COLUMBIA BUSINESS SCHOOL 1

Capital Market Liberalization, Economic Growth, and Instability

JOSEPH E.STIGLITZ The World Bank, Washington, DC, USA Summary. Ð This paper reviews brie¯y the arguments for capital market liberalization, and identi®es their theoretical and empirical weaknesses.This provides the foundations for the argument for intervention in short-term capital ¯ows.The paper concludes with a brief discussion of the various ways in which such interventions may be implemented.

1.INTRODUCTION highway, one suspects that the driverÕs atten- tion may have lapsed.But when there are The world is just emerging from the worst dozens of accidents at the same bend in the ®nancial and economic crisis since the Great same highway, one needs to re-examine the Depression.While ®nancial variables, such as design of the road. exchange rates, have stabilized in East Asia, I suggested that one might compare capital unemployment remains far higher than before account liberalization to putting a race car the crisis, and real wages far lower.The World engine into an old car and setting o€ without Bank estimates that the 1999 output of the ®ve checking the tires or training the driver. crisis countries of East Asia will still be 17% Perhaps with appropriate tires and training, the below what it would have been had the growth car might perform better; but without such trend of the 10 years before the crisis continued. equipment and training, it is almost inevitable In addition, large parts of the world remain in a that an accident will occur.One might actually precarious economic positionÐwith deep have done far better with the older, more reli- recession or depression facing several countries able engine: performance would have been in Latin America, and output in many of the slower, but there would have been less potential economies in transition still markedly below for an accident.Similarly, the international what it was a decade ago. economic architecture must be designed to It has become increasingly clear that ®nancial ``work'' not just in the presence of perfect and capital market liberalizationÐdone economic management, but with the kind of hurriedly, without ®rst putting into place an fallible governments and public ocials that in e€ective regulatory frameworkÐwas at the fact occur in democratic societies. core of the problem.It is no accident that the As the crisis spread from East Asia to Russia, two large developing countries that survived and then to Latin America, it became clear that the crisisÐand continued with remarkably even countries with good economic policies and strong growth in spite of a dicult global relatively sound ®nancial institutions >at least economic environmentÐwere India and China, as conventionally de®ned) were adversely af- both countries with strong controls on these fected, and seriously so.>Indeed, this was capital ¯ows. consistent with earlier research that had shown The crisis in East Asia was not the only crisis that changes in capital ¯ows, and even crises, of recent years.Indeed, there have been, by one were predominantly precipitated by events reckoning, 80±100 crises over the past quarter outside the country, such as changes in interest century >Lindgren et al., 1996, p. 20). Crises rates in the more developed countries >Calvo have become more frequent and more severe, et al., 1993; see also Fernandez-Arias, 1995)). suggesting a fundamental weakness in global Thus, the rhetoric with which the crisis was economic arrangements.As I put it in one begunÐthat globalization, liberalization, and lecture, when there is a single accident on a the market economy delivered its fruits to

Published in: World Development COLUMBIA BUSINESS SCHOOL 2 virtuous countries and that problems were only stabilize in¯ows, interventions on out¯ows visited upon countries that, in one way or remain highly controversial.SomeÐeven another, had sinnedÐwas re-examined, and a manyÐforms of intervention may not bring more cautionary approach was taken to the bene®ts commensurate with their costs.The reforms that had been long advocated by the central argument in this paper is that there exist zealots.At the same time, the analytic argu- some forms of intervention that are likely to be ments forÐand againstÐcapital market liber- welfare-enhancing. alization were subject to greater scrutiny.The Before beginning the discussion, I want to case for capital market liberalization was found make it clear that I am focusing my attention wanting, especially striking given the zeal with on short-term speculative capital ¯ows.The which the International Monetary Fund >IMF) argument for foreign direct investment, for had requested an extension of its mandate to instance, is compelling.Such investment brings include capital market liberalization a short with it not only resources, but technology, two years earlier at the Annual Meetings in access to markets, and >hopefully) valuable Hong Kong.It should have been clear then, training, an improvement in human capital. and it is certainly clear now, that the position Foreign direct investment is also not as vola- was maintained either as a matter of ideology tileÐand therefore as disruptiveÐas the short- or of special interests, and not on the basis term ¯ows that can rush into a country and, of careful analysis of theory, historical experi- just as precipitously, rush out >World Bank, ence or a wealth of econometric studies.Indeed, 1999).The magnitude of these changes in ¯ows it has become increasingly clear that there is not can be enormous, as shown in Figure 1.In the only no case for capital market liberalization, case of Thailand, the change in ¯ows amounted but that there is a fairly compelling case against to 14% of the GDP and in the case of South full liberalization.The fact that the interna- Korea 9% of the GDP.In the case of East Asia tional ®nancial community came so close to as a whole, the turnaround in capital ¯ow adopting a position that could not be justi®ed during 1996±97 amounted to $105 billion, more on the basis of theory or evidence should, in than 10% of the GDP of these combined itself, provide an important cautionary note, economies.If the United States experienced the especially in the context of the debate over change in ¯ow that Thailand did, for example, reforming the international economic architec- this could be equivalent to a change in capital ture.Clearly, before reforms of this magnitude ¯ows of over $1 trillion.Even with its strong are adopted, there needs to be more open ®nancial and other institutions, it is not clear debate, and all the a€ected partiesÐincluding how well the United States would whether such workers who are threatened with unemploy- a storm >Institute of International Finance, ment and falling wages, and small businesses 1998; as cited in Rodrik, 1998).Moreover, it is that are threatened with bankruptcy as also clear that one can intervene in short-term interest rates soar to usurious levelsÐneed to ¯ows, and still provide a hospitable environ- have a seat at the discussion table.Unfortu- ment for foreign direct investment, as China, nately, in some of the circles in which the the largest recipient of foreign direct invest- pivotal issues are being discussed, not only are ment, amply demonstrates. these groups not represented, but the develop- ing countries do not even have a formal membership. 2.THE CASE FOR CAPITAL MARKET In this paper, I want to review brie¯y the LIBERALIZATION arguments for capital market liberalization, and identify their theoretical and empirical The case for capital market liberalization is weaknesses.This will provide the foundations largely based on standard eciency arguments, for the argument for intervention in short-term employing a conventional neoclassical model capital ¯ows.I shall then brie¯y discuss the and ignoring the special ways in which ®nancial various ways in which such interventions may and capital markets di€er from markets for be implemented.Throughout much of the ordinary goods and services, such as steel.The discussion, I shall talk about ``interventions'' in proponents focus on eciency e€ects, ignoring fairly general terms.It should be clear, the distributional consequences, presumably however, that not all interventions are identi- believing that if the gains are large enough, cal.Today, for instance, while there is wide- either the bene®ts will trickle down to the poor, spread acceptance of interventions that or the government will take active measures to COLUMBIA BUSINESS SCHOOL 3

Figure 1. Capital market ¯ows to developing countries. (Source: Euromoney Loanware and Bondware.) ensure that the poor will not be harmed.While for capital market liberalization in East Asia. the evidence in support of either hypothesis After all, the governments had demonstrably may not be there, my concern here is to eval- worked hard to create an environment in uate the case more on its own terms, that is, the which the economy, and the private sector case that capital market liberalization leads to in particular, had ¯ourished; growth rates higher output and greater eciency. had been phenomenal for three decades or There are ®ve components to the argument: more.Savings rates were already very high; >a) Countries should be concerned with indeed, it was remarkable that the countries maximizing GNPÐthe incomes of their citi- were able to absorb the high level of savings, zensÐnot GDP, the output of the country. investing them productively.Other countries If the citizens of a country can ®nd an outlet with such high savings rates had not fared so for their funds with a higher return than any well.One could hardly argue that, given the investment in their country, then GNP is high savings rates, they needed to open their maximized by allowing the funds to leave capital markets to obtain needed funds. the country.>Moreover, the higher returns >d) On the other hand, for much of the rest themselves might stimulate the citizens of of the world, open capital markets were the country to save more.) By the same to- important as a source of funding for needed ken, if a foreign investor ®nds an investment investment projects. opportunity within the country with a higher >e) Finally, the case for opening capital mar- return than the opportunity cost of his kets was made by way of analogy to free funds, complementary factors within the trade in goods and services. A central tenet country will bene®t, as their marginal pro- in economicsÐat least since Adam SmithÐ duct is increased. was that free trade was bene®cial to a coun- >b) International competition for funds pro- try.Indeed, it paid a country to eliminate vides a needed spur for countries to create trade barriers unilaterally, even if trading an economic environment attractive to busi- partners did not.``Capital,'' it was argued, ness.It is behind closed doors that countries was just like another good.The case for can engage in eciency-decreasing practices, capital market liberalization was thus the e.g., regulations for which the bene®ts are same as the case for free trade in general; not commensurate with the costs. that case was so well known, it hardly >c) Open capital markets help stabilize the needed to be repeated. economy through diversi®cation. As a coun- The predictions of the advocates of capital try faces a downturn, the lower wages will at- market liberalization are clear, but unfortu- tract funds into the country, helping to nately, historical experience has not been stimulate it.This was a central argument supportive. COLUMBIA BUSINESS SCHOOL 4

>a) Growth performance, stability.Stability is important for several reasons.Research has shown that insta- There is a wealth of crosscountry studies bility has persistent e€ects on economic supporting the view that trade liberalization growthÐgrowth is slowed down for several leads to faster economic growth >see, e.g., Sachs years after a crisis has occurred >Caprio, 1997). & Warner, 1995; Wacziarg, 1998; Vamvakidis, Indeed, the large unit root literature suggests 1999), though to be sure, there are a few studies that an economy that su€ers a large drop in providing suggestions to the contrary.In output never fully recoversÐoutput remains contrast, for the case of capital market liber- persistently below what it would have been. alization, there are relatively few studies, but Thus, the present discounted value of lost output what evidence there is, is not supportive of associated with the magnitude of declines liberalization.Figure 2, borrowed from Danny observed in East Asia or Ecuador are enormous. RodrikÕs study, shows growth in di€erent Moreover, instability often has marked distrib- countries related to the openness of capital utional consequences, especially in developing markets, as measured by the IMF. This is countries.Even in developed countries, such as particularly important, because it provides a the United States, the poor bear a dispropor- metric that corresponds to the kinds of actions tionate burden in terms of increased unem- that the IMF might have taken in attempting to ployment >Furman & Stiglitz, 1999b).But in open up the capital markets.Figure 3 provides most developing countries, safety nets are some insights into why this might be the caseÐ inadequate or nonexistent.The recent crises it plots investment in di€erent countries related have amply demonstrated this burden, with to the openness of capital markets.Again, there unemployment increasing 3±4 fold in Korea and is no relationship. Thailand >and by more in Indonesia), and with real wages falling l0% in Korea, and by as much >b) Stability as a quarter in Thailand and Indonesia. I already alluded to the increased frequency The global economic crisis has centered of ®nancial and economic crises, and suggested attention around another aspect of economic that this change is related to ®nancial and

Figure 2. Economic growth and capital account liberalization, 1975±89. (Source: Rodrik, 1998.) This scatter plot controls for per capita income, secondary education, quality of governmental institutions, and regional dummies for East Asia, Latin America, and sub-Saharan Africa. COLUMBIA BUSINESS SCHOOL 5

Figure 3. Investment/GDP and capital account liberalization, 1975±89. (Source: Rodrik, 1998.) This scatter plot controls for per capita income, secondary education, quality of governmental institutions, and regional dummies for East Asia, Latin America, and sub-Saharan Africa. capital market liberalization.Cross-country fundamental is this: ®nancial and capital studies have con®rmed this >Demirgucß-Kunt & markets are essentially di€erent from markets Detragiache, 1998). for ordinary goods and services.The central Cross-country econometric studies looking function of capital and ®nancial markets is more broadly at the impact of capital market information-gatheringÐin particular, assessing liberalization on the likelihood of an economy which projects and ®rms are most likely to yield having a recession have again con®rmed the the highest returns, and monitoring to ensure adverse e€ects >Easterly et al., 1999). that the funds are used in the appropriate way. Thus, it is clear that not only is there no Moreover, markets for information are funda- compelling empirical case for capital market mentally di€erent from ``ordinary'' markets. liberalization, there is a compelling case against For instance, whenever information is imper- capital market liberalization, at least until fect, markets are essentially never constrained countries have found ways of managing the Pareto ecientÐin marked contrast to stan- adverse consequences. dard results for competitive markets with perfect information >e.g., Greenwald & Stiglitz, 1986).Thus, the ®fth argument, that the argu- 3.WHY CAPITAL MARKET ment for capital liberalization is exactly the LIBERALIZATION PRODUCES same as the argument for trade liberalization, is INSTABILITY, NOT GROWTH simply false. Perhaps the most telling de®ciency in the Given the seemingly compelling arguments standard case is in the third argument, that for capital market liberalization, why does the opening capital markets allows for diversi®ca- evidence point so much in the opposite direc- tion and thereby enhances stability.As we have tion? seen, capital market liberalization is systemi- cally associated with greater instability, and for >a) Fallacies in the standard arguments good reason: capital ¯ows are markedly pro- cyclical, exacerbating economic ¯uctuations, We begin our discussion by identifying the when they do not actually cause them.The fallacies in the standard arguments.The most behavior is consistent with the popular adage COLUMBIA BUSINESS SCHOOL 6 about bankers being willing to lend when one enhancing a ¯ow of capital into the country is does not need the money.When the bankers see turned on its head: in many instances, the key economic weakness, they pull their money out issue is not capital ¯owing into the country, but of the country.In addition, capital market ¯owing out.Opening the capital account has liberalization exposes countries to vicissitudes facilitated capital ¯ight, and thus contributed associated with changes in economic circum- to the weakening of the economy >see Dooley, stances outside the country; a sudden change in 1998). lendersÕ perceptions concerning ``emerging The argument with which I am most market risk'' can lead to huge capital out¯ows, sympathetic is that opening the capital account undermining the viability of the entire ®nancial imposes ``discipline.'' Countries are ``forced'' to system. have good economic policies, lest capital ¯ow The argument that governments should be out of the country.But I have argued that far concerned with GNPÐthe income of their more relevant for the long-run success of the citizensÐhas some validity, but misses a economy is foreign direct investment; and the central issue in development: there are a variety desire to acquire and sustain FDI provides of reasons to believe that investors do not strong discipline on the economy and the appropriate the full value of their contribu- political process.The question is, does opening tions.Recent literature, for instance, has of the short-term capital accountÐmaking the emphasized the importance of returns to scale, country subject to short-run oscillations in network externalities, and a variety of other sentimentÐprovide signi®cant extra external spillovers >e.g., Ho€, 1997). These externalities discipline? On the negative side, the openness to may be particularly important in early stages capital ¯ight makes countries especially sensi- of development.In addition, whenever there tive, e.g., to corporate or capital tax rates or to are taxes on capital, social bene®ts from changes in interest rates.Thus, openness may investing at home may exceed private bene®ts, impose costly constraints on the ability of unless the government can impose commensu- government to pursue legitimate objectives. rate taxes on investments abroad, which it One of those objectives is economic stability. often cannot. China was able to pursue active countercyclical The issue of whether capital market liberal- macro-policies, staving o€ a recession and ization provides additional sources of funding maintaining robust growth of close to 8%, is also questionable: as the data above sugges- because the capital account restrictions provi- ted, it does not lead to more investment.There ded it some room to maneuver.It had no need are two related issues.First, does more short- to raise interest rates to levels that killed the term capitalÐunstable as it isÐprovide a basis economy in order to ``save'' it from capital for investment? The answer is clearly no.The ¯ight. second is, do restrictions on short-term capital ¯ows discourage foreign direct investment or >b) Why capital account liberalization has not other forms of longer term investment? Again, contributed to growth the answer appears to be no.We already noted that the country that has been the most The result cited earlier that capital account successful in recruiting foreign direct invest- liberalization is not associated with faster ment, China, also imposes a high level of investment, and therefore faster growth, should restrictions on short-term capital ¯ows.But not come as a surprise.We have already noted there is little evidence that countries that have that the case for positive e€ects is weak: ®rms imposed restrictions on short-term ¯ows, Chile are unlikely to engage in productive long-term on in¯ows, Malaysia on out¯ows, have had investments on the basis of short-term funds. their long-term ¯ows adversely a€ected >e.g., But there are even reasons to expect that capital Lee, 1996).Indeed, as I note below, there may market liberalization can have negative e€ects even be reasons why foreign direct investment on growth.We argued above that it leads to may be attracted: as we noted, capital market greater instability, and instability >especially liberalization is associated with greater ®nancial market crises) has adverse e€ects on economic volatility, or at least a higher prob- economic growth.Indeed, it is not only the ability of a recession.Such uncertainty clearly downturn itself which has lasting e€ects, but makes investment less attractive. the very presence of the risk of instability that is Actually, in many cases, the argument that likely to discourage investment.Opening opening the capital account is important for the capital account can, and has in several COLUMBIA BUSINESS SCHOOL 7 countries, facilitated the ¯ow of capital out of Excessively restrictive monetary and ®scal the country >rather than, as promised, acceler- policies >see Stiglitz, 1998, 1999; World Bank, ating the ¯ow of capital into the country), 1998a,b; Lane et al., 1999) resulted in deep providing another channel for adverse e€ects. recessions or depressions.The ``unit root liter- There is an equally compelling argument for ature'' suggests that these negative e€ects are why capital market liberalization >at the short persistent.Moreover, looking forward, busi- end) might be expected to have adverse e€ects nesses will view debt ®nancing as highly risky; on growth.Countries today are encouraged to in the event of another crisis >and as we have maintain adequate reserves, to protect them- noted, such crises have become increasingly selves against volatility in international ®nan- frequent and deep, in spite of rhetoric that cial markets.A key indicator is the ratio of might suggest otherwise), a ®rm with even a reserves to foreign denominated short-term moderate debt equity ratio could be put into indebtedness.When that number falls below distress.Firms will thus have to limit expansion unity, investors and lenders become worried to what they can largely self-®nanceÐwith and indeed recent econometric work has strong adverse e€ects on long-term economic suggested that this variable provides the best growth. explanation for which countries were adversely a€ected by the recent global ®nancial crisis >see Furman & Stiglitz, 1999a).Of course, if all 4.THE CASE FOR INTERVENTION investors believe that all other investors are looking at that variable to determine whether Once one recognizes that short-term capital or when to pull their money out of a country, it ¯ows can give rise to economic instability, there can become a self-ful®lling prophecy.Now is a compelling economic case for intervention: consider a poor developing country.A the instability associated with short-term capi- company within the country borrows, say, $100 tal movements results in there being a marked million from a US bank that charges him 20%. discrepancy between private and social returns If the country has been maintaining what it and risks.The capital ¯ows impose a huge views as minimum prudential reservesÐit negative externality.Indeed, it should be obvi- recognizes the high opportunity cost of ous that the crisis that resulted from these reservesÐthen it will have to add $100 million volatile ¯ows has a€ected many others besides to reserves.For simplicity, assume it holds the borrowers and lendersÐworkers who saw those reserves in US T-bills.Consider the their incomes plummet and small businesses implications from the perspective of the coun- that were forced into bankruptcy as a result of tryÕs balance sheet and income ¯ows: It has lent the soaring interest rates.Ironically, the design the United States $100 million and borrowed of the policy response probably increased the from the United States the same amountÐit magnitude of the externality.The IMF explic- has no new net capital.But it pays to the itly argued for increasing interest rates, with United States every year $20 million in interest, huge adverse e€ects on ®rms not engaged in while it receives from the US $5 million, the international speculation, in order to avoid the interest on the T-bill.Clearly, this is a good adverse e€ects on those who had uncovered deal for the United StatesÐone might under- foreign denominated borrowings. stand why the United States might be in favor The nature of this externality can be seen in a of rules that encourage such transactionsÐbut number of ways.Clearly, the borrowing coun- is hardly the basis for more rapid growth by the triesÐthe workers and small businessmenÐ poor developing country.>The costs may even have paid a high price.Alternatively, we can see be higher than these calculations suggest, the externality exercised through the prudential because the opportunity cost of the funds that reserve management policies described earlier. the government has to use for reserves could A $100 million capital in¯ow that has to be even exceed 20%.) o€set by $100 million in increased reserves To be sure, the adverse e€ects on economic imposes huge costs on those who might have performance may >especially going forward) be bene®ted from other uses of these funds.The unnecessarily increased as a result of the $100 million could have been spent to build particular policies that the IMF has custom- schools, health clinics, or roads to attract more arily employed in response to the crises that investment.Clearly then, the private decision to may, as we have seen, be systemically associ- borrow has imposed a high negative cost on ated with full capital account convertibility. society. 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Whenever there are such discrepancies, the can easily occur in countries with a high degree economistsÕ natural reaction is to impose a of transparency, and that one hardly needs ``tax'' to correct the externality, in order to crony capitalism to generate a crisis.If there eliminate, or at least reduce, the di€erence had been any question about the increasing between social and private returns.To be sure, diculties of good ®nancial regulation posed such taxes might discourage some capital ¯ows; by the growing role of derivatives, the matter but this criticism is like pointing out that a tax was settled by the government-engineered, on air pollution discourages the production of privately ®nanced bailout of Long Term Capi- goods, like steel, that contribute to air pollu- tal Management >LTCM) in October 1998. tion.The point is that ®rms should be made to This single hedge fund had an exposure esti- pay the full social cost of their activity; doing so mated in excess of a trillion dollars that, will, and should, reduce the level of activities according to those who defended the role of the that create negative externalities. government in the bailout >and who resisted The consequences of the externalities may allegations of crony capitalism and corporate depend on the circumstances of the country. misgovernance), posed a threat to global More advanced industrialized economies typi- ®nancial stability.Much of the money for cally have more built-in automatic stabilizers LTCM exposure came from supposedly well- and strong safety nets, so they can absorb the regulated banks. shocks better.Poorer countries may not only Clearly, even without exposing themselves to have no automatic stabilizers, they may face the volatility of short-term capital ¯ows, constraints >e.g., on borrowing) that exacerbate developing countries face greater risks >for ¯uctuations.For instance, while ®scal policy in instance, because of their less diversi®ed econ- developed countries is typically countercyclical, omies and the weaker role of automatic stabi- in developing countries, it is pro-cyclical >see lizers) and they typically have relatively low Easterly et al., 1999; Hausmann & Gavin, regulatory capacity in the ®nancial sector. 1996).Moreover, as we have already noted, Given these features of their economies, the policies recommended to, and in some cases caveat that developing countries should have e€ectively forced on, developing countries may strong ®nancial institutions and regulatory make matters worse >see Stiglitz, 2000).Weak structures in place before liberalizing their ®nancial institutions may make a country capital accounts suggests that the entire ques- particularly vulnerable to large and sudden tion is now moot.In the immediate future, few changes in short-term ¯ows. countries should be pressed to move far in the The recognition of the importance of these direction of liberalization. externality e€ects associated with short-term The market failure analysis presented above ¯ows has constituted perhaps the major shift in >the discrepancy between social and private thinking in discussions over the international returns), the strong empirical evidence of the ®nancial architecture during the past two years. high risks associated with short-term capital During the World Bank and IMF Annual ¯ows, and the absence of convincing evidence Meetings in Hong Kong in October 1997, of growth-enhancing bene®ts associated with shortly after the crisis began, there was a call capital account liberalization >in the short- for a change in the IMF charter to push term)Ðall these points lead one to question the through the agenda of capital account liberal- fundamental premises underlying the drive for ization.This proposal was accompanied, capital account liberalization. appropriately, by several caveats.Proponents of the change recognized that liberalization required suciently strong and stable ®nancial 5.DESIGNING EFFECTIVE institutions, which in turn meant that a strong INTERVENTIONS regulatory framework would have to be in place as a prerequisite. Hence, while 24 months ago there were calls Today, there is a greater recognition of the for full capital account liberalization, today the importance of those caveats.Even advanced debate has shifted.It is no longer whether some industrialized countries have found it dicult form of intervention might be desirable in to establish strong ®nancial institutions and principle, but whether there exist interventions e€ective regulatory structures, as witnessed by that are e€ective and that do not have adverse the ®nancial crises in Scandinavia and the ancillary e€ects.That China and India have United States.These examples show that crises managed to weather the storm and maintain COLUMBIA BUSINESS SCHOOL 9 strong growth; that China already as has been with a shortage of in¯ows, the country might alluded to several times, has managed to attract have a negative tax.But the tax structure is in huge amounts of foreign direct investment place: if global ®nancial markets recover, as while maintaining controls on short-term they almost surely will, and the country again capital; that countries that have capital market faces an excess of capital in¯ows, then the tax restrictions seem to have done as well as those rate could again be raised. that have not suggest that it is possible to Today, the IMF endorses the idea that impose such restrictions without signi®cant countries should consider such stabilizing adverse e€ects. interventions.But this is just one of many The purpose of the interventions is to equate interventions that can help stabilize ®nancial social and private costs and to stabilize the ¯ows.I would argue that, given the potentially short-term ¯ows.To understand what is at severe consequences of volatile ¯ows, the issue, an analogy may be useful.Dams do not international community should encourage stop the ¯ow of water from the top of a experimentation with other interventions.One mountain to the ocean.But without the dam, country, for instance, is discussing limiting the sudden powerful ¯ows may cause death and tax deductibility >for purposes of the corpora- destruction; with the dam in place, not only are tion income tax) of interest on foreign-denom- lives saved and property protected, but the inated, short-term debt.>This intervention has water itself can be channeled into constructive the further advantage of being largely ``self-re- uses.A dam can serve a useful role in averting a porting.'') ¯ood even if it is not perfect, i.e. even if some of the water spills over the top and makes its way >b) Capital out¯ows down the mountainside, bypassing the dam.So too for interventions in capital markets: it is not Malaysia tried a quite di€erent experiment: a valid criticism to say that they are not perfect, controls on the out¯ow of capital.Many within that there will be leaks, or that there will be the international capital markets greeted this some circumvention of the regulations or taxes. experiment with little enthusiasm or even The question is, do they nonetheless serve to explicit expressions of distaste.These rhetorical stabilize the ¯ows, and at not too great a cost to attacks typically failed to note the many the economy? More recently, attention has subtleties of Malaysian policies, including the focused on three sets of interventions: restric- provisions designed to protect interests of long- tions on capital in¯ows, restrictions on capital term investors.Recently, the country moved to out¯ows, and restrictions imposed on the a more market-based exit tax.It is too soon to banking system. evaluate the experiment, but preliminary results suggest that it has been far from the disaster >a) Capital in¯ows that the naysayers had predicted; the removal of the tax went smoothly, the country used the Chile has imposed what amounts to a tax on time provided to make signi®cant progress in short-term in¯ows.In doing so, it has succee- ®nancial and corporate restructuring >far more ded in stabilizing these ¯ows, without adversely progress than some of its neighbors), and a€ecting the ¯ow of long-term productive foreign direct investment continued at a rela- capital.>Incidentally, even a tax on capital tively strong pace. in¯ows can serve to stabilize out¯ows.Those who seek quick returns by taking their money >c) Regulating capital ¯ows out for a brief time in the hopes of a devalua- through the banking system tion, and then bringing it back, are made to pay a high price for this round trip.) The East Asian crisis highlighted the impor- Some critics have interpreted ChileÕs actions tance of the ®nancial system.Weaknesses in the in the recent crisisÐwhere the tax rate was set ®nancial systemÐgenerated, for instance, by a at zeroÐas an abandonment by that country of mismatch between foreign denominated liabil- this policy.But that is simply wrong.The point ities and domestically denominated assetsÐcan of the tax is to stabilize the ¯ow, to discourage give rise to systemic weaknesses in the entire excess in¯ows when that appears to be the economy.Observers of the crisis, however, problem.But in the global ®nancial crisis, no noted that focusing on the ®nancial system may developing country faced excess in¯ows. not be enough; after all, two-thirds of the Indeed, it might even be conceivable that, faced foreign-denominated borrowing in Indonesia COLUMBIA BUSINESS SCHOOL 10 was by corporates.Indeed, the argument was >Norway, Sweden, and Finland), it became put forward that limiting bank borrowing by clear that transparency itself would hardly itself would be like putting a ®nger into a dike. inoculate a country against a crisis.Deeper If foreign banks were o€ering highly favorable analysis further questioned the transparency terms, the pressure for foreign borrowing explanation.The a€ected countries had expe- would show up somewhere else in the system. rienced three decades of rapid and relatively Improved banking regulation might limit direct stable growth; if anything, there had been an weaknesses in the banking system, but lead to increase in transparency.Moreover, many more corporate exposure. countries that were less transparent did not This perspective, however, ignores the central have a crisis.More broadly, while improved role that the ®nancial system plays in the information >transparency) might lead to better economy, and the ability of government to resource allocations, both theoretical and exercise pervasive e€ects through the regulation empirical analyses questioned its role in of the banking system.Governments can and enhancing economic stability >see Furman & indeed should insist that banks look at the Stiglitz, 1999a,b).Enthusiasm for the trans- uncovered exposure of ®rms to which they have parency agenda in some quarters was further lent.For that >uncovered) exposure can a€ect eroded when it was pointed out that to be greatly the likelihood that the ®rms to which meaningful, transparency had to be compre- they have lent will not be able to repay their hensive, including o€-shore banking and hedge loans.Again, Malaysia provides a case in point: funds, and possibly even the actions of central bank regulations succeeded in limiting exposure bankers! of Malaysian ®rms.In principle, the bank A second major strand of reforms focused on regulations can be market-based; that is, bank strengthening of ®nancial institutions.Again, regulators could impose risk weights in the while desirable, the diculties that even capital adequacy requirements so that loans to advanced industrial countries had in establish- ®rms with high exposure received higher risk ing strong ®nancial institutions suggested that weights.Thus, banks would only make loans to this would remain a long-term challenge in such ®rms if they received an interest rate high emerging markets.A host of other reformsÐ enough to compensate them for the higher costs from collective action clauses in bonds, to >and risks).But no government imposes the systemic bankruptcy provisions, to improved kind of sophisticated risk-based capital ade- corporate governanceÐwere put on the table. quacy standards that this would imply; in the Some, like the collective action clauses, received near term, emerging markets are probably active opposition.Some, like systemic bank- better served by employing simple regulatory ruptcy provisions, involved matters that were structures. too technical to receive widespread discussion. In some areas, such as improved corporate governance, progress seemed likely, though 6.CONCLUDING REMARKS their role in the crisis may have been overblown >see Stiglitz, 1999). In the aftermath of the global ®nancial crisis The one area in which there is an emerging and the recognition of the high costs that those consensusÐa major change in perspectivesÐis in the developing world have had to pay, there short-term capital ¯ows.The risks are recog- emerged extensive discussion of a new global nized to be greater, the bene®ts lower, the economic architecture.Everyone agreed that circumstances in which countries should engage attention should be focused on preventing in full liberalization more restrictive than was future crises, though upon further re¯ection, the case before the crisis.Given the growing the goal became modi®ed to making such crises body of theory, evidence, and experience less frequent and less deep.Early discussions against full capital account liberalization, the focused on improving transparency, though speech of the Managing Director of the IMF, nearly everyone recognized that most of the Michel Camdessus, before the Annual Bank- relevant information >e.g., the high leverage of Fund Meetings in Hong Kong in September KoreaÕs ®rms and the heavy investment in the 1997, raised fundamental questions.There he highly cyclical chip industry) was already argued, readily available.When it was further observed that the last major set of crises occurred in Freedom has its risks! LetÕsgothen for an orderly three of the most transparent countries liberalization of capital movements.....the objective COLUMBIA BUSINESS SCHOOL 11

is to foster the smooth operation of international stability and poverty? If that is the case, is there capital markets and encourage countries to remove a more fundamental problem in the interna- controls in a way that supports the drive toward tional economic architecture, going beyond the sustainable macroeconomic policies, strong mone- details discussed above, to issues of account- tary and ®nancial sectors, and lasting liberaliza- tion. ability and representativeness? Do those making decisions that a€ect the lives and live- lihoods of millions of people throughout the Are international policies in this area being world re¯ect the interests and concerns, not just designed on the basis of the best available of ®nancial markets, but of businesses, small economic theories and evidence, or is there and large, and of workers, and the economy another agenda, perhaps a special interest more broadly? These are the deeper questions agenda, seemingly impervious to the e€ects of posed by the crisis through which the world is such policies, not only on growth, but on just emerging.

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