are likely to fall. Profit margins are under pressure. The public has become deeply engaged in the stock market, and the personal savings rate is in negative territory. Consumption has been fueled by the wealth effect, and it can be sustained only by ever-rising stock prices.

It is time to recognize that financial markets are inherently unstable. Imposing market discipline means imposing instability, and how much instability can society take? Market discipline needs to be supplemented by another discipline: maintaining stability in financial markets ought to be an explicit objective of public policy.

To put it bluntly, the choice confronting us is whether we will regulate global financial markets internationally or leave it to each individual state to protect its own interests as best it can. The latter course will surely lead to the breakdown of the gigantic circulatory system. Sovereign states can act as valves within the system. They may not resist the inflow of capital but they will surely resist the outflow, once they consider it permanent.

The most urgent need is to arrest the reverse flow of capital. That would ensure the continued allegiance of the periphery to the global capitalist system, which would in turn reassure the financial markets at the center and moderate the ensuing recession. It is appropriate to lower interest rates in the United States, but that is no longer sufficient to staunch the outflow from the periphery. Liquidity must be pumped more directly into the periphery.

In an article published in the Financial Times on December 31, 1997, I proposed establishing an International Credit Insurance Corporation. The proposal was premature because the reverse flow of capital had not yet become a firmly established trend. My proposal fell flat, but its time has now come.

President Clinton and Treasury Secretary Robert E. Rubin spoke about the need to establish a fund that would enable periphery countries that are following sound economic policies to regain access to the international capital markets. They mentioned a figure of $150 billion. Although their proposal did not receive much support at the annual meeting of the IMF in October 1998, I believe it is exactly what is needed. The IMF programs in Thailand and Korea have failed to produce the desired results because they did not include a debt-to-equity conversion scheme. The external balance of these countries has been re-established at the cost of a severe contraction of domestic demand, but the balance sheets of both banks and companies continue to deteriorate. As things stand now, these countries are doomed to languish in depression for an extended period. A debt-to-equity conversion scheme could clear the decks and allow their domestic economies to recover, but it would force the international creditors to accept and write off losses. They would be unwilling and unable to extend credit, making it impossible to implement such a scheme without finding an alternate source of international credit. That is where the international credit guarantee scheme would come into play. It would significantly reduce the cost of borrowing and enable the countries concerned to finance a higher level of domestic demand than they are able to sustain currently. This would be helpful not only to the countries concerned but also to the world economy. It would provide a reward for belonging to the global capitalist system and discourage defections along the Malaysian lines.

The thorniest problem is how the credit guarantees allocated to an individual country would be distributed among that country's borrowers. To allow the state to exercise the right would be an invitation for abuse. The guarantees ought to be channeled through authorized banks that would compete with each other. The banks would have to be closely supervised and prohibited from engaging in other lines of business that could give rise to unsound credits and conflicts of interest. The banks would have to be reasonably well capitalized in order to provide a cushion against losses on individual credits. In short, the banks would have to be as closely regulated as U.S. banks were after the breakdown of the U.S. banking system in the banking panic of 1933. It would take time to reorganize the banking system and to introduce the appropriate regulations, but the mere announcement of the scheme would have a calming effect on financial markets and allow time for a more thorough elaboration.

Some will wonder whether it is possible to accomplish such a complicated task. The answer is that the new institution is bound to make mistakes, but the markets will provide valuable feedback and the mistakes can be corrected. After all, that is how all central banks operate, and on the whole they do a pretty good job.

It is much more questionable whether such a scheme is politically feasible. There is already a lot of opposition to the IMF from market fundamentalists who are against any kind of market intervention, especially by an international organization. If the banks and financial market participants who currently benefit from the asymmetry cease to support it, it is doubtful whether the IMF can survive even in its present inadequate form. It will require a change of mentality to get governments, parliaments and market participants to recognize that they have a stake in the survival of the system. The question is whether this change of mentality will occur before or after the collapse of the system.

Hedge funds: There has also been much discussion of the role of hedge funds in destabilizing the financial system, especially in the wake of the bailout of Long-Term Capital Management. I believe the discussion is misdirected. Hedge funds are not the only ones to use leverage; the proprietary trading desks of commercial and investment banks are the main players in derivatives and swaps. Most hedge funds are not engaged in those markets. Soros Fund Management, for instance, is not in that line of business at all. We use derivatives sparingly and operate with much less leverage. Long-Term Capital Management was in some ways exceptional: it was, in effect, the proprietary trading desk of an investment bank, Salomon Brothers, transplanted into an independent entity. Having proved successful, it was beginning to spawn imitators. Even so, hedge funds as a group did not equal in size the proprietary trading desks of banks and brokers, and it was the threat that Long-Term Capital Management posed to those institutions that prompted the Federal Reserve Bank of New York to intervene. The correct remedy is to impose margin requirements and so-called haircuts (capital requirements) on derivative and swap transactions and other off-balance-sheet items. These regulations should apply to the banks and their customers, the hedge funds, alike.

I am not defending hedge funds. I believe hedge funds should be regulated like all other investment funds. They are difficult to regulate because many of them operate offshore, but if the regulatory authorities cooperate, this should not present any insuperable difficulties. The important point is that the regulations should apply to all entities equally.

Capital controls: It has become an article of faith that capital controls should be abolished and the financial markets of individual countries, including banking, opened up to international competition. The IMF has even proposed amending its charter to make these goals more explicit. Yet the experience of the Asian crisis ought to make us pause. The countries that kept their financial markets closed weathered the storm better than those that were open. India was less affected than the Southeast Asian countries; China was better insulated than Korea.

Having open capital markets is highly desirable not only for economic but also for political reasons. Capital controls are an invitation for evasion, corruption and the abuse of power. A closed economy is a threat to liberty. Mahathir of Malaysia followed up the closing of capital markets with a political crackdown.

Unfortunately, international financial markets are unstable. Keeping domestic financial markets totally exposed to the vagaries of international financial markets could cause greater instability than a country that has become dependent on foreign capital can endure. Some form of capital controls may therefore be preferable to instability even if it would not constitute good policy in an ideal world. The challenge is to keep international financial markets stable enough to make capital control unnecessary. A credit guarantee scheme could help to accomplish that goal.

The main justification for keeping capital markets open is to facilitate the free flow of capital into long-term instruments, such as stocks and bonds. When the direction of the flow is reversed the justification disappears. It is imperative that countries on the periphery be encouraged not simply to turn their backs on the global system in the Malaysian manner; to ensure this the IMF and other institutions may have to recognize the case for some regulations on capital flows. There are subtle ways in which currency speculation can be discouraged that fall well short of capital controls. Banks can be required to report on the currency positions they hold both for their own and for their clients' accounts and, if necessary, limits can be imposed on the size of such positions. These techniques can be quite effective. The constraint on national central banks is that they can exercise control only over their own banks; but once the principle that some controls are legitimate is established, there could be a lot more cooperation between national central banks. It should be possible to curb speculation without incurring all the harmful side effects of capital controls.

This is about as far as I want to go in prescribing solutions. Perhaps I have already gone too far. All I wanted to do was to stimulate a discussion out of which the appropriate reforms may emerge. There are no permanent and comprehensive solutions; we must always remain on the alert for further problems. One thing is certain: financial markets are inherently unstable; they need supervision and regulation. The only question is whether we have the wisdom to strengthen our international financial authorities, or do we leave it to individual countries to fend for themselves?

To stabilize and regulate a truly global economy, we need some global system of political decision making. In short, we need a global society to support our global economy. A global society does not mean a global state. To abolish the existence of states is neither feasible nor desirable; but insofar as there are collective interests that transcend state boundaries, the sovereignty of states must be subordinated to international law and international institutions. Interestingly, the greatest opposition to this idea is coming from the United States. But there has never been a time when a strong lead from the U.S. and other like-minded countries could achieve such powerful and benign results. With the right sense of leadership and with clarity of purpose, the U.S. and its allies could help to stabilize the global economic system and to extend and uphold universal human values. The opportunity is waiting to be grasped.

Newsweek International, February 1, 1999

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