Problems With Current U.S. Policy.

The Bretton Woods Articles of Agreement were shaped by the Keynesian view--widely shared at the time--that unconstrained financial markets are prone to excessive volatility and speculative mispricing of assets, with adverse repercussions on production and trade. The recent IMF (and U.S.) drive to promote free capital mobility around the globe stands the Bretton Woods perspective on its head. It is argued that if financial markets are allowed to operate freely, these markets will price assets efficiently and optimally. Interventionist policies that distort the markets--and not markets themselves--are deemed the root causes of financial disorder. The corollary of this theory is that lifting capital controls globally advances rather than undermines the basic Bretton Woods goals.

This theory holds that free capital mobility produces an international converging of real interest rates and a more accurate global pricing of capital assets, thus elevating the returns on global capital and the efficiency with which global resources are allocated. In addition, it is claimed that by rewarding "sound" policies with capital inflows and punishing "unsound" ones with capital outflows, the globalized financial markets will also improve domestic policymaking. All this is supposed to accelerate productivity and output growth--especially in the capital-short, technology-dependent developing world, where the return on capital should be highest. Hence, the increased socioeconomic costs of IMF policy demands merely swap short-term pain for greater long-term gain.

Such theorizing, however, builds on an assertion about the innate efficiency of financial markets that has negligible backing from economic theory and is refuted by actual trends after the 1960s. Lifting capital controls has opened the gates to an accelerating volume of international financial flows. But these have been accompanied in most of the developing and industrialized world by slackened growth of investment, savings, output, trade volume, and productivity, compared to the Bretton Woods decades.

Increased capital mobility has caused global growth to slacken for two main reasons: 1) heightened volatility of both nominal and real exchange rates, and 2) much higher real interest rates generated by the explosive growth of cross-currency financial flows. Higher volatility raises the risks of investing long-term, while higher real interest rates raise the cost of capital. Combined, they have tilted private investment after the 1960s toward projects with quicker payoffs, which have contributed less to productivity growth than did the long-term investments characterizing the less volatile Bretton Woods decades.

Since the 1970s there has been an upsurge in investments in mergers and in speculative investments--adding nothing to productive capacity. Over 80% of global foreign exchange (forex) turnover--which exceeded $375 trillion in 1998 compared to $4.6 trillion in 1977--involves round trips of a week or less. Only 3% directly finances trade in commodities and nonfinancial services, compared to 30% in the 1970s. The other 97% represent financial transactions that exploit discrepancies between inter-country interest rates and corresponding exchange rates, speculate on movements of bonds and equities in different markets, and hedge against or speculate on exchange rate changes. The short-term focus of these flows makes them highly skittish. Hence, as their volume has increased, so has the frequency and extent of disruptive flow reversals. Since 1980 around 80% of IMF member countries, industrialized as well as developing, have suffered one or more bouts of currency/banking crises or near crises. In contrast to the localized crises of the Bretton Woods era, the reactions of the globalized financial markets have rendered subsequent crises far more contagious.

The changing economies of the industrialized countries contribute to the rising financial fragility. Since the mid-1950s, each of the G-7 countries has experienced rising shares of gross domestic product (GDP) devoted to finance, insurance, and real estate (FIRE)--activities that facilitate asset trading and risk transfer. Rising FIRE/GDP ratios were associated until the mid-1970s with faster output growth of goods and nonfinancial services in each of the G-7 countries. But the correlation turned negative thereafter, indicating that the surging financial activities since the demise of Bretton Woods have been crowding out production of goods and nonfinancial services.

The rise since 1980 of real interest rates to double real GDP growth rates in the G-7 countries is also indicative of increasing financial fragility. Reinforced by increased debt leveraging, the holders of financial assets--mostly the wealthy elite--have been garnering rising shares of national income and wealth. Over the past 115 years, only the inter-war decades experienced such a prolonged rise, and then mainly because real GDP collapsed in the deflationary 1930s. The massive booms in shares and real estate prices of the 1980s and 1990s, despite the slow growth and high real interest rates, also imply an excessive reduction of investor risk perceptions, resembling the Roaring Twenties that preceded the Great Depression.

Key Problems

* The current IMF mission, imposed by the U.S., is based on flawed theorizing about the efficiency of unconstrained financial markets, which are innately prone to the destabilizing mispricing of capital assets.

* The international decontrol of financial markets has encouraged hot money flows, that have increased exchange rate volatilily and the frequency of contagious currency crises, thus retarding global growth of output, trade, and productivity.

* Debt leveraging, rising real interest rates, and booms of asset prices have fueled prolonged trend toward income and wealth concentration reminiscent of the 1920s.