New York Times, September 20, 1998
by Nicholas D. Kristof
TOKYO, Sept. 19- They were the world's richest and shrewdest investors, and they rode a wave of globalizaiton to buy bonds in a promising developing country. When the country defaulted, they were livid.
"There should be lunatic asylums for nations as well as individuals." one investor wrote The Morning Post of London, denouncing the defaulting country as "a nation with whom no contracts can be made."
It all sounds a bit familiar, but the year was 1842 and the developing country was the United States. After defaults by Maryland, Pennsylvania, Mississippi and Louisiana, the entire United States was blacklisted and scorned on global markets, with Americans barred from the best London clubs and the Rothschilds warning bitterly that America would be unable to "borrow a dollar, not a dollar."
Globalization, in other words, may not be quite as fresh as it sometimes seems. Since at least the 13th century, when Florentine merchants lent to the English to pay for King Edward I's wars, international capital has roamed the world in search of high returns. (The start was inauspicious: England defaulted, causing the collapse of two Florentine banks.)
What has changed, economists say, is the scale of the capital flows and their ability to capsize small nations- or even large ones. Many experts say that one factor behind the economic crisis that has devastated Asia and Russia, wobbled South America, and now come knocking on America's own door is the fantastic increase in the pool of capital that sloshes from one country to the next in search of safety and profit.
The sums are so gargantuan- far greater than the amounts that governments can wield- that a growing number of economists are calling for new steps to control these capital flows or at least soften their impact. Some say that the Bretton Woods economic system, which has governed the global economy for half a century, has been eclipsed by these vast pools of capital, and there are calls to design a new "architecture" for the global economic order.
The topic is expected to be widely discussed at next month's special meeting of finance ministers and central bankers from the Group of SEven industrialized countries, summoned by President Clinton to discuss the global crisis. Japan Finance Minister, Kiichi Miyazawa, has already discussed measures to ease the volatility of capital flows with Treasury Secretary Robert E. Rubin and with their British counterpart, Gordon Brown.
The Federal Reserve chairman, Alan Greenspan, weighed in this week with a denunciation of rigid capital controls but a call to confront the problem by tightening supervision over banks that engage in international finance. All of a sudden, a vigorous debate is under way, and it may shape the global economy for decades to come.
"We'll have to rethink the system in a big way," said Jagdish Bhagwati, a prominent scholar of international economics at Columbia University. "The President has called this conference, and it should be the start of that process."
Professor Bhagwati urged that the new architecture should "give up the notion that the optimal world is one characterized by free capital flows, by capital account convertibility, where you just press a button and take out a billion."
The Clinton Administration has led a global push to free the flow of capital around the world, and any new impediments to capital flows would be an abrupt step back for its campaign. As recently as last March, the International Monetary Fund newsletter carried a front-page headline cheerily declaring capital liberalization to be "an irreversible trend."
These days, it looks more reversible. Some economists believe that despite a wealth of scholarly research showing the need for caution, the United States pushed too hard for capital liberalization. The result, they say, was that tides of investment flooded into ill-prepared developing countries and crated speculative bubbles, and then surged out, leaving behind shattered nations and a global financial crisis.
"I actually think the I.M.F. was too pushy in going around the accepted wisdom and encouraging countries to liberalize their capital accounts too soon," said Ronald I. McKinnon, an economist at Stanford University and author of a book on capital liberalization. "And not the least of the reasons behind this was arm-twisting by the United States Treasury, which always wants American banks and Wall Street people to be in there, competing freely."
Still, there is no question that freer capital flows have brought tremendous benefits to the global economy, as well as perils. Some places, like Hong Kong, have opened themselves to capital flows without restriction and are examples of the prosperity that free movements of capital can reap. Lawrence H. Summers, the Deputy Treasury Secretary, likens the flows to jet planes, observing that jets bring enormous efficiencies and benefits to the world- but that the crashes are more spectacular than ever.
What are these capital flows?
They are not some sinister force, but simply result of ordinary people's cash roaming in search of a good return. When an American deposits money at the corner bank, some of that may end up being lent to a Brazilian company, and the same person's pension fund may dabble in the Hong Kong stock market.
In the United States, trading in foreign securities amount to 2 percent of gross national product in 1975 and 213 percent last year, according to data from the Bank for International Settlements.
Paradoxically, historians sometimes attribute the modern boom in international capital, beyond the easy reach of any regulator, to the Communists. In the 1950's, China and Russia kept their dollars out of the United States, for fear Washington would freeze their accounts, and instead deposited the dollars in Europe.
One result was the "Eudodollar" market and a growing investment pool that flitted from country to country and currency to currency in pursuit of higher interest rates. The amount of foreign currency bank deposits around the world reached $1 billion only in 1961 and now is almost $1.5 trillion.
One problem, though, is that a lot of this is "hot money," or short-term flows that are particularly volatile.
Even in the 19th century, sailing ships used to carry gold to distant countries in pursuit of higher interest rates. In 1849, England raised its interest rate by 2 percentage points, prompting an early demonstration of the volatility of capital flows: ships that were already at sea, headed for America with their gold, turned around and sailed to England to get the higher rate.
Most governments imposed capital controls early in this century and then lifted them in the 1970's and 80's, and limitations on changing money came to be seen as quaint. Paradoxically, it is the holdouts with capital controls, like China and India, that have weathered the financial crisis much better than others, because they were not vulnerable to a sudden exodus of capital.
"I've been told, 'China seems to be coming out of the crisis well because it has capital controls, so what's wrong with reimposing controls?'" said Linda Tsai Yang, the American envoy to the Asian Development Bank.
Ms. Yang and other American officials are wary of capital controls, however, particularly the rigid kind imposed by Malaysia that ban most investments from being taken out of the country within the first year. Scholars say that such capital controls offer short-term benefits but tend to discourage investment in the long run and often get mired in corruption and inefficiency.
"There is a significant risk that over the next three or four quarters short-term results from Malaysia will be seen as beneficial," said William R. Cline, the chief economist of the Institute of International Finance in Washington. "An illusory temporary success could tempt other countries to follow suit."
The United Nations Conference on Trade and Development this week backed the right of countries to adopt emergency capital controls like Malaysia's. Even the Far Eastern Economic Review, a conservative Hong Kong-based magazine owned by Dow Jones & Company, declared its sympathy for capital controls in a recent editorial.
"As we look to Malaysia's unorthodoxy," it said, "we hold our nose and cross our fingers."
While Western economists are mostly unimpressed by Malaysia's controls, many speak highly of a quasi tax that Chile has imposed on short-term borrowings from abroad. With that measure, which the country is in the process of dismantling, Chile has been able to attract foreign capital, but has been less vulnerable to a sudden exodus.
The specific proposals that G-7 finance ministers might discuss to deal with capital flows are unclear. But there is vague talk of increasing supervision over borrowing banks and of establishing funds that could be used to insure depositors or counteract speculative attacks.
"Outright controls on the flow of funds are virtually impossible in this modern, integrated world," said Yuji Tsushima, a finance expert in Japan's Parliament. "But we should have some device through which if the volatility of the market gets too disturbing, it could be mitigated."
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