Lecture 6: Crisis Management and Prevention
Lessons from Asian Financial Crises
Foreign Affairs (1999), “Report---The Future of the International Financial Architecture---A Council on Foreign Relations Task Force,” pp. 169-183.
Council on Foreign Relations: www.cfr.org
Clinton in September 1998, characterized the crisis as “the greatest financial challenge facing the world in the last half century.”
Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture (1999), Report of an Independent Task Force Sponsored by the Council on Foreign Relations. Carla A. Hills and Peter G. Peterson, Co-Chairs, Morris Goldstein, Project Director.
In the crisis countries, currencies and equity prices plummeted, economic growth turned into recession, wealth evaporated, jobs were destroyed, and poverty and school dropout rates soared.
Six principles guided this analysis. The new international financial architecture should
1. encourage emerging economies to intensify their crisis prevention
efforts
2. permit savings to flow to the countries and the uses where they have the best return
3. promote fair burden-sharing among private creditors, official debtors, and official creditors when a crisis does occur
4. increase the role of market-based incentives in crisis prevention and resolution
5. make reform of the architecture a two-way street, with the major industrial countries also doing their part
6. refocus the mandates of the international monetary fund and the world bank on areas they are best equipped to address
Recommendations
1. Greater rewards for joining the “Good Housekeeping Club”
2. Capital flows—avoiding too much of a good thing
3. The private sector: promote fair burden-sharing and market discipline
4. Just say no to pegged exchange rates
In the case of the Asian crisis countries, their currencies appeared to be only modestly overvalued in mid-1997, but large current account deficits, sharply falling export growth, weak banking systems, and highly leveraged corporations made them vulnerable. In addition, because their exchange rates had been relatively stable for a long time, banks and corporations did not protect themselves against currency risk.
5. IMF crisis lending: less will do more
6. Refocus the IMF and the World Bank: back to basics
7. Generate political support for reforms
References
Radelet, Steven and Jeffrey Sachs (1998), “The Onset of the Asian Financial Crisis,” NBER Working Paper, No. 6680.
Summers, L. (2000), “International Financial Crises: Causes, Prevention, and Cures,” American Economic Review, 90(2), 1-16.
Stiglitz, J. (1999), “Must Financial Crises Be This Frequent and Painful?” Policy Option, 23-32.
Crisis Management: The Controversy of the Rescue Plan by the IMF
Globalization and its Discontent (J. Stiglitz)
IMF’s policy to the Asian financial crisis------mission creep, subsidies to the Russian mafia, the reckless encouraging of devaluations, the obstinate staving-off of devaluations, sheer been-there-too-long-ness and so on. ~ Davos Daily
Conditionality
Moral hazard
Adverse selection
Feldstein, Martin (1998), Refocusing the IMF” Foreign Affairs, March/April.
Schwartz, Anna (1998), “Time to Terminate the ESF and the IMF,” August 26, No.48.
Walter Bagehot (1826-1877), editor of the Economist in 1860.
Bagehot (1873) rules: lend freely, to temporarily illiquid but solvent banks, at penalty rates and using collateral that would be good under non-crisis circumstances.
Crisis Prevention
Capital Control and Sequence of Liberalization
Edwards, Sebastian (1999), “A Capital Idea?---Reconsidering a Financial Quick Fix,” Foreign Affairs, May/June, 18-22.
a. Capital controls may foster a false sense of security, encouraging complacent
and careless behavior by policymakers and investors alike.
b. After much talk about a new architecture, we will probably end up with a
slightly embellished IMF that will continue to miss crises, throw good money
after bad, and ultimately try to rationalize why currency crises persist.
c. We must understand what capital controls can and cannot do. The historical
record shows convincingly that, despite their new popularity, controls on
capital outflows and inflows are ineffective. The best prescriptions to
combat financial turmoil, now as then, are sound macroeconomic policies,
sufficiently flexible exchange rates, and banking reforms that introduce
effective prudential regulations and reduce moral hazard and corruption.
Bhagwati, Jadgish (1998), “The Capital Myth: The Difference Between Trade in widgets and Trade in Dollars,” Foreign Affairs, 77, 7-12.
Edwards, Sebastian (1999), “On Crisis Prevention: Lessons form Mexico and East Asia” NBER Working Paper, No. 7232.
Krugman, Paul (1998), “Heresy Time,” <http//web.mit.edu/krugman/www/heresy.html>, September 28.
Urge Malaysia to use the capital control.
Calvo, Guillermo and Carmen Reinhart (1999), “When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options,” unpublished Manuscript, University of Maryland at College Park.
Eichengreen, Barry and Michael Mussa, with Giovanni Dell, Enrica Detragiache, Gian Maria Milesi-Ferretti, and Andrew Tweedie, Capital Account Liberalization: Theoretical and Practical Aspects, Occasional Paper No. 172, Washington, D. C.: IMF (September)
Ito, Takatoshi (1999), “Capital Inflows in Asia,” NBER Working Paper Series, No. 7134, May.
Johnston, R. Barry, Salim M. Darbar and Claudia Echeverria (1999), “Sequencing Capital Account Liberalization: Lessons from Chile, Indonesia, Korea, and Thailand,” in R. Barry Johnston and V. Sundararajan (eds), Sequencing Financial Sector Reforms: Country Experiences and Issues, Washington, D. C.: International Monetary Fund, pp. 245-283.
Obstfeld, Maurice (1998), “The Global Capital Market: Benefactor or Menace?” Journal of Economic Perspectives, 12: 4, Fall, 9-30.
Rodrik, Dani and Andres Velasco (1999), “Short-term Capital Flows, “ Unpublished Manuscript, Harvard University and New York University (april)
Tobin’s tax
“Throw sands on the wheels”
Haq, Mahbub ul, Inge Kaul and Isabelle Grunberg (1996), The Tobin Tax—Coping with Financial Volatility, Oxford University Press.
Asian Development Outlook (1999), The Financial Crisis in Asia, pp. 21-46.
Buiter, Willen H. and Anne C. Sibert (1999), “ DROP: A Small Contribution to the New International Financial Architecture, unpublished manuscript, University of Cambridge and Birkbeck College, University of London.
Eichengreen, Barry (1999), “The International Monetary Fund in the Wake of the Asian Crisis,” University of California, Berkley.
Toward an Architecture of the International Finance System
Eichengreen, Barry (1999), Toward a New International Financial Architecture, Institute for International Economics.
There is no shortage of proposals for reforming the international financial architecture. Many of these proposals are contradictory and mutually incompatible.
The recommendations in this book follow from six assumptions for the operation of the international financial system.
a. Liberalized financial markets have compelling benefits
b. International financial liberalization and growing international capital flows are largely inevitable and irreversible.
c. Capital markets are characterized by information asymmetries that can give rise to overshooting, sharp corrections, and in the extreme, financial crises.
d. Despite the moral hazard that may result, we need to erect a financial safety net, such as deposit insurance and a lender of last resort to contain systemic risks to the financial system.
e. Information and transactions costs can prevent decentralized markets from quickly and efficiently resolving financial problems.
f. Economic policy is framed in a politicized environment.
Recommendations for reforming the international financial architecture flow from these assumptions. They may seem unambitious in comparison, but they at least have a chance of being implemented. In effect, I stake out a middle ground between the overly ambitious and politically unrealistic schemes of independent commentators and the excessively timid and ambiguous reports of international bodies and organizations.
Academics should be bolder than bureaucrats, but their recommendations should take the political realities into account.
Financial crises have always come in different flavors; this will be true in the future as it has been in the past. Macroeconomic imbalances can play a part in second class of financial crises, but theirs is not the leading role. First, some countries will continue to suffer crises purely because their governments follow reckless macroeconomic policies, but there old-fashioned balance of payments crises will become more the exception and less the rule. Second, there is relatively little confusion about how to treat crises caused by macroeconomic excesses. There is less agreement on how to prevent and manage the newfangled Asian-style equivalents---high-tech crises in which financial factors play the dominant role.
My goal instead is to suggest some practical reforms that will improve the tradeoff between financial liberalization and financial stability.
Summary of Recommendations
UK: Creating permanent Standing Committee for Global Financial Regulation bringing together the IMF, the World Bank, the Basle Committee, and other regulatory groups, and to establish and implement international standards for financial regulation and supervision.
French proposal: transforming the Interim Committee into a council that would serve as the ultimate decision-making body for the IMF.
US: creation of a contingency-finance mechanism
Canadian: six-point plan: vigilance on the part of G-7 central banks, the pursuit of strong policies by emerging-market economies, attention to the needs of the poorest countries, steps to strengthen national financial systems and international oversight, development of a specific strategy for prudent liberalization of the capital account, and mechanisms for involving private investors in the resolution of crises.
George Soros: credit insurance agency
Henry Kaufman: international regulator and rating agency
Raffer: International Bankruptcy Court
Meltzer’s true international lender of last resort
Calomiris’ Rules for IMF lending
Jeffrey Garten: Global central bank
Litan’s Put Options in Bank Credit
Edward’s Specialized Agencies
Bergsten’s Target Zones
One thing that these proposals have in common is their impracticality.
Crisis Prevention
Better information
Upgrading the supervision and regulation of financial markets
Exchange rate flexibility
International financial standards
International financial stability is impossible without domestic financial stability
Internationally recognized auditing and accounting practices
Badly managed banks and open international capital markets are a combustible mix.
In developing countries, capital requirements in theory and capital requirements in practice are two very different things, given the inadequacy of auditing and accounting standards.
The first line of defense—banks’ own risk-management
The second line of defense---regulatory supervision
The third line of defense---limiting or taxing bank borrowing abroad
Crisis Prediction
Earthquakes and financial crises are products of complex nonlinear systems whose parts interact in unpredictable ways.
Crisis Management
Capitalism without bankruptcy is like Catholicism without sin.
Words need to give way to deeds. Regulators need to require that internationally traded securities include majority voting, sharing, non-acceleration, minimum legal threshold, and collective-representation clauses.
Reforming the IMF
IMF will have to become less of a fireman and more of a policeman.
1. Standards for Crisis Prevention
Bank supervision and regulation, auditing and accounting, bankruptcy procedures, and corporate governance.
The IMF has sought to encourage the authorities to improve prudential supervision, root out corruption, eliminate subsidies, break up monopolies, and strengthen competition policy---intrusiveness.
Capital is so mobile internationally, stabilizing the balance of payments means stabilizing the capital account, which requires restoring investor confidence. And restoring investor confidence means restoring confidence in the stability of the domestic financial system.
The Standard Solution
IASI: international accounting standards committee
INTOSAI: international organization of supreme audit institutions
International federation of accountants
Committee J of the International Bar Association
ICGN: international corporate governance network
IOSCO: international organization of securities commissions
UNCITRAL: United Nations commission on international trade law
Some Examples
Bank regulation
Securities-market regulation
Data dissemination
Corporate bankruptcy reform
Problems
1. Enforcement
2. Banks and Capital Flows
3. Bailing in the Private Sector
4. What Won’t Work
5. What the IMF Should Do(and What We Should Do About the IMF)
Dornbusch, Rudi (1998), “After Asia: New Directions for the International Financial System,” July, MIT.
Eichengreen, B. and Nathan Sussman (2000), “The International Monetary System in the (Very) Long Run,” IMF Working Paper, WP/00/43, March.
Eichengreen, B. and Ricardo Hausmann (1999), “Exchange Rates and Financial Fragility,” NBER Working Paper, No. 7418, November.
Three Hypotheses:
1. The moral hazard hypothesis:
2. The original sin hypothesis: incompleteness in financial markets
3. The commitment problem hypothesis:
Frankel, Jeffrey A. (1999), “The International Financial Architecture, Policy Brief No. 51, Washington D.C.: The Brookings Institution (June).
Goldstein, Morris (1998), The Asian Financial Crisis: Causes. Cures, and Systemic Implications, Institute for International Economics.
Rogoff, Kenneth (1999), “International Institutions for Reducing Global Financial Instability,” NBER Working Paper, No. 7265, July.