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Closing the casino

John Grieve Smith argues for the reform of the global financial system.

One of the tragic facts of life is that it so often takes a major disaster to spark off any fundamental reform. 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 felt 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.

Exchange rates

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 of industry.

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.


July/August 2001