Financial authorities around the world are edgy. Hardly a month passes without the discovery of a major fraud--Metall Gesellschaft, Barings, Daiwa Securities, Sumitomo Bank, and countless others. From time to time, an entire country goes over the financial cliff. Policymakers hope that new controls, regulations, and surveillance will soon be in place before some new disaster undermines the whole global financial system.

Until then, it's up to the market to punish transgressors. The disintegration of Barings and the vigorous prosecution of Daiwa in New York are cases in point. But punishment is much harder when entire economies are financially mismanaged.

Take the postmortem on Mexico's crash and rescue. The consensus view is that the crisis showed the need for two things: better surveillance and greater financial resources. But a third--no automatic bailout for investors--could be even more important.

Individual countries have the capability of regulating and supervising their own markets. If these jobs are performed conscientiously, large-scale accidents are less likely to happen.

But in the international community, it doesn't work that way. There is no internationally recognized body to establish rules for conduct mn exchange rates or other macroeconomic management. If a country decides, for example, to secretly boost its money supply, no one is likely to challenge the policy. As long as foreign money continues to pour in, the Finance Minister rides high. By the time foreign investors discover the problem and money starts to dry up, it's too late to prevent a crisis. Then, when the International Monetary Fund and central banks try to help, the country is already deeply in trouble.

NO LACK OF DATA. We should not kid ourselves into believing that better availability of data would prevent this kind of crisis. There is plenty of information on growth, banking problems, interest rates, and trade. More data won't help investors who refuse to look at the facts.

In the Mexico rescue, the U.S. Treasury and the International Monetary Fund got together to arrange a colossal loan. Europeans in the IMF were railroaded into participating. The German position was that bailing out investors is a mistake. The Bundesbank in particular believes that bailouts give investors a false sense of security and should be reserved for problems that threaten an entire financial system.

The U.S. view, by contrast, is that the global financial system is highly fragile. The Mexican crisis shows the risk of not having lots of money on hand for speedy intervention. The Clinton Administration had to battle Congress for money even as Mexico was in meltdown.

Both views of the bailout problem are, of course, correct. There is a hazard in telling investors that they will always be rescued. But there also is a risk if a country crisis gets out of hand and threatens the entire global financial system. The question is how to strike a balance. In the 19th century and until the early 1980s, governments stayed away from bailing out private investors. The history of foreign lending is replete with distressed countries, defaulted loans, disappointed investors. Foreign Bond Holders Protective Councils organized the multitude of creditors and renegotiated the terms of settlements with defaulting countries. These councils worked pretty well. The U.S. council lasted till the mid-1960s.

CONFUSING SIGNALS. Nothing in the history of foreign lending suggests that the private market cannot handle credit or that country defaults inevitably become systemic crises. It is important to allow markets to work again and get governments out of the bailout business. Private investors have to learn about risk again and pass on their skepticism about bad policies to would-be borrowers. In such a system, good policies get rewarded by low interest rates and plentiful credit; bad policies bring about high penalty rates and a dearth of credit. The current system of presumptive bailout--based on the assumption that countries are too big to fail--confuses market signals, leads to bad policy, and, thus, creates recurrent problems.

So the next time a country goes into distress, international financial institutions and the major powers should turn their backs. That will demand ice water in the veins of international policymakers, but the world will go on, as it has for 150 years of country defaults. Teaching a lesson on a smaller level frees up the financial system to intervene with great vigor when there is a real crisis.

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