Commentary: Rubin's Tinkering May Avert Future Meltdowns

Last fall, when the world economy seemed ready to implode, desperate cries went up for a new international "financial architecture." Tear down the old system, critics demanded. Replace it with a global central bank, controls on the flow of private capital, and Chapter 11 protection for troubled nations. Amid this near-panic, U.S. Treasury Secretary Robert E. Rubin remained unflappable. All the system needed, he insisted, was modest reform.

Back then, Rubin seemed out of touch with reality. But as the sense of crisis has waned, his proposed tinkering looks like the right approach after all.

Rubin believes a new, powerful central authority to replace the International Monetary Fund would have no more success than the IMF has had in preventing meltdowns--or managing them once they occur. Nor is he enamored of capital controls, which World Bank chief economist Joseph E. Stiglitz advocated as recently as Apr. 27.

PEGGED RATES. Instead, what's needed, the Treasury chief believes, is a return of "risk"--a moderating force that vanished in the investment boom that preceded Asia's bust. Simply put, if investors have no implicit guarantee of government bailouts, they are less likely to go overboard.

"Market discipline will work only if creditors bear the consequences of the risks that they take," Rubin said on Apr. 21. His blueprint was embraced at the IMF's Apr. 26-28 meeting and is likely to be adopted in June, when the Group of Seven holds its annual economic summit in Cologne.

The Rubin plan calls for a "bail in" by private creditors, who would take a hit when countries encounter temporary financial problems. It would end IMF support for pegged exchange rates that put an artificial floor under troubled currencies to protect foreign investment. And it would increase financial disclosure--by borrowing nations as well as highly leveraged hedge funds. "You're making lenders and borrowers aware of the real risks," says Robert D. Hormats, vice-chairman of Goldman Sachs International. "It leads to better outcomes."

Rubin's thrust is a reversal of U.S. Treasury and IMF policy. During Mexico's 1994-95 crunch, the U.S. wound up bailing out creditors, which Rubin later said was a mistake. And the IMF exacerbated the 1997-98 crisis by encouraging futile defenses of currencies under siege.

Short-term, Rubin's reforms are likely to curb investment. "If you create more uncertainty about whether I get repaid, I'll demand a higher premium or lend less," says Merrill Lynch & Co. senior international economist Michael J. Hartnett. But slower, more sustainable growth is preferable to Asia's boom-and-bust cycle and might give emerging nations time to develop the political, legal, and social institutions needed to manage unruly free-market systems. It's no accident that the economies recovering fastest are those that have more stable political infrastructures, such as Korea and Thailand.

DISCIPLINE. It was, in fact, a tremendous flood of capital to Asia--accompanied by looser risk standards--that triggered the 1997-98 tumult. According to the IMF, net capital flows to Asian emerging markets shot up from $18 billion in 1992 to $100 billion by 1996. Lenders did not focus enough on the soundness of emerging-market investments; they counted on exchange rates staying pegged to the dollar and IMF rescue teams to protect their assets. But when the IMF bailouts failed and currencies collapsed, panicked creditors became risk-averse, pulling a net $55 billion out of developing Asia.

Rubin, who specialized in risk assessment when he ran Goldman Sachs's arbitrage operation, wants to restore market discipline. For example, under the IMF's new plan to provide early financing before a crisis occurs, eligible countries will have to make full disclosure of their finances. Likewise, if creditors can't depend on fixed exchange rates, they'll have to set a premium to reflect currency fluctuations. And new transparency requirements for hedge funds should make the dangerously leveraged ones stand out.

These reforms aren't dramatic. And they won't guarantee a painless path to economic development. But they should help smooth free-market capitalism's rough edges--the wild swings that produce great prosperity one day and deep distress the next. That's no small feat.

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