Too many risks, too few rewards: Fresh thinking on the limits of free markets


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For a system that supposedly conquered the world in 1990, free-market capitalism doesn't look so good any more. After Mexico, Thailand, Korea, Indonesia, Russia, which of capitalism's self-appointed disciples will stumble next? And who is to blame? The track record has embarrassed all but hard-liners into thinking there might be a Third Way - between free capital flows with floating exchange rates and the dirigiste controls of the 1960s. Chile, China, James Tobin - they've all been held to ridicule for their batty market ideas. But today it's not just bleeding-hearts and socialists who are looking at their attempts more closely. Michelle Celarier reports.

Global capital turns nasty
Capitalism and serfdom
The spectre of intervention
Can the IMF play supercop?
Throwing good money after bad
A breathing space for the IMF

Imagine yourself in an economics class, handed a pop quiz on the fundamentals of international finance with the following true-false statement: "When capital is allowed to flow freely across borders, it goes to the most productive investments."

Dutifully remembering Adam Smith's The Wealth of Nations, you might be tempted to answer "true". You'd be in good company. A slew of International Monetary Fund officials, along with US treasury secretary Robert Rubin (and no doubt countless investment bankers) would probably agree with you. But then a more recent economics lesson springs to mind: the south-east Asian crisis. All that capital flowing into speculative real estate - that surely couldn't have been the most productive use of it, could it? As a post-modern student of the global capital markets, with their bigger and bloodier crashes, you know the answer has got to be "false".

Conventional wisdom doesn't change quickly, however, and over the past 18 years the mantra of free markets has become firmly entrenched in business, government and academia, from Washington to Moscow to Beijing. As political winds shifted to the right (Reagan, Thatcher, the collapse of the Soviet Union and beyond), such free-market icons as free trade, deregulation and privatization have become unassailable.

But the carnage left in the wake of market meltdowns from Mexico City to Seoul to Jakarta is starting to make some economists, policy makers and even bankers wonder whether unfettered free markets are creating more risks than rewards. As the pendulum begins its somewhat inevitable swing back to the middle, if not the left, there's another quandary: finding the appropriate type of government intervention in an age of globalization - a world that by its very nature seems to defy attempts to rein it in.

Henry Kaufman, president of Henry Kaufman & Co in New York believes: "We live in a global financial market that is more and more deregulated. Those markets are securitized and the securities are actively traded. A variety of new instruments - hedge funds, in particular - also significantly enhance the capacity to leverage and we have today a much greater near-term orientation by a whole series of lenders and investors. Finally, we are moving more and more to financial markets in which there is much greater concentration among institutions."

Kaufman argues that all of this is contributing to volatility in global markets: "We have to find a way in which to limit extreme excesses. Much greater change needs to occur in the next couple of years if we are to prevent an escalation in financial volatility and an escalation in financial mishaps."

Leading the new wave of thinking, at least in terms of public prominence, is the iconoclastic World Bank chief economist and senior vice-president Joseph Stiglitz, who has won praise for his theoretical work explaining the imperfections of financial markets - in other words, the real world. At the same time, he has irritated his colleagues at the IMF with his radical views, in particular his opposition to the IMF's proposed amendment to the articles of agreement that would require all member countries to liberalize their capital account.

That requirement would primarily affect short-term money, allowing for the free flow of hot money in and out of tiny countries - "rowing boats on an open sea" is Stiglitz's analogy of their vulnerable position. Critics such as Stiglitz argue that such capital can exacerbate the instabilities of the global financial system. He also cites a study by Harvard University political economist Dani Rodrik indicating there is no positive correlation between liberalized capital accounts and growth, investment and low inflation in the developing countries. Such capital flows are associated with "enhanced instability and not only lower growth but greater variability in growth that also has huge social costs", says Stiglitz.

As the Asia crisis deepens, engulfing Japan and extending to Latin America and Russia, these views of Stiglitz and others are gaining ground. While IMF managing director Michel Camdessus and others at the Fund such as first deputy managing director Stanley Fischer still endorse capital-account liberalization, the list of caveats is growing so long as to virtually nullify the possibility the amendment will be adopted within the next two decades. That's a sharp contrast to the past. Under prodding from Rubin, the IMF began pushing the idea two years ago and had hoped that by this September there would be enough of a consensus in favour of it to move the proposal to parliaments around the world.

Thinking the unthinkable

Now even the Institute of International Finance (IIF), the policy platform for global financial executives, is rethinking the idea. "As we try to understand how to successfully manage globalization, it's important that we move cautiously in areas like formal liberalization of capital-account transactions," says Charles Dallara, the IIF's managing director. "We are trying to take a balanced approach that acknowledges that a world of completely unrestrained and unsupervised capital flows is not likely to be the most efficient world."

The controversy about capital-account liberalization has become a touchstone for a much broader debate about free markets. The new view starts by acknowledging the limitations on the efficiency of free financial markets and the unevenly distributed pain those distortions cause, and it ends with a variety of prescriptions for government intervention.

Those in the vanguard are a minority, still facing an uphill battle. "The ideology of the market is by definition a set of blinders [blinkers]," says one. "It's a very strong ideology. You reinterpret the world so when the market doesn't work, you don't say the market didn't work, but 'they' didn't do the right thing. It's a self-confirming set of beliefs that almost anything can be rationalized by."

Harvard's Rodrik, who wrote another book critical of the prevailing free-market mood, Has globalization gone too far?, recognizes how profound the shift in thinking will have to be. "We need to have a change in the philosophical way in which we look at international markets," he says."We need to understand that governments and markets are complements. A lot of thinking implies that markets can expand at the expense of governments and essentially do what governments do, more efficiently. It's a very misleading view of how markets operate. Governments need markets as much as markets need governments."

But where should the line be drawn? Even Milton Friedman, in the iconic Capitalism and Freedom, acknowledged government's role as rule-maker and umpire. But Friedman took the view that government had intruded far beyond this basic role and asked the question: Shouldn't the market be given more responsibility, not less?

Overturning the consensus

The ideological spat on capital account liberalization raging between the IMF and the World Bank has opened a wide door to alternative economic views. In the past, the Bretton Woods institutions spoke with a single view, says Rodrik "but now we're having an open debate about these issues." The importance of that can't be overestimated. According to Harvard Business School's Bruce Scott: "The Washington Consensus [economist John Williamson's name for a body of ideas whose common theme is the retreat of government and the development of the market] is what's being taught in 15 to 20 major universities and they're all English-speaking. Most are in the United States." He adds Cambridge and Oxford Universities to the dominant market-think. Scott takes the debate even further, asserting that "almost every society has to learn that in substance it's going to finance its own development. The notion that its development will be financed by international capital is bullshit."

Stiglitz doesn't agree entirely with Scott. "I'd put it a little more moderately," he says, acknowledging that "some of the most successful examples of development have occurred in countries with sufficiently high savings rates so that they can finance almost all of their productive investment". The best examples have been in Asia. While free marketeers view the Asian crisis as evidence that the highly-touted mixed economies weren't all they'd been cracked up to be, economists like Stiglitz say that "the critics have been too harsh". The Asian economies' past achievements should not be "erased" by the crisis, he argues.

Looking at Asia under a different magnifying lens, it's just as rational to blame unsupervised free markets for its downfall. Under pressure from the industrialized countries, Asian economies opened their doors to greater foreign investment - which made no economic sense. "One could question the marginal value of additional capital flows," says Stiglitz. "If you're already saving 35% of GDP, diminishing returns are likely to be setting in." Of course, that's exactly why the money went into such speculative ventures.

Stiglitz gave a keynote speech at the Asia Development Forum in March in which he concluded that "in approaching the challenges of globalization, we must eschew ideology and over-simplified models". The fallacy of those models is part of his well-argued view on the "imperfect" nature of financial markets. (Stiglitz is a former Stanford University economics professor who spent four years on president Clinton's council of economic advisers before joining the World Bank last year. He is tipped as a likely Nobel prize winner for his persuasive economic arguments on the imperfect nature of markets.)

"The standard theories of the efficiency of competitive markets are based on the premise that there is perfect information," explains Stiglitz. The problem is that financial markets are inherently different from other markets and have even less perfect information, he says. "Left to themselves, financial markets will not become deep, efficient or robust."

The canniest traders and investors have always thrived on the imperfect nature of markets, using better information and quicker analysis to effect arbitrage. Innovations in finance often take things to the limit, operating on the borders of government regulation. And from the birth of the Euromarket to that of derivatives, it has often seemed that the role of the international capital markets was to capture the so-called "inefficiencies" created by differing regulatory regimes. "Whenever you have regulations, there's money to be made by arbitraging around them," says Richard Cooper, a Harvard University professor of international economics, who has also served as chairman of the Federal Reserve Bank of Boston and under-secretary of state for economic affairs. "The implicit assumption is that the system is going to hold and I'm going to take advantage of this little squiggle."

But this is dangerous. Exploiting structural distortions is not true arbitrage. Those caused by regulation cannot be removed by the action of market exploitation, only by government or the regulators. By definition, any change will be systemic and often abrupt.

What makes financial markets different from others and thus so susceptible to distortions that result in crashes is the so-called "beauty contest" phenomenon described by John Maynard Keynes, and revisited by Stiglitz and Rodrik. In Keynes's view, elaborates Rodrik, "everybody is trying to figure out who everybody else thinks is the most attractive contestant". Keynesian wisdom has come to be known as market psychology, or herd behaviour. It implies that the value of financial assets is not solely determined by their true value but by others' expectations of the future. It is clearly true. Fund managers admit they spend much of their time trying to work out the effect of new information on their peers, not what it will be on the underlying companies themselves.

As a result of such behaviour, financial markets tend to diverge from fundamental valuations. "Open capital markets always overshoot," says Merrill Lynch's chairman of global financial institutions, John Heimann, a former US bank regulator. "Traders have only two gears: overdrive and reverse."

Economists have long noted the result. Financial crises - overshoots - have occurred approximately every 10 years for the past 400. Yet the pressure for countries to liberalize their financial markets has gone unabated, coming predominantly from the US government and financial institutions.

Protecting the weak

Cooper finds this baffling: "The uninhibited free market approach has never applied to financial markets," he says. Both he and Rodrik contributed to a recent Princeton University collection of essays entitled "Should the IMF pursue capital account convertibility?" Both cited the herd behaviour of financial markets as one of the drawbacks in such liberalizations.

In the essay's lead piece, the IMF's Fischer remained intellectually wedded to the idea of capital liberalization, offering up the classical view: "Put abstractly, free capital movements facilitate an efficient global allocation of savings and help channel resources into their most productive uses, thus increasing economic growth and welfare." But even he had to admit that "there are dangers in liberalizing capital movements in an economy in which the macroeconomic framework and the financial sector are weak". Those with weak financial systems should restrict short-term inflows, he advised.

The key word in Fischer's statement is "abstractly". But the real world is not an abstract theory. One problem of traditional economic theory, according to Scott, is that it assumes that the institutions to make free markets work already exist. In the real world, however, those "countries with weak financial systems" cover almost the entire developing world - and some developed countries, such as Japan. Strengthening those countries with a robust supervisory and regulatory system will take at least a generation.

Another issue for countries with weak financial systems is not just that financial crises are bound to occur, but that they are occurring with greater frequency than the historical 10-year norm - 1997's Asian crisis, 1994's Mexican peso crisis, 1987's US stock market crash. And the ups and downs are more extreme. "What's new today is the gross amount of liquidity that's out there," explains Rodrik. As a result, "these boom and bust cycles can cause consequences much larger than ever before".

Poor track record

While Russia and Asia have attracted the most attention recently, the history of Mexico over the past 15 years is a well-documented and grim example of the failure of many fashionable market-based reforms. According to Mexican economist Juan Enriquez, more than 15 years after the debt crisis erupted in Mexico and after a decade of market reforms, the country's foreign debt is higher than ever ($160 billion, if the proposed bank bail-out is included). The minimum wage is 28% of what it was in 1976 and per capita income is similar to the levels in the 1960s. Enriquez, a fellow at Harvard's Center for International Affairs, led the Mexico City Urban Development Corp in the administration of president Carlos Salinas.

"People are saying 'we've had 20 years of economic adjustment and we don't see a real improvement'," he says. Despite these statistics, the international financial markets seem to perceive the country as a success story. "Without doubt there is the presumption that Mexico has recovered," says Enriquez, who likens the Mexican financial situation to playing a "shell game [sleight of hand], where you are shifting the forms of finance".

In Enriquez's view, Mexico's bank privatization has been a total failure - as have the privatizations of some other key industries. But he isn't opposed to privatization: "Should you privatize things like banks? Yes. Do you have the infrastructure in place to be able to manage the process and the supervision required? No."

Enriquez argues that the issue isn't whether the country should control inflation or have a balanced fiscal policy, policies few economists would argue with. "What the technicians and economists have done is assume if we get the instruments right, and do what the textbooks say, everything else will follow. But it's a flawed notion that if you put in money, the investment and growth will occur. Mexico is a country that keeps crashing and crashing and crashing and the answer every time is tighten up again, control inflation." It isn't just nationals like Enriquez who view Mexico as a disaster in the making. Despite Nafta, (the North American Free Trade Agreement), and a border with the US, "things could go very badly wrong in Mexico, mainly on the political front", warns Harvard's Cooper.

The austerity imposed by the IMF in the wake of crises, enabling countries to qualify for assistance and appease the markets, has long been decried for the hardships it creates. Previously, most complaints came from populists in the developing countries. Now even finance industry executives such as Heimann have to admit that the consequences are borne unevenly. "The market discipline is on the people of the country," he says, "not the suppliers of capital."

To economists, this inequity touches on the "moral hazard" issue - the notion that lenders (or investors as was the case with Mexican tesobonos in 1995) will be bailed out so they don't worry about monitoring their risks adequately when they go in. Bankers argue that they do worry because they do suffer during financial crises. And many have taken trading hits since Asia's collapse. But Stiglitz, talking about the recent crisis, is adamant on the point: "Most people who have lent money have been able to recover most of it. Their loans are being rolled over and they are getting good interest on their loans. Who is bearing the costs? It is the workers forced into unemployment, small businessmen who never speculated on real estate or borrowed from abroad. But the policy response imposed has entailed high interest rates and fiscal contractions that have imposed huge costs on these innocent bystanders."

To Stiglitz, the problem goes beyond moral hazard to being a form of pollution or toxic waste. The question is: can we regulate and tax the financial market polluters as western countries have done with industrial polluters since the 1970s? It's somewhat encouraging to remember what a struggle that was, says Stiglitz, recalling that anti-environmentalists claimed the costs of such regulation would outweigh the benefits: "They actually said we'd be better off living in smog-filled cities because the damage to the economy would be so great that we ought to live with it." And while the original systems were costly, "relatively few people today would say that it wasn't worth doing", he adds. Even today, when others criticize him for opening the door to government intervention, fearing it will become more and more intrusive, he says: "I go back to the environmental issue. People made the same kind of argument."

When it comes to discussing the role of government, the typical prescription now given by the IMF is for greater transparency and disclosure and stronger supervisory systems for the financial industries in the developing world. But most of the critical economists believe these proposals do not go far enough or are themselves somewhat flawed. "Transparency is like motherhood and apple pie," says Richard Portes, professor of economics at the London Business School. "Everybody is for it. The trouble is it will not prevent crises." One reason, he says, is that market participants tend to ignore information in the heat of a bull market. Looking back at the Mexican situation, he claims: "The data were perfectly, publicly available. All the things people talked about ex-post, it was all there." As for Asia, he agrees "it probably would have been helpful if the Bank of Thailand had told the world how much forward exposure it was taking. But would it have stopped Thailand from having to devalue? Certainly not."

Stiglitz thinks the Asian crisis was predictable even on known information though its severity probably could not have been forecast. Some even argue that there's already too much information in the markets today, contributing to its higher volatility. "Markets respond to information and the more information that flows the more things there are for them to respond to," says Stiglitz.

As for strengthening the banking regulatory and supervisory systems, says Portes, "yes, we all agree about that". Many are glad to see the focus shift in this direction. Says Heimann: "Clearly in the past not enough attention has been paid to this in light of the push for liberalization and deregulation." Even with bad macroeconomic policy and a strong banking system, he notes, "you will have problems but they won't be so virulent".

Yet even the most sophisticated risk-weighting systems in the industrialized countries aren't foolproof - and may even exacerbate risks. Indeed, former Brown University economist Peter Garber, now at Deutsche Bank in London, argues that the sophisticated risk management systems of major financial institutions are "a primary source of crisis contagion."

"Such systems require, for example, that bond index funds hold only investment-grade securities, so that a downgrading of a country's credit rating leads to an immediate sell-off of its bonds and to the country's inability to approach the market for additional funding," he writes in his Princeton essay. Operating on the basis of "international variance-covariance matrices of market prices or macroeconomic variables to get at the best statistical models of market and credit events", these risk management systems "imply that a jump in volatility in one country will automatically generate an upward re-estimate of credit and market risk in a correlated country, mechanically triggering margin calls and tightening credit lines.

"These operations are not the responses of panicked screen traders arbitrarily driving economies from a good to a bad equilibrium. Rather they work with relentless predictability and under the seal of approval of supervisors in the main financial centres." In conclusion, says Garber, the herd behaviour actually "emanates from the discipline imposed by supervisory authorities in the principal financial centres".

Capital controls can work

But the belief in risk management continues. Now bankers say they are working closely with the international supervisors to amend international bank capital-adequacy standards to better distinguish credit risk and allocate capital accordingly. (Currently all bank risk is weighted the same.) Requiring banks with more diversified portfolios to post less capital as a result, is also under consideration. This might diminish the attractiveness of concentrated lending in, say, real estate. But whether such proposals would contribute to contagion under Garber's analysis is another matter. At any rate, without further changes, such a new standard would have had little effect on tightening credit to south-east Asia pre-crash. That's because short-term claims on banks from any country carry only 20% risk weight.

To address the problem of short-term loans, one popular remedy being discussed is that of requiring banks to post reserve requirements for their foreign interbank loans. Federal Reserve Board chairman Alan Greenspan has suggested it as a possible preventative for the problem of moral hazard, since it is the interbank loans that are typically bailed out.

Such reserve requirements "might work" asserts Heimann, but the problem is "who is going to impose it?" Central banks in individual countries would have to institute the requirements, and "the local banks will be squawking", he says. Reserve requirements, in effect, raise the cost of a loan. If a bank has to reserve, say 50% of a loan at 8%, it effectively raises the cost of that money to 16%. Since the reserve requirement proposal puts the financial burden on the borrower country, Greenspan argues that increasing the capital charge on lending banks might also be effective. That is unlikely to appeal to banks which are hoping that the new standard will lower, not raise, their capital requirements overall.

And then there are the controversial capital controls - adopted most recently by Malaysia. The fuss over their introduction is odd given that they have existed in Chile for over a decade, a period in which it became the most stable and economically sound Latin American country. Chile instituted some controls following a banking crisis in the country in the 1980s and has been liberalizing them slowly as the country's economy has developed.

Chile wanted to discourage arbitrage between the higher domestic rates of interest and international ones, thus avoiding an overvaluation of the currency and the attendant difficulties of running an effective national monetary policy. Today, some 30% of the value of any capital inflow in the form of debt or speculative investment must be set aside in a non-interest-bearing deposit with the central bank. To discourage speculation, foreign direct and portfolio investments, except for primary and secondary American depositary receipts (ADRs), must be made for a minimum term of one year.

Carlos Massad, governor of Chile's central bank, in his Princeton contribution, says the effect of the reserve requirement has been to increase long-term over short-term financing. It has also stemmed overall flows somewhat. He notes that between 1990 and 1995 Chile received capital inflows at 6% of GDP, while Malaysia and Thailand, which did not restrict them, received capital inflows equal to 10% of GDP. And controls have also buffered Chile from the Asian contagion that has hit other Latin American countries over the past year.

Stiglitz points to other measures, such as Colombia's banking regulations that limit foreign-exchange exposure by forcing bank borrowings in dollars to be re-lent in dollars, as evidence more tinkering is possible. He argues that tax incentives for short-term borrowings should be avoided and notes that El Salvador is considering limiting the deductibility of short-term foreign-denominated debt for corporate income tax purposes.

Another idea that is gaining ground again is the so-called "Tobin tax", a proposal put forth by Nobel laureate economist James Tobin back in 1972. Then Tobin envisioned "an internationally agreed uniform tax, say 1%, on all spot currency conversions of one currency into another". In revisiting the tax in 1996, Tobin wrote that "the tax rate must be lower than I originally thought. It should not exceed 0.25% and perhaps should be as low as 0.1%."

He has also concluded that forwards and swaps should also be taxed. And to get international cooperation, he suggests each country retain at least 50% of the proceeds, the rest possibly going to the World Bank. He estimated a revenue yield of $94 billion a year though raising money is not the goal. Rather, the tax acts to discourage speculation and to preserve the autonomy of national macro-economic and monetary policies. ("I realize here, as is often the case, I am opposed by a powerful tide," he writes.)

The Tobin tax has long been criticized as unworkable, even as an intrusion into what Tobin refers to as the "markets-always-know-best" philosophy of economic life. But those who are dissatisfied with today's market structure find themselves going back to the Tobin proposal.

"It's an action that recognizes there are costs to these volatile flows and tries to discourage them," says Stiglitz, a long-time friend of Tobin. But the world has become more complex, making the tax even more cumbersome to apply since Tobin first proposed it. "The problem of defining what a capital flow is has become much more difficult because of derivatives," says Stiglitz. Firms can borrow in domestic currency, use derivatives to convert those to foreign positions "and it looks like they only have domestic positions", he says. One way around that would be to require firms to register all their derivatives positions, then net them out, and the net foreign borrowing would be taxed. Another issue that derivatives raise is whether the tax would be on the full exposure of the position or not. Stiglitz thinks it should probably be on the full amount.

Many market opponents of the Tobin tax have argued that it would merely send more money into offshore centres, beyond the reach of the tax authorities. That may be true, says Stiglitz, but "the objective here is not perfection. The issue is not to stop the short-term capital flows but to stabilize them, and a dam with an overspill is still effective and still stabilizes the water flow. The consequences for these countries is so huge that it's a mistake not to try to explore those possibilities."

Amid the controversy, protagonists tend to ignore the point that while risks are heavily skewed toward developing countries, the re-wards of international finance revert largely to the providers of capital, who have more power today over more countries than most economists ever dreamed possible. The political reality of such a power shift makes a new era of regulation exceedingly difficult to accomplish.

Mexican economist Enriquez says: "You can't go back to the government regulation intervention of the 1960s," , the era that Rodrik refers to as the "golden age" of government and corporate cooperation in the industrialized world. What's changed irrevocably is that information technology, more than ideology, drives globalization, says Enriquez. "Societies are demanding smaller governments and lower taxes, national borders are porous, and if you've got a series of traders who can use a market distortion to profit, no central bank can control its currency as it used to."

Even such economists as Tobin admit the proposed interventions are, to use one phrase, "sand in the wheels of international finance". Others, like Enriquez, are searching for something else to keep their countries from drifting into disaster.

"The world is so dominated by open economies and capitalist ideology," he says, "that there's really not another side to debate. Is capitalism better than socialism or communism? The answer is yes. But does capitalism always work? No."