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Give the world's current economic crisis, Wolf's book is timely.
— Kirsten Wandschneider
— Wayne E. Yang
— Harold James
— Andrew Bast
— John M. Mason
The only inkling of hope is that policy makers everywhere have been so shaken by events that they will heed what Wolf advises. This book is a great and important contribution to everyone's welfare on the globe. It can be paid no higher accolade.
The people who benefit from roiling the world currency markets are speculators, and as far as I'm concerned, they provide not much useful value. PAUL O'NEILL, FORMER U.S. TREASURY SECRETARY
FINANCE IS THE BRAIN OF THE MARKET ECONOMY. Unfortunately, as the world has been reminded too frequently over the past three decades-not least in the credit squeeze that began in the summer of 2007-this brain is susceptible to a variety of infirmities. In particular, it is prone to wild swings of mood, from euphoria to panic. The history of global finance since 1980 has, as a result, been one of frighteningly expensive financial crises-expensive not just in terms of the costs to the taxpayer or of output forgone, but in terms of the shattered lives of innocent victims.
Waves of Crises
These disasters have turned global finance into the biggest economic challenge for those who support the integration of the world economy, a process now almost universally known as globalization. It is far from the only such challenge: international conflict, terrorism, and environmental catastrophe may ultimately prove far more important. But these challenges are not for economic policy alone. The workings of the financial system fall squarely within the economist's domain. If global finance does little more than bring catastrophe in its wake, it becomes almost impossible to defend existing, let alone increased, levels of financial integration. Pointing to these waves of crises, some eminent economists have condemned financial integration outright. Among them have been the Nobel laureate Joseph Stiglitz of Columbia and Manchester universities and Jagdish Bhagwati, also of Columbia, the most distinguished contemporary proponent of liberal trade. These two economists agree on few things, but they do agree on this. While almost all economists concur on the benefits of free trade, the same is decidedly not true for liberal finance. On this topic, opinions in the profession are far more evenly divided. George Soros, the contemporary world's best example of a financial poacher turned would-be gamekeeper, has also been a persistent critic of the financial markets. The financial disasters have also had direct and dire consequences on the politics of emerging economies. Because of a wave of devastating financial crises, the public mood in Latin America has swung sharply against what is widely condemned as "neoliberalism" on that continent.
I am not quite so pessimistic. There are potential advantages to liberal financial markets. But exploiting those advantages, while minimizing the risks, poses an enormous challenge. The experience of the past three decades has demonstrated that conclusively. Even in the mid-1980s, few economists understood the potential for disaster in the interplay between liberalized finance, global financial integration, and the international monetary system. A notable exception was the late Carlos Díaz-Alejandro, wisest of all Latin American economists, in a prescient article published in 1985. We all know better now, but only after a long series of brutal lessons.
If we are to do better, however, we need to understand both the advantages and the dangers of liberal global finance. Even today, a harvest failure or a huge shift in the price of a particular commodity may have a significant impact on a developing country. The price of oil is an obvious example. Yet in high-income countries and in most of the larger developing countries as well, no single productive sector has an economy-wide effect. But a financial crisis can have a huge impact on an entire economy. Indeed, it can have a serious impact on many economies at once. To understand the nature of these risks and the policy challenges they pose, we need to understand both the microeconomics of finance and the macroeconomics of exchange rates, public finance, and monetary policy. It is in finance that microeconomics and macroeconomics meet. It has always been so.
Financial crises are most significant when they are international. A purely domestic financial crisis is not inconceivable. Of the significant crises of the past three decades, the Japanese crisis of the 1990s comes closest to being such a predominantly domestic event. While the crisis had both international causes and international consequences, Japan was (and remains) a creditor country. For this reason, it was relatively easy for the authorities to manage the crisis without drastic consequences for the rest of the world. Indeed, they should have been able to resolve that crisis far more swiftly and effectively. It was, above all, quite easy for them to raise the resources they needed by borrowing from their own people.
Crises that involve foreign suppliers of capital-and, by definition, globalization means that financial systems include foreigners-have tended to be far costlier and more difficult to manage. Foreigners, by and large, do not place much trust in the governments of other countries, particularly of less-developed countries. More important, the domestic authorities of the country in crisis cannot dragoon foreigners. Above all, crises involving foreign capital usually result in exchange rate crises and so quite often in a "twin crisis," in which the interaction between a collapsing exchange rate and large net foreign-currency liabilities ensures mass insolvency in the private sector, including a bankrupt financial system. In this situation, the domestic authorities frequently lose their access to world financial markets and are then unable to rescue their financial systems without foreign assistance.
Fixing What Has Gone Wrong
This book argues that the failure to make international finance work tolerably well has had consequences, for both the affected countries and the world economy as a whole. It has created a number of large global economic shocks. The "subprime crisis" that began in the United States in 2007 was itself a direct result of those shocks. This history raises two fundamental questions: What has gone wrong? And how is it to be fixed?
In the 1970s, 1980s, and 1990s financial crises always followed periods of large-scale net capital flows into emerging market economies. Subsequently most of the latter decided (or were compelled by the markets) to cease being net importers of capital. Many even became substantial capital exporters. In the 2000s, the desire of private investors to invest once again in many of these countries has led the emerging market economies to engage in large-scale foreign-currency intervention and accumulation of foreign-currency reserves. Emerging market economies "smoke, but do not inhale" in global capital markets. The majority are prepared to engage in capital markets, but do not accept-indeed have worked hard to avoid accepting-net capital inflows into their economies. This is astonishingly -and disturbingly-different from the experience with financial globalization in the late nineteenth and early twentieth centuries.
Happily, as late as fall 2007, no sizable emerging market crises had occurred after 2001 (when Argentina defaulted), while the last global wave of crises to affect emerging economies occurred between 1997 and early 1999. This may suggest that the world economy has attained stability. That would be a premature judgment. Since emerging market economies are unable or unwilling to absorb surplus savings generated in the world economy and, on the contrary, are generating surpluses themselves, some high-income countries must instead absorb those funds. Thus the net flows of capital were from the rest of the world to a few creditworthy high-income countries and, above all, to the United States, which has become the superpower of global borrowing. The emergence of America as an enormous borrower did indeed generate a welcome degree of economic and financial stability. Having the largest economy and the world's most important currency, the United States is far better able to borrow abroad on a large scale than any other economy or even group of economies. But even there the domestic counterpart of the external borrowing generated what ultimately proved to be unsustainable increases in household indebtedness. These led to the "subprime" crisis-a wider crisis that had its roots in U.S. mortgage lending practices-and to a financial shock that began to ripple across the high-income countries in 2007. The U.S. external deficit then started shrinking, as demand weakened and the dollar tumbled.
We have not reached the end of financial history. The events described above raised two questions: Was this pattern of global net capital flows sustainable? And is the flow of capital from poor to rich countries desirable? The former question is the more controversial. While the course on which U.S. external liabilities were launched looked unsustainable in the long term, because it implied an explosive rise in the country's net liability position, it might have endured for a long time. But the domestic counterparts of that external borrowing became problematic far sooner.
The undesirability of this reaction to the prior instability of capital flows to emerging market economies is evident. A large-scale flow of capital from poor countries to the world's richest nations is perverse. What makes it even more perverse is that strong political forces within the beneficiary country, the United States, resent the generosity of their creditors. Adding to this incendiary situation is the likelihood that the suppliers of finance will ultimately suffer large losses when the United States is called upon to repay-or at least to service-the capital it has received. Indeed, many are already experiencing such losses as the dollar tumbles.
The macroeconomic question is how adjustment of the global balance of payments might occur. A key issue is the time horizon, since that is likely to have an important impact on the needed changes in real (and nominal) exchange rates: the slower the adjustment, the smaller these changes will need to be. But a deeper set of questions must be addressed: whether there exist a set of policy changes and developments that would allow a liberal global financial system to transfer capital to emerging market economies without precipitating large-scale crises. For only under these conditions can one imagine an outcome that would be both sustainable and satisfactory.
This book argues that such changes are indeed feasible. But they will require substantial reforms, particularly in emerging market economies, and, first and foremost, greater congruence between the currency system and the pattern of international finance. In a multicurrency world, we must have multicurrency finance. Countries must borrow in their own currencies, accept capital in the form of equity, or help their domestic private sectors find some other way of hedging long-term currency risks. These changes should occur naturally if emerging market economies are prepared to accept the full disciplines-both micro- and macroeconomic-of running internationally open financial systems. But they will take some time. Meanwhile, the international financial institutions might be able to help, largely through improved pooling of foreign-currency reserves. The less pooling there is, the more tightly emerging market economies must regulate their financial systems, the more determined they must be to eliminate significant currency mismatches within their economies, and the more they must insure themselves against externally generated financial crises.
A Prescription for Change
What is special about finance? Why is it so important, and why can it so easily go wrong, particularly in emerging market economies? Chapter 2 attempts to answer these questions. Finance rests on promises-which, by their nature, can be broken. Above all, the recipients of the promises know they can be broken. This makes the financial system vulnerable to changes in expectations about an inherently uncertain future. Uncertainty is likely to be particularly significant when promises are made across frontiers, and even more so when they are made to foreigners. Governments are always essential players in any set of financial promises, even if they themselves have not made them. They provide the institutions that help make certain that promises are kept, and they can intervene to ensure that they cannot be kept. The debts they incur and the money they issue are the basis for any set of financial contracts. Trust in foreign governments is often limited, since outsiders know that such a government is not accountable to them. It is particularly limited in the governments of emerging market economies, which tend to be more corrupt, more inefficient, and often more populist than those of the high-income countries.
The discussion turns, in Chapter 3, not just to what can go wrong but to what has gone wrong in global finance. The chapter recounts the crises of the past three decades and describes their huge costs. In most cases, the largest costs arise when devaluations occur in emerging market countries that have had significant current account deficits and, almost inevitably, substantial mismatches in currency denomination between liabilities and assets. These crises, in turn, imposed heavy costs, particularly on the taxpayers of affected economies and on those who lost their incomes in the crises. These painful outcomes have led to a swing away from borrowing by emerging economies and to determined efforts to keep exchange rates down, sustain strong current account positions, and accumulate official reserves. This is particularly true in East Asia, where the scars of the 1997-98 crisis ran deep, not just in the victims but also among the bystanders. China is far and away the most important of such bystanders.
If there exist some countries with sizable structural current account surpluses and thus surpluses of savings over investment or income over expenditure, others must show the opposite behavior. Chapter 4 discusses the result-the arrival of the so-called global imbalances in the late 1990s and 2000s, partly as a legacy of financial crises past and partly as a result of the considerable rise in oil prices since 2003. I argue that Ben Bernanke, currently chairman of the U.S. Federal Reserve, was fundamentally right when he stated that these imbalances were the consequence of a "global saving glut," so long as this glut is understood as a surplus of savings over investment in the rest of the world-that is, the world apart from the United States. In recent years, that surplus has been about a sixth of the savings of the rest of the world. The result has been a tendency toward low real interest rates, even at a time of rapid economic growth, and pressure on the United States to run very large current account deficits.
The fact that real interest rates were so low strongly suggests that U.S. deficits were not crowding out investment elsewhere. Instead low spending elsewhere was crowding in U.S. spending and external deficits. These outcomes were not the result of decisions by the private sector alone. The exchange rates and associated macroeconomic policies of much of Asia-above all, the targeting of the U.S. dollar and the sterilization of the consequent reserve accumulations-helped create the surpluses that the United States has been absorbing. If the United States had been unwilling to implement expansionary fiscal and monetary policies capable of absorbing the surpluses and so refused to accept a huge and growing current account deficit, the U.S. economy would have been stuck in recession, and the rest of the world would have suffered economically as well.
In Chapter 5 I suggest that the period of global financial calm may prove misleading. I begin by asking whether the current "solution" to the instability of the global financial system is either desirable or sustainable. It had obvious advantages for the creditor and debtor countries and indeed for the rest of the world. So long as the United States was the dominant borrower in the system, the chances of another series of crises were much reduced. But the path on which the U.S. economy was launched was unsustainable in the long run. The problem was not only the accumulation of external liabilities but also the need for either the U.S. government, the U.S. private sector (in practice, the household sector), or both to go ever more deeply into debt. These trends could continue for some time, but not forever.
Meanwhile, the creditor countries gained real advantages from the currency link to the United States, but their vast accumulated claims on that country made little sense. Not only was there likely to be a protectionist backlash in the United States, but they were likely to lose a great deal of money when adjustment finally occurred. (Indeed, the evidence suggests that some creditor countries have already lost a great deal of money.) Above all, these countries should be able to find higher-return uses for surplus funds at home, such as in additional public or private consumption. Thus the "solution" to global financial instability afforded by U.S. external borrowing, and the associated current account deficits, itself caused significant problems.
Excerpted from Fixing Global Finance by MARTIN WOLF Copyright © 2008 by Martin Wolf. Excerpted by permission.
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Ch. 1 Learning Lessons 1
Ch. 2 Blessings and Perils of Liberal Finance 10
Ch. 3 Financial Crises in the Era of Globalization 28
Ch. 4 From Crises to Imbalances 58
Ch. 5 Calm before a Storm 111
Ch. 6 Toward Adjustment and Domestic Reform 151
Ch. 7 Toward Global Reform 183
Ch. 8 Toward a More Stable World 193
Posted January 5, 2010
Questions about current account deficits and international savings rates send many fiscal analysts into jingoistic declamations. But Martin Wolf isn't that kind of economic commentator. He's the sort who realizes that global financial markets are fiendishly complex and, thus, that easy answers are likely to be too easy. In this study, Wolf adds depth and texture to such hot topics as China's massive savings rate and its huge foreign-currency holdings. This is primarily an economist's analysis, so Wolf doesn't address the way financial markets affect everyday consumers and entrepreneurs. getAbstract recommends his book to observers who seek a learned, lucid, forward-looking perspective on global financial markets.Was this review helpful? Yes NoThank you for your feedback. Report this reviewThank you, this review has been flagged.
Posted October 30, 2008
No text was provided for this review.