A quarterly magazine of the IMF

June 2001, Volume 38, Number 2

Financial Crises in Emerging Markets: An Essay on Financial Globalisation and Fragility

New Haven, Connecticut, and London, Yale University Press, 2000, xx + 199 pp., $25/£16.95 (cloth).

A dominant aspect of recent economic history is the rapidly growing role of market forces in the world economy, reflected in growing economic integration across countries and increasingly liberal financial markets. These trends have confronted economic policymakers with a number of questions. For example, financial crises seem to have been occurring with greater frequency at the same time that economies are becoming globalized. Is this more than a coincidence? If so, what are the implications for the management and prevention of financial crises?

It is ambitious to address such a broad topic with any hope of being both relevant and interesting, but this book succeeds masterfully on both counts. Drawing on the distilled wisdom of a long career spent close to financial markets, Baron Alexandre Lamfalussy (a former general manager of the Bank for International Settlements and now chairman of the "Committee of Wise Men" on the Regulation of European Securities Markets) presents—in fewer than 200 pages—a clear view of each of the major financial market issues raised by the experience of the last three decades. This is a rare book that practicing economists will find both useful and enjoyable.

Lamfalussy starts by identifying features common to the recent financial crises in emerging market countries. The four major crises—Latin America in the early 1980s and Mexico, Asia, and Russia in the 1990s—had at their core a buildup of short-term foreign debt to levels that eventually proved unsustainable. The buildup was due, in part, to the exuberance of international investors and the pegging of exchange rates. The pain of the crises was exacerbated, in turn, by conditions in domestic banking systems, whose problems often included large maturity mismatches and unhedged currency mismatches (in which fixed exchange rates played a role), and by contagion, which tended to develop both regionally and across emerging markets as an asset class.

Does globalization play an aggravating or an alleviating role in such crises? Lamfalussy argues that it does both, but that, on balance, it aggravates more than it alleviates. Globalization nonetheless remains a worthy objective because its overall economic benefits outweigh its costs. Two trends accompanying globalization are ongoing shifts from "bank-centric" to "market-centric" finance and from debt flows to equity flows. Both contribute to a wider distribution of risk. In addition, new financial instruments, such as derivatives, are potentially useful for hedging risk. These features of globalization help alleviate the effects of crises.

However, globalization has several features that aggravate crises. As financial institutions grow relative to emerging market flows, small changes in their positions can have large effects on these markets. Among international investors, growing global competition arguably encourages herd behavior as well as a more aggressive approach to risk taking. The "market-centric" nature of finance goes hand in hand with growing off-balance-sheet activity and securitization, which, in turn, make markets less transparent. A number of parties are usually involved in a derivative contract, for example, making credit risk harder to assess.

Similarly, in the mainstream literature, Paul Krugman argues in "Crises: The Price of Globalization?," a paper presented at the Jackson Hole Symposium in 2000, that growing global integration is a positive development overall but does predispose the world economy to more crises, principally because financial deregulation often runs ahead of prudence. In addition, even if the argument sounds uncontroversial, the reader may note that, in fact, it represents a substantive departure from the conventional wisdom of just a few years ago that openness made crises less likely—for example, by making debt repudiation more costly for borrowers.

While financial crises cannot be prevented, certain conditions, in the author's view, can reduce their likelihood. Key among them are sound macroeconomic policy and well-functioning, well-regulated domestic financial intermediation in emerging market countries, as well as greater resilience of financial systems in industrial countries. The appropriate exchange rate regime would depend on the country and specific circumstances; no one regime is appropriate for all countries, and, indeed, there is room for intermediate arrangements between free floating exchange rates and currency boards. Short-term capital flows, which have been central to most crises, should be liberalized last of all and only after the domestic legal, institutional, and financial infrastructure is capable of dealing with large flows. There may be a role for prudential regulation, which should be market friendly, to limit short-term inflows and maturity and currency mismatches.

Lamfalussy emphasizes that globalization is a process rather than a steady state. In this context, he says, "the question of how to operate a fully liberalised system worldwide is not the most urgent one. . . . Our more practical concern should be to manage the transition from here to there."

Vivek Arora

From Subsistence to Exchange and Other Essays

Princeton University Press, Princeton, New Jersey, 2000, xi + 153 pp., $19.95/£12.50 (cloth).

This eclectic collection of essays by a leading conservative voice in development economics includes not only the staples of the author's work (his pioneering writing on the emergence of exchange economies and on foreign aid and overpopulation) but also more exotic fare (essays on "ecclesiastical economics" and the British class system). Nonetheless, many of the articles are linked by Bauer's overarching theme that inequality has a rational basis and does not necessarily need to be "fixed."

His credo is this: "Wide economic differences between people in an open and free society result from differences in aptitudes, motivations, and circumstances, and state action to remove these economic differences entails such extensive coercion of market forces that society would cease to be open and free." Compounding the coercion is the inefficiency implied in the forced transfer of resources from productive to less productive people. Bauer finds that poverty in developing countries is caused mostly by the failure of government to follow sound policies and provide a safe and secure civil environment.

It is important to remember that Bauer, along with Harry G. Johnson and Bela Balassa, developed a neoclassical approach to development economics in the 1960s and 1970s, when neo-Marxian and structuralist views held sway. Moreover, this was a period of burgeoning social consciousness in the West, where certain ideas gained widespread currency because of pop-culture fashion rather than rigorous economic, political, or philosophical analysis or commitment. One of these ideas was that the industrial countries were directly responsible for poverty in the Third World, a view that Bauer lambastes in this volume.

Bauer raises good counterarguments to a number of accepted wisdoms. For example, on the links between poverty and either a shortage of land or a surplus of population, Bauer points out that contemporary famines and food shortages have arisen in sparsely populated economies where land is abundant (for example, Ethiopia). Again, he finds that other factors, such as a subsistence or near-subsistence economy that has been prevented from developing into an exchange economy by poor government policies or a lack of public security, are the real culprits.

But despite the context and the rationalism of Bauer's work, the reader bristles at the proposition that "income differences normally reflect not exploitation but differences in performance." This reviewer is more persuaded by Amartya Sen's witty rebuttal of Bauer's fundamental theses. Responding in the early 1980s to Bauer's proposition that one's income reflects one's relative industriousness and productivity, Sen wrote, "An Indian barber or circus performer may not be producing any less than a British barber or circus performer— just the opposite if I am any judge—but will certainly earn a great deal less." As Sen, who contributed a gracious introduction to the present volume, goes on to point out, Bauer overlooks the power of relative prices on income and its distribution.

An extremely negative view of foreign aid also characterizes Bauer, who has been described as "not really a Cambridge [where he studied] man but rather an L.S.E. [the London School of Economics and Political Science, where he taught for almost a quarter of a century] man with some quite radical laissez-faire instincts." In the chapter "Foreign Aid: Abiding Issues," Bauer finds that aid is more likely to inhibit economic advancement than to promote it because it tends to prop up antidevelopment policies or activities. Bauer points to Western subsidies that have poured into countries where the recipient governments pursued policies damaging to their poorest citizens, such as barring productive sectors of the economy from employment because of gender or ethnic considerations or large-scale spending on armaments.

But again, the reader must part company with Bauer before he reaches his conclusion. Certainly, recent major studies on the efficacy of foreign aid—such as the 1998 World Bank report Assessing Aid: What Works, What Doesn't, and Why—confirm that sound economic management and robust government institutions are crucial. But they also find that foreign assistance has been highly successful in reducing poverty in countries where these conditions prevail.

The assorted conclusions of laissez-faire thinkers can make strange bedfellows, in part because such thinkers are not tied to as fixed a party line as is a card-carrying liberal or conservative. In the essay "Ecclesiastical Economics," Bauer engages in some serious pope-bashing, accusing recent pontiffs of promoting envy, resentment, obsession with material wealth, and, worst of all, the eighth deadly sin of fuzzy economics. However, Bauer's essay on population, which posits that Western con- cerns about overpopulation reflect patronizing assumptions about the inability of the poor to make rational decisions and the disutility of human life, might well find favor in the Vatican.

Ultimately, Bauer goes either too far or not far enough. In the first category would be his procession from the realization that aid is not sufficient for development to the conclusion that it is antidevelopment. In the second would be his failure to venture past the conclusion that incomes that reflect productivity and legitimate property rights are "fair" to the larger realization that there are moral imperatives more important than ownership rights. Nonetheless, this provocative collection of essays makes good reading in a millennial age when the issues of poverty and equality are once again preeminent.

Lynn Aylward

Maestro: Greenspan's Fed and the American Boom

Simon & Schuster, New York, 2000, 270 pp., $25 (cloth).

Greenspan: The Man Behind Money

Perseus Publishing, Cambridge, Massachusetts, 2000, xviii + 284 pp., $28/Can$42.50 (cloth).

Alan Greenspan has made his reputation the old-fashioned way: He has earned it. In Maestro, Bob Woodward traces Greenspan's "unusual intellectual journey" as Chairman of the U.S. Federal Reserve "from cautious and nervous beginner . . . to the innovative technician who spotted productivity growth in the 1990s and refused to raise interest rates when the traditional economic models and theories cried out for it."

In a fortuitous division of labor, Justin Martin devotes two-thirds of his book to the period before Greenspan became Chairman of the Fed. It comes as no surprise to read that the 5-year-old Greenspan could add up three-digit numbers in his head. To this day, his former colleague Lawrence Lindsey notes,

Greenspan's grasp of the facts can be a bit overwhelming to both the staff and his colleagues. I remember one instance when spring floods were making many of the bridges on the Mississippi River unusable. At the time of the weekly Board of Governors meeting, the U.S. economy was literally linked together by a single bridge. Greenspan not only knew the location of the bridge, but also the various reroutings that could be used to get merchandise there. Those types of facts fit naturally into the mind of a man who studies statistics on boxcar loadings at all the major terminals in the country (Lawrence Lindsey, Economic Puppetmasters (Washington: American Enterprise Institute Press, 1998)).

Woodward suggests that it was during the mid-1990s that Greenspan was able to put his love of data and his intellectual curiosity to best use. The U.S. economy, Greenspan was convinced, was experiencing an unprecedented burst in productivity, but one that was not being reflected in the statistics issued by government agencies or in studies by academic economists. Woodward describes how Greenspan hectored the Fed staff into conducting their own detailed studies of productivity and into "slicing and dicing" the data until credence could be given to the notion that the United States was indeed a New Economy. The evidence helped Greenspan persuade colleagues on the Federal Open Market Committee (FOMC) to keep interest rates lower than what conventional models of the economy would have recommended.

At the same time, Greenspan has not bought completely into the idea of the New Economy. As Woodward documents, Greenspan's caution is manifested in his periodic attempts to talk down the stock market and his guiding the FOMC to raise interest rates at every hint of inflationary pressure. For instance, the FOMC started raising interest rates in June 1999 on concerns that the economy was growing faster than was desirable, even allowing for the acceleration in productivity growth.

Greenspan was tested very early in his tenure as Fed Chairman by the October 1987 stock market crash. His major act was to issue an uncharacteristically clear one-sentence statement affirming the Fed's intention to provide liquidity to the market as needed, in keeping with its role as lender of last resort. Whether or not the statement did the trick, it clearly passed the "first, do no harm" test.

Greenspan's conduct of monetary policy in the years that followed, Woodward notes, remained somewhat tentative. He was late to recognize the recession of 1990 and, though he recognized the dampening effects of the credit crunch of the early 1990s on the economy, he may have been too slow in cutting interest rates. That certainly was the opinion of former President George Bush, who said later of Greenspan: "I reappointed him, and he disappointed me."

During the Clinton years, Greenspan hit his stride. Here, Woodward rehashes, to some extent, material covered in his earlier book, The Agenda. He describes the now-famous meeting in which Greenspan reportedly convinced President-Elect Bill Clinton of the need to rein in fiscal deficits to lower inflationary expectations and, thereby, long-term interest rates. Woodward also documents Greenspan's increasingly deft handling of monetary policy over this period. Convinced that inflation was resurfacing, in 1994 Greenspan guided the FOMC to raise interest rates to 6 percent from 3 percent, engineering a slowdown but no recession—a "soft landing." Then, he cut rates, and growth picked up again with little sign of inflationary pressures.

It is well known by now that Greenspan's initial career choice was to be a jazz musician. Martin describes these early years at some length, but they do not make for riveting reading—it's rather like reading about the time basketball legend Michael Jordan spent trying to become a baseball player. After giving up on a career in music, Greenspan turned to economics.

As an undergraduate student at New York University, he was exposed to the work of Geoffrey Moore, who, "unlike some of Greenspan's other NYU professors, was incredibly knowledgeable" about the nuts and bolts of the American economy. Indeed, according to Martin, "Moore's future inflation gauge . . . would prove to be one of Greenspan's favorite indicators as Fed chairman." During his graduate work at Columbia University, Greenspan came into contact with Arthur Burns, who, in contrast to the spirit of the times and despite the experience of the Great Depression, believed that markets and economies had the capacity to self-correct. Martin attributes Greenspan's support of laissez-faire and limited government in part to Burns's influence. These views were cemented by Greenspan's interactions with novelist and philosopher Ayn Rand and her acolytes. Greenspan has often credited Rand with convincing him that capitalism was not just efficient, but moral.

Greenspan found his calling as a business consultant starting in the 1950s. Over the next two decades, his economic consulting firm, Townsend-Greenspan, built up an impressive roster of clients among U.S. blue-chip companies, which looked to Greenspan for "available data sliced and diced in new ways." These experiences honed Greenspan's skills to the point where he felt he had an instinctive sense of where the economy was headed. This is a point also made by Woodward, who notes that Greenspan's decisions are driven not just by the evidence and economic arguments, but by instinct. To persuade his colleagues to go along with one particular interest rate decision, Greenspan pleaded: "I've been in the economic forecasting business since 1948, and I've been on Wall Street since 1948, and I'm telling you I have a pain in the pit of my stomach."

Woodward memorably sums up Greenspan's speaking and operating styles. On the former, he writes: "It is almost as if his words were scouting parties, sent less to convey than to probe and explore." And, on the latter: "After he was Chairman more than a year, Greenspan's operating style was beginning to emerge—intellectual engagement, tempered by emotional detachment; near obsession with economic data, tempered by a steady stream of doubt and uncertainty over the impact; indirectness as a means of achieving a desired outcome, tempered by sudden directness and a desire to have it his way; and a pronounced deference to political power."

Prakash Loungani

Il Fondo monetario internazionale

Il Mulino, Bologna, 2000, 128 pp., EUR 7.23 (paper).

More than 50 years after its creation, the IMF is still widely misunderstood. Some perceive it as a development bank that extends long-term loans, others as a sort of global central bank. A lack of knowledge is often at the root of the criticism directed against the institution, criticism echoed in recent antiglobalization movements. Giuseppe Schlitzer, an economist at the Bank of Italy who has spent more than four years as a Technical Assistant and then as an Advisor in the Office of the Italian Executive Director of the IMF, tries to dispel some of the misunderstandings that color the public's perception of the IMF.

The book explains the IMF's raison d'être by reviewing the context that gave rise to the Bretton Woods agreements in the 1940s and by describing the institution's objectives, organization, and main functions. The author illustrates how the institution has continually adapted to the changing needs of its membership and to a globalizing world economy. In the final chapter, Schlitzer provides a flavor of the current debate on reform of the IMF. His main thesis is that the IMF's primary purposes are still fully valid. Indeed, continual adaptation is a prerequisite for the IMF to effectively address the new challenges posed by globalization.