New Rules for Global Finance

The Bush Team on the

International Financial Architecture

Randall Dodd

Economist, New Rules for Global Finance

Marcy 27, 2001

Very little has changed since the East Asian financial crisis nearly derailed the world economy several years ago. Trillions of dollars continue to flow through global financial markets, with little or no regulation, almost as if nothing had happened. So it is welcome news that President Bush has appointed new economic advisors who want to refocus attention on the need for “new global financial architecture.”

Senior U.S. officials like Treasury Secretary, Paul O’Neill, and chief presidential economic adviser, Lawrence Lindsey, have joined the growing international circle of policy analysts and street protestors who have been demanding the reform of international financial institutions, particularly the International Monetary Fund (IMF). Unfortunately, the Bush team's definition of the problem is too narrow and their single solution impractical.

According to the Bush team, the financial crises in developing countries were caused by "moral hazard"--a situation in which investors, who expect to be bailed-out by governments or international financial institutions, take greater risks than they would otherwise. The Bush solution is to announce that, henceforth, there will be no bailouts. For developing countries feeling the heat of a financial meltdown, this approach gives new meaning to the term benign neglect. More likely, however, this is an empty threat. Most economists believe that the Bush Administration, faced with the likelihood of serious harm to U.S. interests, would take whatever rescue measures were necessary.

The financial markets, understanding this, will not act more responsibly..

This is a textbook case of how faulty analysis leads to bad policy. Almost all observers now agree that the financial crises of the past decade were caused by a combination of problems including over-valued fixed exchange rates, large trade deficits, "hot money" flowing into the small emerging capital markets, poorly regulated financial markets and various forms of local corruption or "cronyism." Developing country financial crises were not caused by any one factor and will not be prevented by any single policy change.

Benign neglect will not fix these problems. And unfortunately a lack of preventive measures is exactly what got us where we are today. No real changes were made after the Mexican peso crisis in December of 1994, or the East Asia crisis in the summer of 1997. The Russian and Brazilian crises followed in 1998. And although the IMF and World Bank have created new Departments--the World Bank promises to focus more on poverty and the IMF to conduct better market surveillance--still there is no major change.

Although the critical posture of the Bush team is appropriate, its passivity is not. New and more severe financial crises cannot be prevented or mitigated unless real changes are made to the regulation of international capital markets and trade relations.

The Bush team should consider some new rules for global finance:

1) End the IMF's pressure on developing countries to deregulate their >financial markets and to lift controls on foreign capital-particularly speculation and short-term investments.

2) Close or tighten regulation of tax havens and money laundering centers where investors and financial institutions also evade market regulations.

3) Safeguard financial investments and transactions by raising capital requirements and establishing collateral and margin requirements; impose more thorough reporting requirements that include off-balance sheet transactions; and eliminating loans that can be recalled on demand.

4) Slow down the rate at which short-term and speculative investments move in and out of nations. One approach, suggested by Nobel Laureate economist James Tobin, is to tax foreign currency transactions in order to reduce the likelihood of financial panics.

5) Regulate the riskiest types of speculative investments, such as hedge >funds which pool billions of dollars from wealthy investors, and often turn to developing country markets to speculate against their currencies.

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