Problems With Current U.S. Policy.

The major flaw in U.S. policy is its pursuit of objectives that cripple the primary instrument that national governments have used to moderate boom/bust cycles and ensure stable economic growth: countercyclical monetary operations. Instead, its policies promoting capital flows liberalization encourage procyclical investment behavior, thereby worsening volatility rather than dampening dangerous volatility in capital flows.

Traditionally, central banks have had the power to cool economic activity through countercyclical policies, e.g., raising interest rates. However, high interest rates may attract, rather than discourage, increased foreign inflows, thereby stimulating economic expansion rather than contraction. And attempts by central banks to revive economic activity by lowering interest rates may prove ineffectual when such action precipitates or intensifies capital outflows and reduces the flow of credit in a national economy.

Institutional investors can currently shift their holdings of bonds and equities from one market to another in response to cyclical developments that raise or lower returns. By rejecting efforts to moderate these procyclical flows, U.S. policy has systematically undermined the ability of central banks to control credit expansion and contraction.

Industrialized countries also experience the negative effects of volatile foreign investment flows. In the 1980s and 1990s, capital inflows produced effects in the U.S. similar to those in Mexico and other emerging markets: rising equity prices, currency appreciation, large current-account deficits, and a boom in consumption.

In the early 1980s, foreign capital flowed into the U.S. in response to the combination of easy fiscal and tight monetary policies that drove up the value of the dollar and real interest rates. However, massive capital inflows continued throughout the 1980s, even as monetary policy eased and the dollar depreciated. Highly indebted developing countries exported goods to the U.S. to earn dollars and then exported those dollars to repay debt; countries with financial surpluses invested dollars in the U.S. market in order to build foreign exchange reserves--raising the value of the dollar, lowering the prices of imports, and making additional credit available to U.S. borrowers.

U.S. consumers borrowed the recycled dollars to buy even more foreign goods. As foreign capital flowed in, the aggregate debt of all U.S. borrowers--government, households, and businesses--doubled between 1983 and 1990, rising from $5.4 trillion to $10.9 trillion and pushing debt to GDP ratios in these sectors to unprecedented levels for a period of low inflation. Meanwhile, the amount of debt owed to foreigners also increased in both nominal terms and as a share of GDP.

Unsustainable debt levels in the U.S. and other industrialized countries contributed to the depth and duration of the recession at the beginning of the 1990s. Moreover, central banks in the U.S. and other industrialized countries had difficulty reviving economic activity. Instead of reigniting economies, interest rate cuts sparked outflows of portfolio investment. Though these outflows only lengthened the U.S. recession by a few months, subsequent outflows from emerging markets had a much greater impact, crippling those countries and weakening the global economy.

Meanwhile, abetted by an immense consumer credit structure, the chronic U.S. current-account deficit poses a growing concern. The U.S. has become dangerously dependent upon the continued willingness of foreigners to invest in its economy. With its huge external debt, the U.S. may be increasingly susceptible to harsh judgments by the liberalized financial system. Ironically, U.S. policies imposed this liberalized system on the rest of the world.

The U.S. government and other advocates of financial liberalization believe that greater capital mobility will spur, not undermine, national economic growth and development. The U.S. Treasury regards capital outflows as an inevitable response to poor policies and an acceptable tool of market discipline. Emerging market countries are urged to adjust stocks of foreign exchange reserves to cover foreign liabilities. Such views assume that a country's primary obligation is to assure returns on investments rather than to promote the welfare of its citizens.

Key Problems

* The U.S. ignores the extensive damage done by massive capital flows and continues to press developing countries to open their financial markets.

* Capital flows into the U.S. also contribute to rising equity prices, currency appreciation, large current-account deficits, and a boom in consumption.

* The ability of central banks to conduct countercyclical policies has been weakened by large and rapid shifts in foreign portfolio investment across open markets.