Globalization and the International Financial System: What's Wrong and What Can Be Done

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This book provides perspectives on various aspects of the international financial system that contribute to financial crises and growth failures, and it discusses the remedies that economists have suggested for addressing the underlying problems. It also sheds light on a central feature of the international financial system that remains mysterious to many economists and most noneconomists: the activities of the International Monetary Fund and the factors that influence its effectiveness. Dr. Isard offers policy perspectives on what countries can do to reduce their vulnerabilities to financial crises and growth failures, as well as a number of general directions for systemic reform. The breadth of the agenda provides grounds for optimism that the international financial system can be strengthened considerably without revolutionary change.
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Editorial Reviews

From the Publisher
"Peter Isard diligently and skillfully tackles the two major economic concerns of globalization—financial crises and groth failures—in a thorough but highly readable book that will appeal to both scholars and a broader objective and balanced discussion...His chapter on IMF operations is a must-read for students of international monetary relations. The depth and clarity of his descriptions of these operations are difficult to find anywhere else, and indeed were sorely lacking in the international political economy literature." - Political Science Quarterly

"...a thorough but highly readable book that will appeal to both scholars and a broader audience...His chapter on IMF operations is a must-read for students of international monetary relations. The depth and clarity of his descriptions of these operations are difficult to find anywhere else, and indeed were sorely lacking in the international political economy literature." Political Science Quarterly Anastasia Xenias, Columbia University

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Product Details

  • ISBN-13: 9780521605076
  • Publisher: Cambridge University Press
  • Publication date: 12/28/2004
  • Edition description: New Edition
  • Pages: 384
  • Product dimensions: 5.98 (w) x 8.98 (h) x 1.02 (d)

Meet the Author

Peter Isard is Assistant Director in the Research Department of the International Monetary Fund, where he has worked since 1985. From 1972 through 1985 Dr Isard held research and managerial positions in the International Finance Division of the Federal Reserve Board. He has published numerous articles on the behavior of exchange rates, strategies for monetary policy, and directions for reforming the international financial system. His book Exchange Rate Economics (Cambridge University Press, 1995) has been widely acclaimed.

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Read an Excerpt

Cambridge University Press
0521843898 - Globalization and the International Financial System - what's wrong and what can be done - by Peter Isard





This book is motivated by two major concerns about the globalization process and the international financial system: the prevailing global economic environment has given rise to frequent and severe financial crises in emerging market economies, and it has also left many countries unsuccessful in their efforts to generate economic growth and reduce poverty. In addressing these concerns, the book seeks to achieve three objectives. One aim is to provide perspectives on the various problems that contribute to financial crises and growth failures. A second is to describe the remedies that economists have proposed for mitigating these problems. The third is to shed light on a central feature of the international financial system that remains mysterious to many economists and most noneconomists: the activities of the International Monetary Fund and the factors that influence its effectiveness.

This chapter begins with some perspectives on the globalization process and then presents an overview of the book.

1.1 Globalization

Throughout the centuries, advances in transportation and communications technologies have brought people progressively closer together in space and time. By some measures, the process has accelerated since the mid-twentieth century.1 Along with the advent and rapid growth of commercial air travel following the Second World War, the revolution in communication technologies during recent decades has profoundly affected the lives of people throughout the world. Thanks to a series of advances—including the laying of transatlantic and transpacific telephone cables beginning in the 1950s, the launching of communication satellites starting in 1960, the development of fiber-optic communications in the 1970s, the widespread adoption of personal computers during the 1980s, and the takeoff in use of the Internet and electronic mail during the 1990s—it is now possible to transmit information around the globe instantaneously and at negligible cost. As a result, countries and communities have become more closely connected in various ways, for better and for worse.

The process that has led to this increasing connectedness is often referred to as globalization, a term that crept into the common vernacular during the 1990s and is now widely used by business gurus, labor unions, antipoverty campaigners, environmentalists, politicians, and economists, among others. The increasing connectedness of people and countries—combined with the choices that policymakers have made in constraining or not constraining the behavior of individuals, businesses, and government agencies—has significantly affected the structure, growth, and vulnerabilities of national economies while also contributing to changes in cultural institutions, political regimes, and the environment.

Because groups with different economic, political, and social interests naturally focus on different issues, globalization has become a slippery term, with different connotations for different people. Certain aspects of the process have elicited harsh criticism. The media have been blamed for contributing to the breakdown of traditional family values and other cherished cultural institutions, but they have also been recognized for their role in energizing opposition to certain corrupt and inefficient bureaucratic practices and political regimes. The spread of large multinational conglomerates, with control over a significant share of the world's economic activity and substantial influence over national policy decisions, has triggered strong protest from advocates for the economic survival of smaller businesses and their employees and from groups concerned about the environment. The strength of these diverse concerns has led to an antiglobalist movement that national authorities and international policymaking institutions have appropriately been forced to take seriously.

This book focuses on issues associated with the process of international economic integration—or economic globalization—as evident in increasing flows of goods and services, financial resources, workers, and technologies across national borders. In doing so, it limits attention to the implications for economic welfare, ignoring implications for the environment, the stability of cultures and political systems, and other important noneconomic considerations.

Although international economic integration has increased substantially during recent decades, economic globalization is not a new process. The expansion of international trade and migration and the spread of economically useful knowledge and technology across national borders date back many centuries.2 Advances in communication and transportation have provided a major driving force. Such advances do not occur spontaneously; they are themselves a reflection of the desire of people to take advantage of the perceived benefits of closer integration.3 Public policies can have significant effects on the pace of economic globalization by providing stimulus or discouragement to innovations in communication and transportation technologies and by influencing the extent to which existing technologies give rise to cross-border flows of goods, money, people, and ideas.

Some of the consequences of economic globalization are quite visible, whereas others materialize slowly and are less widely appreciated. Proponents of economic globalization point to many significant benefits. Better communication mechanisms and lower transportation costs have provided consumers with access to lower-priced goods and a much broader range of products. International capital flows have financed production facilities in countries where labor is relatively abundant and ready to be profitably employed in more productive and remunerative activities. The spread of technological and marketing know-how and other ideas across national borders has also contributed to the more productive employment of local labor forces, enabling them to raise their standards of living. At the same time, opportunities for idle or low-wage labor to migrate to countries with relatively low unemployment rates have enabled workers to earn better incomes and acquire new skills while also easing labor shortages in the countries to which they have moved.

Nevertheless, globalization has also disrupted the economic circumstances of many people and bypassed the economies of many others. Accordingly, critics of economic globalization have strong reasons for concern. Some point to widening income gaps between rich and poor countries along with growing inequality and persistent poverty within countries. Many regard international capital flows as a force that has often destabilized economies and destroyed livelihoods.

Although they recognize that the benefits of economic globalization have come with some very high costs, most international economists regard it as a process that cannot be stopped or substantially reversed without very damaging consequences—results of the kind associated with the protectionist and other inward-looking beggar-thy-neighbor policies that contributed to the Great Depression of the 1930s.4 It is also clear that economic integration within countries is much greater than economic integration across national borders,5 suggesting that the process of economic globalization has the potential to extend considerably further. From these perspectives, the key challenge is not to resolve whether the pros outweigh the cons but rather to devise effective ways for national policymakers and international agencies to address the problems associated with globalization. The appropriate focus, in other words, is on how to strengthen both national institutions and policies and the international financial system to make the process of economic globalization work better.

1.2 Overview of the Book

The two major concerns about the economic aspects of the globalization process—financial crises and growth failures—have received considerable attention from policymakers and academic economists in recent years. This has led to a better understanding of the multiplicity of problems that contribute to the frequency and severity of international financial crises and that stand in the way of efforts to generate economic growth and reduce poverty.

As already noted, this book aims to provide perspectives on the various problems that underlie the bad side of the economic globalization process, to discuss the measures that have been proposed or initiated for addressing these problems, and to describe the activities of the International Monetary Fund (IMF) and the various factors that limit its effectiveness in preventing and mitigating financial crises and growth disappointments. The material is divided into three parts. Part One provides background on the evolution of the international monetary system and the functions and activities of its central institution, the IMF. Part Two discusses the factors that contribute to international financial crises, the effects of such crises, and the controversies over how policymakers should respond. It also provides various perspectives on the determinants of economic growth and the obstacles to poverty reduction. Part Three presents an agenda for reform, focusing both on a list of problems for countries to address individually and on a number of areas in which the international financial system can be strengthened.

The book is intended for a broad audience, including teachers, students, research economists, and policymakers. The level of exposition presumes familiarity with elementary macroeconomics, but beyond that most of the material is presented in a nontechnical manner, with boxes used to house more technical digressions. To cover the broad range of topics in a few hundred pages, the book provides relatively compact discussions of relevant historical and institutional material and the various proposals for strengthening national policymaking and the international financial system.6 Readers who wish to pursue topics in greater depth will find an extensive list of references. Readers who already are well informed about some of the topics, or who have limited interest in them, will find summaries of the topics in the concluding perspectives of each chapter.

Chapter 2 presents background on the evolution of international monetary regimes since the late nineteenth century and on how the world economy performed under the successive regimes. It also describes the sea change that has taken place in international capital flows during the past several decades. The review of past international monetary regimes reveals that international financial crises have a long history, and that international monetary cooperation can have a very important influence on the performance of the global economy. In addition, historical experience provides strong evidence that, unless countries can control international capital flows, they will not find it possible to stabilize the exchange rates between their currencies and simultaneously retain the autonomy to focus their monetary policies on achieving domestic economic growth and price stability. This fundamental impossibility theorem, when combined with political and financial market realities, helps explain why currency crises have become so intense under the prevailing international monetary system. It also sheds light on why the relatively high degrees of exchange rate stability that have been achieved under previous international monetary regimes—in particular, under both the international gold standard regime that prevailed prior to the First World War and the Bretton Woods regime that lasted from the mid-1940s until the early 1970s—are much less feasible today for exchange rates between the major currencies of the world. In many countries, the political empowerment of the working classes since the First World War has greatly reduced the scope for policy authorities to give exchange rate stability high priority over domestic macroeconomic stability, as was the practice during the gold standard era. And the rapid growth in the volume of internationally mobile private financial capital, together with its proven agility in evading official restrictions, has made it much less feasible for national authorities to control international capital flows effectively, as they were able to do until the latter part of the Bretton Woods era. By the same token, these political and financial market developments imply that the functioning of the global economy has become more dependent on effective international monetary cooperation.

Chapter 3 provides background on the functions of the IMF and how it operates. This includes descriptions of the purposes of the IMF; its decision-making structure; the nature of its surveillance over individual countries and the global economy; the broad guidelines that shape its policy advice; its lending policies and facilities; the process of designing and modifying the economic policy programs on which it conditions its loans; and the ways in which its activities and focus have changed over the past decade. In describing how the IMF operates, the chapter tries to convey a sense for various difficulties that hamper its effectiveness. It emphasizes that the IMF faces several types of constraints: namely, constraints imposed by its legal authority, by the views of its major shareholders, by the behavior of member countries, by its limited pool of financial resources, and by the state of economists' knowledge. The chapter lists a number of criticisms of the IMF, addressing several of them and leaving the rest for discussion in subsequent chapters.

Chapters 4 and 5 focus on international financial crises. Chapter 4 begins with some historical perspectives on crisis episodes and an overview of the conceptual literature on their underlying causes. It then provides brief case-by-case reviews of seven of the major currency crises experienced by emerging market countries since the mid-1990s—Mexico (1994-95), Thailand (1997), Indonesia (1997-98), Korea (1997-98), Malaysia (1997-98), Russia (1998), and Brazil (1998-99). The reviews concentrate on the contributing factors and the initial stages of the crises, with the objective of gaining insights relevant to crisis prevention. In general, these crises were not triggered by sharp and sudden changes in economic fundamentals, but all seven countries suffered from a buildup of large macroeconomic imbalances, major structural weaknesses, or both that gave market participants rational reasons for concern about their abilities to repay their debts and avoid currency depreciation. The reviews underscore several different types of macroeconomic imbalances and structural weaknesses that make countries vulnerable to financial crises. The chapter also tries to shed light on why the IMF has not been more effective in preventing crises. This issue is separated into two parts: one pertaining to the effectiveness of the IMF in detecting potential problems at an early stage and providing appropriate and timely policy advice, and the other relating to countries' willingness and political capacity to heed the IMF's advice.

Chapter 5 turns to the effects of financial crises and the issue of how policymakers should respond. The chapter focuses first on two common and troublesome patterns in international capital flows: sudden stops, in which large volumes of capital inflows are followed by sharp decelerations or reversals, and contagion, in which a financial crisis in one country triggers substantial financial market turbulence or crises in other countries. These phenomena are indicative of market imperfections and the need to address their underlying causes through reforms of the international financial system. The chapter next considers various controversies over how crisis-stricken countries and the international community should respond to financial crises, along with related criticisms of the IMF's policy advice. The topics covered include controversies about choices of exchange rate arrangements; about appropriate monetary and fiscal policy responses; about the extent to which the IMF should require countries to implement structural reforms as a condition for financial assistance; and about the moral hazard that may be generated by the practice of providing IMF bailout loans. The chapter also looks for lessons from the adjustment policies pursued by Korea, a country that engineered a relatively successful recovery from financial crisis.

In discussing ways to strengthen the architecture of the international financial system, the academic and policymaking communities have devoted considerable attention to the challenges of preventing and resolving financial crises. It is also important to focus on the longer-run objectives of raising living standards and reducing poverty. These longer-run objectives are the subject of Chapter 6. The chapter provides a condensed review of the literature on economic growth, focusing first on three proximate determinants—physical capital accumulation, human capital formation, and technological change or productivity growth—and then on a set of deeper determinants. It emphasizes the Schumpeterian view of economic growth as a process of creative destruction. This view highlights the importance of incentives for technological innovation along with the relevance of institutions and the openness of economies—factors that are highly influential in shaping the incentives of market participants and that can thereby play critical roles as deeper determinants of economic growth. The wide range of relevant institutions includes institutions for defining property rights and enforcing contracts; for regulating markets and correcting market failures; for stabilizing economies through monetary and fiscal policies and prudential supervision; and for legitimizing market systems through the provision of political voice and social safety nets. In addressing the issue of poverty, the chapter notes that economists generally regard economic growth as the most effective vehicle for reducing poverty. Hence, the quality of institutions has central importance not only for sustaining growth but also in determining outcomes for the poor. The chapter includes a discussion of the need for reforming the manner in which the international community provides debt relief and other forms of aid. It notes, on the one hand, that low-income countries face dim prospects of growing out of poverty traps as long as they are burdened with high levels of debt, and, on the other hand, that official development aid has not been very effective as a vehicle for promoting economic growth over the past half century.

For reasons discussed in Chapter 2, a complete rebuilding of the international financial system is not in the cards. However, there are numerous ways in which the current system can be improved, thus providing scope for making the economic globalization process work substantially better within the not-too-distant future. The last two chapters of the book describe an agenda for strengthening the system to mitigate its propensity to trigger and propagate financial crises and to enhance its capacity to promote economic growth and reduce poverty.

© Cambridge University Press
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Table of Contents

1 Introduction 3
2 The evolution of the International Monetary System 13
3 The International Monetary Fund 69
4 Factors contributing to international financial crises 119
5 The effects of crises and controversies over how to respond 162
6 Perspectives on economic growth and poverty reduction 207
7 What can individual countries do? 243
8 How can the international financial system be reformed? 283
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