The free flows of international capital have been enormously beneficial for developed and developing countries alike but they also pose risks, says J. Bradford De Long, a University of California at Berkeley professor and former Treasury Department official."Countries that seek to take advantage of the large benefits of global capital flows need to make sure that they do not destroy their own ability to handle crises," says De Long, who served as Deputy Assistant Secretary of Treasury for Economic Policy from 1993 to 1995.
This will require vigilance against the accumulation of foreign currency-denominated debt, which can be a catastrophic burden if the country has to devalue its currency, and the creation of a good banking supervisory system with the power to close down insolvent or nearly insolvent banks, De Long says. Most important, however, is a well-capitalized International Monetary Fund that can lend assistance in times of emergencies, something that only the developed countries can provide, he notes.
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. The flows also allowed workers in the resource-rich periphery access to the fixed and working capital they needed to multiply their productivity -- and 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, as international investors sought to put their wealth in safe havens: first Britain, and then, as Britain began to look shaky, the United States. Central bank and finance ministry beliefs that long-run growth required holding on to the gold standard -- keeping their currency worth a fixed and set amount of gold -- led them to induce recessions in order to maintain that standard. In the end, the maintenance of the gold standard proved impossible. The political will to keep the gold value of the currency and the exchange rate constant dissipated as unemployment deepened in the Great Depression. The only thing 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 otherwise would 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. They saw the freer flow of capital as bringing little more than trouble: destabilizing speculation, irrational capital flight, and the potential for chains of contagious panic like those that had brought on the Great Depression. Stable, if not actually fixed, 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 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 second and third generations of post-World War II economists regretted the fact that capital controls kept people in industrial countries with money to lend away from people in developing economies who could make good use of the money to expand economic growth. They 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.
BALANCING BENEFITS AND PROBLEMS
So now we have all the benefits of free flows of international capital. These benefits are enormous. The ability to borrow from abroad kept the Reagan deficits from crushing U.S. economic growth like an egg, and it has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge with those of the industrial core.
But the free flow of financial capital is also giving us one major international financial crisis every two years. The root cause of the crises is the sudden shift in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996; then they turned around and are all going the opposite way today. Economists will dispute which movement was or is 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 capital out of emerging markets today an irrational panic? The correct answer is probably "yes" -- the market was manic, it is now overly pessimistic; 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 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 signaled 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. This is what happens if the banks and firms in a country that is devaluing have borrowed not in their local currency but in the major international currencies -- U.S. dollars, pounds, yen, or marks.
Thus, the first thing that a country seeking to take advantage of international capital flows must do is establish a system to detect and penalize home-country institutions and firms that borrow in money-center currencies. A large amount of such borrowing is what turns a shift in the confidence of foreign investors from an annoyance to a catastrophe. Governments in countries that borrow heavily from abroad should discourage and curtail their citizens (and themselves) from borrowing directly in the international currencies, such as yen, dollars, pounds, and marks.
The second thing that must be done is the creation of a good system of domestic banking regulation: a system that will detect -- and close down -- financial institutions that are insolvent or nearly insolvent, and that thus have strong incentives to make risky but uneconomic investments. After all, if a firm is already insolvent, any further investments it makes are "heads, we win; tails, our creditors lose" propositions. Only if the financial system can be kept well-capitalized and solvent will the inflow of foreign capital generate productive and profitable investments.
But most of all there needs to be sufficient international liquidity to handle the kind of large-scale financial crisis that springs from a sudden shift in the degree of optimism of investors in the industrial core. There needs to be a well-capitalized International Monetary Fund (IMF) to make structural adjustment loans to countries willing to adopt policies that will generate future export surpluses. There needs to be a willingness on the part of creditor countries to accept flows of imports from developing countries that are the counterparts of financial flows.
IMPORTANCE OF IMF AND G-7 SUPPORT
And it is from this perspective that recent political developments are very troubling. It is not that there is anything wrong with the conclusions of the Birmingham Group of Seven (G-7) summit of industrial country leaders: they are all good ideas. But in our current international financial system, sudden changes in investors' sentiment will generate large shifts in hot money around the globe -- and there must be sufficient reserves in the G-7 and the IMF to neutralize the effects of such shifts, and there must be the willingness on the part of the G-7 and the IMF to use their reserves when necessary.
Yet congressional leaders in the United States -- who must appropriate new money for the IMF -- appear to scorn the Fund as an alien and untrustworthy institution, rather than as one of the key instrumentalities in maintaining the extraordinarily successful international economic order that the Truman administration put into place at the end of World War II. The internationalist consensus that dominated the U.S. government since the end of World War II appears to be gone.
Only by the skin of its teeth -- and by a very creative reading of the legislative mandate governing use of the U.S. government's Exchange Stabilization Fund -- did the U.S. government contribute to the successful resolution of Mexico's peso crisis in 1995. There is no guarantee that there will be more congressional realization of America's national interest in a prosperous world economy in any future crisis.
Thus, from the perspective of any developing country preparing for international capital flows, the most important thing that needs to be done is completely outside its power: the creation of an IMF and a G-7 that can provide support to deal with international financial crises in the absence of U.S. leadership.
Charles Kindleberger, a noted economist and historian, thought that, at the deepest level, the cause of the Great Depression was that Britain could no longer and the United States would not take responsibility for dealing with international financial crises. It is hard to escape the conclusion that we are about to enter an era in which once again the United States will not take responsibility. And as in the 1920s, no other institution or coalition that could take over the role of managing the world economy is visible.
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