A Few Home Truths Amid The Global Tumultby
What's an economic pundit to do when faced with the challenge of writing an opinion column for business readers in a period of such great uncertainty in global financial markets? There are so many momentous questions to explore. Will Japan pass a credible bank reform? Who will lead Russia from the brink of bankruptcy? Will China devalue? Will the hordes of new investors in the U.S. stock market lose their cool and flee to safer portfolios? Will the Federal Reserve lower interest rates?
Frankly, I can't answer any of these questions with certainty, and unlike many pundits, I'm not foolish enough to pretend I can. So I've decided to reflect on the economic truths that have been confirmed by recent developments.
First, greed is not enough. Without a strong rule of law, transparent financial institutions, and legitimate corporate and political governance, greed spawns not the marvels of the market but the mischief of crony capitalism. A working tax system may distort market incentives. But Oliver Wendell Holmes was right--taxes are the price for a civilized and orderly society. Strong central banks may create large bureaucracies and regulatory headaches. But without them, economies can be brought to their knees by the excesses of misguided, sometimes corrupt, investors. With rules in place, privatization can promote innovation; without them, it can amount to little more than sophisticated robbery.
DISRUPTIVE CHANGE. Second, growing economic interdependence among nations has both benefits and drawbacks. Although freer cross-border flows of capital facilitate the efficient allocation of investment around the world, they can also produce disruptive changes in exchange rates and asset prices, setting off a vicious cycle of financial collapse, deflation, and contagion. Unfortunately, what Alan Greenspan refers to as the "patchwork of arrangements and conventions to govern the international financial system" has not kept pace with its breakneck dynamics. The world needs new multilateral governance arrangements, and whatever its shortcomings in Asia and Russia, the International Monetary Fund must play a key role.
Third, massive short-term borrowing in foreign currency is especially risky business. Countries with the deepest crises over the past year attracted vast amounts of short-term foreign capital by offering the promise of high returns and fixed exchange rates. When the promise proved hollow, foreign lending contracted suddenly and violently, and even creditworthy projects found themselves starved for liquidity. By contrast, China's insulation from short-term capital also insulated it from overnight changes in credit availability. Even some straitlaced economists have begun to question the case for the free movement of short-term capital into emerging-market economies. Is Prime Minister Mahathir Mohamad of Malaysia right?
THE UNTHINKABLE. Fourth, the U.S., along with the other members of the Group of Seven, should have put together a new Marshall Plan to ease the transition of the former Soviet empire into the global economy. It was willing to finance a huge cold-war military budget but not spend even a fraction of that amount to promote Russian reform. Now, Russia has done the unthinkable. It has unilaterally declared a debt rescheduling that has badly burned foreign private creditors, making it even less likely that private capital flows will be sufficient to transform Russia into a stable market democracy. The recent riots in Indonesia were unnerving; the possibility of similar riots in Russia with its nuclear weapons is positively chilling.
Fifth, at critical moments in the world economy, whether it's the old economy of the 1930s or the new economy of the 1990s, human emotions can overwhelm market fundamentals. Euphoria about the Asian economic model, about development in Russia, about the potential of Internet and information technologies, and about the end of the business cycle in a world of flexible production techniques led investors to discount risk and to price equity markets for perfection. Then, as they began to realize that their expectations were unrealistic, panic blurred their ability to perceive meaningful differences in the economic fundamentals of individual countries and companies. "Irrational exuberance" gave way to an irrational rush for the door, and confidence, which is essential to the smooth functioning of markets, was shattered. Which just goes to show that no matter how sophisticated the world's technologies become, they may never be able to control the recurrent bouts of euphoria and panic that are part of the human psyche and an essential ingredient of the business cycle.