ne of the tragic facts of life is that it
so often takes a major disaster to spark off any fundamental
This certainly seems to be the case with the global economy.
Do we need an American recession and a full blown financial
crisis before governments make any serious attempt to tackle
the major weaknesses of the present world financial system?
The 1997 Asian crisis was serious enough for the countries
directly affected; and when the industrialised countries
themselves under threat there was much talk of the need for
a new 'Global financial architecture', but as the West emerged
relatively unscathed, any impetus for major reform disappeared.
Crises differ in detail but they tend to have three common
features. The first is the volatility of international
capital flows. For example, one minute the 'Asian miracle'
countries were all the rage and money poured in. The next
minute there was a loss of confidence, banks refused to renew
their loans and there was talk of 'crony capitalism'. The
second feature is the boom and bust proclivity of markets
for shares and property: asset prices rise sharply, and then
when the bubble bursts, they collapse. The third is
the instability of exchange rates.
These three features are closely inter-related. The inflows
and outflows of foreign capital drive asset prices up or down
and put upward or downward pressure on exchange rates. Conversely
movements in share prices attract or repel foreign investors.
The consequent movement of money in or out of the country
puts upward or downward pressure on exchange rates and falling
exchange rates accelerate the exodus of foreign investors.
To establish a more stable system we need to tackle all three
problems on a broad front.
Stabilising capital movements
Pressures from international financial institutions to liberalise
financial markets and dismantle controls on foreign investment
have increased the vulnerability of developing countries to
variations in capital movements. The idea that free movement
of capital would benefit these countries by giving them greater
access to foreign capital has proved false. Many have paid
dearly for premature liberalisation forced on them.
The IMF should no longer press developing countries to open
their financial markets to international investors more rapidly
than their governments consider prudent. The use of capital
controls in various forms by developing countries, when inflows
seem excessive, or crises threaten, should be regarded as
acceptable. The aim should be to encourage an expanding, but
stable, flow of long term capital to developing countries.
It is a fallacy is to assume that each crisis is solely due
to weaknesses or policy mistakes in the countries most directly
affected, rather than in the system as a whole. For every
over-stretched borrower, there is a rash lender. Any moves
to increase stability must be directed at lenders as well
as borrowers. The "herd behaviour" of investing
institutions is a major source of instability, as they follow
each other into investing in whatever country or market is
fashionable at the time. Prudential regulation of major financial
institutions needs to be tightened up. This is the one field
in which finance ministers have made some tentative steps
forward. In 1999 they set up a new Financial Stability Forum
to co-ordinate the work of (mainly national) regulatory organisations.
In addition, the Basle Committee on Banking Supervision has
made proposals to revise its supervisory code for banks.
There are no signs as yet however, that the regulators are
addressing the fundamental problem behind the excessive speculative
activity in the system. This is the growing amount of "leverage"
(the ratio of borrowed monies to assets in a firm's capital
structure) and consequently the ability to make a large profit
(or loss) with only a small stake. The degree of leverage
in the system partly reflects the amount of credit that banks
make available to speculators of various kinds. It has also
been increased by the development of various forms of "derivatives",
(products bought at a price fixed ahead of the actual purchase
- sometimes known as futures) which enable speculators to
take a large bet on movements in interest rates or exchange
rates for a relatively small stake. The regulators should
be looking to reduce the amount of leverage in the system.
This must involve an international review of the use of derivatives
and credit for speculative purposes.
The time has come to consider the role of taxation as a means
of reducing speculative activity in financial markets. A long
standing proposal in this field is the 'Tobin Tax', first
proposed by Professor James Tobin in 1972 - a small tax on
all foreign exchange transactions. Tobin originally conceived
this as a means of damping down fluctuations in foreign exchange
markets, but it has also attracted considerable support from
NGOs, such as War on Want, as a means of raising money for
development and other international purposes. It has been
estimated that a 0.1 per cent tax on all foreign exchange
transactions could raise over $200 billion a year. Such a
tax would reduce the volume of short-term transactions, but
not deter speculation on major changes in exchange rates.
Technically, it would be simpler to impose than many existing
taxes. The main difficulty would be that all countries with
significant currency markets would need to agree to levy it.
As an incentive to do so, countries could be permitted to
keep part of the revenue raised. Similar scope for international
actions on taxation to reduce speculative activity exists
for share transactions.
The instability of exchange rates is not only a feature of
financial crises, but a continuing threat to industries involved
in international trade. An over-valued exchange rate, such
as sterling at the present time, can have devastating effects
on output and employment in industries like steel and motors.
If, and when, the pound falls again, firms will not suddenly
expand employment and open closed plant. The damage is largely
irrevocable. More stable rates, at a level which provide a
fair competitive balance between countries, should be a basic
feature of a system geared to a growing internationalisation
The post-war Bretton Woods system of fixed (but adjustable)
rates came to grief with the growing liberalisation of financial
markets in the 1960s and 1970s; but even in its heyday, it
suffered from the difficulty of adjusting rates save under
conditions of economic and political crisis. The floating
rate system which has replaced it lets finance ministers off
the hook - in that they are less likely to be faced with currency
crises and their political consequences.
But their abdication of any responsibility for the behaviour
of exchange rates can have serious economic consequences,
as large sections of British manufacturing industry can testify.
One reaction is to go to the other extreme and advocate the
adoption of irrevocably fixed rates in a currency union such
as EMU. The difficulty then is that there is no possibility
of adjusting rates if a member's costs get out of line. Thus
a country whose costs rise rapidly will find itself in trouble,
with growing unemployment until its costs become competitive
again. Currency unions are therefore only appropriate where
potential members have already achieved a high degree of integration
and convergence. Moreover the common currency will still be
unstable in relation to currencies elsewhere. Joining the
euro would give UK industry stability against its continental
competitors but not those elsewhere.
The need is to devise exchange rate systems that will provide
greater stability, but still have room for adjustments when
required. We should be looking at ways of managing exchange
rates on a much wider scale. In doing so, there are important
lessons to be learnt from the ERM. The moral is that any such
system must start with rates at realistic levels and there
must be a readiness to make adjustments as required. The way
to ensure this is to review rates at relatively frequent intervals,
say monthly, and make changes in parities in relatively small
steps, say 1 per cent at a time. The other major lesson is
the need to agree on a system of automatic intervention in
currency markets to keep rates within their prescribed bands,
rather than relying on ad hoc action by central banks.
There is a strong case today for setting up such a scheme
to manage the rates between the pound, other EU non-euro countries,
and the euro. This would achieve greater stability while leaving
open the question of eventual membership. It is strange that
Treasury ministers should be so violently opposed to such
a step. (If the problem is that calling it ERM2 calls up unhappy
memories of ERM1, they could always call it the GB Scheme!)
On a global basis, the approach to managing exchange rates
must be a two-tier one : with a number of regional schemes
(initially based on the euro, the dollar and the yen) linked
by a system of global management. (It would be impractical
to attempt to manage getting on for 200 different currencies
directly in one global scheme.) Regional schemes may well
differ in approach, but it will be essential to avoid the
"dollarisation" approach of adopting another country's
currency. In the long run this is potentially embarrassing
both economically and politically. The interest rates set
by the Federal Reserve in response to conditions in the US
may not be appropriate for its Latin American neighbours,
and the US authorities would not want to be held responsible
for monetary conditions in other countries.
A Charter for change
Exchange rate management might at first sight seem a largely
technical economic issue, but it raises fundamental issues
about the relations between governments and markets. Although
the prevailing neo-liberal (or Thatcherite) economic consensus
has reduced the role of government, it is still assumed that
national governments have responsibilities for maintaining
economic stability - indeed 'stability' is Gordon Brown's
favourite mantra. But now, even more than in the past, any
such stability depends as much on international, as on national,
events. There is a growing need for economic governance on
a regional and global, as well as a national scale. This has
been recognised in Europe. Economic integration on a global
scale could in the longer run lessen the risks of major conflict.
But the immediate need is to establish more effective international
machinery to handle the issues we have been discussing: improving
capital flows to developing countries; reducing speculative
activity on global financial markets; and stabilising exchange
rates. This requires both a fundamental review of existing
global international institutions - the IMF, World Bank, the
UN organisations and the OECD - and a recognition by governments
that financial markets should no longer reign supreme.
John Grieve Smith is the author of the Fabian pamphlet
Closing the Casino: Reform of the Global Financial System.