The most disturbing part of an "unexpected financial crisis" is that it is indeed unexpected. The whole basis of finance theory rests on the notion that investors and borrowers are able to establish the appropriate cost of capital that reflects their mutual assessment of anticipated risk relative to potential reward for any given project over any given time. But when careful calculations of imputed rates of return are annihilated by money meltdown -- such as Mexico's peso devaluation in 1994, the Asian crisis that began in 1997, or Russia's debt moratorium and ruble collapse last summer -- all assumptions regarding normal performance on financial transactions are thrown out of whack. Indeed, the foundation of capitalism is shaken when individuals who have made investment capital available to others in expectation of future income streams are suddenly confronted with a disastrous breakdown of the perceived parameters of the financial understanding.

A Monetary Cornerstone

The word "credit" is derived from the classical Latin credere, to trust, believe. To violate the implicit terms of a financial agreement that involves accepting capital funds today under a contractual obligation to restore them at maturity is to undermine the most basic tenet of capitalism: faith in the future. No wonder Federal Reserve Board Chairman Alan Greenspan emphasized this point in September 1998, shortly after the Russian debacle had paralyzed international financial markets. Speaking at the University of California at Berkeley, Greenspan noted that the "vicious cycles" leading to global crisis revealed "the key role in a market economy of a critical human attribute: confidence or trust in the functioning of a market system." We take it for granted that contracts will be fulfilled in the normal course of business and that others will perform as promised, Greenspan explained. "A key characteristic, perhaps the fundamental cause of a vicious cycle, is the loss of trust."

That is why stable monetary relations are a critical component of efficient global markets. Governments issue money, and citizens make contracts denominated in terms of those national monies, often making assumptions about the likely change in the future relationship between two different currencies. Hedging contracts are an attempt to insulate business parties from the risk of currency loss on cross-border transactions. And such contracts impose a cost on private commerce. But hedging cannot protect the world from the devastation imposed by crashing currencies on the scale witnessed over this last decade. And while the relative calm of recent months has produced an outward appearance of economic recovery, the inner sense of financial fear still lingers. Why? Because nothing has fundamentally changed since the grim days of last October when developing countries were recoiling from global capitalism and heads of major industrialized nations meeting in Washington were calling for a new international financial architecture.

It was, perhaps, the darkest moment for the future of the world economy. It looked as if all the recent converts to free markets and free trade could become so disillusioned by the battering they were suffering due to currency speculation and financial free fall that they might just decide it was not worth the effort. The loss of trust had disabled their desire for economic integration and frozen their faith. Here we are in August of the following year. How do things look with regard to currency developments and the prospects for global monetary stability? What are the chances we can avoid yet another "unexpected" financial crisis with the potential to deliver a crushing blow to the world in both economic and political terms?

More crises to come?

First, consider the options facing China. Just one year ago, Western leaders were praising Beijing for its refusal to succumb to pressure to devalue the renminbi against the U.S. dollar. President Clinton went so far as to gush on a Shanghai radio show that China was doing "a very good job in holding its currency stable" and had proved to be a stabilizing force during the Asian crisis. "And I personally appreciate it," he added. Now that the United States appears to be considerably less appreciative in the wake of Chinese espionage charges, military tensions over Taiwan and a crackdown on religion by Chinese authorities, one wonders if Beijing might well be reconsidering its stable currency policies. And if it does, what are the implications for Japan -- already trying desperately to keep the yen weak -- and for struggling Asian nations such as South Korea and Indonesia?

Meanwhile, back in the Americas, the breakdown in trade and financial relations that occurs as a direct result of currency devaluation is encapsulated by the rising acrimony between Brazil and Argentina. Former close trading partners, these two nations are now straining to preserve what had been the successful Southern Cone trade bloc known as Mercosur. Brazil is angry at Argentina's moves to curb imports from Brazil, branding them "protectionist measures" devoid of legal support. But Argentine officials counter that they have the right to invoke "safeguards" under certain circumstances -- such as an unexpected currency devaluation -- and that Brazil's decision earlier this year to abandon its indexed currency regime violates the spirit of free regional trade agreements. It is a powerful argument, to be sure. Too bad it will likely result in more protectionism rather than more stable currency arrangements.

No one should think that using weak currencies to promote exports is a cheap trick only used by emerging market nations. The incoming president of Germany's central bank recently was quoted as saying that European exporters could suffer if the euro becomes too strong. Given that Europe's new single currency already has declined some 13% against the dollar since its January debut, it is difficult to fathom why influential German finance authorities would be warning against the dangers of a strong euro -- unless they see it as a useful tool for manipulating the terms of trade -- not a good omen for U.S.-European relations.

Rewarding betrayals of trust

Are there any good signs out there of substantive improvements in global monetary and financial conditions? Have governments and international institutions risen to the challenge of garnering trust and restoring faith by establishing solid mechanisms for achieving stable global monetary relations? Sadly, no. A few bold individuals in Mexico have pushed the issue of dollarization to the level of public debate and enlightened discussion. But false appeals to patriotism already are taking their toll on the proposal in this highly charged political season before Mexico's presidential election next July.

A final discouraging observation: The Russian central bank lied to the International Monetary Fund (IMF) in 1996 about the level of its foreign-exchange reserves to encourage the agency to continue lending to the country, according to a newly released auditor's report. But it gets worse. In spite of having been lied to, the IMF chose to proceed to grant an extra $4.5 billion to Russia last week for reasons largely viewed as political and strategic.
So do not look for an end to unexpected financial crisis any time soon. Governments seem to have little concern over the loss of trust that unleashes the vicious cycle. Indeed, they reward it.

Judy Shelton, an economist, is the author of Money Meltdown. She serves on the board of Empower America in Washington, D.C. She is a regular commentator for intellectualcapital.com.
IntellectualCapital.com. August 12, 1999 issue