No easy answer to market reform
News Analysis: Everyone agrees on the need to change the world's `financial architecture' - but how?
Friday 05 February 1999
What does it mean? Why does this architecture, whatever it is, need reforming? And what are the chances of any substantive changes being brought about, given the perceived global nature of the problem?
The answer to these questions necessitates a small history lesson. There was little understanding in the West either of the causes or consequences of the financial crisis in emerging markets when it first began to hit home in the summer of 1997.
Almost universally it was blamed on bad government and bad policy, on cronyism and corruption, and on poor accountability and transparency in the economies most effected by the flight of capital. The immediate analysis was that there had been a huge misallocation of capital by the financial markets which was being legitimately corrected.
However, as the crisis began to spread like a contagious disease from one economy to another - some of them, such as Hong Kong, apparently healthy and thriving - it became clear this was not the whole story. Was there not something fundamentally wrong with the capital markets themselves that they should boom and bust in this destructive and arbitrary way?
Perhaps, it was said with growing certainty, the problem lay in the unregulated nature of global money and capital. In all developed countries the capital markets are highly regulated: there are checks and balances that dampen their wilder excesses, there are investor compensation schemes, and there are lenders of last resort to bail out the banking system when it shows signs of cracking.
Few of these things exist in developing countries. On a global scale, there is no such system of regulation, and outside the International Monetary Fund and the World Bank, there are no institutions to act as a safety net. Capital flows are unmonitored and untamed.
What we have just witnessed, it is often said, is the wild west frontier of unfettered capitalism. The effect of this trigger-happy lawlessness has been to plunge the majority of the world (in terms of population) into deep and pervasive recession, and led many policy makers and economists to question some of the fundamentals of the free market system.
So when policy makers talk of the "global financial architecture", what they tend to be referring to is its absence.
Those institutions that do exist - such as the IMF - have been subjected to unprecedented criticism. On the one hand, the IMF has been accused of imposing socially unjust and economically flawed policy programmes on countries it has tried to help. On the other, it is accused of bailing out Western creditors and investors through its aid and assistance - as the money lent by the IMF has almost invariably been used merely to pay them back - thus absolving the capital markets from responsibility for their actions.
Some of these criticisms are exaggerated or only partially true. For instance, in no case was the IMF money sufficient to bail out all Western creditors, and many have suffered catastrophic loss. In some cases, the higher interest rates imposed by the IMF have succeeded in stabilising currencies. And hardly anyone would seriously challenge the structural economic reform the IMF has attempted to impose - generally unsuccessfully, it ought to be said - as part of its programmes.
Even so, it is testament to the scale and persistence of the attacks that Stanley Fischer, the IMF's normally measured deputy chairman, was visibly shaking with anger and emotion as he sought to defend the IMF from its critics in Davos.
Nor are these doubts about the behaviour of global money, or the ability of international organisations as presently constructed to police it, confined to Asian and left-leaning European politicians. Even in the US, land of the free, there is widespread acceptance that the market-based system needs to be reinforced and strengthened in order to maintain and restore financial stability.
Robert Rubin, US Treasury Secretary and before that an investment banker of 27 years standing, says: "There is no question but that unfettered markets do not and cannot by their nature best deal with all needs, and that there are enormous challenges ahead for us if we are to have a market based system that fulfils its potential."
Just two years ago any such statement from a US Treasury Secretary, let alone one who had formerly been head of Goldman Sachs, would have been considered almost heresy.
So what are the remedies? As ever, there is a legion of possible cures and there is little agreement on any of them. So let's start with what mainstream policy makers - that is, those in the G7 countries - can agree on.
First, they agree that a single global regulator to enforce adequate standards of accountability, transparency, discipline and banking supervision worldwide is a practical impossibility.
As the newly created Financial Services Authority in Britain is discovering, it is hard enough to achieve all encompassing regulation on a national level. Think about the bureaucracy required to do it internationally.
Instead, Hans Tietmeyer, the Bundesbank President instructed to draw up a report for the G7 on reforming the international financial architecture, is opting for "a standing committee on global financial regulation".
What is proposed is that national regulators are brought together under a federal, umbrella organisation to agree on common best practice standards of supervision, accountancy and transparency. In Britain, the FSA already imposes higher capital standards for bank lending to countries with poor policy regimes or unsound banking systems. This is seen as a possible model.
Some politicians - such as Gordon Brown, the Chancellor - want to go further and establish codes of conduct for macro-economic policy too.
For instance, countries that wish to avail themselves of the benefits of capital markets might be required to operate a credible independent monetary policy. Fiscal policy would have to be conducted along lines similar to those agreed in the Maastricht Treaty to govern European Monetary Union.
So far, so good. Even though some of these proposals interfere quite substantially with the operation of the free market system, there is a broad consensus around them. But do they go far enough?
Financial markets are very human in the way they operate, and after a severe shock, such as the one we have just been through, they are always repentant and risk averse. As things stand, they don't need to be told not to invest in high-risk regions.
However, like the compulsive gambler, they always eventually return to the gaming table. The present frenzy in Internet stocks might be viewed as an example of how little they have learned.
As the good times roll, markets become ever more careless about analysing and weighing risk. In a recent, reflective speech on these issues, Mr Rubin called this phenomenon "reaching for yield".
The effect is to create excesses and bubbles. In the emerging markets crisis, these excesses combined with the macro-economic and structural problems of developing countries to produce a fatally poisonous cocktail.
Such carelessness is not confined to emerging markets. We've already mentioned the Internet boom. To this must be added Long-Term Capital Management, which operated from the world's largest and most successful economy in an entirely unregulated way. The only figures available from LTCM were cursory monthly profit statements. Yet banks were still queuing at the door to lend it money, even though they had not the faintest idea of who else had lent and on what terms.
The lesson is that, however much regulation is put in place, the markets generally find a way round it. Markets have always been largely driven by greed and fear - no code of conduct, however robust, would be sufficient to stop these extremes of behaviour.
As a consequence, some policy makers favour more radical measures to bring markets to heel. One such proposal would be to create a world lender of last resort, which would act much like national central banks in flooding regions with liquidity when problems begin to emerge. Such support would be made conditional; only countries pursuing appropriate economic policies would be availed of it. In other words, there would be a public and private insurance mechanism, based on a pre-qualification procedure of some sort.
Another proposal, favoured by Gordon Brown, is an "early warning" system that would anticipate crises and allow policy makers to take evasive action.
However, all such solutions suffer from a basic flaw. Capital markets cannot work effectively unless creditors and investors are made to bear the consequences of the risk they take. Investment bankers call this characteristic "moral hazard". Furthermore, the vast scale of today's capital markets mean there can never be sufficient public finance to deal with the kind of crises encountered in the past two years.
Nor is there much sympathy among US policy makers for fixed exchange- rate systems, dollarisation of emerging markets or capital controls. So, despite all the talk of reform, what we actually end up with may not be terribly dramatic.
Few countries want to opt out of globalisation and even fewer think there is any realistic alternative to the free market system. But, as everyone knows, the free market doesn't sit easily with meddlesome policy makers. Once you start interfering with the market's freedom to take risk and allocate capital as it sees fit, you undermine many of its benefits. As Mr Rubin has said: "There are no easy answers and no magic wands."
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