Small economies that perform well and attract large global capital flows are most at risk of being victims of a global financial crisis, the former president of the United States Federal Reserve, Mr Paul Volcker, has warned. In a paper delivered last weekend to the Reserve Bank's annual policy conference in Sydney, Mr Volcker was caustic about the prospects of reform of global financial markets, and warned that even those reforms on which there is agreement would be easy to evade.The former head of the Fed, whose tough policies pitchforked the US in 1982 into a temporary recession and lasting low inflation, warned that there would be more financial crises, perhaps becoming increasingly severe, because of the weak political will and regulatory ability to control international financial flows. "The points about which the greatest degree of consensus has emerged - the reforms that have received the most emphasis in official circles - provide little basis for expecting that future crises can be ameliorated," Mr Volcker said. "By all means, let's work on improving financial supervision and regulations. But let's recognise that it is unrealistic to assume that that is adequate to deal with the truly systemic problem before us."

Mr Volcker was one of many speakers to the conference, on "Capital Flows and the International Financial System", to warn that the core problem was one of exchange-rate volatility. Small economies exposed to the global economy could find their currencies overwhelmed by a handful of global institutions running for cover when trouble surfaced. In a joint paper, the Reserve Bank's research director, Dr David Gruen, and its deputy governor, Dr Stephen Grenville, argued that while floating exchange rates had been "an undoubted success" in countries such as Australia and Singapore, they were not a realistic option for smaller developing countries lacking local capital markets of any depth or a sympathetic understanding in global markets. Reiterating the Reserve's support for such countries to control capital inflows as a way of warding off excessive capital inflow, Dr Gruen and Dr Grenville said the textbook assumption that counter-cyclical speculators would come to the rescue of currencies under attack had failed under test in the 1997 crisis. "The exchange rate can depart substantially from its fundamentals because there are few stabilising speculators, and there are few because the rate departs from its fundamentals in ways that will make risk-aware speculators nervous."

The chief economist of the International Monetary Fund, Mr Michael Mussa, argued against American claims that the IMF's intervention to rescue Indonesia, Korea and Thailand had created "moral hazard", which would absolve institutions of potential losses from speculating in high-risk markets. Mr Mussa said the IMF was more concerned about the "real hazards" facing the five troubled countries in the wake of massive capital flight. Mr Mussa said the IMF quotas established in the 1940s allowed emerging economies deeply exposed to international trade to borrow up to 4per cent of their GDP. Yet by 1997 inadequate funding of the IMF had allowed the quotas of the Asian five to run down to "well under 1per cent of GDP", inadequate for it to be a lender of last resort.
 

Tim Colebatch, Economics Editor.
The Age (Melbourne) dated  13/08/1999