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The disappointment of financial globalization
Tuesday, 18 January 2011 12:56

Well before we entered the depths of the global financial crisis, many economists like Dani Rodrik were writing of how disappointing financial globalization had been for economic development.     


The crisis has only highlighted the disappointments of integrating domestic financial markets with global financial markets -- and what's more, the grave dangers of global finance.


Many economists used to equate the case for free flows of capital with free trade.  As Jagdish Bhagwati argued over a decade ago, there is no more fallacious analogy than this one.  True, free movements of foreign direct investment can bring many benefits.  But when you allow free movement of portfolio capital (bonds, stocks, banks finance, etc), it invariably results in excessive borrowings of short-term capital, ultimately resulting in financial crises.  Free capital movements are inherently crisis-prone – that is certainly not the case for free trade. 


This is exactly what happened in East Asia in the 1990s when governments loosened up their controls on short-term capital, enabling their banks and firms to borrow abroad.  And when the crisis struck East Asia, “capital account convertibility” (the freedom to move foreign currency into and out of a foreign country) meant that local residents could quickly move their capital out of the region, thereby exacerbating the crisis. 


Even beyond crises, the reality of global capital is that countries invariably receive either too much of it or too little of it.  Capital inflows usually result in an overvaluation of the exchange rate, a big negative for economic development.  And holding large foreign exchange reserves to protect against financial crises can be very expensive. 


History shows that successful economic development takes place without free capital movements.  Western Europe’s return to prosperity after the war, and the remarkable development of Japan, Korea, Taiwan and China, all took place without capital account convertibility. 


Indeed, most developing countries today do not suffer from a shortage of savings, but rather a shortage of investment opportunities because an unfavorable investment climate due to weak property rights, red tape and corruption.  In these circumstances, opening up the capital account will likely encourage borrowing for consumption, a clearly unsustainable path.


In the 1980s and 1990s, there was a big push from the US to open up capital accounts in emerging economies.  Where did the push come from?  Ideology and interests -- most particularly the ideology and interests of Wall Street, whose financial firms who wanted to do more business in the emerging world.  In the US there is a clear Wall Street-Treasury “complex” as senior staff members move from one to the other, and are brainwashed by ideology of free financial markets. 


These are the same guys who created the current global financial crisis.  And while these guys believe in the ideology of free markets, ironically they benefit enormously when emerging economies get bailed out by the IMF following a financial crisis.  The bail-out packages arguably bail out the Wall Street firm which would otherwise have suffered if the country defaulted on its debt.


Fast-forward to today and the global financial crisis. 


Financial globalization was arguably one of the underlying causes of the global financial crisis.  Global financial markets permitted a massive buildup in current account imbalances, especially between the US and China.  Everyone was worried that there would be a change in sentiment, and a turn against the dollar.  This is how financial markets operate.  They let things get out of control, and then they backlash.  But before this could happen, a major debt crisis arose in the US, fed in part by the global imbalances.   


When the global financial crisis erupted, capital volatility struck again.  Foreign banks repatriated capital back to Wall Street or the City of London to cope with their crisis back home.  Several Asian countries like Singapore, Korea and Indonesia were caught high and dry by this trick and suffered sharp liquidity shortages.


Then capital markets which had happily financed large current account deficits for many years in a number of countries, especially in Europe, suddenly turned against them and withdrew capital – once again, leaving these countries high and dry!


And then many international investors, more so in Europe than in Asia, invested in new innovative American financial products.  These investors could have validly believed that they were a good deal thanks to the US financial regulators and supervisors who were overseeing the US financial system – and also thanks to the credit rating agencies which were rating the credit risks on these products.  But no, many of these fancy new financial products were “toxic assets”!  The US regulators and supervisors, and credit rating agencies hadn’t done their job properly.


And last but certainly not least, our unfortunate emerging economies now find themselves being flooded with international capital once again.  As interest rates are near zero in the US and Europe, and as the US floods the world with its “quantitative easing”, countries like Brazil, Indonesia, Korea and Thailand are once again awash with capital inflows, and are suffering from appreciating exchange rates and emerging asset bubbles.  The risk is that the US economy will start picking up over the next year or so and much of this capital could then rush back home to the US.


Even the IMF, the big promoter of financial globalization, has now softened its position.  It has recognized that countries can face sudden and temporary spikes in different forms of foreign capital flows which can cause problems for economic management or the health of the financial system.  According to the IMF, controls on foreign capital into emerging economies can be part of the policy options available to governments to counter the potential negative economic and financial effects of sudden surges in capital.


The IMF argues that there are a number of policy choices governments can make when faced with a short-term or sudden surge in foreign capital, including: allowing the currency to appreciate; accumulating more reserves; changing fiscal and monetary policy; strengthening rules to prevent excessive risk in the financial system; and capital controls.  While admitting a role for capital controls, the IMF notes that the evidence to date on the relative effectiveness of capital controls is ambiguous.  Controls appear to work better in countries with existing restrictions, or with strong administrative capacity. Evidence also suggests that controls have more effect on the composition of capital flows than on their volume.


So these are the main disappointments of financial globalization.  The grave dangers come from the havoc wreaked on our economies and societies by financial crises.  Financial globalization has the potential to destroy the whole globalization project!




Why did financial globalization disappoint?  By Dani Rodrik and Arvind Subramanian



Financial Globalization, Growth and Volatility in Developing Countries By Eswar S. Prasad, Kenneth S. Rogoff, Shang-Jin Wei, M. Ayhan Kose.  NBER Working Paper No. 10942. Issued in December 2004



The Capital Myth: The Difference between Trade in Widgets and Dollars

By Jagdish N. Bhagwati.  Foreign Affairs.  May/June 1998.



Controls on Capital Part of the Policy Mix, IMF Survey online




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