stiglitz - capital market liberalization

Capital Market Liberalization, Economic Growth,

and Instability

JOSEPH E. STIGLITZThe World Bank, Washington, DC, USA

Summary. Ð This paper reviews brie¯y the arguments for capital market liberalization, andidenti®es their theoretical and empirical weaknesses. This provides the foundations for theargument for intervention in short-term capital ¯ows. The paper concludes with a brief discussionof the various ways in which such interventions may be implemented. Ó 2000 Elsevier Science Ltd.All rights reserved.

1. INTRODUCTION

The world is just emerging from the worst®nancial and economic crisis since the GreatDepression. While ®nancial variables, such asexchange rates, have stabilized in East Asia,unemployment remains far higher than beforethe crisis, and real wages far lower. The WorldBank estimates that the 1999 output of the ®vecrisis countries of East Asia will still be 17%below what it would have been had the growthtrend of the 10 years before the crisis continued.In addition, large parts of the world remain in aprecarious economic positionÐwith deeprecession or depression facing several countriesin Latin America, and output in many of theeconomies in transition still markedly belowwhat it was a decade ago.

It has become increasingly clear that ®nancialand capital market liberalizationÐdonehurriedly, without ®rst putting into place ane�ective regulatory frameworkÐwas at thecore of the problem. It is no accident that thetwo large developing countries that survivedthe crisisÐand continued with remarkablystrong growth in spite of a di�cult globaleconomic environmentÐwere India and China,both countries with strong controls on thesecapital ¯ows.

The crisis in East Asia was not the only crisisof recent years. Indeed, there have been, by onereckoning, 80±100 crises over the past quartercentury (Lindgren et al., 1996, p. 20). Criseshave become more frequent and more severe,suggesting a fundamental weakness in globaleconomic arrangements. As I put it in onelecture, when there is a single accident on a

highway, one suspects that the driverÕs atten-tion may have lapsed. But when there aredozens of accidents at the same bend in thesame highway, one needs to re-examine thedesign of the road.

I suggested that one might compare capitalaccount liberalization to putting a race carengine into an old car and setting o� withoutchecking the tires or training the driver.Perhaps with appropriate tires and training, thecar might perform better; but without suchequipment and training, it is almost inevitablethat an accident will occur. One might actuallyhave done far better with the older, more reli-able engine: performance would have beenslower, but there would have been less potentialfor an accident. Similarly, the internationaleconomic architecture must be designed to``work'' not just in the presence of perfecteconomic management, but with the kind offallible governments and public o�cials that infact occur in democratic societies.

As the crisis spread from East Asia to Russia,and then to Latin America, it became clear thateven countries with good economic policies andrelatively sound ®nancial institutions (at leastas conventionally de®ned) were adversely af-fected, and seriously so. (Indeed, this wasconsistent with earlier research that had shownthat changes in capital ¯ows, and even crises,were predominantly precipitated by eventsoutside the country, such as changes in interestrates in the more developed countries (Calvoet al., 1993; see also Fern�andez-Arias, 1995)).Thus, the rhetoric with which the crisis wasbegunÐthat globalization, liberalization, andthe market economy delivered its fruits to

World Development Vol. 28, No. 6, pp. 1075±1086, 2000Ó 2000 Elsevier Science Ltd. All rights reserved

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1075

virtuous countries and that problems were onlyvisited upon countries that, in one way oranother, had sinnedÐwas re-examined, and amore cautionary approach was taken to thereforms that had been long advocated by thezealots. At the same time, the analytic argu-ments forÐand againstÐcapital market liber-alization were subject to greater scrutiny. Thecase for capital market liberalization was foundwanting, especially striking given the zeal withwhich the International Monetary Fund (IMF)had requested an extension of its mandate toinclude capital market liberalization a shorttwo years earlier at the Annual Meetings inHong Kong. It should have been clear then,and it is certainly clear now, that the positionwas maintained either as a matter of ideologyor of special interests, and not on the basisof careful analysis of theory, historical experi-ence or a wealth of econometric studies. Indeed,it has become increasingly clear that there is notonly no case for capital market liberalization,but that there is a fairly compelling case againstfull liberalization. The fact that the interna-tional ®nancial community came so close toadopting a position that could not be justi®edon the basis of theory or evidence should, initself, provide an important cautionary note,especially in the context of the debate overreforming the international economic architec-ture. Clearly, before reforms of this magnitudeare adopted, there needs to be more opendebate, and all the a�ected partiesÐincludingworkers who are threatened with unemploy-ment and falling wages, and small businessesthat are threatened with bankruptcy asinterest rates soar to usurious levelsÐneed tohave a seat at the discussion table. Unfortu-nately, in some of the circles in which thepivotal issues are being discussed, not only arethese groups not represented, but the develop-ing countries do not even have a formalmembership.

In this paper, I want to review brie¯y thearguments for capital market liberalization,and identify their theoretical and empiricalweaknesses. This will provide the foundationsfor the argument for intervention in short-termcapital ¯ows. I shall then brie¯y discuss thevarious ways in which such interventions maybe implemented. Throughout much of thediscussion, I shall talk about ``interventions'' infairly general terms. It should be clear,however, that not all interventions are identi-cal. Today, for instance, while there is wide-spread acceptance of interventions that

stabilize in¯ows, interventions on out¯owsremain highly controversial. SomeÐevenmanyÐforms of intervention may not bringbene®ts commensurate with their costs. Thecentral argument in this paper is that there existsome forms of intervention that are likely to bewelfare-enhancing.

Before beginning the discussion, I want tomake it clear that I am focusing my attentionon short-term speculative capital ¯ows. Theargument for foreign direct investment, forinstance, is compelling. Such investment bringswith it not only resources, but technology,access to markets, and (hopefully) valuabletraining, an improvement in human capital.Foreign direct investment is also not as vola-tileÐand therefore as disruptiveÐas the short-term ¯ows that can rush into a country and,just as precipitously, rush out (World Bank,1999). The magnitude of these changes in ¯owscan be enormous, as shown in Figure 1. In thecase of Thailand, the change in ¯ows amountedto 14% of the GDP and in the case of SouthKorea 9% of the GDP. In the case of East Asiaas a whole, the turnaround in capital ¯owduring 1996±97 amounted to $105 billion, morethan 10% of the GDP of these combinedeconomies. If the United States experienced thechange in ¯ow that Thailand did, for example,this could be equivalent to a change in capital¯ows of over $1 trillion. Even with its strong®nancial and other institutions, it is not clearhow well the United States would whether sucha storm (Institute of International Finance,1998; as cited in Rodrik, 1998). Moreover, it isalso clear that one can intervene in short-term¯ows, and still provide a hospitable environ-ment for foreign direct investment, as China,the largest recipient of foreign direct invest-ment, amply demonstrates.

2. THE CASE FOR CAPITAL MARKETLIBERALIZATION

The case for capital market liberalization islargely based on standard e�ciency arguments,employing a conventional neoclassical modeland ignoring the special ways in which ®nancialand capital markets di�er from markets forordinary goods and services, such as steel. Theproponents focus on e�ciency e�ects, ignoringthe distributional consequences, presumablybelieving that if the gains are large enough,either the bene®ts will trickle down to the poor,or the government will take active measures to

WORLD DEVELOPMENT1076

ensure that the poor will not be harmed. Whilethe evidence in support of either hypothesismay not be there, my concern here is to eval-uate the case more on its own terms, that is, thecase that capital market liberalization leads tohigher output and greater e�ciency.

There are ®ve components to the argument:(a) Countries should be concerned withmaximizing GNPÐthe incomes of their citi-zensÐnot GDP, the output of the country.If the citizens of a country can ®nd an outletfor their funds with a higher return than anyinvestment in their country, then GNP ismaximized by allowing the funds to leavethe country. (Moreover, the higher returnsthemselves might stimulate the citizens ofthe country to save more.) By the same to-ken, if a foreign investor ®nds an investmentopportunity within the country with a higherreturn than the opportunity cost of hisfunds, complementary factors within thecountry will bene®t, as their marginal pro-duct is increased.(b) International competition for funds pro-vides a needed spur for countries to createan economic environment attractive to busi-ness. It is behind closed doors that countriescan engage in e�ciency-decreasing practices,e.g., regulations for which the bene®ts arenot commensurate with the costs.(c) Open capital markets help stabilize theeconomy through diversi®cation. As a coun-try faces a downturn, the lower wages will at-tract funds into the country, helping tostimulate it. This was a central argument

for capital market liberalization in East Asia.After all, the governments had demonstrablyworked hard to create an environment inwhich the economy, and the private sectorin particular, had ¯ourished; growth rateshad been phenomenal for three decades ormore. Savings rates were already very high;indeed, it was remarkable that the countrieswere able to absorb the high level of savings,investing them productively. Other countrieswith such high savings rates had not fared sowell. One could hardly argue that, given thehigh savings rates, they needed to open theircapital markets to obtain needed funds.(d) On the other hand, for much of the restof the world, open capital markets wereimportant as a source of funding for neededinvestment projects.(e) Finally, the case for opening capital mar-kets was made by way of analogy to freetrade in goods and services. A central tenetin economicsÐat least since Adam SmithÐwas that free trade was bene®cial to a coun-try. Indeed, it paid a country to eliminatetrade barriers unilaterally, even if tradingpartners did not. ``Capital,'' it was argued,was just like another good. The case forcapital market liberalization was thus thesame as the case for free trade in general;that case was so well known, it hardlyneeded to be repeated.

The predictions of the advocates of capitalmarket liberalization are clear, but unfortu-nately, historical experience has not beensupportive.

Figure 1. Capital market ¯ows to developing countries. (Source: Euromoney Loanware and Bondware.)

CAPITAL MARKET LIBERALIZATION 1077

(a) Growth

There is a wealth of crosscountry studiessupporting the view that trade liberalizationleads to faster economic growth (see, e.g., Sachs& Warner, 1995; Wacziarg, 1998; Vamvakidis,1999), though to be sure, there are a few studiesproviding suggestions to the contrary. Incontrast, for the case of capital market liber-alization, there are relatively few studies, butwhat evidence there is, is not supportive ofliberalization. Figure 2, borrowed from DannyRodrikÕs study, shows growth in di�erentcountries related to the openness of capitalmarkets, as measured by the IMF. This isparticularly important, because it provides ametric that corresponds to the kinds of actionsthat the IMF might have taken in attempting toopen up the capital markets. Figure 3 providessome insights into why this might be the caseÐit plots investment in di�erent countries relatedto the openness of capital markets. Again, thereis no relationship.

(b) Stability

The global economic crisis has centeredattention around another aspect of economic

performance, stability. Stability is important forseveral reasons. Research has shown that insta-bility has persistent e�ects on economicgrowthÐgrowth is slowed down for severalyears after a crisis has occurred (Caprio, 1997).Indeed, the large unit root literature suggeststhat an economy that su�ers a large drop inoutput never fully recoversÐoutput remainspersistently below what it would have been.Thus, the present discounted value of lost outputassociated with the magnitude of declinesobserved in East Asia or Ecuador are enormous.Moreover, instability often has marked distrib-utional consequences, especially in developingcountries. Even in developed countries, such asthe United States, the poor bear a dispropor-tionate burden in terms of increased unem-ployment (Furman & Stiglitz, 1999b). But inmost developing countries, safety nets areinadequate or nonexistent. The recent criseshave amply demonstrated this burden, withunemployment increasing 3±4 fold in Korea andThailand (and by more in Indonesia), and withreal wages falling l0% in Korea, and by as muchas a quarter in Thailand and Indonesia.

I already alluded to the increased frequencyof ®nancial and economic crises, and suggestedthat this change is related to ®nancial and

Figure 2. Economic growth and capital account liberalization, 1975±89. (Source: Rodrik, 1998.) This scatter plotcontrols for per capita income, secondary education, quality of governmental institutions, and regional dummies for East

Asia, Latin America, and sub-Saharan Africa.


capital market liberalization. Cross-countrystudies have con®rmed this (Demirg�ucß-Kunt &Detragiache, 1998).

Cross-country econometric studies lookingmore broadly at the impact of capital marketliberalization on the likelihood of an economyhaving a recession have again con®rmed theadverse e�ects (Easterly et al., 1999).

Thus, it is clear that not only is there nocompelling empirical case for capital marketliberalization, there is a compelling case againstcapital market liberalization, at least untilcountries have found ways of managing theadverse consequences.

3. WHY CAPITAL MARKETLIBERALIZATION PRODUCESINSTABILITY, NOT GROWTH

Given the seemingly compelling argumentsfor capital market liberalization, why does theevidence point so much in the opposite direc-tion?

(a) Fallacies in the standard arguments

We begin our discussion by identifying thefallacies in the standard arguments. The most

fundamental is this: ®nancial and capitalmarkets are essentially di�erent from marketsfor ordinary goods and services. The centralfunction of capital and ®nancial markets isinformation-gatheringÐin particular, assessingwhich projects and ®rms are most likely to yieldthe highest returns, and monitoring to ensurethat the funds are used in the appropriate way.Moreover, markets for information are funda-mentally di�erent from ``ordinary'' markets.For instance, whenever information is imper-fect, markets are essentially never constrainedPareto e�cientÐin marked contrast to stan-dard results for competitive markets withperfect information (e.g., Greenwald & Stiglitz,1986). Thus, the ®fth argument, that the argu-ment for capital liberalization is exactly thesame as the argument for trade liberalization, issimply false.

Perhaps the most telling de®ciency in thestandard case is in the third argument, thatopening capital markets allows for diversi®ca-tion and thereby enhances stability. As we haveseen, capital market liberalization is systemi-cally associated with greater instability, and forgood reason: capital ¯ows are markedly pro-cyclical, exacerbating economic ¯uctuations,when they do not actually cause them. Thebehavior is consistent with the popular adage

Figure 3. Investment/GDP and capital account liberalization, 1975±89. (Source: Rodrik, 1998.) This scatter plotcontrols for per capita income, secondary education, quality of governmental institutions, and regional dummies for East

Asia, Latin America, and sub-Saharan Africa.


about bankers being willing to lend when onedoes not need the money. When the bankers seeeconomic weakness, they pull their money outof the country. In addition, capital marketliberalization exposes countries to vicissitudesassociated with changes in economic circum-stances outside the country; a sudden change inlendersÕ perceptions concerning ``emergingmarket risk'' can lead to huge capital out¯ows,undermining the viability of the entire ®nancialsystem.

The argument that governments should beconcerned with GNPÐthe income of theircitizensÐhas some validity, but misses acentral issue in development: there are a varietyof reasons to believe that investors do notappropriate the full value of their contribu-tions. Recent literature, for instance, hasemphasized the importance of returns to scale,network externalities, and a variety of otherspillovers (e.g., Ho�, 1997). These externalitiesmay be particularly important in early stagesof development. In addition, whenever thereare taxes on capital, social bene®ts frominvesting at home may exceed private bene®ts,unless the government can impose commensu-rate taxes on investments abroad, which itoften cannot.

The issue of whether capital market liberal-ization provides additional sources of fundingis also questionable: as the data above sugges-ted, it does not lead to more investment. Thereare two related issues. First, does more short-term capitalÐunstable as it isÐprovide a basisfor investment? The answer is clearly no. Thesecond is, do restrictions on short-term capital¯ows discourage foreign direct investment orother forms of longer term investment? Again,the answer appears to be no. We already notedthat the country that has been the mostsuccessful in recruiting foreign direct invest-ment, China, also imposes a high level ofrestrictions on short-term capital ¯ows. Butthere is little evidence that countries that haveimposed restrictions on short-term ¯ows, Chileon in¯ows, Malaysia on out¯ows, have hadtheir long-term ¯ows adversely a�ected (e.g.,Lee, 1996). Indeed, as I note below, there mayeven be reasons why foreign direct investmentmay be attracted: as we noted, capital marketliberalization is associated with greatereconomic volatility, or at least a higher prob-ability of a recession. Such uncertainty clearlymakes investment less attractive.

Actually, in many cases, the argument thatopening the capital account is important for

enhancing a ¯ow of capital into the country isturned on its head: in many instances, the keyissue is not capital ¯owing into the country, but¯owing out. Opening the capital account hasfacilitated capital ¯ight, and thus contributedto the weakening of the economy (see Dooley,1998).

The argument with which I am mostsympathetic is that opening the capital accountimposes ``discipline.'' Countries are ``forced'' tohave good economic policies, lest capital ¯owout of the country. But I have argued that farmore relevant for the long-run success of theeconomy is foreign direct investment; and thedesire to acquire and sustain FDI providesstrong discipline on the economy and thepolitical process. The question is, does openingof the short-term capital accountÐmaking thecountry subject to short-run oscillations insentimentÐprovide signi®cant extra externaldiscipline? On the negative side, the openness tocapital ¯ight makes countries especially sensi-tive, e.g., to corporate or capital tax rates or tochanges in interest rates. Thus, openness mayimpose costly constraints on the ability ofgovernment to pursue legitimate objectives.

One of those objectives is economic stability.China was able to pursue active countercyclicalmacro-policies, staving o� a recession andmaintaining robust growth of close to 8%,because the capital account restrictions provi-ded it some room to maneuver. It had no needto raise interest rates to levels that killed theeconomy in order to ``save'' it from capital¯ight.

(b) Why capital account liberalization has notcontributed to growth

The result cited earlier that capital accountliberalization is not associated with fasterinvestment, and therefore faster growth, shouldnot come as a surprise. We have already notedthat the case for positive e�ects is weak: ®rmsare unlikely to engage in productive long-terminvestments on the basis of short-term funds.But there are even reasons to expect that capitalmarket liberalization can have negative e�ectson growth. We argued above that it leads togreater instability, and instability (especially®nancial market crises) has adverse e�ects oneconomic growth. Indeed, it is not only thedownturn itself which has lasting e�ects, butthe very presence of the risk of instability that islikely to discourage investment. Openingthe capital account can, and has in several


countries, facilitated the ¯ow of capital out ofthe country (rather than, as promised, acceler-ating the ¯ow of capital into the country),providing another channel for adverse e�ects.

There is an equally compelling argument forwhy capital market liberalization (at the shortend) might be expected to have adverse e�ectson growth. Countries today are encouraged tomaintain adequate reserves, to protect them-selves against volatility in international ®nan-cial markets. A key indicator is the ratio ofreserves to foreign denominated short-termindebtedness. When that number falls belowunity, investors and lenders become worriedand indeed recent econometric work hassuggested that this variable provides the bestexplanation for which countries were adverselya�ected by the recent global ®nancial crisis (seeFurman & Stiglitz, 1999a). Of course, if allinvestors believe that all other investors arelooking at that variable to determine whetheror when to pull their money out of a country, itcan become a self-ful®lling prophecy. Nowconsider a poor developing country. Acompany within the country borrows, say, $100million from a US bank that charges him 20%.If the country has been maintaining what itviews as minimum prudential reservesÐitrecognizes the high opportunity cost ofreservesÐthen it will have to add $100 millionto reserves. For simplicity, assume it holdsthose reserves in US T-bills. Consider theimplications from the perspective of the coun-tryÕs balance sheet and income ¯ows: It has lentthe United States $100 million and borrowedfrom the United States the same amountÐithas no new net capital. But it pays to theUnited States every year $20 million in interest,while it receives from the US $5 million, theinterest on the T-bill. Clearly, this is a gooddeal for the United StatesÐone might under-stand why the United States might be in favorof rules that encourage such transactionsÐbutis hardly the basis for more rapid growth by thepoor developing country. (The costs may evenbe higher than these calculations suggest,because the opportunity cost of the funds thatthe government has to use for reserves couldeven exceed 20%.)

To be sure, the adverse e�ects on economicperformance may (especially going forward) beunnecessarily increased as a result of theparticular policies that the IMF has custom-arily employed in response to the crises thatmay, as we have seen, be systemically associ-ated with full capital account convertibility.

Excessively restrictive monetary and ®scalpolicies (see Stiglitz, 1998, 1999; World Bank,1998a,b; Lane et al., 1999) resulted in deeprecessions or depressions. The ``unit root liter-ature'' suggests that these negative e�ects arepersistent. Moreover, looking forward, busi-nesses will view debt ®nancing as highly risky;in the event of another crisis (and as we havenoted, such crises have become increasinglyfrequent and deep, in spite of rhetoric thatmight suggest otherwise), a ®rm with even amoderate debt equity ratio could be put intodistress. Firms will thus have to limit expansionto what they can largely self-®nanceÐwithstrong adverse e�ects on long-term economicgrowth.

4. THE CASE FOR INTERVENTION

Once one recognizes that short-term capital¯ows can give rise to economic instability, thereis a compelling economic case for intervention:the instability associated with short-term capi-tal movements results in there being a markeddiscrepancy between private and social returnsand risks. The capital ¯ows impose a hugenegative externality. Indeed, it should be obvi-ous that the crisis that resulted from thesevolatile ¯ows has a�ected many others besidesthe borrowers and lendersÐworkers who sawtheir incomes plummet and small businessesthat were forced into bankruptcy as a result ofthe soaring interest rates. Ironically, the designof the policy response probably increased themagnitude of the externality. The IMF explic-itly argued for increasing interest rates, withhuge adverse e�ects on ®rms not engaged ininternational speculation, in order to avoid theadverse e�ects on those who had uncoveredforeign denominated borrowings.

The nature of this externality can be seen in anumber of ways. Clearly, the borrowing coun-triesÐthe workers and small businessmenÐhave paid a high price. Alternatively, we can seethe externality exercised through the prudentialreserve management policies described earlier.A $100 million capital in¯ow that has to beo�set by $100 million in increased reservesimposes huge costs on those who might havebene®ted from other uses of these funds. The$100 million could have been spent to buildschools, health clinics, or roads to attract moreinvestment. Clearly then, the private decision toborrow has imposed a high negative cost onsociety.


Whenever there are such discrepancies, theeconomistsÕ natural reaction is to impose a``tax'' to correct the externality, in order toeliminate, or at least reduce, the di�erencebetween social and private returns. To be sure,such taxes might discourage some capital ¯ows;but this criticism is like pointing out that a taxon air pollution discourages the production ofgoods, like steel, that contribute to air pollu-tion. The point is that ®rms should be made topay the full social cost of their activity; doing sowill, and should, reduce the level of activitiesthat create negative externalities.

The consequences of the externalities maydepend on the circumstances of the country.More advanced industrialized economies typi-cally have more built-in automatic stabilizersand strong safety nets, so they can absorb theshocks better. Poorer countries may not onlyhave no automatic stabilizers, they may faceconstraints (e.g., on borrowing) that exacerbate¯uctuations. For instance, while ®scal policy indeveloped countries is typically countercyclical,in developing countries, it is pro-cyclical (seeEasterly et al., 1999; Hausmann & Gavin,1996). Moreover, as we have already noted,policies recommended to, and in some casese�ectively forced on, developing countries maymake matters worse (see Stiglitz, 2000). Weak®nancial institutions may make a countryparticularly vulnerable to large and suddenchanges in short-term ¯ows.

The recognition of the importance of theseexternality e�ects associated with short-term¯ows has constituted perhaps the major shift inthinking in discussions over the international®nancial architecture during the past two years.During the World Bank and IMF AnnualMeetings in Hong Kong in October 1997,shortly after the crisis began, there was a callfor a change in the IMF charter to pushthrough the agenda of capital account liberal-ization. This proposal was accompanied,appropriately, by several caveats. Proponentsof the change recognized that liberalizationrequired su�ciently strong and stable ®nancialinstitutions, which in turn meant that a strongregulatory framework would have to be inplace as a prerequisite.

Today, there is a greater recognition of theimportance of those caveats. Even advancedindustrialized countries have found it di�cultto establish strong ®nancial institutions ande�ective regulatory structures, as witnessed bythe ®nancial crises in Scandinavia and theUnited States. These examples show that crises

can easily occur in countries with a high degreeof transparency, and that one hardly needscrony capitalism to generate a crisis. If therehad been any question about the increasingdi�culties of good ®nancial regulation posedby the growing role of derivatives, the matterwas settled by the government-engineered,privately ®nanced bailout of Long Term Capi-tal Management (LTCM) in October 1998.This single hedge fund had an exposure esti-mated in excess of a trillion dollars that,according to those who defended the role of thegovernment in the bailout (and who resistedallegations of crony capitalism and corporatemisgovernance), posed a threat to global®nancial stability. Much of the money forLTCM exposure came from supposedly well-regulated banks.

Clearly, even without exposing themselves tothe volatility of short-term capital ¯ows,developing countries face greater risks (forinstance, because of their less diversi®ed econ-omies and the weaker role of automatic stabi-lizers) and they typically have relatively lowregulatory capacity in the ®nancial sector.Given these features of their economies, thecaveat that developing countries should havestrong ®nancial institutions and regulatorystructures in place before liberalizing theircapital accounts suggests that the entire ques-tion is now moot. In the immediate future, fewcountries should be pressed to move far in thedirection of liberalization.

The market failure analysis presented above(the discrepancy between social and privatereturns), the strong empirical evidence of thehigh risks associated with short-term capital¯ows, and the absence of convincing evidenceof growth-enhancing bene®ts associated withcapital account liberalization (in the short-term)Ðall these points lead one to question thefundamental premises underlying the drive forcapital account liberalization.

5. DESIGNING EFFECTIVEINTERVENTIONS

Hence, while 24 months ago there were callsfor full capital account liberalization, today thedebate has shifted. It is no longer whether someform of intervention might be desirable inprinciple, but whether there exist interventionsthat are e�ective and that do not have adverseancillary e�ects. That China and India havemanaged to weather the storm and maintain


strong growth; that China already as has beenalluded to several times, has managed to attracthuge amounts of foreign direct investmentwhile maintaining controls on short-termcapital; that countries that have capital marketrestrictions seem to have done as well as thosethat have not suggest that it is possible toimpose such restrictions without signi®cantadverse e�ects.

The purpose of the interventions is to equatesocial and private costs and to stabilize theshort-term ¯ows. To understand what is atissue, an analogy may be useful. Dams do notstop the ¯ow of water from the top of amountain to the ocean. But without the dam,sudden powerful ¯ows may cause death anddestruction; with the dam in place, not only arelives saved and property protected, but thewater itself can be channeled into constructiveuses. A dam can serve a useful role in averting a¯ood even if it is not perfect, i.e. even if some ofthe water spills over the top and makes its waydown the mountainside, bypassing the dam. Sotoo for interventions in capital markets: it is nota valid criticism to say that they are not perfect,that there will be leaks, or that there will besome circumvention of the regulations or taxes.The question is, do they nonetheless serve tostabilize the ¯ows, and at not too great a cost tothe economy? More recently, attention hasfocused on three sets of interventions: restric-tions on capital in¯ows, restrictions on capitalout¯ows, and restrictions imposed on thebanking system.

(a) Capital in¯ows

Chile has imposed what amounts to a tax onshort-term in¯ows. In doing so, it has succee-ded in stabilizing these ¯ows, without adverselya�ecting the ¯ow of long-term productivecapital. (Incidentally, even a tax on capitalin¯ows can serve to stabilize out¯ows. Thosewho seek quick returns by taking their moneyout for a brief time in the hopes of a devalua-tion, and then bringing it back, are made to paya high price for this round trip.)

Some critics have interpreted ChileÕs actionsin the recent crisisÐwhere the tax rate was setat zeroÐas an abandonment by that country ofthis policy. But that is simply wrong. The pointof the tax is to stabilize the ¯ow, to discourageexcess in¯ows when that appears to be theproblem. But in the global ®nancial crisis, nodeveloping country faced excess in¯ows.Indeed, it might even be conceivable that, faced

with a shortage of in¯ows, the country mighthave a negative tax. But the tax structure is inplace: if global ®nancial markets recover, asthey almost surely will, and the country againfaces an excess of capital in¯ows, then the taxrate could again be raised.

Today, the IMF endorses the idea thatcountries should consider such stabilizinginterventions. But this is just one of manyinterventions that can help stabilize ®nancial¯ows. I would argue that, given the potentiallysevere consequences of volatile ¯ows, theinternational community should encourageexperimentation with other interventions. Onecountry, for instance, is discussing limiting thetax deductibility (for purposes of the corpora-tion income tax) of interest on foreign-denom-inated, short-term debt. (This intervention hasthe further advantage of being largely ``self-re-porting.'')

(b) Capital out¯ows

Malaysia tried a quite di�erent experiment:controls on the out¯ow of capital. Many withinthe international capital markets greeted thisexperiment with little enthusiasm or evenexplicit expressions of distaste. These rhetoricalattacks typically failed to note the manysubtleties of Malaysian policies, including theprovisions designed to protect interests of long-term investors. Recently, the country moved toa more market-based exit tax. It is too soon toevaluate the experiment, but preliminary resultssuggest that it has been far from the disasterthat the naysayers had predicted; the removalof the tax went smoothly, the country used thetime provided to make signi®cant progress in®nancial and corporate restructuring (far moreprogress than some of its neighbors), andforeign direct investment continued at a rela-tively strong pace.

(c) Regulating capital ¯owsthrough the banking system

The East Asian crisis highlighted the impor-tance of the ®nancial system. Weaknesses in the®nancial systemÐgenerated, for instance, by amismatch between foreign denominated liabil-ities and domestically denominated assetsÐcangive rise to systemic weaknesses in the entireeconomy. Observers of the crisis, however,noted that focusing on the ®nancial system maynot be enough; after all, two-thirds of theforeign-denominated borrowing in Indonesia


was by corporates. Indeed, the argument wasput forward that limiting bank borrowing byitself would be like putting a ®nger into a dike.If foreign banks were o�ering highly favorableterms, the pressure for foreign borrowingwould show up somewhere else in the system.Improved banking regulation might limit directweaknesses in the banking system, but lead tomore corporate exposure.

This perspective, however, ignores the centralrole that the ®nancial system plays in theeconomy, and the ability of government toexercise pervasive e�ects through the regulationof the banking system. Governments can andindeed should insist that banks look at theuncovered exposure of ®rms to which they havelent. For that (uncovered) exposure can a�ectgreatly the likelihood that the ®rms to whichthey have lent will not be able to repay theirloans. Again, Malaysia provides a case in point:bank regulations succeeded in limiting exposureof Malaysian ®rms. In principle, the bankregulations can be market-based; that is, bankregulators could impose risk weights in thecapital adequacy requirements so that loans to®rms with high exposure received higher riskweights. Thus, banks would only make loans tosuch ®rms if they received an interest rate highenough to compensate them for the higher costs(and risks). But no government imposes thekind of sophisticated risk-based capital ade-quacy standards that this would imply; in thenear term, emerging markets are probablybetter served by employing simple regulatorystructures.

6. CONCLUDING REMARKS

In the aftermath of the global ®nancial crisisand the recognition of the high costs that thosein the developing world have had to pay, thereemerged extensive discussion of a new globaleconomic architecture. Everyone agreed thatattention should be focused on preventingfuture crises, though upon further re¯ection,the goal became modi®ed to making such crisesless frequent and less deep. Early discussionsfocused on improving transparency, thoughnearly everyone recognized that most of therelevant information (e.g., the high leverage ofKoreaÕs ®rms and the heavy investment in thehighly cyclical chip industry) was alreadyreadily available. When it was further observedthat the last major set of crises occurred inthree of the most transparent countries

(Norway, Sweden, and Finland), it becameclear that transparency itself would hardlyinoculate a country against a crisis. Deeperanalysis further questioned the transparencyexplanation. The a�ected countries had expe-rienced three decades of rapid and relativelystable growth; if anything, there had been anincrease in transparency. Moreover, manycountries that were less transparent did nothave a crisis. More broadly, while improvedinformation (transparency) might lead to betterresource allocations, both theoretical andempirical analyses questioned its role inenhancing economic stability (see Furman &Stiglitz, 1999a,b). Enthusiasm for the trans-parency agenda in some quarters was furthereroded when it was pointed out that to bemeaningful, transparency had to be compre-hensive, including o�-shore banking and hedgefunds, and possibly even the actions of centralbankers!

A second major strand of reforms focused onstrengthening of ®nancial institutions. Again,while desirable, the di�culties that evenadvanced industrial countries had in establish-ing strong ®nancial institutions suggested thatthis would remain a long-term challenge inemerging markets. A host of other reformsÐfrom collective action clauses in bonds, tosystemic bankruptcy provisions, to improvedcorporate governanceÐwere put on the table.Some, like the collective action clauses, receivedactive opposition. Some, like systemic bank-ruptcy provisions, involved matters that weretoo technical to receive widespread discussion.In some areas, such as improved corporategovernance, progress seemed likely, thoughtheir role in the crisis may have been overblown(see Stiglitz, 1999).

The one area in which there is an emergingconsensusÐa major change in perspectivesÐisshort-term capital ¯ows. The risks are recog-nized to be greater, the bene®ts lower, thecircumstances in which countries should engagein full liberalization more restrictive than wasthe case before the crisis. Given the growingbody of theory, evidence, and experienceagainst full capital account liberalization, thespeech of the Managing Director of the IMF,Michel Camdessus, before the Annual Bank-Fund Meetings in Hong Kong in September1997, raised fundamental questions. There heargued,

Freedom has its risks! LetÕs go then for an orderlyliberalization of capital movements.....the objective


is to foster the smooth operation of internationalcapital markets and encourage countries to removecontrols in a way that supports the drive towardsustainable macroeconomic policies, strong mone-tary and ®nancial sectors, and lasting liberaliza-tion.

Are international policies in this area beingdesigned on the basis of the best availableeconomic theories and evidence, or is thereanother agenda, perhaps a special interestagenda, seemingly impervious to the e�ects ofsuch policies, not only on growth, but on

stability and poverty? If that is the case, is therea more fundamental problem in the interna-tional economic architecture, going beyond thedetails discussed above, to issues of account-ability and representativeness? Do thosemaking decisions that a�ect the lives and live-lihoods of millions of people throughout theworld re¯ect the interests and concerns, not justof ®nancial markets, but of businesses, smalland large, and of workers, and the economymore broadly? These are the deeper questionsposed by the crisis through which the world isjust emerging.

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