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IMF ECONOMIC FORUM
CAPITAL ACCOUNT LIBERALIZATION:
WHAT'S THE BEST STANCE?
October 2, 1998, 2:30 p.m.
International Monetary Fund
JAGDISH BHAGWATI, Arthur Lehman Professor of Economics, Columbia University
RICHARD COOPER, Maurits C. Boas Professor of International Economics, Harvard University
RICARDO HAUSMANN, Chief Economist, Inter-American Development Bank
MICHAEL MUSSA, Economic Counsellor and Director, IMF's Research Department
MR. WIJNHOLDS: Well, good afternoon, ladies and gentlemen. We are going to discuss today, in this Economic Forum, capital account liberalization, what’s the best stance?
Let me very briefly introduce our forum members and then say a few words by introduction and, of course, give them the floor.
On my far right, we have Professor Barry Eichengreen of the University of California in Berkeley. Next to me is Professor Richard Cooper of Harvard University. On my left is Michael Mussa, who is the Economic Counsellor of the Fund; next to him, Professor Bhagwati from Columbia University. And on my far left is Ricardo Hausmann who is the Chief Economist of the Inter-American Development Bank.
I think we have been very fortunate in getting together these very eminent economists today, and I am looking forward to a very good debate here.
Let me briefly introduce today's discussion with a few remarks. A little over a year ago, we had an annual meeting in Hong Kong, and at that time, the Interim Committee of the IMF, which is the Ministerial Committee, came out with a statement which has become known as the Hong Kong Declaration on the liberalization of capital movements, under an amendment of the articles.
Well, as you know, after that, the Asian crisis, which already had a small beginning in Thailand, was becoming progressively worse, and I myself, after Hong Kong, traveled to Indonesia and could with some sense of disbelief see how the exchange rate was dropping at that time, 2,500 rupiahs per dollar, and at some point went down to as low as 16,000 or more. We are only now getting back to roughly 10,000, of which the Fund's program with Indonesia is based.
At that time, however, in Hong Kong, it was felt by the Interim Committee--and this is what is in the statement--that it was time to add a new chapter to the Articles of Agreement of the Fund, and to have jurisdiction for the Fund over capital account transactions, as it already had since its inception, for current transactions.
It was emphasized that such liberalization had to be done in an orderly manner, but that has perhaps been forgotten somewhat.
Anyway, I need not spell out to you what happened subsequently in Asia and how via the problems in Korea, Indonesia, and more recently Russia, and I might add some of the difficulties in Latin America nowadays, that we came to where we are now. I do not think I exaggerate when I say we have a full-fledged emerging market crisis going on.
I think that is important as a background for what we are going to discuss today because not only will these things be the focal point, of course, for the upcoming meetings of the Interim and Development Committees, but they do influence the thinking on this issue.
While there were always doubters about the blessings of capital account liberalization, they had, more or less, clearly surrendered by the time of the Hong Kong meeting. However, recent events have reopened the debate very much I think, and those who have, let's say, a more restrictive view concerning capital account liberalization have sudden regained strength and gained more attention, as have our politicians.
In fact, a number of countries, as you are aware, have reversed their stance with regard to capital transactions. I need only mention Malaysia here that recently imposed a wide series of capital controls, and I could also mention Russia which has imposed exchange controls, but has also, of course, a moratorium on its debt payments, this, of course, all to the horror of the IMF, but not only of the IMF.
I think it is fair to say that there is a renewed debate, indeed, on whether capital controls are such a bad thing or whether they might be not such a bad thing certainly at the present time.
Let me also, not to lose perspective, mention to you that the pendulum is not perhaps swinging that far to the other side. At least there are still some countries--and this is not given that much publicity--that have continued recently on the path of liberalization, and I would mention here countries like India and Israel.
I would also recall that in March, the Fund organized a seminar on whether the IMF should pursue capital account convertibility. At that time, we saw a considerable divergence of views on this matter, and I am curious as to see whether we will have more of a convergence this time or not.
We in the Fund have continued to address this issue. Recently, we discussed in the board of the Fund this paper (now published as an Occasional Paper), "Capital Account Liberalization:Theoretical and Practical Aspects," which was prepared by a staff team led by Barry Eichengreen and Michael Mussa who are both here at the table.
So I think it would only be right to start off with Barry Eichengreen and to introduce his views on this subject, but before I do so,
Let me then turn to Professor Eichengreen as the first speaker. Let me just introduce him. Barry Eichengreen holds a Ph.D. in economics from Yale University. I should also mention that he has three master's degrees, one in economics, one in philosophy, and one in history.
He started his career at Harvard University where he was an assistant and associate professor, and at that time, he was also a research fellow at the National Bureau of Economic Research.
In 1986, he moved to the University of California at Berkeley where he presently is the John L. Simpson Professor of Economics and Professor of Political Science.
He recently spent a year with the Fund as senior policy advisor and worked on this subject.
Let me just mention a few titles from his long list of publications. In 1996, he published a book entitled "Globalizing Capital: A History of the International Monetary System," and last year, his book on "European Monetary Unification" appeared.
Among his articles, I would like to draw your attention to "Hedge Funds and Financial Market Dynamics," which was written while he was associated with the Fund, and has appeared in our occasional paper series, also.
Professor Eichengreen, you have the floor.
MR. EICHENGREEN: Thank you, Mr. Chairman.
My talk today, like the paper before you, has a simple point. High and rising international capital mobility is an inevitable fact of life at the end of the 20th century. It is being driven by powerful changes in information and communications technologies. Those technological changes are irreversible. So, too, therefore, is the rise of capital mobility.
There being no possibility of turning the clock back on a sustained basis, the problem for policy-makers, therefore, becomes how to live with this new reality. The paper before you, therefore, tries to articulate a sensible, prudent, measured strategy. The list of adjectives grows longer, I think, by the day for doing so.
To say that there are pressures for the liberalization of international financial transactions and that there is something inevitable about the process does not imply that those transactions should be left unregulated. To the contrary, we see that this is not what is done in the domestic context. Where it is widely understood that banks and other financial intermediaries are fragile, it is widely understood that because their assets are relatively illiquid, but their liabilities are demandable, they are susceptible to self-fulfilling crises of depositor confidence.
Because banks act as delegated monitors, because they gather proprietary information about the creditworthiness of their customers, distressed financial institutions can find themselves in a situation where they are unable to dispose of their assets at full value. They can raise liquidity in emergencies, only at the cost of further damage to their balance sheets. People in the audience will have some particular examples in mind, no doubt, of cases where this has occurred recently.
Because these institutions are linked together, the financial distress of some can spread contagiously to others and potentially endanger the entire system. Because their creditors are less than fully informed about the quality of their loans, a run on one may be taken as a signal of potential problems elsewhere in the system.
So it is these recognitions that prompt governments to impose a panoply of prudential regulations on the transactions and positions of financial intermediaries where they think those transactions and positions have implications for systemic stability.
Such regulations are especially strict where the techniques of risk management are thought to be least well developed, where auditing and accounting practices leave the most to be desired, and where financial disclosure is least adequate, weakening market discipline.
These same grounds justify in my view the prudential regulation of international financial transactions as well, and they justify the prudential regulation of international financial transactions even more strongly than they justify the regulation of purely domestic transactions.
Information problems are even more pervasive in international financial markets. The difficulty of raising liquidity in emergencies can be even greater. The scope for contagion, therefore, can be even greater.
Insofar as the liabilities of banks and other borrowers are denominated in foreign currency, as they are in many emerging markets, the domestic central bank not being able to print foreign currency has limited ability to undertake the lender-of-last-resort operations necessary for those debtors to make good on their obligations.
This does not mean that such international financial transactions should be prohibited or rigidly controlled. Rather, it means that their costs should be influenced by regulation that takes into account their implications for systemic risks.
Banks should be required to purchase cover in currency forward or futures markets for their open foreign positions in ways that better align the private and social costs of offshore funding.
They could be required to close their open positions by matching the currency composition of their assets and liabilities when borrowing in foreign currency, making only foreign currency-denominated loans.
Of course, additional measures would be required to the extent that this only transforms currency risk into credit risk; in other words, that shifts the risk to bank customers who find themselves equally unable to handle it.
Capital requirements. One important determinant of the cost of foreign funding could be adjusted to take the systemic risks into account. Specifically, there is an argument. Chairman Greenspan has advanced it. I would subscribe to it, that capital requirements ought to be keyed to the source of bank funding and ought to be higher for banks that borrow abroad.
If bank capital in emerging markets is only too rarely written down ex-post because of political pressures, one might have to resort to differential reserve requirements, requiring banks' borrowing abroad to put up additional reserves with the Central Bank, ex-ante.
Alternatively, the problem could be addressed from the lending side by requiring lending banks in the advanced industrial countries to attach higher risk weights to short-term claims on banks in emerging markets since the additional cost would then be passed onto the borrowing banks.
Finally, to the extent that measures designed to raise the cost of bank borrowing abroad only encourage non-banks to do the borrowing for them and then to on lend to the banks or other borrowers, leaving the risks to the financial system essentially unchanged, there is an argument, again, one that I personally subscribe to, for using taxes for non-remunerated deposit requirements on all capital inflows, not just on capital inflows into the banking system.
Where does this leave IMF policy toward the capital account? Where does this leave the discussion to which our chairman alluded before regarding a possible amendment to the IMF Articles of Agreement to give the Fund jurisdiction over the capital account?
On the one hand, I strongly believe that there is no contradiction between the use of taxes and tax-like instruments to manage international capital flows and capital account convertibility and the maintenance of capital account convertibility as a desirable goal.
Convertibility means shunning prohibitions. It means shunning quantitative restrictions that prevent market participants from undertaking certain transactions at any price, but convertibility is compatible with the use of taxes that are designed to better align private and social costs. So, clearly, a blanket prohibition on foreign borrowing is much more distortionary, can be much more distortionary than a tax which still permits those with especially attractive investment projects to finance them externally, so long as they are willing to pay the tax intended to help them internalize the implications of their decisions for the country as a whole.
That, in fact, is precisely the distinction, in my view, that the Fund has always made regarding the current account of the balance of payments. Current account convertibility is a goal of IMF policy under the Articles of Agreement, and it has been from the start, but while current account convertibility is defined there as freedom from restrictions on payments and transfers for current account transactions, the Articles of Agreement do not proscribe the use of import tariffs and taxes on the underlying transactions to better align private and social costs.
Similarly, capital account convertibility, while implying the removal of controls and prohibitions, need not mean abjuring taxes and tax-like levies on the underlying transactions.
So, in principle, amending the Articles of Agreement to give the Fund jurisdiction over the capital account would enable the Fund to encourage its members to implement that important distinction. In principle, it could put the Fund in a strong position to give guidance to its members on the optimal speed and the optimal sequencing of capital account liberalization, process with implications not only for individual countries, but for the international system as a whole.
It could lend legitimacy to the use of tax and tax-like instruments designed to limit the level and shape the term structure of foreign debts, and it could give the Fund leverage to encourage countries utilizing taxes on inflows to accelerate financial sector reforms.
The proof of the pudding is in the eating, of course, and there are plenty who worry about how IMF jurisdiction over the capital account would, in fact, be used. I think that experience with Article VIII, which gives the Fund jurisdiction over current account convertibility, does not suggest that the IMF would inevitably become the rigid enforcer of specific obligations and would rigidly push its members to precipitously liberalize the capital account.
In practice, the Fund has always acknowledged the validity of a wide range of exceptions and unusual circumstances when it comes to current account liberalization. There is no reason, in my view, that the Fund's policy toward the capital account need be or will be much different from that, but I think to reassure the skeptics, the Fund needs to first articulate its strategy for capital account liberalization. It needs to continue to explain its approach to the problem of sequencing. It needs to continue to make clear its policy toward its members' use of taxes and tax-like instruments on short-term capital inflows.
It needs to make clear that amending the Articles of Agreement does not mean eliminating the provisions in the Articles, part of Article VI, that gives its members the right to apply capital controls under exceptional circumstances.
I think only then, having dismissed fears that it might push for precipitous liberalization and that it might oppose the use of taxes on excessive short-term capital inflows would its efforts to amend the articles deserve international support.
MR. WIJNHOLDS: Thank you very much, Mr. Eichengreen.
We now turn to Professor Jagdish Bhagwati. He is the Arthur Lehman Professor of Economics and Professor of Political Science at Columbia University in New York.
Until 1980, he was a Professor of Economics at MIT. He also served as the Economic Policy Advisor to the Director-General of ATT in the early '90s.
He is generally considered to be one of the foremost experts on the economics of international trade, but has also expressed his views on capital transactions; recently, for instance, in foreign affairs.
Five volumes of his scientific essays have been published by the MIT press, and three volumes have been published in his honor in the United States, the U.K., and in my own country, the Netherlands.
Among his many books are "Protectionism," which appeared 10 years ago and became an international best seller, and the recent "A Stream of Windows: Unsettling Reflections on Trade, Immigration, and Democracy," which is a selection of his popular writings.
He has received several prizes in various countries, and I would not be surprised if some maybe even more prestigious prizes were to follow.
Finally, I would like to mention that Professor Bhagwati is married to Padma Desai, who is a Professor of Comparative Economic Systems at Columbia University and a leading expert on the Russian economy.
Mr. Bhagwati, you have the floor.
MR. BHAGWATI: Thank you, Mr. Chairman.
I usually tell my students that I not merely preach comparative advantage, but also practice it. So today is an exception as you have properly pointed out.
The reason we have to be interested, even as people interested in trade, in the topic today is I think the two topics, the free trade and free capital mobility, have become inextricably tied not at the level of intellectual ideas necessarily, though there are definitely similarities, but at the level of political discourse.
I have been engaged for the last 3 months in several arguments and debates with people like Ralph Nader and Jeff Forth in arguments about free trade. Inevitably, no matter what the audience, they always throw at you the fact of the East Asian crisis, and now, of course, the world crisis, and say the globalization on capital account is the same thing as all globalization. So this contagion effect has really drummed capital mobility to trade. It is really bothersome.
So, when I wrote the article in the May "Foreign Affairs," the main focus of the article was basically to point out that these two kinds of arguments were very different; that if you believed in free trade, you did not necessarily believe in capital account convertibility, which I define quite in a purist sense, as simply being able to walk in a kiosk, take a billion dollars worth of rubles out, if you happen to have those billion rubles to begin with, and bring it back in without any restraints.
I agree with Barry that one can define convertibility as consistent with trade with taxes, but that is not the way we do it in free trade. In free trade, quotas, tariffs, any restraints are incompatible with free trade. Then we even have subsidiary arguments about whether in fact quotas are better or worse than tariffs as ways of dealing with a protectionist outcome when you need to have protectionist objective, like a revenue objective, or you are dealing with uncertainty and you want to be able to deal with it.
So I took it as essentially a full-blooded capital account convertibility, and I think this is really what the issue is. If we really want to deal with the issue, then I think it is true that today we have a far better gradation of different forms of capital account convertibility, and I will come back to it, but in trying to deal with how one addresses this issue, let me first say that Barry himself has correctly pointed out the large numbers of asymmetries. The kinds of things he was talking about, about capital flows and capital account convertibility, surely would not enter a discussion of free trade.
Trade in goods and services also is a different animal from capital flows. It is not subject to herd behavior, panics, crashes, destabilizing speculation, which we all studied going back to Aliber and Triffen, self-justifying outflows of capital currency speculation and so on. So we have always known this, but it has never entered into free trade discussions. So there is an asymmetry, and the question is how do we try and retain the advantages of capital flows, which I think any sensible economist will say that any time you segment a market--there is a presumption of what we call dead-weight economic laws.
I am not denying that, far from it. I would be foolish to do that, but the question is how do we handle this market, the capital flows part. That is really what the issue is.
I would say that in organizing my thinking, I would be at the lions, in their own den, and ask you to think back about in terms of organizing the questions--not condemnations or judgments--but questions as to how the crisis arose and spread because that is what we are dealing with, the aftermath and how to fix the system, which is really our concern this afternoon.
I think there are three main elements in the story. First, the U.S. and IMF and G7, what have you, all those who took decisions were a bit too optimistic and therefore imprudent, in my judgment, about spreading capital account convertibility around the emerging markets, despite all the things we have heard from Professor Eichengreen.
It’s not that people like Michael Mussa and so on don’t understand these issues. They understand it far better than I do. However, when it came to decision-taking, I think it is undeniable that there was an ethos.
I have talked to the Indian finance ministers who were mentioned, I think, as part of the Interim Committee, 3 months after the Thailand crisis begin. These ministers amazingly came out as if the crisis was not happening and reinforced the move to its capital account convertibility and wanting to put it to the IMF, not on the ground that something wild might happen as the capital flows were growing, but that they really thought it was a wonderful opportunity for the Fund to regulate something else, an additional set of transactions.
I do not see in that [Interim Committee] statement any great awareness of the notion that we are dealing with something which is extremely difficult to handle and which can really get out of hand. So the prudential part is kind of in low key, I would say, and the finance ministers I have talked to--and I have talked to some others as well from other emerging markets--they say, "The pressure on us to sign onto these things is so intense. If we say no, than it will be treated as being against reforms. Therefore, we sign on, but we are not going to rush into it because it is really a cockeyed thing to go for," until you are politically, extremely stable, an assassination can be taken in stride in this part of the world, and many other countries, political instability is a fact of life, and the judgment, the perception of political instability is also a bigger factor of life.
Economic growth is often fragile. Macroeconomic management is extremely difficult to handle. It is all very well to say you should have transparency and optimal management, but who knows what that is, in many cases?
Once I had lumbago. The doctor said I had lumbago. I looked it up in the dictionary. It just said pain in the lumbar region. It was not a diagnosis.
So all I am saying is that this is a highly difficult area, and there are lots of emerging markets which have not emerged at all yet. Many countries are not on capital account convertibility, and I think the better ones, the more successful ones, were, in fact, moving into this somewhat imprudently, as we know. So I think that was the first mistake, and I think in a way, we were all caught up.
Fortunately, it was not my field. So I was not caught up, but most people working in this area were sort of caught up in the ethos. I have sort of called that in the "Foreign Affairs" article, the Treasury-Wall Street Complex, and I meant it simply as a networking ethos. So, in that sense, there is an ethos, a kind of networking in which you use a sociological concept. It has now made me into a left-wing hero, I find. So beware of what language you use.
If you remember, President Eisenhower, when he talked with the military-industrial complex, it is hard to think of him as a radical, but he was Columbia president at that time. C. Wright Mills wrote the "Power Elite," for those of you who read sociology and political science. He was also teaching sociology at Columbia. In some circles, we three are known as the "Columbia Trio," and I suppose this is the next best to being the Beatles or the Spice Girls, I guess.
Anyway, the point is that I think there was a little bit of exuberance about the whole spread of this around the world, and a little forgetfulness--not lack of knowledge, but forgetfulness in the circles of where these things are being discussed--of the downside of these things and the need for prudential behavior.
So that, I think, was the first step of the crisis in Asia and certainly for most of these countries, there were some fundamentals that were wrong. There are always fundamentals that are never quite right. However, the fact that they had short-run exposure without prudential controls in place and monitoring and reviewing, I think that has to be the kind of Prince in Hamlet in the play.
The second one, I think, is really much more problematic. Supposing if the crisis in Indonesia, as many people point out, was largely one of panic, and if the Japanese were willing to put up something up to $100 billion, without conditionality, which we at our end in Washington objected to, then I think that was a mistake because, if it was a panic situation, and the fundamentals that were wrong were very minimal, then you did not need to impose conditionality.
As I read on my web site all the things that were written at that time, that is where you have essentially a missed opportunity. So that was a mistake.
The third one is on the conditionality, which is really what we are going to have to discuss. How should the Fund operate these things? There, I am with the Fund. There is no fine-tuning possible.
You raised interest rates in Indonesia. It did not help, in retrospect, but supposing if you had not raised them, how do we know it would have worked?
Ken Galbraith said once about Milton Friedman, what I would ask Jeffrey Sachs or comment on him when he criticized the Fund, that Milton Friedman has the advantage. His theories have never been tried. This is, unfortunately, no longer true, but this was true at that time.
So we do not know. This kind of criticism of the Fund in an area which is inherently complex, where we know in macroeconomics that fine-tuning is impossible, it does not really make sense.
I will give a big handshake to Mike Mussa on that and defend him and Stanley Fisher against this kind of criticism, but it still raises a question. The conditionality really remains a very big issue, and where conditionality has to be imposed, we still do not have any substantial agreements on this.
Let me return to the theme. There are lots of countries which are not at the moment on capital account convertibility. Why don't we let them be where they are? Take them off the radar screen because most of them are actually at the bottom end of the countries which can manage this sort of thing.
Take them off the radar screen. Let them not enter the game. For those who are already in the game, I would simply use the analogy that if you wanted to move out of it, it is like leaving the Mafia. You do not go up to Mr. Gambino and say, "Look, I am going to leave." You will leave in a coffin. You call up the FBI and get into the witness protection program and so on.
When the market actually says zilch, I am going to move out of it. At a time when a lot of capital has been lost, it is just crazy to try and "leave the game," to reinforce the kind of lack of confidence.
Of course, as Paul Coleman says, the interest rates will fall, but so what? Because nobody will invest if there is lack of confidence.
Once you are in the game, you have different rules to work with. So I would say those guys better stay in the game, work with the Fund, whose approach, I think on the whole is quite reasonable.
For the OECD countries, there is hardly any problem. As far as the institutional reform is concerned, I would simply say that the moral hazard question, I think, is a big one, and I am delighted to see from one of the many papers I read every day that the Fund is, in fact, addressing the issue of not getting in so quick as to bail out the guys who have made bad investments.
I think they should figure out a way--they are smart enough--whereby you let these guys go to the wall and then move in to help just when credit dries up and all this bankruptcy has been brought about. But that means taking on the Wall Street complex because you are at the apex of the financial system. How do you really enforce that kind of thing against your people on whom you depend? So I do not know how it is to be done.
Finally, I would say, looking at my own community, that there is also moral hazard. I mean, you should just let everybody else go to the wall who has made bad judgments. I am only half-facetious. How about it if we were to ask the economists? We never go to the wall. Everybody you quote, you never point out what we said five years ago or 10 years ago, like when you said Jeffrey Sachs says this. You never say his shock therapy was a major disaster.
I think there. I would just like to add one thing. The IMF should also be accountable. If the IMF says that you must have--if you give $5 billion to Russia and say defends the ruble and it has lost defending the ruble, should it not be written off? I do not know. I am just raising a question because conditionality from the Fund is very strict, unlike from the Bank.
Two, if we make a lot of mistakes, should we not be held accountable in some way? I do not know. I mean, they are my own friends.
MR. WIJNHOLDS: Thank you very much, Dr. Bhagwati.
MR. WIJNHOLDS: It is hard to describe Professor Richard Cooper's career in a few sentences, given the wide range of activities he has pursued.
He started his professional career as a senior staff economist at the Council of Economic Advisors in the early '60s and then moved to Yale University where he became professor of international economics.
During the mid-'60s, he served a stint as Assistant Secretary of State for International Monetary Affairs.
In 1977, during the Carter administration, he returned to the State Department as Under Secretary for Economic Affairs.
Since 1981, he is the Maurits C. Boas Professor of International Economics at Harvard University, but this is not all, of course. Let me just mention that Professor Cooper was also chairman of the Federal Reserve Bank of Boston in the early '90s, and that he is the director on the board of several companies.
He is also a member of such influential bodies as the Trilateral Commission, the Council of Foreign Relations, and the Brookings Panel on Economic Activity.
He has been a prolific and widely read author in the area of international economics, but has also published on other subjects such as development economics and environmental issues.
Personally, I am most familiar with his work on international liquidity and adjustment; for instance, his contribution to the 1970 IMF Conference on International Reserves--I see Jack Pollack there--which greatly influenced me as a young economist.
Professor Cooper, you have the floor.
MR. COOPER: Thank you very much.
Our topic is capital account convertibility and whether the Fund's Article should be amended to make that an objective of the international community with respect to all of its members, and you will detect in my remarks a tremendous ambivalence about this whole question of capital account convertibility.
I can think of four reasons to favor as wide as possible freedom of capital movements, two positive and two negative.
The first and, in my view, of course, the most important is that I want to live in a country that has capital account convertibility. I do not want some bureaucrat telling me that I can or cannot invest my funds here, there, or someplace else.
Like Alfred Marshall, I believe that introspection is a perfectly legitimate and, indeed, highly productive mode of economic research. So I attach some importance to my preferences on this matter. I consider it a good thing to be able to have the freedom to invest wherever possible.
The second reason, which is the one that is most emphasized by economists, is that it improves the allocation of resource, of world resources. We know that resources are still scarce. We know that rates of return vary from country to country. Real rates of return vary from country to country. Savings rates vary from country to country. There is no reason that national savings rates and investment opportunities should match, and that suggests real social gain all around from having capital movements across boundaries.
The two negative reasons--one, Barry Eichengreen alluded to--in today's world, one has to ask whether it is possible to control capital movements, even if one wanted to in principle with instant information and instant communication and all kinds of channels by which funds can be moved. Even if a country determined to control capital movements, it might find itself unable to. So there is an effectiveness issue that has to be raised, and if, in fact, countries have capital controls and they are ineffective or even partially ineffective, it encourages disrespect for the law. Scofflaw becomes routine behavior, and there is a social cost to a system that encourages disrespect for the law.
Finally, another negative reason, wherever there are capital controls, of course, there are not typically absolute barriers. There are administrative exceptions, and therefore, there has to be an apparatus for making exceptions. That leads to corruption, not to mince words, and that is also a disadvantage.
So there are these four reasons. There are probably others one could find with sufficient imagination, but, anyway, I find four reasons for thinking that capital movements might be a good thing.
Curiously enough, I actually find the second reason, improvement of world's allocation of capital, less persuasive than many economists do, and I find it less persuasive to me than the other three reasons I have given.
I have no doubt, as I have said, that moving capital across boundaries can improve and often does improve the world's allocation of resources. That is not the issue. The issue is whether freedom of capital movements all around would improve the world allocation of resources, and I actually have serious doubts about that question.
We know from the theoretical literature that as long as there are restrictions on trade, you are likely to get capital movements under a regime of free capital movements that are actually perverse, worsen the world's allocation of resources. That is a high probability bordering on certainty.
What I observe in the real world is that an enormous amount of capital moves in order to evade taxes, and there is a fine question about whether tax evasion does or does not improve the allocation of resources, but it is certainly anti-social from the point of view of the taxing jurisdictions. Taxes are the price of civilization, as someone observed, and to have a system which encourages the evasion or the avoidance--usually the evasion of taxes--seems to me not desirable.
Finally, there is well-known herd behavior by financial investors. This herd behavior, I want to emphasize, is not irrational behavior. There are well-defined reasons why mutual funds, for example, or even bankers follow the herd in their behavior. They are rational reasons. They are, however, myopic, and they are not system-maintaining, but, of course, private investors should not be expected to engage in system-maintaining behavior. They engage in capital-protecting behavior, but, again, the presence of herd behavior suggests that free movements of capital do not necessarily--and in fact, frequently, I would argue do not--result in optimal use of real capital. We have to translate financial capital movements into real capital movements. That is another step.
I want to say that my skepticism that I have just registered about that point does not lead me to advocate capital controls for the other reasons that I have mentioned. That is my ambivalence. Other things being equal, I prefer not to see capital controls, but I have had in the last few months a subversive thought about the nature of the system as a whole.
Economists have known for many years now that high capital mobility, de facto capital mobility, is not compatible with an adjustable peg system of exchange rates, the system that was actually written down at Bretton Woods. Those two things are not compatible, and in my judgment, that future of the Bretton Woods system broke down precisely as international capital movements increased and became more mobile, that famous one-way option.
My subversive thought is that high capital mobility, freedom of capital movements, may not be compatible with floating exchange rates either, and I do not here now speak of big diverse economies with well-developed capital markets, like the United States or the European Union, but most countries of the world are not of that character.
We have lots and lots of many states and lots of medium-sized states with very poorly developed capital markets, basically their banking system plus some fringe activities. So it is those countries I am concerned about.
It is worth recalling that the exchange rate is the rate of exchange between two nominal variables, two currencies, and these nominal variables fundamentally are not rooted in anything. Therefore, the exchange rate just from a mathematical, conceptual point of view is an entirely arbitrary number. It is an entirely arbitrary number.
It happens to be inherited from yesterday. Today, we inherit the exchange rates of yesterday and so forth. There are initial countries at every day, but it is basically an extremely arbitrary number.
This means that it is very hard in turbulent periods to build strong expectations around where the exchange rate of a particular country that is not a rich, highly developed capital market will settle, and in particular, to put it the other way around, in an unsettled period, it is very easy for one big player, a buyer or seller, or even just the rumors of big sales or purchases to move the exchange rate a lot.
Of course, for all open economies, but especially small ones, small- and medium-sized ones, the exchange rate is an extremely important macroeconomic variable, impacting the real side of the economy.
So you have the possibility of essentially arbitrary movements emanating in the financial market, having a real impact on economies, and to the extent that economies function better, that real economies function better with some continuity, this kind of disturbance is highly, highly disruptive and results in a misallocation of resources.
This is not a conviction yet in my thoughts. It is a subversive thought. I am still turning it over in my mind, but assuming it does become a conviction, the question is where does it leave one, and it leaves one with some unhappy choices, actually, but logically it leads one either to prefer common currencies or their functional equivalent, the functional equivalent of common currencies, or capital controls, in spite of the disadvantages that I have mentioned of capital controls. These are capital controls not designed to inhibit the international movement of capital, but they are designed to inhibit the large short-term surges, one way or the other, of movements in capital.
I guess I am not now making fine legal points, as Barry correctly did in his remarks, but Jagdish did not. I am using capital controls in the most general sense of the term, including market-oriented capital controls because I very much take Barry's point.
So I would just conclude by, again, expressing my ambivalence, my general presumption in favor of free capital mobility, but possibly, seriously qualified by my subversive thought about its compatibility with any kind of an exchange rate regime short of a single currency.
I am not ambivalent about one point, and that has a bearing on the topic before us. It was discussed in the Interim Committee. I see no reason whatsoever to take this on as an international commitment. It seems to me, precisely because of the ambiguity surrounding this, that this is an area of what the Europeans call subsidiary should come into play. Each community should decide for itself the balance it wants to strike between corruption and scofflaws and so forth. Those are all legitimate national choices, usually made, of course, by a small elite in the country, but I do not see any compelling reason why the international community as such should pressure or continually pressure through the IMF, for example, over the next two decades, the pressure of countries to move to freedom of capital movements. I would leave that as a national choice.
I suspect that most countries will end up with relatively free movements for practical reasons, but I do not see any reason to make it an international norm. In this respect, like Jagdish, I draw a sharp distinction between trading goods and services and freedom of capital movements.
In the half-a-minute remaining, just to remind us, I think so far the speakers have been consistent on this, but the journalists are not always consistent on this. It is very important to draw a distinction between the right of establishment of financial institutions and freedom of capital movements.
In the real world, those issues get mixed up, but, in fact, they are analytically separable. If you work at it, they are separable in practice. I think one of the major thrusts over the last decade for freedom of capital movements has actually come from folks who desire freedom of establishment of financial institutions. I just want to keep in mind that distinction.
MR. WIJNHOLDS: Thank you very much, Professor Cooper, for your ambivalence and perhaps somewhat agnostic view, but there were some very interesting thoughts there.
We now turn to Ricardo Hausmann who is the Chief Economist of the Inter-American Development Bank, right here in Washington.
Previously, he was Minister of Coordination and Planning of Venezuela and the chairman of the Joint Development Committee of the IMF and the World Bank body that is meeting this Monday again, but you are not the chair.
He was also a member of the Board of the Central Bank of Venezuela. He is on leave from IESA. I will not attempt the Spanish pronunciation, if you do not mind. Venezuela's leading graduate school of business where he is Professor of Economics and founder of the Center of Public Policy--he holds a Ph.D. in Economics from Cornell University, and he is a leading Latin American economist with a host of publications on issues relating to macroeconomic adjustment, international finance, and fiscal policy.
He has been a research consultant for the World Bank, the Inter-American Development Bank also, and the IMF. You have done them all here.
Professor Hausmann is the chairman of the Standing Committee of the Latin American Chapter of the Econometric Society and a member of the Board of the Latin American and the Caribbean Economic Association.
Mr. Hausmann, you have the floor.
MR. HAUSMANN: Thank you. Thank you very much.
It is really very good to be in this sister institution, and I do not mean it as a pun in the sense that you do not get to choose your sisters.
I want to congratulate Barry for the substance of the work, and Mike Mussa, too, and the other authors. I think that the substance of the work is right on target, but they are trapped in this funny language of liberalization of the capital account which in a way makes their explanations a little bit harder to sell because people immediately see it as part of a paradigm in which we are all going to the Promised Land. In the Promised Land, there are no controls.
So some countries eventually will get there, and others will get there sooner before others. The only question that is relevant is what is the sequence of policy reforms to get you there, but in the long run, there are no controls.
What they are saying is very clearly that in the long run, there are controls. So the question is not what is a sequence in which you get rid of the controls. The question is what are the controls we need.
So I guess that if they had called it capital account controls, it would have been just as an appropriate subject. I guess since half of the audience is in agreement with capital account liberalization and the other half with capital account controls, and since the title can be either one, then I guess we are all in agreement.
I think that there is something important in the conversion of many of our beliefs, and I am sure in the conversion of the beliefs of Mike [Mussa] and Barry and many others, and myself--because if you look at the IMF programs, the World Bank programs, the Inter-American Development Bank programs, in terms of financial liberalization, say 1988, 1989, 1990, the only thing that you found in conditionality was get rid of public banks, get rid of interest rate controls, get rid of targeted credit.
There was nothing in the conditionality until '91, '92, '93, or maybe later in other countries, on regulation, prudential regulation, supervision, etc. That came later. We learned. So it is nice to say we have learned some things, and I think that there is a lot of learning that went into this report.
So this is not that we’re always right. We now have different beliefs on what we used to have, and I think that it is important as a recognition.
In his remarks, Barry gave a very good, general, theoretical case for why regulation might be required. I would like to elaborate a little bit on the specific conditions that emerging markets face that may make the requirements of that regulation more special or harder.
The first one is that we are--when I say "we," I think as a Venezuelan that I am an emerging market, but I take Jagdish's point that we might be a submerging market. You have essentially a developed capital market. It is one that looks like, say, the Port of Rotterdam, to take an example from our chair's country, while an emerging market looks like the Coast of Britain or Normandy.
In the sense that if you do not go to the Port of Rotterdam in high tide or in low tide, it looks the same. In the Coast of Britain, in high tide, you have all of these beautiful little bays, bays with all these little fishermen's boats parked in the middle of the bay, and in low tide, there is no bay. There is just a lot of sand, and these boats laying on their side on the sand. That is a little bit how it feels when you are in an emerging markets. Some days, they love you, and the question is how you get rid of all that excess capital inflow.
The other day, there is no market out there. It is just a lot of dry sand. So it is not a question of sand in the wheels. There is no wheels. It is all sand.
That means that these markets are very particular. You can show that they are particular because some of the things that we believe as economists, we believe in this concept called country risk, which we measure as the difference in the spread between a sovereign dollar bond and the U.S. Treasury bond. So sovereign risk is supposed to measure some idiosyncratic risk about the country.
We have done some studies showing what is the degree of correlation of sovereign risks across emerging markets, and especially across emerging markets where you do not think that they are particularly related.
For example, what is the relationship between Russia and Latin America? We do not trade. They are 1 percent of the world economy. It is true they have 30,000 atomic bombs, but they are not particularly pointed at us. So what is the connection?
The connection is through our lenders. What connects us, a catch phrase is that Soros is in both places. I think Soros does a lot of good. He mobilizes valuable resources.
What I mean is that we have to understand a little bit the fact that our lenders are not this infinite pool of capital that just has an international price. It is a restricted pool of capital where there is limited capital, where the macroeconomics of that market are barely known. They are very slowly developing. It is a market that developed involuntarily because one day we dumped on that market billions of dollars in Brady bonds that were the conversion of some involuntary debts that were inherited from the past.
It is a market that, for example, we see the shock of other investment-grade countries that had paper placed in the insurance companies and pension funds, and when they were downgraded to non-investment grade, had to dump all those assets into this very narrow market of people who can have non-investment grade paper and so on. So it is a very funny market.
Sometimes, as I say, they love us, and sometimes there is no market. So that makes an emerging market have to behave like a skin diver. You have to know when it is that you can breathe, and when you can breathe, breathe a lot and hold it.
So that means that in terms of regulation, we have to have financial markets that are very, very liquid. This is an important lesson because the OECD has no requirements on liquidity of the banks, for example, and when Mexico joined the OECD, they eliminated all liquidity requirements on their banking system, and I think that was a mistake, not unrelated to what eventually happened in 1994 and 1995 in Mexico.
So I think that we need financial systems that are very liquid, and you need to impose liquidity requirements on those banks. You may want to impose the liquidity to requirements not only on domestic deposits, but on foreign borrowings. So there you have the equivalent of a tax or a withholding requirement or something on foreign transactions. So that is indirectly what some at the table would call capital account controls, but with convertibility and so on; it is an appropriate form of regulation if you are playing the skin diver game.
I think that those lines of liquidity have to be complemented by contingent lines of liquidity. Emerging markets might be able to contract out with the international private sector, but they may need some support from the international financial institutions, or if the world becomes more generous than it seems to be right now, they may be provided by some public international institutions, but I do not think it is needed.
What is important for a country is that they should have not only a lot of liquidity, but in addition, pay to have access to additional lines of the liquidity if needed.
I take Barry's point, that the corporate sector, not just the banks--need to be regulated in terms of their borrowings or at least in terms of provisioning adequate levels of liquidity for those obligations, but he has already made that case.
I think that one major interesting thing that requires further study on the side of the northern countries, not the southern countries, is that we have some evidence that there is a tremendous discontinuity between investment grade and non-investment grade markets. That discontinuity is a regulatory discontinuity, and it makes the market work in very funny ways that I do not think are efficient. So we might want to think if you are investment grade, then pension funds, insurance companies can buy, and your provisioning requirements are different and so on.
More interestingly, if you are in fear of losing your investment grade, then everybody starts dumping your paper before they are forced to. So you have countries when there is rumors of them being downgraded, it can have very, very disequilibrating.
Internationalization of banks, I think that this is a very, very important point. If there was something about sequencing, I would really want to see a lot of internationalization of the domestic banking system. This, I think, is very good because, among other things, it not only allows diversification of risk, access to secondary lines of liquidity of the parent institution, but it also indirectly generates competition between regulators because foreign banks have home country-consolidated supervision.
For example, in an airline, you can travel, say, in American or in Aer Lingus, right? They both are regulated, one by the Federal Aviation Administration, and the other one by some ministry of transport or something.
If you are an Argentinean and you do not trust the regulator, you might travel on American for security reasons. Banks are a little bit like planes. They fly most of the time, but every so often, they crash, and when they do so, it is with quite horrible consequences.
So, if you are in Argentina and you can choose between a domestic regulator and a foreign regulator, that will generate competition between regulators, and that will generate a political economy that will operate regulations. So I think that is a very important element that I think we should move on.
Finally, to the main question that was asked of these panelists, should the IMF get these added powers to develop conditionality on capital account convertibility? Here, I think that the IMF is at its best when it tries to convince, and you do not need a change in your charter in order to convince people. Make your case. State your case. Convince people that this is the way to go, that these capital account controls that you are now in favor of are good, and let the sovereign nations decide on that.
When I was in government, everybody had this tendency that in order to do something, you had to go to Congress and change a law. Well, you do not really need to go to Congress many times. I think you can do a lot of it without going to Congress.
Let me stop there. Thank you.
MR. WIJNHOLDS: Well, it is hard to get an increase from Congress, but that is another question.
I now turn to Michael Mussa, who is the Economic Counsellor and Director of Research at the IMF, a position he has held since 1991. In this capacity, he is responsible for advising the management of the Fund and its Board on broad issues of economic policy and in providing analysis of ongoing developments in the world economy.
You are all familiar with the publications like "The World Economic Outlook" and "International Capital Markets Report," I take it, and they are done under his supervision.
Mike appears on a regular basis in the Executive Board of the IMF where he does not only treat the board members to his economic insights, but also to his very special brand of humor. Perhaps he will show you some of that, but we will see.
Before joining the Fund, Mike Mussa was a longtime member of the faculty of the Graduate School of Business of the University of Chicago, and before that, he taught at the University of Rochester.
Let me say last, but not least, Mr. Mussa served as a member of the U.S. Council of Economic Advisors for 2 years during the Reagan administration. Mike Mussa's main areas of research are international economics, macroeconomics, monetary economics, and municipal finance. I did not know that, Mike.
He has published widely in these fields in professional journals and research volumes, and he is also a research fellow of the National Bureau of Economic Research.
Mike, you have the floor.
MR. MUSSA: Thank you very much, Onno.
Well, I think it is interesting and, indeed, prophetic that the Interim Committee statement on capital account liberalization and an amendment of the Articles has a picture of the Hong Kong skyline. That real estate has depreciated in value by approximately 50 percent since this statement was issued.
It is also, I think, not entirely accidental that the Fund's position on how rapidly and under what circumstances to pursue capital account liberalization has changed a little bit since the early '90s when I joined the Fund staff.
I like to think of the issue of whether capital account liberalization is good or bad, and how we should deal with it, as similar to the issue of how the human race should make use of fire. Fire warms our homes. It cooks our food, our internal combustion engines. It powers our automobiles and trucks and our turbojets. It powers our airplanes. No doubt, fire is very useful, and we are not going to give up its manifold benefits.
On the other hand, fire can also burn you down and do a great deal of damage, and that seems to me to be the main concern with capital account liberalization, that it does have important benefits, and few of us would want to give up the benefits of living in an economy that has both a fairly liberal domestic financial order and a fairly liberal international financial order.
On the other hand, liberalization in the financial sector--and I would emphasize here both domestically and internationally--has far too often in far too many countries around the world been associated with a variety of economic disasters.
So there are dangers that are associated with financial liberalization in both its domestic and its international dimension, and that, I think, tells us two things. One, I think financial liberalization domestically and internationally is coming. It is being driven by technology and by the desire of people all around the world to take advantage of its benefits, and while there may be occasional retrogression and steps backward, I think the direction in which things are going is unmistakable and essentially inevitable. That will bring benefits, but it will also bring risks, and the question is how to maximize the benefits and minimize the risks.
Barry has spoken about describing the overall approach in this paper, and I want to return to it at least briefly.
When I was in the Reagan administration, we got an inquiry from Congress. Congress wanted the President to describe the level of oil imports which would represent a threat to national security. I suggested that we write back to them and say that there is no level of oil imports that represents a threat to national security. The threat is that oil imports might be withdrawn.
I fear this is the main problem with international capital movements. The problem that people perceive, to some extent, is associated with capital inflows. Even then, the worry is what might happen when the tide flows out and all of Ricardo's fishing fleet is laying high and dry on the sand. That is the principal difficulty that arises with capital account liberalization for emerging-market countries. It is not the only difficulty, but the principal difficulty.
Dick Cooper suggests that, therefore, this issue should be viewed largely as a national issue, an issue of national economic policy, and the choice should be left to national governments about how rapidly and under what circumstances they want to pursue it, and I think there is something to be said for that, but the consequences of these types of financial crises that we are seeing now in Asia and more broadly around the world affect not only the emerging-market countries that are most keenly and directly affected. They affect the functioning of the world economic system as a whole, and I think there is, therefore, a broader systemic interest in having capital account liberalization handled in a manner that maximizes the benefits for the world economy as a whole and limits the risks as best as possible for the world economy as a whole. Therefore, there is not only a national interest, but there is also an international interest in having capital account liberalization pursued in a manner that does not generate unduly large risk.
In addressing that question, I think it is critically important to assess what are the main areas of risk and how can they be dealt with.
I think experience suggests that flows of direct foreign investment, although they, too, can be volatile, do not generally seem to possess the types of risk of financial crisis that are associated with other types of capital flows. So an attitude that is open and fairly liberal on a progressive basis towards flows of direct investment seems to me to be prudent and in the interest of many countries.
There is no reason why it needs to be done all at once by any means, especially in countries where you have large control of enterprises in the state sector. It is senseless to privatize them all at once. A gradual approach to that issue certainly makes sense.
Where real problems, I think, do arise also are not with portfolio equity flows. Certainly, the instability in the Hong Kong stock market has been a problem for economic policy management in Hong Kong, but the problems associated with up-and-down movements in the value of equities, to the extent they are influenced by international capital flows--and sometimes that is an important influence--generally do not create acute crisis problems for economies.
What generates those types of problem is default on credits or the threat of default on credits. That is, I think, where the primary dangers lie, and here, one should distinguish the government, the banks, and the rest of the private sector economy.
Of course, if the sovereign defaults, then the credit rating for the entire country is written down to total junk. So the number-one problem is to limit the risk of default by the sovereign, and there the principal instrument of choice is the sovereign needs to control the term structure and the foreign currency structure of its debt so that it does not get itself into a situation where over a relatively brief period of time, it has a large volume of debt maturing and does not have adequate reserves or other resources to be able to deal with that situation.
We certainly see the number of circumstances, both in the 1980's and more recently, where that fundamental principle of prudent debt management by the government was not practiced, and it became the source of difficulty.
Russia is clearly an example of that, even though the debt was domestic currency debt. Its short-term character was a very critical problem.
The second key area of concern is the banking system and its internal, but particularly external foreign currency-denominated debt. No national government can stand by and watch the totality of its banking system get blown away because that completely disrupts the financing mechanism within the domestic economy.
So the government in the event of a systemic threat to the banking system needs to step in and provide support. That means the government has a legitimate, strong, prudential interest in regulating the banking system in such a way that the banking system does not undertake undue risk that will put the system in jeopardy in the event that a change needs to be made and the exchange rate or the interest rates need to be pushed up either to defend an exchange rate peg or to resist massive unwarranted depreciation of the currency.
Failures in that area, indeed policies that encouraged in some countries, large-scale international borrowing by the banking system or by the broader financial system in Thailand and Korea were at the root of some of the difficulties that we have experienced recently in the international economy and for the countries particularly concerned.
And here, I would assert it is not only in the national interest of the countries concerned. It is in the broader interest of the international community to have governments put in place policies that countervail the other incentives that do exist for large-scale, short-term borrowing, intermediated through the banking system.
Finally, there is the issue of debt flows beyond the banking system and whether broader types of taxes and other discouragements to excessive short-term borrowing are appropriate in some cases. I think it is desirable to maintain an open mind on that issue.
An additional and related concern was raised by Dick Cooper which is the issue of the exchange rate regime, and there again, I think in many countries, the either de facto or de jure institution of a fixed exchange rate, but without the maintenance of adequate policies to make that fixed exchange rate viable. When I say adequate policies, I mean high levels of reserves, the flexibility to raise interest rates in the event of pressure, which means not having the banking system or the economy very heavily exposed, so that they cannot tolerate even for a few months a sharp increase in domestic interest rates, large exposure to foreign currency-denominated debt which can be encouraged by a fixed exchange rate system, which then means if you have to change the exchange rate, it makes that change a catastrophic result.
So you cannot hold the rate, and you cannot let it depreciate. Either one produces a disaster. No country should be placing itself in a situation where it exposes itself to that type of risk.
While I think that that is primarily a responsibility of a national government to conduct its policy in that way, I think it is also a responsibility of the international community to be aware of those situations and to caution governments about the dangers to which they may be exposing themselves and others as they move, I think, more or less inevitably, though not necessarily in a straight line, to adopt more liberal policies toward the capital account.
Finally, Mr. Chairman, I want to emphasize a more systemic-level problem. We saw in the course of the 1990's that flows of capital of all forms to emerging-market countries, direct investment, portfolio equity investment, debt flows, debt flows to governments, not primarily to government, debt flows to the banking system, debt flows to private corporations. All of those things expanded very rapidly as the tide flowed in.
And prices of equities went up until 1996 and emerging markets in 1997 as there were in industrial countries. Spreads on emerging-market debts, particularly after the tequila crisis got down to very, very low levels. World capital markets were pushing a large flood of capital into emerging markets. In terms of gross flows, that reached an annual rate of $400 billion in the summer of 1997. After the middle of August of this year, those gross flows reached zero, just died completely.
No country, no matter how soundly managed are its economic policies, no matter how solid is its banking system, can maintain an open attitude towards international capital flows in the face of that type of systemic disturbance, and the international community has some responsibility to face up to that fact, and to not simply say that all of the responsibility for dealing with that type of systemic-level problem rests with the emerging-market countries themselves.
There needs to be some effective mechanism to resist that type of--I think on the one hand, an inward movement of capital to slow that down, but also to be prepared to deal with the circumstance when the market panics in the other direction.
MR. WIJNHOLDS: Thank you very much, Mike.
I am now going to upset the panel a little bit by not giving them an opportunity to respond, but by turning it over to the audience right now, but certainly, in their answers, I am sure, if they still want to react to what some of their forum members, they certainly can come back to it. We have been running a little late, even though I tried to be a little strict.
There are microphones for those who want to question. Over here, please. Please state your name and affiliation.
MR. ENGELA: Klaus Engela from Handlsblatt. This whole discussion reminds me of a presentation of the report on capital flows we had in Madrid with a similar cast of Washington characters.
We had no European on the panel, which I criticized, but we had a very solid warning that maybe Chile might be our salvation, and interestingly, the investment bankers and the commercial bankers all told us journalists bullshit. They knew better, and I wrote several articles, very nasty and very critical. Basically, it was almost of no relevance.
In the following years, we had the Inter-American Bank as the only international multilevel body at their annual meetings exploring the risks, and the interesting thing is that from a European angle, this whole discussion looks a little one-sided.
We have a Dutch chairman, but I would like to get your response to the following theories. What Mussa said, that it is the market sectors that drive the capital machine, it was a fight between the U.S., what Mr. Bhagwati said, the Wall Street-Treasury notion of rapid opening of the emerging markets, and the Europeans were a little more hesitant.
Europe just got off the capital control, just a few years before, in the '80s. So we had a totally different approach and a big fight. Mr. Blumenstein [ph] from the OECD was one--about how we do with Russia, speedy, building up the banks for a good legal system, and get out these American investment banks, and do not make a casino out of Russia. That was the European attitude.
What happened was a disaster, and I ask you, isn't it what Mussa said, we have a systemic problem, one 400--we have 400 billion and now we have zero? And I think you also should mention that basically your report comes at a time when we have a crash, a more hazard problem, because after Russia and the hedge funds, where is the more hazard still? It is no longer there.
So we have a big presentation by the IMF at a time when the problem has exploded, and you should have done it 2 years earlier.
MR. WIJNHOLDS: Well, any other questions or comments?
Let's take one further at the back. I do not want to discriminate against people who came a little later.
FLOOR QUESTION: We know that not all capitalists are equal. Some are more equal than others, and as we are discussing now, capital liberalization or flows of capital, I was wondering whether any of you very erudite and distinguished gentlemen have given much thought as to whose capital is it that is moving in and out of these vulnerable countries, perhaps to take advantage of disastrous consequences that follow.
The only name I hear is Soros. Who are these? Are they the Rockefellers, the Rothchilds? Have you given much thought as to whose capital is causing all these problems?
MR. WIJNHOLDS: Okay, this gentleman, and then we move to this side. State your name, please.
FLOOR QUESTION: The IMF and most economists traditionally have been great champions of free trade, liberalization of the current account, and so going back to David Ricardo, they base their arguments on comparative advantage and all of the benefits that flow from comparative advantage.
If we go back and have another look at David Ricardo, we see that his argument for comparative advantage is premised precisely on immobile capital between nations. So, if you have mobile capital between trading partners, you are in the world of absolute advantage, not comparative advantage anymore. So it seems to me that if the IMF now moves toward liberalization of the capital account, free mobility of capital, you are implicitly undercutting your traditional argument of comparative advantage in favor of free trade, liberalization of the current account.
So I wonder if you agree with that, and if you do, do you plan to shift your defense of liberalization of the current account towards an absolute-advantage argument or some other argument?
MR. WIJNHOLDS: We will take one more, maybe on this side. Yes, the gentleman here.
MR. ROWLEN: Anthony Rowlen [ph], Emerging Markets.
I would like to hear it stated quite explicitly what is the primary objective of the IMF in seeking jurisdiction over the capital account. Is it to control capital flows, to control capital account convertibility, or is it to encourage it?
If I could just be permitted a quick observation, I live in Japan and I find it slightly ironic that back in the early 1990's the Bank of Japan and the Finance Ministry in Japan were urging the Southeast Asian countries to be extremely cautious in liberalizing their capital accounts, to strengthen their banking systems, et cetera, before they did this, and, of course, that advice was totally ignored and overwritten by other countries, but it is rather ironic, I think, in these days when Japan is so criticized to remember that--or important to remember it, I should say.
MR. WIJNHOLDS: Let's start with Barry Eichengreen. He was the first speaker. Could you tackle perhaps also the first question? Pick whatever you want, but Mr. Engela has to be answered first.
MR. EICHENGREEN: No. I think I will resist engaging in 20/20 hindsight. I think as Dick Cooper said, introspection may be the best way for all of us to deal with those issues.
I do want to raise one of the other deep philosophical questions that was posed by a member of the audience. Whose capital is it? These are obviously issues that are addressed in the Fund's own Capital Markets Report. That is one of the fundamental questions that is asked there every year in the study of hedge funds that the IMF did.
The answer, I think, is in an obvious sense everybody's capital. It is hedge funds moving in and out of emerging markets, but also pension funds, mutual funds, investment banks, commercial banks, all the places where we all and everybody else puts their money, and importantly, domestics.
MR. COOPER: I want to emphasize on what Barry just touched on at the end. I do not have access to all of the data that the Fund does, but I have looked at where the BIS publishes the banking data. What is remarkable about the banking data for the second half of 1997 is how little Bank money left Southeast Asia, and yet, we had this tremendous decline in net capital inflow.
I think the answer is residents. Once you get into a period of crisis, it is not just foreigners that will want to protect their assets. It is residents who want to protect their assets, particularly if they have borrowed heavily in foreign currency. So the very strong pressures on the exchange rates in the fall of 1997 was essentially residents covering and very little on the other side.
So, in turbulent circumstances, everyone becomes a "speculator," although I put that in quotes because it has the wrong connotation. Everyone is trying to preserve his assets. Now, that does not answer the question of what the capital went in, but once things begin to move out, it is not just the foreign or even the mainly--mainly the foreign capital that moves out. It is resident capital that moves, and that, of course, is a great danger for any country once its own public loses confidence in the financial system of the country.
MR. WIJNHOLDS: Thank you.
Professor Bhagwati, what about this question on Ricardo? You are definitely an expert in that area. Would you want to tackle that one, please?
MR. BHAGWATI: Just a brief statement. The gains in trade do not depend on lack of capital mobility or its presence. We have gone 200 years beyond Ricardo.
MR. WIJNHOLDS: Anybody else on these questions? Mr. Hausmann?
MR. HAUSMANN: Yes. I want just to react to this idea that the old people had it right in terms of having the capital controls and then there came some new people that said take them away and they were wrong, the old guys had it right. I think that that is the wrong approach. I think that what we need is adequate regulation, modern up-to-date regulation.
It is not the case that had you left the regulation as you had it before, you would not have had any problems. Here, there was one reading that the press made of the '94-'95 tequila crisis.
In Argentina and Mexico, which were the two countries that had the most liberal capital account, got into trouble during the tequila, while Chile, Colombia, and Brazil that had capital controls did more or less okay.
Well, now you have Chile, Colombia, and Brazil doing not well at all, and comparatively, Argentina and Mexico doing better. So that comes to show that we probably read too much out of a previous story.
So I would say let's not assign blame or responsibility to history. Let's take very seriously--these are dangerous times--what it is that countries should be doing now, and I think that this is an area that requires a lot of thought because what Mike Mussa just said about these two numbers, 400 and zero, means that, for example, a country-by-country statewide approach is through such a systemic world crisis may not be the appropriate way to go, that we may not have yet the adequate instruments, that this whole issue of international financial architecture is very deep and serious, and that if we do not act sort of promptly and aggressively, we may be creating very serious problems on a global basis.
MR. WIJNHOLDS: Thank you.
Let's have some more questions.
MR. SIMM: Hi. My name is Andrew Simm. I am with New Economics Magazine.
I have got a question about taxes. They have been mentioned twice this afternoon, and I notice it is just the academics who have been brave enough to talk about taxes and not the officials, which was quite interesting.
Two, Barry Eichengreen and Professor Cooper--Barry Eichengreen talked about taxes in the context of regulating flows. I am interesting whether he sees that they--first of all, what kind of taxes is he thinking of in terms of regulation, and secondly, whether these just have the purpose of putting sand in the wheels, some ballast in the system, or whether there is actually a revenue-raising function there as well, because we are here at a time when aid levels have reached a historic low, and there is appalling difficulty in finding the resources for debt relief, for example.
On the other hand, Professor Cooper pointed out that taxes are the price we pay for civilization, and it is not just through the capital account liberalization, which the Fund is promoting at the moment, but through other arms like the multilateral agreements on investment which is going to liberalize transfer payments. We already have the problem of transfer pricing which is alluded to and tax evasion.
So a question to Professor Cooper is: How do we recapture the funds to pay for civilization?
MR. WIJNHOLDS: I will take a few more questions.
Yes, this person.
MR. POTROSKY: Paul Potrosky [ph] from Dow Jones News Wires.
I wanted to hone in on the point raised by Professor Cooper about the country he would like to live in being one with open capital markets and to especially look at the example of Russia and Eastern Europe.
It would seem like there is a lesson to be drawn here, and I would be interested in the panelists' reaction on where these policies are implemented because similar advice was applied to the entire region. And in certain places like Poland and the Czech Republic and Hungary, they seemed to have survived the whole thing quite nicely. And other places like in Russia, it seems like it has ended in complete disaster.
It seems like, for lack of a better term, the political maturity of the systems in which these policies are implemented is a crucial issue.
MR. WIJNHOLDS: Over there, please.
MR. SHANE: Yes. Matthew Shane with the Economic Research Service.
I guess my concern--the focus I appreciate is on liberalizing capital markets and capital flows, but it seems to me that part of the problem of what happened is that there was an imbalance between liberalizing capital flows and institutional development and equivalent developments in terms of other markets, so that when a crisis came, what happened is that this was the avenue by which movements of funds could cause and, in fact, exaggerate the crisis.
So, I mean, it seems to me there is sort of an appropriate balance between capital market liberalization and other kinds of liberalization in institutional development, and when that balance is off, you generate potentials for real serious problems.
I would just generally open that up.
MR. WIJNHOLDS: Okay. One more on this side.
MR. GERTZ: I am Matt Gertz [ph] from Business Report in South Africa.
One of the things that Professor Cooper said is that a big reason for capital account liberalization is that most capital accounts are already liberalized; that it's there. The problem is what can the financial community do to prevent or mitigate the fear of panic.
Through Mr. Mussa's three big problems, you know, in terms of one of the forgotten countries of this crisis, no mention of Latvia. We have had many of the effects of the others.
The three biggest dangers that he put on sovereign debt, collapse of the banking system, and problems of debt flows to corporates which has not--none of those were in South Africa--do obtain, and I believe in certain South American countries, but the panic spread, and we had our bond spreads go up as anyone else, more than others. There was portfolio equity in bond flows that totally hurt us, in a fairly liquid market as well.
I mean, liquidity cannot totally prevent losses, as we have seen in America at the moment. So what kind of response can the international financial institutions come up with against that?
MR. WIJNHOLDS: I think we will start with Professor Cooper because there were a number of questions asked of him, for instance, on the role of taxes and so on.
Would you like to start, please?
MR. COOPER: Well, the evolution we have seen actually over the last 50 years has been a kind of race between what we now call globalization--that is the buzz word, but it has been going on for a long time--and authorities trying to catch up.
One of the interesting developments is that agencies in this city, in the U.S. Government, which were once considered entirely domestic in their orientation, most rapidly growing parts of them are the international divisions of those. I am thinking of the SEC, the Commodity Futures Trading Commission, the Antitrust Division and so forth, and now to come to taxes, I think we have the same story in taxes.
To the extent that capital becomes mobile internationally with--what do we have now? 190, roughly, jurisdictions, states in the world, with a vast array of distances in laws and administrative capacity and so forth. The possibilities for tax evasion go way up, and we have to do, it seems to me, either of two things.
One is to abandon the notion that we should tax income on capital, and there are lots of people in rich societies that would be real reluctant to do that, although some people would certainly favor it.
The other is to have much-enhanced cooperation among tax authorities.
The first step--and in a sense, the easiest, but it turns out to be difficult to implement--is simply exchanging information, not have Tax Authority A act to enforce the laws of Tax Authority B, but just to exchange information between tax authorities. So this is a process that is actually evolving. It is evolving rather slowly.
If you want a paradoxical example, at least to me as an outsider, we were criticized for having no Europeans, except for our chairman up here, but the European Union is going through this inside the Union. Luxembourg, the smallest member of the Union, has so far resisted successfully pressures from both Germany and France to have withholding taxes on capital income.
I actually find it bizarre, but there is no forum within Europe. There is one forum within Europe where this issue can be discussed and resolved definitively. It is all done sort of behind doors among the governments and tax authority, an issue the European Parliament, for example, might take up.
On the question about the imbalance between liberalized flows and institutional development, I think that is dead on. I think what happened in the East Asian countries--I have in mind particularly Korea and Thailand and Malaysia--is that the real side of the economy developed much more rapidly than the financial infrastructure which we know every modern economy requires, and they got caught by this crisis. The details are known to many of you, but my guess is that as we look back on this episode of 1997 and 1998 from the perspective of, say, 2005--I have in mind those economies in particular--we will see these as adolescent growing pains.
The economies will be stronger. They will have made the corrections, the institutional building that they have to make.
It is worth recalling, lest folks, Americans and Europeans, become smug about this issue. We in this country had a crisis roughly once a decade from the 1830's to the 1930's. The 1930 one happened to be a real disaster, before we put in place the regulatory and supervisory structure, which we are now more or less comfortable with--and even that did not save us from the savings-and-loan crisis.
So this is a question of institutional development. It is a very important part, and it is a sad commentary on human beings, human society, that we have great difficulty learning from the mistakes of others. We seem to have to make the mistakes ourselves before we really learn.
The one useful role of the IMF is to remind people that mistakes can be made and try to stay ahead of the game.
MR. WIJNHOLDS: Thank you very much for these wise words.
Mike Mussa, I am sure you would want to say something on these matters.
MR. MUSSA: Well, we did have the question about why if we were recommending similar policies in Central and Eastern Europe, including the former Soviet Union, we are getting different results.
I think a key issue here is what we refer to as ownership. There is no question that the Polish government that came in at the beginning of the decade was very strongly committed to a rapid move away from the central planning model and to the adoption of a market-oriented economic system to bring the budget deficit within reasonable boundaries and to a degree of monetary discipline that at least kept the inflation rate within tolerable limits. We are prepared to undertake the policies necessary to achieve that result. The same was true, I think, in the Czech Republic and in Hungary.
The record has been much more spotty in other of the countries of Central and Eastern Europe, including, of course, Russia. Indeed, in Russia, to an important extent, the market mechanism never really functioned. There was a great deal of business that was done sort of on the side with no direct means of payment, just barter deals, and the taxes were also very largely a barter arrangement between major taxpayers and the tax collectors. There never was, I think, the degree of commitment in Russia by many important elements of society to move towards reasonably well-disciplined, well-ordered, market-type economy. That, I think in the end, proved to be the Achilles' heel of the whole effort for stabilization and reform.
It was suggested earlier that the creation of the short-term debt market in Russia was a serious mistake. There, I think the issue does really cut in both directions. One of the successes of the Russian stabilization program was that they were able to bring the inflation rate down to actually quite low levels, and an important part of being able to accomplish that was creating a market in which the government could finance itself other than by resort to the printing press as a means of finance; that is to say, by borrowing on an interest-paying basis to finance the government deficit, rather than just printing money or borrowing it directly from the banks.
The difficulty with creating a GKO market that facilitated that development is it turned out in the end, really, to be, you know, giving the key of the liquor cabinet to a drunk, and there was no way to discipline the resort to borrowing and keep it within reasonable boundaries. Then the situation became explosive as confidence in the stabilization and reform program eroded in the spring and summer of this year, and interest rates on GKO debt got pushed to very high levels. And the situation became fiscally unsustainable, and there was no way out of that, and no way that the Russian government, including the Duma, was going to credibly commit itself to raising tax revenues sufficiently so that people could perceive that in the medium term, the budgetary problem could be solved.
Instead, people were persuaded it was a Ponzi scheme and that they were going to run out of new suckers for that scheme within a fairly short time horizon, and then the thing got blown away, but that was clear in hindsight.
I think it is important to recognize that the creation of the GKO market earlier on was playing a very important role in assisting the stabilization effort. It was the failure later on to be able to enforce adequate fiscal discipline that really turned that from a positive development into a quite negative one.
MR. WIJNHOLDS: Thank you, Mike.
Well, we went a little over the time allotted to us, but I think it was well worthwhile.
Let me just say finally that I think it is very hard to draw any firm conclusions from this very interesting debate by these eminent economists. I, however, thought there might be a little more degree of convergence than before, but that was my perception and perhaps you would have a different view.
Anyway, I did not hear anybody abfucate fully unfettered capital account liberalization. Neither did I hear anybody abfucate Malaysian type of reimposition of control. So that is something, perhaps not very much, but it is something.
I thought that there might be at least agreement that if you do liberalize, and not everybody agreed on, of course, the exact cost and benefits, but if you do liberalize, a number of things seem--capital, of course, I am talking about--a number of things seem to be essential.
First of all, you have to have a certain degree of political stability. Professor Bhagwati emphasized that.
There was also quite a bit of emphasis on the need for sound macroeconomic policies, and I think very important also--and this came through, too, a few times--that your domestic financial system, your banks have to be reasonably sound, and that you have to have adequate supervision in place.
I would add, I think that is quite obvious, also, although it was not perhaps emphasized so much that liberalization will have to be tailored to specifics of countries. So there is not a one-size-fit-all type of approach.
Finally, sequencing is important. Do not start liberalizing short-term flows and then later decide that you might also want to open up your market to the long flows.
So these are some of the things I think that there was perhaps not disagreement at least, and indeed, as Mike Mussa said, capital account liberalization is a difficult thing. It is like fire. You do not want to play around with it. You want to get it right. You want to heat your house, but be careful that you do not burn yourself.
Well, thank you very much for listening to this panel, and I would like to thank the forum members very much for their contributions. Let's see how things develop.
Thank you very much.
IMF EXTERNAL RELATIONS DEPARTMENT