Seeking Economic Truth

Friends: In light of the superb Electric Politics interview with Keynes’s biographer Robert Skidelsky, as well as the current and ongoing financial crisis, I’m posting here an excerpt from a paper by the late economist David Felix: "Why International Capital Mobility Should Be Curbed, and How it Could Be Done" (February, 2001, pp. 44-49). The paper was prepared on behalf of the International Confederation of Free Trade Unions (Brussels). At the time he wrote it, Felix was an Emeritus Professor of Economics at Washington University in St. Louis, USA. He died in June 2009.

The relevance of Felix's analysis to the kind of "austerity" demands being imposed upon the general population in country after country by a supranational elite that exists in a stratosphere, beyond democratic control, ought to be obvious.

David Peterson
Chicago, USA

"Global Financial Markets as Discipliners of Policy and Producers of Crises"

The ballooning of financial flows [since the dismantling in 1971 of Bretton Woods' fixed foreign- exchange system] has greatly increased the power of the financial markets to "discipline" national policy-making around the globe. The rise of the dollar value of daily forex [foreign exchange] trades has vastly overtaken the rise of official reserves. Table 1 shows that in 1977 global official reserves equaled 16.2 days of forex trading, whereas in 1998 they barely equaled one day's global turnover. This precipitous decline of relative "fire power" has greatly reduced the ability of central banks to intervene in the foreign exchange markets to restrain volatility, or to stabilize the real exchange rate. The success of the 1985 Plaza agreement between the U.S., Japan, West Germany, the U.K. and France to collectively knock down an overvalued dollar was short-lived. Follow-up collective and individual attempts by the central banks of these countries to stabilize the dollar-yen and dollar-mark exchange rates were soon overridden by the financial markets. Short of ammunition for effectively countering unwanted exchange rate movements, central banks have turned to appeasing the markets. Raising interest rates has become the weapon of choice against runs on the currency, which is essentially rewarding financial capital for not fleeing.

Broader economic and social policies are also being reshaped under pressure from the financial markets. Egged on by the IMF and World Bank, developing countries try to deter capital flight by adopting "sound" policies, notably by measures to stabilize the price level and balance the fiscal budget. They compete for foreign investment by reducing progressive taxes, deregulating their goods and financial markets, privatizing state assets and functions, and "leveling the playing field" between foreign and domestic investors. Despite their thicker financial markets and greater productive prowess, economic policy making of the industrial countries has also been giving way to these pressures.[1]

Nevertheless, this pro-capital trend of economic and social policy has been paralleled by a rising frequency of national banking and currency crises, with some spilling over into international crises. Nearly three-fourths of the 182 members of the IMF, including a substantial number of developed countries, suffered one or more bouts of banking crises of "significant banking problems" during 1980-95. Banking crises, defined in this IMF survey as "cases where there were runs or other substantial portfolio shifts, collapses of financial firms, or massive government intervention," afflicted 36 countries. "Significant banking problems," defined as "extensive unsoundness short of a crisis," afflicted another 108.[2] The recent Asian crisis [of 1997-98] and its repercussions have since raised these numbers significantly.

An analysis of 26 developing and industrialized countries suffering banking and currency crises during 1980-95 found that financial sector liberalization within the five years preceding the crisis accurately predicted 67% of the banking crises and 71% of the currency crises. Liberalization, by broadening access to foreign funds, had encouraged domestic banks and companies to raise their liability leveraging to crisis levels.[3]

The social and economic costs of the frequent crises have been substantial. A World Bank study of a sample of developing country banking crises estimates that during the crises GDP declined by 14.6% below its trend-line growth. The study also points out that banking crises have become intertwined with currency crises due to "surges of international capital inflows — especially private-to-private flows — to developing countries and the growing integration of these economies with world financial markets." The costs of these twin crises have also been much higher than for each occurring in isolation, averaging 18% of GDP in developing countries and 17.6% in industrialized countries.[4]

With events demolishing the welfare claims for capital decontrol, economists have been edging back to the Bretton Woods position that capital decontrol is incompatible with macroeconomic stability. Harvard economist Dani Rodrik observes:[5]

A sad commentary on our understanding of what drives capital flows is that every crisis spawns a new generation of economic models. When a new crisis hits, it turns out that the previous generation of models was hardly adequate….The earliest models were based on the incompatibility of monetary and fiscal policies with fixed exchange rates. These seemed to account well for the myriad balance of payments crises experienced through the 1970s. The debt crisis of 1982 unleashed an entire literature on over-borrowing in developing countries, placing the blame squarely on expansionary fiscal policies (and in some countries on inappropriate sequencing of liberalization). But crises did not go away when governments became better behaved on the fiscal and monetary front. The exchange rate mechanism (ERM) crisis in 1992 could not be blamed on lax monetary and fiscal policies in Europe, and therefore led to a new set of models with multiple equilibria. The peso crisis of 1994-95 did not fit well either, so economists came up with yet other explanations — this time focusing on real exchange rate overvaluations and the need for more timely and accurate information on government policies. In the Asian crisis [of 1997-98] neither real exchange rate nor inadequate information seems to have played a major role, so attention has shifted to moral hazard and crony capitalism in these countries.

The IMF still bases its "sound" policy demands on the first generation of models, which puts full blame on its clients. Events, however, have forced the IMF to muddy its "soundness" accolade. Overvaluing the exchange rate to anchor the price level and to reassure nervous financial markets, and devaluing to balance the trade account, have each qualified as "sound," but with no clarification on how to square the contradiction. The IMF now acknowledges that the crises may involve investor miscalculations, but blames crony capitalism and inadequate information from the client governments for misleading investors. And it clings to the view that more timely and "transparent" information from governments and improved risk evaluation procedures by banks are the keys to enabling free capital mobility to function smoothly.

This tenacious faith in the EMH [efficient market hypothesis] and in the virtues of policy disciplining by the financial markets brushes aside the accumulation of econometric findings that the actual behavior of foreign exchange markets refutes the predictions of Ratex [rational expectations theory] and the EMH. The "forward discount anomaly," that is, the failure of the forward rates in the exchange markets to predict correctly even the direction in which the future spot rate will move, is now a generally accepted finding.[6] The forecast errors of forex dealers, according to various surveys, are usually serially correlated rather than mean reverting, which indicates that they follow trends in the short-term.[7] And their successive shot-term forecasts during 3, 6 or 12 month intervals usually badly over- or under-shoot their forecasts made at the beginning of each interval as to what the spot rate will be at the end of that interval. The practical inference is that in the absence of liquid long-term hedging instruments, investors cannot safely hedge long-term investments against exchange risk by rolling over liquid short-term hedges. Knowing this, investors in a volatile exchange rate environment can be expected to raise the risk premium and the hurdle rate of return for undertaking long-term investments.

The faith also disregards the likelihood that neither "transparency" nor improved risk procedures can stabilize the capital flows. Faster and more "transparent" information about impending difficulties for portfolio investments could merely hasten the onset of currency crises by triggering faster capital flight. The value-at-risk (VAR) models used by international banks to guide their foreign exchange dealing, financing of hedge funds, and customized derivative mongering, have been accused of having encouraged excessive risk-taking, and of having intensified contagion during the 1997-98 global financial crisis.[8] The charge is that in applying their variance - covariance matrices to historic data, and assuming normal risk distributions, they tended to underestimate the possibility of larger deviations from "normal" that could produce large losses from taking highly leveraged positions. This was, indeed, the basic flaw that bankrupted Long-Term Capital Management Hedge Fund. Contagion was intensified because an unexpected reversal in one country automatically generated, through the VAR models, a reassessment of credit and market risk in a correlated country. This then triggered margin calls and a tightening of credit lines in both countries. Such risk control methods help explain why Malaysia's 1997 imposition of capital controls, and Russia's 1998 default, produced a rapid cutoff of lending to other developing countries. Tightening the VAR methodology, as called for in the proposed new Basel Accord, could well reinforce contagious reactions.

Following the 1994-95 Mexican crisis, Michel Camdessus, the then Managing Director of the IMF, sketched the road ahead for the IMF as follows: "In today's globalized markets, we must ensure that our ability to react approaches the instant decision making of investors, if we want to have the ability to give confidence to markets and our members."[9] But the message from both economic theory and the array of recent financial disasters is quite the opposite. Slowing the reaction speed of the globalized financial markets to allow the more measured speed of production and policy decisions to take effect ought to be the primary focus of the IMF and its members.


---- Endnotes ----

[1] In the OECD countries the share of gross investment in financial facilities averaged 104% higher in 1980-93 than in the 1970s [Malcolm Edey and Ketil Hvding, "An Assessment of Financial Reform in OECD Countries," OECD Economic Studies (Paris), No. 25, 1995,...]. Financial services have been the fastest growing component of international trade, rising at 13% per annum from 1975 to 1993, while investment in financial facilities was the fastest growing component of FDI in that period [OECD Economic Outlook (Paris), December, 1994, pp. 38-40].
[2] See Carl-Johan Lindgren et al., Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund, 1996), Annex 1.
[3] A summary of other studies that highlight the various channels by which financial liberalization has encouraged risky behavior is given in the World Bank's report, Global Economic Prospects and the Developing Countries (Washington, D.C., 1998/99), pp. 135-141.
[4] Ibid, pp. 125-126; and Box 3-1.
[5] Dani Rodrik, "Who Needs Capital Account Convertibility?" in Stanley Fischer et al., Should the IMF Pursue Capital Account Convertibility?, Princeton Essays in International Finance, No. 207 (Princeton, NJ: Princeton University Press, May, 1998), pp. 58-59.
[6] See Charles Engel, The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence, National Bureau of Economic Research Working Paper No. 5312 (Cambridge, MA), 1995.
[7] See Takatoshi Ito, "Foreign Exchange Expectations: Micro Survey Data," American Economic Review, Vol. 80, June, 1990; and Sinji Takagi, "Exchange Rate Expectations: A Survey of Survey Studies," IMF Staff Papers, Vol. 38, March, 1991.
[8] David Folkert-Landau and Peter Garber, "Capital Flows from Emerging Markets in a Closing Environment," Global Emerging Markets (London: Deutsche Bank Research, 1998), Vol. 1, No. 3.
[9] Michel Camdessus, "The IMF in the Globalized World Economy," IMF Survey, June 19, 1995.