Global finance must be the most risky, dangerous and problematic form of globalization.  But it should not be …

Theory tells us that finance should flow from mature, OECD economies to emerging and developing economies which have greater investment opportunities.  In reality, much finance flows out of these emerging and developing economies and into countries like the US, the UK and Australia (the "Lucas paradox").

The globalization of finance should also facilitate better portfolio diversification and risk management.  But, global investors tend to follow each other like sheep with investment usually being concentrated in the same industries (like real estate) or countries.

Global finance should foster long term economic development.  But too many investors focus on the short term, rather than the long term.  Finance can rush into a country.  Then the herd hears another signal and the finance flows out again as quickly as it came.  Economists used to believe in the “efficient markets hypothesis” which means that at any point in time, investment was efficient because it reflected all available information.  Thus, changes in investment flows reflected new information.  Now we have less confidence in the rationality of financial markets.

Because of all the money involved, Wall Street and London’s “City” attract our best and brightest.  But many of them work as glorified gamblers.  Some are scientists (not economists) who know how to create fancy mathematical models.  As the global financial crisis demonstrated, these models can turn out to be weapons of financial mass destruction.  These guys (and they are usually guys) should be inventing something useful, like new medicines or computers.

And because of all the money involved in financial markets, they attract massive corruption like Ponzi schemes.

Global finance has a history of crises, manias and instability.  These overpaid golden boys and their financial institutions get bailed out in times of crisis.  If not, the whole financial and economic system could come crumbling down (“systemic risk”).  But it is poor people like you and me that pay through the nose for these bailout packages.

Financial markets are particularly susceptible to crises where asset prices rise to extraordinary heights only for confidence and greed to turn to fear and despair, sending the market into freefall. One of the first analysts of these phenomena was Walter Bagehot, nineteenth century editor of The Economist. His 1873 book, Lombard Street, is a powerful account of the psychology of financial markets: how investors overdose on hope and then despair, and how central banking may, to some degree, restrain self-destructive cycles of elation and panic.

Many of the classic stories of market mayhem are told in Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds, written in the 1840s. This study of crowd psychology and mass mania through the ages includes accounts of numerous market scams, madnesses and deceptions, notably the Mississippi Scheme that swept France in 1720; the South Sea Bubble that ruined thousands in England at the same time; and the Dutch tulip mania, when fortunes were made and lost on single tulip bulbs.

In “Manias, Panics and Crashes” by economist Charles Kindleberger, the author argues that there is a consistent pattern to financial manias and panics - quite apart from the ebb and flow of the business cycle.  He spells out the stages of the credit cycle of boom and bust:

- The upswing usually starts with an opportunity - new markets, new technologies or some dramatic political change - and investors looking for good returns.

- It proceeds through the euphoria of rising prices, particularly of assets, while an expansion of credit inflates the bubble.

- In the manic phase, investors scramble to get out of money and into illiquid things such as stocks, commodities, real estate or tulip bulbs: 'a larger and larger group of people seeks to become rich without a real understanding of the processes involved'.

- Ultimately, the markets stop rising and people who have borrowed heavily find themselves overstretched. This is 'distress', which generates unexpected failures, followed by 'revulsion' or 'discredit'.

- The final phase is a self-feeding panic, where the bubble bursts. People of wealth and credit scramble to unload whatever they have bought at greater and greater losses, and cash becomes king.

Events of the last couple of years show that Kindleberger is as right today as he was at the time of his writing.

The classic response to all of this is that financial markets need to be appropriately regulated to minimize systemic risk.  But even here, it is not so simple.  Financial institutions lobby governments and legislatures to keep regulation light.  Regulatory authorities are usually understaffed and underpaid.  And when there is a good young regulator, he or she will be snapped up by an investment bank.  Perhaps the biggest problem is complacency.  When markets are sailing high, we all take it for granted and imagine that it will go on forever.  It never does.  And the biggest challenge is globalizing regulation.  Countries have enormous difficulty agreeing on global regulatory standards, let along the idea of a global regulator.  The Financial Stability Board is a “toothless tiger”.

We should know better after all these years.  After all, today we are living in the second great era of financial globalization. The first era of globalization ended in 1914. By every measure of financial sector globalization, international capital markets were more open in 1914 than they were at any time up to the 1970s.

Having said all that, the real paradox of global finance is that those countries with the most sophisticated, advanced and globalized financial markets are in fact the most innovative, developed and prosperous.  The US capacity to finance high risk, innovative projects is unparalleled.  Financial markets are in fact one of the most innovative parts of our economy.

Controls on capital movements are now basically non-existent in the advanced world.  But more caution is necessary for emerging and developing countries.  Full integration into the global financial system requires stepped up efforts to modernize financial systems and to upgrade regulatory/supervisory frameworks.  A country that wants to integrate into the capital markets needs to ensure that its macroeconomic framework is sufficiently strong and that the domestic financial system is sufficiently strong to deal with the possible strains that liberalization might create.  In terms of the type of capital flow, the principles of liberalization are: to liberalize inflows before or simultaneously with outflows; to liberalize long-term capital flows before short-term flows; to liberalize foreign direct investment before portfolio investment.  In terms of which sectors to liberalize: first, the business sector; second, individuals; and third, the financial sector.

All things considered capital account liberalization is desirable for giving people the freedom to invest where and when they want, and for allowing, for example, countries with ageing populations to be net savers and vice versa.  Another reason is that financial sector liberalization is a way of increasing financial sector competition and improving the quality of the financial system.  A third reason that financial sector liberalization is a good thing in that it changes the outlook of domestic companies, and leads them to think globally.

There is always a dark side to globalization, and global finance is no exception.  Technology and complexity have opened even more opportunities for tax evasion, money laundering, bribery, corruption and other forms of international economic crime.