ANNALS, AAPSS, 579, January 2002

RISKTHE ANNALS WITHOUT OF REWARD THE AMERICAN ACADEMY

Capital Market Liberalization and Exchange Rate Regimes: Risk without Reward

By JOSEPH E. STIGLITZ

ABSTRACT: This paper examines the consequences of capital mar- ket liberalization, with special reference to its effects under different exchange rate regimes. Capital market liberalization has not lead to faster growth in developing countries, but has led to greater risks. It describes how International Monetary Fund policies have exacer- bated the risks, as a result of the macro-economic response to crises, with bail-out packages that have intensified moral hazard problems. The paper provides a critique of the arguments for capital market lib- eralization. It argues that capital flows give rise to large externali- ties, which affect others than the borrower and lender, and whenever there are large externalities, there is potential scope for government interventions, some of which are welfare increasing.

Joseph E. Stiglitz holds joint professorships at Columbia University’s Economics Department, School of International and Public Affairs, and Business School. From 1997 to 2000 he was the World Bank’s Senior Vice President for Development Economics and Chief Economist. From 1995 to 1997, he served as Chairman of the U.S. Council of Economic Advisers and a member of President Bill Clinton’s cabinet. He was previously a professor of economics at Stanford, Princeton, Yale, and All Souls College, Oxford. He was awarded the Nobel Prize in Economics in 2001 for his analysis of markets with asymmetric information.

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OR almost half a decade, capital well as fuel for nuclear reactors). F market liberalization raged as Only capital market liberalization— the prime battleground between eliminating the restrictions on the those who were pushing for and free flow of short-term capital—re- against globalization, and for good mained as a point of contention. At reason: By the mid-1990s, the notion its annual meetings in Hong Kong, that free trade or at least freer trade the International Monetary Fund brought benefits both to the devel- (IMF) sought to settle this issue too: oped and the less developed coun- it asked for a change in its charter, to tries seemed well accepted. Presi- give it a mandate to push for capital dent Clinton could claim passage of market liberalization, just as it had a NAFTA and the Uruguay Round, mandate, in its founding, for the with the establishment of the World elimination of capital controls that Trade Organization, among the ma- interfered with trade. jor achievements of his first four The timing could not have been years. APEC and the Americas had worse: the East Asia crisis was brew- both committed themselves to creat- ing. Thailand had already suc- ing a free-trade area. Not only had cumbed, with a crisis that began on the intellectual battle been won— 2 July. The delegates to the Hong only special interests resisted trade Kong meeting had hardly unpacked liberalization—but so seemingly had their bags on returning home when the political battle. On other fronts, the crisis struck in Indonesia. Within the broader liberalization/free- a little more than a year, it had market agenda was winning victory become a global economic crisis, after victory: the Uruguay round had touching virtually every corner of the extended the scope of traditional globe, with bailouts billed at more trade liberalization to include liber- than 150 billion dollars occurring not alization in financial services, the only in Thailand and Indonesia, but protection of intellectual property Korea, Brazil, and Russia. And it was rights, and even investment. Al- clear that hot, speculative money— though the Multilateral Investment short-term capital flows—was at the Agreement was having trouble, in- heart of the crisis: if they had not vestment protections in NAFTA caused it, they at least played a cen- were cited as a basis on which further tral role in its propagation. The only agreements could be reached. Even two large emerging markets to be “liberal” governments—the demo- spared the ravages of the global cratic administration in the United financial crisis were India and States, the labor government in Brit- China, both of which had imposed ain—embraced privatization and de- capital controls. (Even as the global regulation, with the United States economy faced a major slowdown, going so far as to push through the China managed to grow by more privatization of the corporation mak- than 7 percent, India by more than 5 ing enriched uranium, the core ingre- percent). Malaysia had imposed capi- dient in making nuclear weapons (as tal controls to help it manage its way RISK WITHOUT REWARD 221 through the crisis, and as a result, its both about economics and politics. It downturn was shorter, and as it is precisely because the disjunction recovered, it was left with less of a between the positions that the IMF legacy of debt than the other coun- took and the theory and evidence tries because it had imposed capital concerning capital market liberaliza- controls. By the time matters settled tion, between their mandate to pro- down, the IMF had markedly mote global stability, and the policy changed its tune: its chief economist which seem so patently to lead to (Mussa 2000) admitted that finan- global instability was so great that cial market liberalization could have the debate on capital market liberal- markedly adverse effects on less ization throws into such stark relief developed countries that were not broader aspects of the globalization adequately prepared for it (in the controversy.(In other arenas, such as view of many economists in the trade liberalization, theory and evi- developing world, this meant virtu- dence are more ambiguous, and ally all developing countries).1 It while the IMF may have pushed poli- admitted that its predictions (and cies that could not be defended as those of the U.S. Treasury) that fulfilling its mandate, neither could Malaysia’s imposition of controls they, by and large, be criticized would prove to be a disaster had been for actually going against their wrong—they had succeeded in spite mandate.) of what might have seemed as efforts The consequences of capital mar- to undermine the country through ket liberalization depend, of course, public criticism of an almost unprec- in part, but only in part, on the 2 edented nature. exchange rate regime, which is the But while the intellectual battle focus of many of the articles in this was thus seemingly over,the political issue. But before turning to that battle continued: the managing issue, it is important to understand director of the IMF, Michel Cam- the more general case against and for dessus, continued pushing for capital capital market liberalization. Ac- market liberalization in his annual cordingly, in this article, I propose speeches until his departure from the first to explain the strength of the IMF. And countries that propose opposition to capital market liberal- going back on capital market liberal- ization: it increases the risks facing a ization are strongly advised against country while it does not promote it—to the point of implicit or explicit economic growth. Given the over- 3 threats of having programs cut off. whelming theory and evidence But these political battles are, for against capital market liberaliza- the most part, going on behind the tion, one wonders: how could the scenes. The more visible political major international organization debate has moved back to issues responsible for promoting growth thought at one time settled—for and stability have promoted a policy instance, to trade and intellectual that seemed so contrary to its objec- property rights. Still, revisiting that tives? I first review the arguments earlier debate has much to teach us, that were put forward for capital 222 THE ANNALS OF THE AMERICAN ACADEMY market liberalization. I then turn to nature of such studies is highlighted the deeper political economy ques- by the contradictory results that tions, exploring the role of ideology have been obtained in the trade liber- and interests. I conclude by arguing alization literature, with scholars that at the root of the problem is gov- like Sachs and Warner (1995) argu- ernance: the governance structure of ing that trade liberalization is sys- the IMF led it to push for policies that tematically associated with growth, were contradictory to its mandate for and others, like Rodriguez and promoting global stability and that Rodrik (1999), questioning the reflected the interests and ideology of results. The results are highly sensi- those to whom it was directly tive to issues like how to weight the accountable. There is, in this, an experience of different countries and important lesson for the evolving how to separate causal factors with globalization debate, to which I turn mere association. For instance, briefly in the concluding section. China with its more than 1 billion people has been the fastest growing THE ECONOMIC CASE developing country in the world; AGAINST CAPITAL growth in China accounts for a sub- MARKET LIBERALIZAITON stantial fraction (by some accounts, two-thirds or more) of total growth The evidence is that capital mar- among the low-income countries. But ket liberalization is not associated should China—which did not liberal- with faster economic growth or ize—be given the same weight in the higher levels of investment but is analysis as some small country in associated with higher levels of eco- Africa with a couple million people? nomic volatility and risk. And, in If some of these small countries grew general, the poor bear the brunt of slightly faster, some grew slightly much of this risk, especially in devel- slower,and on average, those who lib- oping countries, where safety nets eralized grew slightly faster, are we (like unemployment insurance sys- to infer that liberalization is an tems) are nonexistent or inadequate. important ingredient in growth— when the world’s major success story, Growth with growth a multiple of that of any Ascertaining whether trade liber- of the African countries, did not liber- alization, or capital market liberal- alize? The matter can be put another ization, leads to faster economic way: if one treated the separate prov- growth is not an easy matter. A stan- inces of China as separate data dard, though widely discredited, points—and they are each large, methodology entails looking at the many times the size of the average growth rates of different countries, African states, and each followed attempting to ascertain whether slightly different policies—then the those who have liberalized more or twenty fastest growers in the past faster have grown faster, controlling two decades are all in China. A study for other factors that might have that treated these provinces as units affected growth. The problematic of analysis might conclude strongly RISK WITHOUT REWARD 223 that liberalization was not good for risks, may say a great deal about the growth, while a study that treated nature of the organization, a point to China as a single data point might which we return later. conclude that it was. But there is, perhaps, a simpler There are other statistical prob- reason: Rodrik’s (1998) study merely lems. Assume it were the case that corroborated what was obvious, both countries that did not liberalize, on empirically and theoretically. It was average, were more authoritarian not only China that had grown rap- and that authoritarianism is bad for idly without capital market liberal- growth; but in the statistical analysis ization; India, too, had experienced of growth, no measure of authoritari- rapid growth over the 1990s, and it anism was included, or a measure too had not liberalized. Russia had that did not capture the relevant liberalized, and the liberalization dimensions of a multidimensional had led not to a flow of capital into political construct. Then, the statisti- the country but to massive capital cal analysis might conclude that lib- flight, and the country’s GDP had, eralization was good for growth, partly as a result, plummeted by when the correct conclusion is that more than 40 percent, a decline that nonauthoritarian political struc- was reflected in socioeconomic statis- tures, appropriately defined, are tics, such as marked shortening of good for growth. life spans, and in data, collected What was most remarkable about through household surveys, showing the drive for capital market liberal- an increase in poverty from around ization from the IMF was that at the 2 percent to between 25 percent and time they pushed for this change in 40 percent, depending on the mea- the global economic architecture, sure used. there was no study even of the cross- But these results should not have country statistical kind that sup- come as a surprise. Growth is related ported trade liberalization, as dis- to investment, to new enterprises credited as those studies might be, and old enterprises expanding. Such which provided empirical evidence in investments cannot be based on spec- support of capital market liberaliza- ulative money that can come into and tion. The one widely cited study by out of a country on a moment’s notice. Rodrik (1998)—using the IMF’s own On the contrary, the high volatility measures of liberalization—showed associated with such flows de- that it did not lead to faster economic stabilizes the economy, as we shall growth. One might have thought that see in the next section, and the the IMF would have made a major higher economic volatility makes effort to refute Rodrik’s study and to investment less attractive. present countervailing studies show- There is another channel through ing the contrary. That they did not, which capital market liberalization and that they seemingly did not feel hurts growth. The flow of funds into the need to refute the even more com- the country leads, under flexible ex- pelling evidence showing that capital change rates, into a higher exchange market liberalization led to greater rate, making it more difficult for a 224 THE ANNALS OF THE AMERICAN ACADEMY country to export or compete against unlikely to have a substantial posi- imports (a version of the so-called tive effect on the growth of the Dutch disease problem). In some developing country.5 cases, such as Thailand, the funds helped feed a speculative real estate Risk boom, which distorted the economy. The rapid movement of funds into To prevent inflation, to sterilize the and out of a country is clearly inflow of funds, which might other- destabilizing, a point brought home wise have led to an excess demand for forcefully by the East Asian crisis, goods, the monetary authorities had where the capital outflows exceeded to raise interest rates, which stifled 4 in some cases 10 percent of GDP. investment in other sectors. The dis- Flows of that magnitude (equivalent tinction between foreign direct to close to $1 trillion for the United investment and these short-term States) would be highly disruptive, flows could not be clearer.The foreign even in a country with strong finan- direct investment leads directly to an cial markets. The effects on develop- increase in GDP and in employment; ing countries have been devastating. it brings with it new technology, Empirical studies have shown access to markets, and training— that there is a systematic relation- none of which accompany specula- ship between capital market liberal- tive portfolio flows. ization and instability (see Demirgüç- There is another way of seeing the Kunt and Detragiache 1997, 1999). adverse effects on growth: today, The period immediately following countries are told to keep reserves liberalization is one in which risk is equal to their foreign denominated particularly marked, as markets short-term liabilities. Consider the often respond to the new opportuni- consequence of a company within a ties in an overly exuberant manner, poor small country borrowing money as they see previously closed oppor- from an American bank $100 million tunities opened up. The increased in dollars short term, paying say macro-economic risk would imply a 18 percent or 20 percent interest. The necessity for increased monitoring of country then is forced to put a corre- financial institutions, as the fran- sponding amount in reserves— chise value, the expected present dis- money that could have gone toward counted value of future profits, is high-return investments in schools, likely to be eroded given the higher health clinics, roads, or factories. The probability of an economic downturn; reserves are held in the form of U.S. and in the absence of increased moni- treasury bills, yielding 4 percent. toring, the higher level of risk taking In effect, the country is lending itself would contribute to greater $100 million to the United States at 4 instability. Unfortunately, typically percent and borrowing it back again governments have not done a better at 20 percent—at a net cost of $16 job of regulation, for two reasons. million a year to the country,a trans- Often, the capital market liberaliza- action that clearly might be good for tion is in response to external pres- growth in the United States but is sure (e.g., from the IMF or the United RISK WITHOUT REWARD 225

States), and that same pressure has than any of the OECD countries. If been accompanied by pressure to lib- they were vulnerable, it was a newly eralize financial markets, that is, acquired vulnerability because of the remove restrictions that, in part, capital and financial market liberal- result in less exposure to risk (the ization that had been foisted on these elimination of Thailand’s restric- countries. tions on speculative real estate IMF responses exacerbated the investments are a case in point). Sec- risk. The nature of the response to a ond, the process of liberalization has crisis affects the consequences, been accompanied by huge increases including who bears the burden. In in demand for the relatively few the case of the East Asia crisis, the trained personnel, many of whom IMF responded with fiscal contrac- worked for the regulatory authorities tions and monetary tightening, and the central bank; the public sec- which deepened the economic down- tor simply cannot compete in paying turns and failed in their intended salaries against the private sector. effects of sustaining the exchange Hence, just at the time when the need rate. In addition, the restructuring for improved regulation is greatest, strategy, which involved closing the country’s capacity is reduced (see financial institutions (in the case of Hellman, Murdock, and Stiglitz Indonesia, closing sixteen banks, 1996). with an announcement that more Capital market flows to which cap- were to follow, but that depositors ital market liberalization gave rise would not have their deposits guar- are now recognized to be the pivotal anteed, leading to a run on the bank- factor in the East Asia crisis.6 But ing system), led to a further collapse there have been more crises that in the supply of credit; and the more have been deeper and longer lasting hands-off corporate restructuring in the past quarter century—more strategies meant that corporate dis- than one hundred countries have tress was addressed at an extremely been afflicted (see Caprio and slow pace—four years after the crisis, Klingebiel 1996; Lindgren, Garcia, between 25 and 40 percent of Thai and Saal 1996), and it is apparent loans remained nonperforming. that the trend toward increased capi- The failure was predicted by econ- tal and financial market liberaliza- omists within the World Bank, and tion has been a key factor. The IMF the reason was obvious: given the and U.S. Treasury suggested that the high leverage, the high interest rates East Asian countries were vulnera- forced many firms into distress and ble because of a number of structural worsened the problems of the finan- failings; on the contrary, these coun- cial institutions. The combination of tries had performed better over the the normal Keynesian demand-side preceding three decades, not only in and supply-side contractions proved terms of growth but also in stability: devastating. Although at this junc- two of the affected countries had had ture, the IMF admits several of the only one of economic downturn, two failures, on the critical issue of mone- had had none, a better performance tary policy it remains adamant. It 226 THE ANNALS OF THE AMERICAN ACADEMY believes that higher interest rates country, bolstering the exchange lead to a capital inflow that supports rate. In fact, the economic disruption a country’s currency, evidently even not only does not attract funds into in circumstances such as those of the country but also leads to massive East Asia with high levels of lever- capital flight. Lenders care not just age, in spite of the absence of evi- about the interest rate promised but dence in support and some evidence also about the probability of being against and in spite of the over- repaid; it was concern about default whelming theoretical arguments that led banks to refuse to roll over against the policy. The statistical their loans. Thus, this was a variable analyses of whether raising interest of first-order importance—but left rates leads to higher exchange rates out from the IMF analyses. The poli- is even more problematic than the cies increased the probability of cross-country regressions referred to default so that the total impact was earlier. Here, the critical issue is to to make it less attractive to put funds 7 identify the appropriate counter- into the country. factual, that is, what would have hap- The important point is this: hav- pened but for the policy. It is clear ing failed to identify the reasons for that the IMF interventions in East their admitted failures in their fiscal Asia, which included not only the and financial policies and having high interest rates but also massive even refused to acknowledge the mis- bailouts and contractionary fiscal takes in monetary policy means that policies, did not prevent a slide in the in the future, the mistakes are likely exchange rates; indeed, looking at to be repeated so that countries can exchange rate movements, it is hard anticipate facing major economic to detect evidence of interventions downturns in the event of a crisis. having any positive impact. It is, of There are further aspects of IMF course, possible that the mistaken responses that exacerbated the part of the IMF packages systemati- downturn in Indonesia. Even in the cally undermined the positive effects best of circumstances, major eco- of the interest rate policies, or that nomic downturns can give rise to just at the moment of the interven- political and social turmoil. In the tions, the pace of decline in exchange case of ethnically fractionated societ- rate would have accelerated, and this ies, such turmoil is even more likely acceleration was reversed by the (see, for instance, Collier and interventions. But neither of these is Hoeffler 1998). A perception that the plausible, and a more detailed analy- burden is borne unfairly by the poor sis of interest rate increases in other increases the likelihood of turmoil crises does not suggest that they are even more. I predicted in early very effective instruments (see December 1997 at a meeting of Furman and Stiglitz 1998a). The the- finance ministers and central bank oretical arguments put forward by officials at Kuala Lumpur that if the the advocates of this policy are not IMF maintained its macro-economic compelling: the higher interest rates policies in Indonesia, there was a are supposed to attract funds into the high probability of such turmoil RISK WITHOUT REWARD 227 within six months. I argued that even essential part of limited liability cor- if the IMF did not care about social porations. (Critics pointed out that costs, especially those borne by the while the IMF was willing to put up poor, it was simply bad economic pol- billions to preserve the sanctity of icy. All that the head of the IMF, who the debt contract, it was reluctant to was in attendance, could say in reply put up the millions needed to pre- was that the country had to bear the serve the social contract, for example, pain. I was perhaps overly optimistic: the food and fuel subsidies for the riots, every bit as bad as my worse poor, and the social and economic fears, broke out within five months. consequences of the abrogation of the But I had not anticipated that just as social contract were far more severe the economy was plunged into than the consequences of bankruptcy depression, with unemployment could possibly have been.) Bank- soaring and real wages plummeting, ruptcy (or a debt moratorium) would food and fuel subsidies for the very have relieved downward pressure on poor would be cut back. Evidently, the exchange rate (see Miller and the IMF could provide billions to bail Stiglitz 1999)—indeed, it was only out Western banks and lenders, but with the essentially forced rollover of there were not the measly millions Korea’s debt that its exchange rate required to finance subsidies for the was stabilized. Those who opposed very poor. The outrage was under- such policies said that it would be standable and the consequences long impossible to engineer them, but lasting: it will take years before that Korea showed that that was wrong. country recovers to its precrisis level. They argued that capital would not There were other aspects of IMF flow back into the country, and that policies that exacerbated the down- was partially irrelevant, partially turns. In East Asia, the debt was just wrong, both in terms of theory largely private. When private parties and evidence. Capital was not going cannot meet their obligations, the to be flowing into these countries in normal mechanism by which the the short run in any case. And the problem is handled is bankruptcy. countries in East Asia, given their (Sovereign defaults pose special high savings rate, had little need for problems, which is why it is impor- capital even in the longer run. But tant to note that the debt in East Asia capital markets are forward looking: was private. The governments them- there is not a single participant who selves had been running surpluses.) can decide to punish someone who But the IMF was dead set against does not obey his strictures. Rather, bankruptcy and facilitating the pro- there are a multitude of participants, cess of debt workout, for example, each of whom must decide on through a debt moratorium. Its first whether the return is sufficient to deputy managing director referred to justify the risk. A country in deep bankruptcy as if it were an abroga- recession, with a large overhang of tion of the debt contract, failing to debt, public and/or private, is less note that bankruptcy was at the core likely to attract funds than a country of modern capitalism and was an that has put the past behind it. More- 228 THE ANNALS OF THE AMERICAN ACADEMY over, why should investors hold a developing countries, these sectors new government to blame for mis- predominate. In some less developed takes made by past governments; if countries, flexible labor markets anything, a new government that has imply that reductions in the demand rectified the problems of the past will for labor do not show up in the form of gain in credibility. All of these pro- unemployment but are reflected in vide part of the reason that countries changes in real wages. But the reduc- that default do regain access to inter- tions in real wages may be very national capital markets, and often large—in some of the countries in after a remarkably short time—per- East Asia, real wages fell by more haps more determined by the time it than a quarter. takes to restore economic stability One of the important arguments and growth prospects than anything to emerge from the 2000 World De- else. velopment Report (World Bank 2000) One country in the region took an is that the poor are not only alternative course; after first flirting adversely affected by lower incomes with an IMF program without the but also by higher insecurity. De- IMF, Malaysia imposed capital con- prived of the instruments with which trols. Its downturn was shorter, and to deal with economic volatility,their it was left with less of a legacy of debt, lives are particularly affected by the as a result. In the next section, we instability that is associated with 9 shall explain why, but first, I want to capital market liberalization. discuss briefly some of the conse- Moreover, extended periods of quences of the increased risk, besides high unemployment and low wages the adverse effect on growth that I can have a devastating effect in have already discussed. undermining social capital, the social fabric that enables a society, and a market economy, to function—wit- The consequences of increased ness the increase in urban violence in macro-economic risk. Normally, as Latin America following the debt cri- countries go into a downturn, it is the sis. Not only are there severe social poor who disproportionately bear consequences, but the social instabil- those costs. Their unemployment ity provides adverse conditions for rate goes up more,8 perhaps because investment and thus growth. employers value of the firm-specific human capital of the more skilled The defenses workers, and as their demand for la- bor decreases, they would rather re- Given the overwhelming theory deploy them to less skilled jobs and evidence against capital market rather than having them leave the liberalization, one might wonder, on firm. what grounds did the IMF argue in Less developed countries typically its favor? While they refused to have limited safety nets. Even in refute the arguments put forward developed countries, unemployment above, in particular, never address- insurance in the self-employed and ing the issue of the impact of liberal- agricultural sectors is limited, and in ization on the poor, they argued that RISK WITHOUT REWARD 229 capital market liberalization en- has not liberalized its capital market, hanced growth and actually reduced and yet has been able to attract more risk! foreign investment than any other emerging market. Growth. Underlying the analysis The second is more subtle. It is a simple analogy: free mobility of argues that capital market liberal- capital is like free mobility of goods; ization provides an important disci- and just as free trade increases in- pline device—countries that fail to comes, so too does free mobility of pursue good policies are quickly pun- capital. But capital markets are dis- ished, and thus capital market liber- tinctly different from goods markets. alization helps keep countries on a Risk and information are at the solid path of economic reform. center of capital markets: capital Underlying this argument is a highly markets are concerned with the ac- antidemocratic bias: the belief that quisition, analysis, and dissemina- democratic processes provide an tion of information; with making inadequate check and the willing- choices about how to allocate of ness to delegate discipline to foreign scarce capital to investment opportu- financial interests. But the argument nities; and with spreading, sharing, is more problematic. If one is to and pooling risks. Markets for infor- choose an outside disciplinarian, one mation are markedly different from wants one that punishes one if and markets for goods. While with perfect only if one has “misbehaved.” But as information and perfect risk, compet- many countries—for example, in itive markets are in general (pareto) Latin America—learned with great efficient, with imperfect information pain, with capital market liberaliza- and incomplete risk markets, mar- tion, they can be punished even if kets typically do not behave in the they do everything “right.” If emerg- way predicted by standard competi- ing markets fall from favor, in the tive models, and market equilibrium inevitable vicissitudes that charac- is in general not (constrained pareto) terize capital markets, then even the efficient.10 Thus, while there may countries that have been awarded A’s be some presumption that trade lib- from the IMF are punished. Equally eralization may be welfare improv- bad, capital markets may have cer- ing,11 there is little basis for tain biases—they may, in the first presuming that liberalization in fi- stance, overreact to certain actions a nancial and capital markets is wel- country undertakes and fail to react fare improving.12 to other actions. There are two more specific argu- This point may be highlighted by ments that the advocates of capital considering the consequences of dele- market liberalization put forward. gating the responsibility of “discipli- One is patently wrong: that without narian” to labor markets. Labor mar- capital market liberalization, coun- kets might discipline a country for tries will not be able to attract the following bad environmental policies foreign direct investment, which is so with a rush of skilled labor out of a important to economic growth. China country should it decide, for instance, 230 THE ANNALS OF THE AMERICAN ACADEMY to allow arsenic in its water supply. Risk. They argued that capital The choice of a disciplinarian deter- market liberalization would reduce mines what a country is to be risk, enabling countries to have ac- rewarded, or punished, for—and cess to outside funds in the face of a therefore affects what a country does threatened economic slowdown. Di- or does not do. It affects the very versification of the source of funding nature of the evolution of society. would enhance economic stability. Who gets to play the role of disci- What was remarkable about this ar- plinarian is affected by mobility. gument was the overwhelming em- Capital market liberalization does pirical evidence against it, even at give capital markets more power, in the time it was put forward: short- this sense. And in doing so, it affects term flows of funds are procyclical, the ability of society to redistribute: exacerbating, not dampening, eco- any threat to increase the taxes on nomic fluctuations. As the expression capital can result in quick retribu- goes, bankers are most willing to pro- tion in the form of the withdrawal of vide credit to those who do not need funds. Whether such funds contrib- it; and as a country faces a downturn, 14 ute to the long-term growth of the bankers withdraw credit. economy is not the issue: the with- drawal of funds can impose enor- Externalities and mous costs, especially in the context capital controls 13 of the IMF-style responses. Thus, today, there is widespread Enhancing the mobility of capital agreement that capital flows impose thus has real consequences: it affects huge costs on others—on innocent bargaining positions and the out- bystanders, small businesses, and come of bargaining processes in ways workers who neither participated in that are advantageous to capital and nor benefited from these flows. They disadvantageous to labor. impose huge externalities. Whenever The argument that capital market there are externalities, there are liberalization was good for growth standard remedies—government was, to be sure, fairly unpersuasive interventions—that can take a vari- in the context of the countries in East ety of forms, for example, regulatory Asia, where domestic savings rates or tax. There is a large literature were very high. Although the coun- addressing the relative merits of var- tries did an impressive job in invest- ious forms of intervention.15 ing these savings productively, little One of the standard objections to argument could be put forward that these interventions is that they raise additional funds from more devel- the cost of funds, especially short- oped countries would substantially term funds. But that objection is like increase growth. the steel industry complaining that In the face of this, the IMF and the taxes on pollution will discourage the U.S. Treasury used an even more production of steel. It will—but that peculiar argument. is precisely the point. Efficiency RISK WITHOUT REWARD 231 requires that the marginal social cost in the meanwhile, the drivers needed of production equal the marginal to be better trained. Critics respond- social benefit; and the steel industry, ed that roads and cars have to be in its private calculations, does not designed for ordinary mortals; if only include the social cost of pollution. those with years of experience as Once that is included, production racetrack drivers can survive, then should be reduced. So too, since there something is fundamentally wrong. is a large social cost associated with Moreover, they suggested that the short-term capital flows (and ques- only repair work on the road system tionable social benefits), these capi- that the international community tal flows should be discouraged. had proposed was better road signs (improved information)—and even The battle of the metaphors. While that initiative was halfhearted and the economic case for some form of in- incomplete, as the United States tervention is compelling, opponents refused to allow the posting of signs (and proponents) of intervention at the most dangerous turns (disclos- have often resorted to metaphors and ing information concerning the activ- false analogies to help “prove” their ities of hedge funds and offshore point. We have already disposed of banking centers). one such: the argument that the free Another popular metaphor lik- flow of capital is just like the free flow ened small developing countries to of goods; and just as free trade is wel- small boats on a rough and wily sea. fare enhancing, so are free capital Even if well designed and well cap- movements. tained, they are likely eventually to One popular metaphor has be hit broadside by a big wave and involved the automobile. Critics of turned over. But the IMF program of capital market liberalization have capital market liberalization had set argued that capital market liberal- them forth into the most tempestu- ization, at least for most developing ous parts of the sea, in boats that countries, is like giving a teenage kid were leaky, without life vests or a high-powered car before making safety nets, and without training. sure that the tires were in good con- Still a third metaphor involved dition and before installing seatbelts, aviation: the undersecretary of Trea- let alone airbags. They noted that sury (who at one time, before he had when there was an isolated accident taken up the job of representing Wall on a highway, one might infer that Street’s interests, had argued that the problem was with the driver, but failing to regulate capital markets when there were repeated pile-ups at was like failing to regulate nuclear the same bend in the highway, the power plants—doing either was an problem was more likely with the invitation to disaster) used to argue design of the road. Supporters of cap- that simply because planes occasion- ital market liberalization responded ally crash was no reason to give up that the appropriate response was to flying. But critics responded: but if a widen the highway, not to return to particular model of a plane consis- the days of the horse and buggy, and tently crashed, one would want to 232 THE ANNALS OF THE AMERICAN ACADEMY ground it; and all governments take managed of developing countries, it strong policies to ensure that those had become clear that the rhetoric who fly planes are well trained, and blaming the countries of East Asia those who fly more powerful planes for the crisis had been largely self- have better training. And one cer- serving. By the same token, the pri- tainly wanted to be particularly care- vately financed but government ful in flying over territory where the engineered bailout of the world’s terrain was particularly rough since largest hedge fund, Long Term Man- the dangers of a crash landing agement Corporation, on the were then particularly severe, and grounds that the failure of this one even more so if the inhabitants in firm would exacerbate markedly the the territory had a penchant for global financial crisis, provided the cannibalism. answer to the IMF study arguing The metaphors, of course, were that speculative hedge funds did not hardly a substitute for deeper eco- play an important role in the 1997 nomic analysis. But, especially when crisis, partly because they were sim- accompanied by such an analysis, ply too small to do so—and further they helped bring home the concerns undermined the credibility of those and the depth of passions, on both who claimed that capital market lib- sides. For instance, the fact that, as eralization had little to do with the Paul Volcker, former governor of the instability. The sad fact, though, was Federal Reserve Bank, emphasized, that advocates of capital market lib- the total stock market of a country eralization had forced developing like Thailand was smaller in size countries to liberalize, without any than a medium-sized American com- analytic basis showing that it would pany like Home Depot, and that even be good for growth, ignoring the the- when well managed, such companies ory and evidence that it imposed experience huge volatility in their enormous risks, without a clear set of market value, brought home the guidelines for the circumstances in point that the developing countries which countries might be able to bear those risks, and without a set of pre- were like small boats on a rough sea. scriptions for how they might pre- Analytic studies showing that most pare themselves appropriately for of the shocks that developing coun- dealing with them. tries experience were external— caused, for instance, by sudden The purposes of interventions changes in investor sentiment in the more developed countries, having Having established that, in princi- nothing to do with the particular pol- ple, some form of intervention is icies and events in their particular desirable, the next natural question country—provided the answer to the is, are there forms of intervention charge that the problems were of the where the benefits exceed the costs, country’s own making; and by the that is, there are not ancillary costs time the East Asian crisis of 1997 that more than offset the benefits, or had become the global financial crisis in which evasion is not so large that of 1998, touching even the best the benefits are largely eroded? RISK WITHOUT REWARD 233

Interventions by Chile, Malaysia, stop every flood, it can contribute and China, among others, showed greatly to increased well-being. that at least some countries could Most of the well-known ways of manage such interventions well and avoiding many forms of capital mar- that they could take on a variety of ket controls (discussed below) do not forms. These countries demonstrated undermine the ability of such inter- that these interventions need not ventions to stabilize flows, for most of hinder economic growth—or even the evasion tactics (e.g., under- and the ability of a country to attract for- overinvoicing) work slowly. They are eign funds—but they could help more like the flows of water going ensure economic stability.Before dis- around the dam; in the long run, the cussing the alternative interven- aggregate amounts may be signifi- tions, it is desirable to describe the cant, but in the short run, the flows multiple purposes that such inter- are still moderate, and it is the huge ventions might serve. flows that cause the problem.

Stabilizing capital flows. The on- Dampening the rush of capital out rush of short-term capital into a of a country. In the event of a crisis, country poses two problems: first, it there may be an irrational pessi- can result in inflationary pressures; mism, matching the irrational exu- and second, such money can leave a berance that brought the capital into country just as fast as it can enter, the country. Policies designed to leaving in its wake economic devas- make it more difficult or more costly tation. On purpose of intervention is for capital to leave a country slow the to stabilize the flows. Note that inter- rush of capital out; and, like the cir- ventions designed for this purpose cuit breakers that have been put into (or several of the other purposes de- stock markets, the extra “pause for scribed below) do not have to be per- reflection” can have large positive ef- fect to be effective. Two metaphors fects. Before they fully work out bring this point home: a leaky um- mechanisms for avoiding the con- brella can still be useful in a thunder- trols, matters are seen in a calmer storm; even if one gets damp, it is light—and markets themselves may better than being drenched. The pur- have calmed down. pose of a dam is not to stop the flow of water from the melting of snow from Designing more effective and lower the mountaintop to the ocean but cost stabilization measures for the merely to stabilize it; without the economy. In simple models, where dam, the onrush of water can cause there is free flow of capital, there is death and destruction; the dam can little scope for monetary policy. A de- convert this natural disaster into a crease in interest rates leads to a source of water for food and suste- rush of capital out of the country. nance. Even with a good dam, there Thus, governments must rely on can be spillage; some of the water can costly fiscal policy measures to stim- go around the dam. Even if it does not ulate the economy in the event of an 234 THE ANNALS OF THE AMERICAN ACADEMY economic downturn. If, however, increases economic volatility means there are effective restrictions on that the return that it must receive— short-term capital movements, then to compensate it for the risks that it monetary policy can be used. This itself has caused—is higher. Hence, has benefits both in the short run and capital market liberalization can the long, as Malaysia so forcefully drive up the before-tax returns at the showed. Reliance on fiscal policy same time that it reduces the scope forces governments to have large def- for taxation. icits, which can put a damper on fu- ture growth. Financing the deficit is Preventing massive capital out- also problematic in countries with flows. The rush of capital out of Rus- limited access to foreign borrowing. sia has played an important role in Government borrowings crowd out the economic demise of that country; private investment, with the net af- China’s investing its huge savings in- fect on recovery limited. At the high side the country has similarly been interest rates, lending to firms be- critical in its success. With open capi- comes particularly risky (Stiglitz- tal markets, the oligarchs in Russia Weiss 1981), and banks prefer what were posed with a simple choice: they perceive to be relatively safe where in the world to invest their loans to government. In countries wealth—whether in Russia, which where many firms have high lever- was going into a prolonged depres- age, the high interest rates induce sion of an almost unprecedented massive corporate distress, weaken- scale, or in the United States (say), ing the banking system and reducing which was, at the time, experiencing its ability to lend even more. The cost one of the strongest expansions in its to the public of resolving the corpo- history, with a stock market boom to rate and financial stress is all the match? The fact that the wealth of larger, again with adverse effects on the oligarchs was widely perceived to the country’s future growth. be ill-gotten, based on political con- nections in a process of privatization Providing greater scope for without political legitimacy, and redistributive taxation. The irony is therefore (rightly perceived) subject that while short-term capital im- to be reversed in a subsequent ad- poses enormous costs on society, the ministration only reinforced the wis- ability of a country to tax such capi- dom of taking the money out of the tal, should it become fixated on keep- country. And as each oligarch (and ing it, is limited. This is a reflection of smaller investors) decided to do so, it a general principle in taxation: gov- made it more desirable for others do ernments can impose only limited so. taxes as factors whose supply is Although of all the objectives of highly elastic. Capital market liber- intervention listed, this may be the alization, in effect, enhances the elas- most difficult to achieve, the analysis ticity of supply, thereby lowering the above suggests that even when the scope for redistribution. As a second purpose is discouraging long-term irony,the fact that short-term capital capital outflows, the interventions RISK WITHOUT REWARD 235 may be effective even when there are his money out of the country over- ways of circumventing them. This is night to bring it back in again the because there may be multiple equi- next day, for there was a large effec- libria; if most people keep their tive tax on such a roundtrip. There money in the economy, it grows, and was little evidence that the tax dis- it becomes attractive for others to do couraged overall inflows, but it so. Conversely, if most people pull lengthened the maturity of funds, their money out of the country, it thus stabilizing the economy. Chile becomes attractive for others to do so. was, of course, adversely affected by The restrictions on capital outflows the global financial crisis, as were all can “force” the economy to the “good” countries, and especially countries equilibrium, and once there, it is self- heavily dependent on commodity sustaining. exports. No one believed that it would eliminate all sources of insta- The forms and mechanisms bility. In the aftermath of the crisis, of interventions as funds for emerging markets dried up everywhere, Chile decided that Intervention has taken on a num- the problem was not a surfeit of funds ber of different forms and been but a lack of funds, and hence the tax implemented through a number of was reduced to zero. different mechanisms. Some of these rely more on “market mechanisms” that are both more flexible and that Controls on capital outflows.In avoid the opprobrium associated the uncertainty of the early days of with the term controls the global financial crisis following Russia’s default, Malaysia responded Taxes on capital inflows. For a long by imposing controls on capital out- time, Chile had an effective system of flows. It noted high levels of specula- what amounted in effect to a tax on tive activity on the ringit, especially short-term capital inflows. (A third of occurring in Singapore, and worried the money coming into Chile had to that such speculation would de- be deposited in the central bank for a stabilize the economy. The controls year at a zero-interest rate; hence, were carefully designed to ensure the first-year return was taxed, in ef- that those who had invested long fect, at 33 percent.) The tax rate could term in the country would be able to vary with economic circumstances— take their profits out. And they were discouraging inflows more when they announced as short term, to be re- seemed to pose a greater problem. In moved within a year. The vituper- principle, a subsidy could be provided ativeness with which these controls if the government wished to encour- were greeted was almost unprece- age an inflow. dented, not only from the IMF, the At the same time, the tax on self-appointed guardian of capital inflows discouraged speculative out- market liberalization, but also from flows: an investor worried about the the U.S. Treasury. They forecast that possibility of a small devaluation the controls would be ineffective; would not find it attractive to take that the country would never be able 236 THE ANNALS OF THE AMERICAN ACADEMY to attract capital; that they would be row at home as well as abroad, these counterproductive, exacerbating the regulations can be highly effective. economic downturn; that they would Even before the crisis, Malaysia had never be removed; and that without succeeded in limiting the foreign ex- the discipline of capital markets, the change exposure of its banks. country would never address its Such changes can be implemented problems. Their forecasts were as far either through direct regulations or from the mark and as based on ideol- through more price-based mecha- ogy and interests as their earlier ad- nisms, for example, through deposit vocacy of capital market liberaliza- insurance systems where the premia tion had been. Just as Malaysia had increase with risk and where the for- once before imposed capital controls eign exchange exposure of the bank in an emergency and removed them (direct and indirect) is included in as promised, so too did it fulfill its the risk measure, or through risk commitment. Its downturn was adjusted capital adequacy require- shorter than any of the other coun- ments, again where foreign exchange tries,16 and the country was left with exposure is included in the risk less of a legacy of indebtedness. (See measure. the discussion in the preceding sec- tion.) It did use the time well to re- Taxes. Many countries have indi- structure, with a program that was vidual and corporate income tax sys- far more effective than that of its tems that allow the deduction of neighbor, who remained under IMF interest payments. By disallowing tutelage. Capital (foreign direct in- the deduction of interest on short- vestment) continued to flow into the term foreign denominated debt, country.17 households and firms would be pro- The World Bank worked with vided with an incentive not to under- Malaysia to convert the controls into take such debt.18 an exit tax, with the tax rate gradu- ally lowered. The result was that when the controls (taxes) were EXCHANGE RATE REGIMES AND CAPITAL finally removed, there was no distur- MARKET CONTROLS bance to the market: it was a virtu- ally seamless change. So far,we have argued that capital controls increase risk but do not Bank regulations. Today, increas- increase growth. We have elided the ingly, capital controls are imple- question of the extent to which these mented through bank regulations, results are dependent on the ex- which limit not only the (uncovered) change rate regime. In this section, foreign exchange exposure of banks we shall argue that in the absence of but also of the firms to which they capital controls, the only exchange lend. Since most financial transac- rate regimes that, in practice, can tions are intermediated through work effectively are floating ex- banks and most domestic firms bor- change rates or dollarization, but RISK WITHOUT REWARD 237 that even with floating exchange rate elimination of fiat money. In effect, systems, capital controls can en- then, a country with full capital mar- hance economic stability. ket liberalization surrenders control over its money supply and monetary Why fixed exchange policy.The consequences are not only rate systems fail that the government cannot engage without capital controls in stabilizing macro-policy, but also A major failing of fixed exchange there may actually be a destabilizing rate systems is their vulnerability to dynamic put into place. speculative attack, especially when Assume, for instance, its firms there is a perception that the decide to borrow more abroad. It exchange rate is overvalued and can- must then increase reserves or take not be sustained. Countries are not strong actions to discourage such for- given the grace of a gradual adjust- eign borrowing. Assume that the ment. When there is not sufficient mantra is that the country not only reserves to back up the demands for cannot control the capital inflows, dollars, then there can be a run on the but it cannot tax them or the uses to currency,just as there can be a run on which the funds are put. Then, if it a bank when there is not sufficient wishes to add to reserves, it will put reserves available to meet its liabili- downward pressure on the exchange ties (see Diamond and Dybvig 1983). rate. But given that it is committed to If all creditors and potential claim- maintaining the exchange rate at its ants believed that the country could fixed level, it must offset this pres- meet its obligations, then, of course, sure by increasing the interest rate. they would not wish to “cash in,” to It might well justify that measure pull their funds out of the country; further by noting that it dampens the but if they believe that the exchange inflationary pressures that are often rate is not sustainable and will crash, associated with the capital inflows. the returns to doing so are enormous. But this induces domestic firms that They can pull their funds out today, expect the government to fulfill its putting them back in tomorrow, and commitment to a fixed exchange rate make an enormous return from the to borrow even more abroad, espe- speculative activity. cially if foreign borrowing is being, in The problem is that the amount of effect, encouraged by the foreign reserves required to ensure that a lenders, as was the case in East Asia. country can meet its commitment to (The Basle capital adequacy stan- maintain the exchange rate is enor- dards provide preferential risk treat- mous under full capital market liber- ment for short-term lending, and the alization: it equals the total value of underregulation of the undercapital- the money supply plus short-term, ized Japanese banks provided them foreign-denominated credit, for any with an incentive to engage in risky domestic currency can be converted lending.19) There is thus a vicious cir- into dollars on demand. In short, the cle, one that can easily lead to mas- country has to have a fully backed sive distortions of resource alloca- currency—equivalent to the tion, as in the case of Thailand: the 238 THE ANNALS OF THE AMERICAN ACADEMY foreign lending goes into areas that politically unpalatable increases in are collateralizable, feeds a specula- taxes—in a country already running tive real estate boom, while the high a fiscal surplus. interest rates meanwhile choke off (There is still a third alternative more valuable domestic invest- strategy, from which the countries 20 ment. It made little sense to build were discouraged under the doc- empty office buildings in Bangkok trines of liberalization, and that is and Jakarta when there were micro-economic interventions, such other investments that would have as taxing real estate capital gains.) enhanced the growth prospects and The dynamic is worse than just job opportunities. Yet, that is what described: If the monetary and fiscal happened under deregulation. measures designed to maintain the There is an alternative strategy exchange rate do not, at the same that few countries have followed. To time, perfectly offset any inflationary discourage foreign borrowing, the pressures, then the capital inflow country can make loans available at may well lead to a real appreciation, more attractive terms to domestic leading to a trade deficit. (In some borrowers. One argument holds that sense, the trade deficit is the inevita- lowering interest rates to domestic ble accompaniment of the capital borrowers will lead to lower deposit inflow, and the trade deficit will rates and a possible flow of money typically21 be generated by a real out of the country. This argument, appreciation.) But the increasingly while often mentioned, is unpersua- large trade deficit, under standard sive: the objective was to stem an excess flow of foreign borrowing, and doctrines and models, will be viewed there must exist a “fixed point,” a as “unsustainable.” That is, markets level of interest rates that attracts may increasingly anticipate a correc- the desired level of capital. tion in the overvalued exchange rate, a correction more likely to occur But there is another argument through a sudden change in the that is somewhat more compelling. exchange rate than in adjustments in The lower interest rate will normally lead to an increased level of domestic wages and prices. investment and hence possibly con- The fact of the matter is that few tribute to inflationary pressures. In governments have been willing to effect, a country in such a situation is maintain high-cost reserves equal to forced to cut back on public expendi- their money supply and foreign- tures or increase taxes in response to denominated short-term indebted- an onslaught of foreign capital, no ness, and short of that, the countries matter whether that onslaught is will be vulnerable to a speculative based on irrational exuberance or attack. Even the massive amount of not. If such policies had been pursued money that the IMF has been able to in Thailand, investments in empty mobilize in recent crises is not office buildings would have crowded enough to fill the gap and therefore to out higher return investments in maintain confidence in the overval- education or infrastructure or forced ued exchange rate. RISK WITHOUT REWARD 239

But the fact that the IMF has engi- bear the costs through high interest neered massive (and typically unsuc- rates to save those that should have cessful) bailouts has exacerbated the purchased insurance. Doing so, it overall problem in three distinct could be argued, is not only contrib- ways. First, in effect, the IMF has fed uting to a moral-hazard problem but the speculative sharks (though the to a moral problem. cost is borne by the taxpayers in the The arguments put forward for developing country). In the absence fixed exchange rate systems apply of outside funds, speculation is a with equal force to controlled zero-sum game, with some specula- exchange rate systems, for example, tors gaining at the expense of others. where the exchange rate is allowed to The IMF engineered bailouts convert move within a well-defined band. what would be a zero-sum game into When it becomes apparent that the a positive-sum game for speculators: band cannot be sustained, there will they stand to gain at the expense of be a speculative attack. taxpayers, and they have indeed gained handsomely. Second, the Dollarization. While capital mar- funds have facilitated the bailout of ket liberalization has thus made creditors, generating the moral- fixed exchange rate systems of the hazard problem—lenders do not bear conventional kind untenable, it has the full costs of their lending deci- enhanced the argument for sions (even ignoring the macro- dollarization, in which the country economic externality). IMF econo- gives up control over its money sup- mists (including their chief econo- ply. Under standard criteria, Argen- mist, Michael Mussa) have argued tina and the United States, or that the lenders have borne some Ecuador and the United States, do costs, but that is not the point: moral- not constitute an optimal currency hazard problems arise whenever area (see Mundell 1961). But they do not bear the full costs, and Mundell (1961) wrote his classic arti- this they clearly have not. Third, the cle before capital market liberaliza- IMF efforts to sustain the exchange tion was the vogue. The shocks facing rate (even if only partially success- Ecuador and the United States are ful), and the rhetoric that, otherwise, markedly different, and giving up borrowers who have borrowed in for- conventional monetary policy in- eign denominations will be hurt, struments will impair the ability have led to a “foreign exchange cover to stabilize the economy. But the moral hazard.” Private borrowers alternative—allowing the country to have felt that they do not need to buy be buffeted by speculative exchange insurance against the risk of devalu- rate movements—may be even ation or as much insurance as they worse, and even with dollarization, otherwise would, and in this they are there may be some scope for mone- right: when enough of them take that tary policy (see Stiglitz 2001b). position, the IMF will use that fact to help support the exchange rate. They Volatility among the major cur- are willing to force small firms to rency areas. Dollarization, however, 240 THE ANNALS OF THE AMERICAN ACADEMY is not really a viable solution for appreciated, increasing the trade countries engaged in trade with deficit, distorting the economy many different countries, for exam- through that channel. When the col- ple, Japan, Europe, and the United lapse came, it might have even been States, simply because of the huge worse, simply because the fall in the volatility of the exchange rates exchange rate would have been from among their currencies. Fixing the a higher, more overvalued level. exchange rate to the dollar means Some argue that investors were that firms face enormous risks in the lulled by the seemingly fixed exchange rate with Japan and Eu- exchange rate to take a more exposed rope. In short, there really is no such position than they otherwise would thing as a fixed exchange rate, only have, but this argument is unpersua- an exchange rate that is fixed in sive on two grounds. First, prudent terms of one of the many currencies behavior required the purchase of that the country interacts with. Sta- insurance, and insurance markets bilizing on a basket of exchange rates are particularly well designed (in does not solve the problem of particu- principle) for handling the risks asso- lar firms. It leaves a firm that exports ciated with fixed exchange rate sys- in the dollar zone, or imports from tems—small probability events with the yen zone, or imports from one large consequences. There never has zone and exports to another, bearing been a truly fixed exchange rate sys- enormous risk. It does a firm little tem; fixed exchange rate systems good to know that on average, ex- only mean that adjustments occur in change rates are stable, if it faces large steps but infrequently. If the bankruptcy, because imports have market shared the investors’ percep- undermined it. Today, small coun- tions that the probability of an tries around the world have to face adjustment was small, then the this challenge in risk management: insurance premium would have been there is nothing they can do about correspondingly small. Thus, the fail- this volatility. But given the high ure to obtain cover, exposing them- level of risk that they have to manage selves and the country to large risk, in any case, the burden of managing was as much, or more, a case of mar- the additional risk posed by short- ket failure than of government fail- term speculative capital flows in the ure, of markets either being irratio- absence of capital controls is all the nal (investors believing that they greater. know better than the market, as reflected in insurance premia, about Flexible exchange rates the future course of exchange rates) Some critics of Thailand suggest or inefficient, with the cost of cover that the problems it faced in the East being excessively high relative to the Asia crisis lie with the fixed exchange risk being divested. Second, there rate system, but that contention is have been “crashes”—rapid changes wrong (See Furman and Stiglitz in asset prices—in “flexible”-price 1998a). Had the exchange rate been markets as there have been in fixed- allowed to adjust, it would have price markets. RISK WITHOUT REWARD 241

With flexible exchange rates, ment would simply have to apprise there are high costs of the absence of the adverse real balance effect of capital controls, especially given the firms and households that were net imperfections of risk markets.22 foreign debtors, the positive real bal- Changes in speculative attitudes, ance effect of those who were net say, toward the exchange rate, can creditors, and the positive effect on force the exchange rate up or down, net exports (taking into account the imposing huge problems for export- dynamics of adjustment). Fiscal and ers and those in import competing monetary policy could freely be used sectors, or even to domestic produc- to adjust the level and composition of ers relying on imported inputs. output, either increasing or decreas- Typically, neither the producers nor ing the extent of devaluation. (To be consumers can divest themselves of sure, the calculations of the appropri- the resulting large risks. Especially ate policies would be complicated not in the presence of imperfections of only by the dynamics of adjustment capital markets,23 the costs of such but also by the complexity of expecta- risks can be enormous: workers, tion formation. But these are details underprotected by social safety nets, that need not detain us here.) cannot borrow against the prospect In practice, the IMF has seldom of future income; firms may be forced allowed governments the freedom to shut down, with an enormous loss just described. It has worried that of firm-specific human capital and devaluations would lead to inflation, organizational capital. And the it has inveighed against what it anticipation of such costs will make describes as competitive devalua- investment in the country less tions (never mind that such devalua- attractive. Even when there are tions are effectively typically aimed futures and forward markets, they at changing the exchange rates extend only to a limited extent into against the dollar, not just at gaining the future, not enough to deal with a competitive edge over similar coun- the risks associated with long-term tries), and it has worried that with real investments. devaluation, those who owe money abroad in dollars would not be able to Macro-stability. The huge volatil- meet their obligations or lead to con- ity in exchange rates provides real tagion. While in other spheres, it has challenges (to put it mildly) on those taken a strong promarket line, in this responsible for macro-stability, espe- area, it has talked about overshoot- 24 cially if traditional IMF/central bank ing; but it has never provided a responses are employed. A loss of coherent explanation for why over- confidence in the currency will lead shooting should be more prevalent in depreciation. If true free-market this market than in other asset mar- principles were adhered to, so that kets, why government interven- the government simply allowed the tion—and, in effect, government sub- exchange rate to be whatever the sidies—should be more acceptable in market determined, then the govern- this market than in other markets, or 242 THE ANNALS OF THE AMERICAN ACADEMY why the interventions should be lim- the devaluation in terms of exports ited to the particular kinds of inter- than they would lose on their balance vention (high interest rates, fiscal sheets.25 contraction, direct exchange rate But those who come under the support) that it favors. Their argu- sway of the IMF have to respond to ments have rung an increasingly hol- the devaluation by interest rate low note: the large devaluations asso- increases and fiscal contractions, ciated the global financial crisis did which lead to recession and, in some not set off inflationary spirals; cases, depression. Indeed, the basic Brazil’s large devaluation did not framework, which has come to be lead to contagion; the bankruptcies called “beggar-thy-self policies,” is that marked East Asia were as much designed to bring about an economic a result of the high interest rate and downturn—and to bring with it contractionary fiscal policies put in adverse contagion to neighbors. A place to stave off a devaluation than common (but not universal) charac- to the devaluation itself (though to be teristic of the precrisis situation is a sure, the devaluation had a greater 26 trade deficit. Countries are told to impact on the foreign creditors, the redress the deficit; the resulting sur- clientele of the IMF, while the high plus facilitates the ability to repay its interest rates had a greater impact creditors. But given that devalua- on domestic creditors, which seem- tions are discouraged, tariff and ingly were of little direct concern). other barriers to imports are not Adjustments in exchange rates in allowed, and exports cannot be other noncrisis countries, like Tai- wan, followed along the lines of the increased overnight; the only way to crisis countries: there was no compet- do so is to decrease incomes—cause a itive devaluation, just an exchange recession—which reduces imports. rate adjustment. Most tellingly,care- Trading partners, of course, do not ful micro-studies, for example, of care much about why their exports Thailand, showed that the seeming are down; all they know is that they worry about the impact of devalua- have fallen. The downturn in one tion on the economy was largely country is thus transmitted to its bogus and certainly of second order neighbors, just as in the beggar-thy- compared to the adverse conse- neighbor policies that played such an quences of the high interest rates important role in the propagation of and excessive fiscal contraction. the Great Depression. But these poli- Those with large foreign indebted- cies do not even have the saving ness were largely in the real estate grace of helping the domestic econ- sector and already dead; further omy as they hurt those of trading devaluation would not make them partners. Thus, countries with capi- any deader,and arresting the devalu- tal market liberalization (under ation would not lead to a revival of fixed or flexible exchange rates) that this sector. The second most heavily have their responses to large varia- indebted group were exporters, who tions in capital flows dictated by the would, on the whole, gain more from IMF are likely to find themselves RISK WITHOUT REWARD 243 confronting the consequences of actually have adverse effects on large economic downturns. growth, and given the theory and evi- In short, with fixed exchange rates dence that it enhances economic and full capital market liberalzation, instability, one might well ask, how the government absorbs some of the could an international body, the IMF, costs that the huge movements in founded to promote global economic short-term capital impose under stability be so active in promoting it, flexible exchange rates; but the gov- going so far as to seek a change in its ernment’s ability to do so is limited. If charter to mandate it? it wishes to do so, it must bear huge A full answer to this would take us costs, both in terms of the size of well beyond the scope of this article: a reserves that have to be maintained mixture of bad economics (using old and in terms of its loss of ability to macro-economic models that simply maintain macro-economic stability. failed to incorporate in a meaningful But with flexible exchange rates, full way finance, although this has been capital market liberalization im- one of the major areas of advance in poses enormous risks on firms, and economic theory in the past quarter while there are macro-policies that century27), ideology, and special may do a reasonable job of offsetting interests: financial markets would the effects, ensuring a modicum of gain from the opening up of new mar- macro-stability,in practice, countries kets, and American financial mar- are likely to face significant macro- kets wanted them to be opened up instability under these exchange quickly, before others were in a posi- rate regimes as well. tion to take advantage of these new opportunities; and the free-market CONCLUDING REMARKS ideology served these interests well (even if there was a note of intellec- Developing countries differ from tual incoherence in free-marketers more developed countries in many asking the government to use its ways, besides the lower level of power to force others to open up their incomes. In particular, they face markets and in defending multi- greater economic volatility and a billion dollar bailouts for Western lower ability to manage that volatil- creditors). But the lack of transpar- ity, even though they may have more ency with which the IMF operates flexible wages and labor markets exacerbates these problems: its poli- than more developed countries (see cies were not subject to the kinds of Easterly, Islam, and Stiglitz 2000). intensive scrutiny that should be the Capital market liberalization in- hallmark of democratic processes, creases the risks they face—under simply because much of what it does any exchange rate regime, although goes on behind closed doors, with it may enhance the arguments for public announcements coming too flexible exchange rates. Given the late for meaningful inputs from other absence of evidence that it promotes stakeholders. Secrecy is the hall- growth, given the compelling theo- mark of financial markets, and the retical arguments that it may IMF has borrowed its culture from 244 THE ANNALS OF THE AMERICAN ACADEMY those it has sought to serve, with ing the risks of capital market liberalization. whom it interacts constantly, and By the time he reached Jakarta, the Indone- sians already were discussing ways by which from whom it draws so much of its the new thinking might be reflected in prac- personnel. tice. But by then, the IMF staff had reportedly But underlying all of these prob- gotten to their new managing director, and lems is governance: to whom the there was quick backtracking: it was put to the institution is accountable. With vot- Indonesians in no uncertain terms that going back on capital market liberalization was not ing rights allocated according to mar- to be part of their economic agenda. ket power at the end of World War II, 4. See below for a more extended discus- with some adjustments since then, sion of the Thai case. with finance ministries and central 5. The only possible justification might be banks speaking for the governments, that banks in the United States do a better job at allocating scarce funds in the developing with other stakeholders precluded from country, so much better that income in the having a seat at the table, the policies country is higher than it would otherwise have pushed by the IMF become under- been. There is no evidence in support of this standable but no more acceptable.28 position. 6. See Furman and Stiglitz (1998a) and Capital market liberalization rep- Rodrik and Velasco (2000). To be sure, other resents a major change in the rules of factors played a role, some of which are de- the game. It was a change in the rules scribed below. that did not serve the interests of the 7. There were deeper failings in their ar- developing countries well. The fun- guments: they seemed to believe that a tempo- rary intervention in the market would lead to damental problem facing globaliza- a permanent shift in the demand functions, for tion is how these rules of the game example, for investment. The mechanism by are made. Dissatisfaction with the which this might occur, other than through current system is well deserved. some vague appeal to the intervention result- ing in a restoration of confidence, were never spelled out. There was no systematic analysis of investor psychology (with empirical support Notes for the maintained hypotheses), nor was there 1. Interestingly, many in the Interna- any appeal to rational expectations models tional Monetary Fund (IMF) claimed that they that are the normal staple of much of modern never had really pushed for capital market lib- macroeconomics. Krugman (1998) criticized eralization for countries that were unpre- the IMF for playing the role of armchair mar- pared. At best, this was a semantic quibble: al- ket psychologists, a role for which they were though they had often accompanied their eminently unqualified, with a commensu- demands for capital market liberalization by rately weak track record. Stiglitz (1999) pro- demands for other reforms, they had never vided a more detailed critique of the underly- said not to go forward with capital market lib- ing theories. eralization until those other reforms were 8. For an econometric analysis for the made. United States, see Furman and Stiglitz 2. With even the U.S. secretary of treasury (1998b). joining the attack, it was not left just to the 9. In the jargon of standard economics, normal bureaucratic processes. low-income individuals have a high level of 3. The most notorious example involved risk aversion and have little access to mecha- the newly appointed managing director giving nisms with which to divest themselves of the a speech in Bangkok, in which he reflected risks they face. This can be viewed as an im- some of the new thinking in the fund concern- portant instance of market failure. RISK WITHOUT REWARD 245

10. That is, taking into account the imper- tions that are not disclosed, or giving them ju- fections of information and the costs of trans- nior positions in the event of bankruptcy). actions, for example, associated with creating Similarly, debt covenants making debt imme- markets. See, for example, Greenwald and diately callable in the event of certain circum- Stiglitz (1986). stances (such as those associated with a crisis) 11. But even this needs to be qualified. should either be made not enforceable or Newbery and Stiglitz showed that when risk bonds with those provisions not be given favor- markets are imperfect—which they always able tax treatment. are in practice—free trade may actually make 19. A situation analogous to that encoun- everyone worse off. See Newbery and Stiglitz tered in the United States in the savings and (1984). loan debacle. 12. In particular, Murdock and Stiglitz 20. Proponents of capital market liberal- (1993) and Hellmann, Murdock, and Stiglitz ization (including those in the IMF) underesti- (1996, 2000) showed that restrictions on finan- mated these distortions, simply because they cial markets may be welfare enhancing. did not understand the functioning of capital 13. This is the essential point of the large markets and the ways that such markets differ literature on “local public goods.” See Tiebout from ordinary markets for goods and services. (1956) and Stiglitz (1983a, 1983b). In their simplistic models, capital in a well- 14. For an analysis of the Latin American functioning economy (which most developing case, refer to Galvin and Hausman (1996). countries are not) is allocated (as if) by an auc- 15. See, for example, Weitzman (1974) or a tion process to the borrower offering the high- standard public sector textbook, such as est interest rate, just like any other good is al- Stiglitz (2000b). located to the buyer offering the highest price. 16. See Kaplan and Rodrik (2001). To be Thus, the fact that real estate was offering the sure, its downturn was somewhat longer than best interest rates meant that that had to be it might otherwise have been because Finance the highest return activity. And it was simply Minister Anwar at first tried the standard assumed that if there were mistakes in judg- IMF recipes (in what was called an IMF pro- ment, only the lender would bear the cost of gram without the IMF), raising interest rates such mistakes. In fact, capital is not allocated and cutting back on public expenditures. by an auction process (see Stiglitz and Weiss Recovery only began when these policies were 1981; Greenwald and Stiglitz forthcoming) but reversed. by a screening process, and for an obvious rea- 17. There remains some controversy over son: those offering the highest interest rates whether in 2000 Thailand was more successful may not be those most likely to repay. More- in attracting foreign investment than Malay- over,we have seen that when large numbers of sia, with disputes both about data and their in- debtors cannot repay the loans, there are terpretation. What matters for growth, of macro-economic consequences, with others be- course, are greenfield investments, not simply sides those who have borrowed and lent hav- foreigners buying already existing assets, un- ing to bear the costs. less the funds they provide to the country in 21. Although not necessarily: the availabil- doing so are themselves turned into invest- ity of new sources of credit can increase the de- ments. Large fire sales in Thailand might tem- mand for imports, even if relative prices re- porarily succeed in diverting funds from Ma- main relatively unchanged. This seems to laysia but are hardly indicative of a better have been the case recently in Iceland. See “strategy.” Stiglitz (2001a). 18. There are certain practical problems in 22. Many advocates of capital market liber- the implementation of such provisions, which alization, especially those that appeal to the can easily be overcome. Because firms will be analogy of the benefits of free markets for tempted to use derivatives to subvert the in- goods, fail to appreciate these market failures tent of these tax provisions, there will have to and their consequences. be netting provisions, with full disclosure of 23. Themselves explicable in terms of im- derivative positions (enforced, e.g., by laws perfect information. See Stiglitz (2000b). that limit the enforceability of derivative posi- 246 THE ANNALS OF THE AMERICAN ACADEMY

24. That is, if the initial exchange rate is Easterly, William Russel, Roumeen Is- 140 to the dollar, the true equilibrium is 190 to lam, and Joseph E. Stiglitz. 2000. the dollar; in the initial adjustment, the ex- Shaken and stirred: Volatility and change rate may overshoot to 210 to the dollar. macroeconomic paradigms for rich 25. Moreover, while the IMF tried to char- and poor countries. Michael Bruno acterize there being a trade-off, as we saw ear- lier there was none: the high interest rates in- Memorial Lecture. Washington, DC: tended to prevent a devaluation simply World Bank. pushed the economy deeper into recession, Furman, Jason, and Joseph E. Stiglitz. weakening confidence in the country and its 1998a. Economic crises: Evidence and currency. insights from East Asia.Brookings Pa- 26. For instance, Korea, at the time that the pers on Economic Activity 2:1-114. crisis struck, did not have a balance of trade . 1998b. On the economic causes of deficit. In the old world, before capital market inequality. Paper presented at Income liberalization, the link between trade deficits Inequality: Issues and Policy Options, and crises was closer. 27. Highlighted by the fact that in the typi- a symposium sponsored by the Fed- cal macro-models employed by the IMF, bank- eral Reserve Bank of Kansas City, ruptcy and default were not modeled, although Jackson Hole, Wyoming, 27-29 Au- bankruptcy and default were at the center of gust, Kansas City, Missouri. the global financial crisis. Galvin, Michael, and Ricardo Hausman. 28. For a more extensive discussion of these 1996. The roots of banking crises: The points, see Stiglitz (forthcoming). macroeconomic context. In Banking crises in Latin America, edited by References Ricardo Hausmann and Liliana Rojas- Suarez. Washington, DC: Inter- Caprio, Gerard, and Daniela Klingebiel. american Development Bank. 1996. Bank insolvencies: Cross- Greenwald, Bruce, and Joseph E. Stiglitz. country experience. Policy research 1986. Externalities in economies with working paper no. 1620. Washington, imperfect information and incomplete DC: World Bank. markets. Quarterly Journal of Eco- Collier,Paul, and Anke Hoeffler.1998. On nomics 101 (2): 229-64. economic causes of civil war. Oxford . Forthcoming. Towards a new par- Economic Papers 50 (4): 563-73. adigm for monetary economics. Demirgüç-Kunt, Asli, and Enrica Mattioli lecture, Milan. Detragiache. 1997. The determinants Hellman, Thomas F., Kevin C. Murdock, of banking crises: Evidence from in- and Joseph E. Stiglitz. 1996. Deposit dustrial and developing countries. mobilization through financial re- World Bank working paper no. 1828. straint. In Financial development and Washington, DC: World Bank. economic growth: Theory and experi- . 1999. Financial liberalization ences fromdeveloping economies ,ed- and financial fragility. In Annual ited by N. Hermes and R. Lensink. World Bank conference on develop- London: Routledge. ment economics 1998, edited by Boris . 2000. Liberalization, moral haz- Pleskovic and Joseph E. Stiglitz. ard in banking and prudential regula- Washington, DC: World Bank. tion: Are capital requirements Diamond, Douglas W., and Philip H. enough? American Economic Review Dybvig. 1983. Bank runs, deposit in- 90 (1): 147-65. surance, and liquidity. Journal of Po- Kaplan, Ethan, and Dani Rodrik. 2001. litical Economy 91 (3): 401-19. Did the Malaysian capital controls RISK WITHOUT REWARD 247

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