In the years following World War II almost all countries had extensive controls over capital markets. For domestic markets there were detailed regulations governing the banking and financial sectors (e.g. restrictions on mergers and the type of activities banks could undertake). Such regulations were designed to prevent the kind of speculative activity that had occurred in the 1920s and had played a major part in causing the Great Depression of the 1930s. Governments were also allowed and, in fact, encouraged to control capital flows into and out of their countries because it was felt that these could threaten international stability. The IMF charter contained specific provisions to allow this.
The situation changed in the 1970s and 1980s.
(1) The energy crises of that decade resulted in the accumulation of billions of US dollars by the oil exporting countries. These so-called “petrodollars” were deposited in commercial banks in such centers as New York and London so that there was a huge increase in the sums available for international lending.
(2) At the same time an ideological shift in western countries towards an emphasis on free markets led to the lifting of restrictions on financial institutions and international capital flows in the 1970s and 1980s.
(3) The development of new information technology made international financial transactions easier and faster.
The result was an enormous increase in international financial flows, many of them to the LDCs, which were suffering from real declines in international aid flows. Private capital flows to the LDCs increased six-fold between 1990 and 1997. This was the background to the debt crisis in Latin America and Africa in the 1980s and the Mexican peso crisis of 1994-95. In 1997 it was the turn of Asia. On 2 July of that year Thailand devalued its currency (the baht) by 20%. The result was a massive capital flight so that by the end of the year the baht had fallen by 93%. The crisis rapidly spread to other countries in East and Southeast Asia. Indonesia and South Korea were especially hard hit but no country was completely safe.
The Failure of Private Capital Markets:
Some economists see market failures in private capital markets as primarily responsible for the crises. They point to the following problems connected with financial markets:
(1) “Information asymmetry”. Undue haste in opening capital markets to foreign investors contributes to a climate of excessive lending to firms by foreign investors. The evident success of the Latin American economies in the 1970s and the East Asian economies in the 1990s at times when the world economy was generally sluggish led to “irrational exuberance” on the part of those investors.
Borrowers possess better understanding of the projects they are engaged in than do lenders but frequently have an incentive to provide their potential creditors with inaccurate information. In other words, there is an “information asymmetry” which is especially serious when lenders and borrowers are based in different countries. Foreign lending should therefore be undertaken with caution but the haste of lenders often leads them to finance individuals and firms engaged in very speculative activities (e.g. real estate).
(2) In all the crises referred to above an excessively high proportion of the foreign capital was in the form of short-term debt (i.e. bank loans of 1 year or less). This made the recipient countries very vulnerable to nervousness on the part of foreign lenders.
The IMF has the responsibility of dealing with international financial crises but has had limited success, in part because its resources are small relative to the volume of transactions involved. Some economists believe that the ineffectiveness of the IMF is also a result of the inadequacy of the adjustment programmed that it imposes on countries needing assistance. These programmed have been criticized on three major grounds:
(1) They invariably include government expenditure cuts, tax increases, and increases in interest rates. Such policies are not only hard on the people of the countries concerned but are often not appropriate as solutions. The problems of Latin American countries in the 1980s were at least partly due to faulty macroeconomic policies but this was not generally the case in Asia, where budgets were balanced, or nearly so. This calls into question the need for tax increases and expenditure cuts. Increases in interest rates have been defended on the grounds that they are needed to prevent capital flight but they might instead increase capital flight since by increasing debt-servicing costs they lead to reduced confidence in the economy.
(2) The IMF has required both Latin American and Asian countries to reduce government intervention in the economy and place greater emphasis on the market. Critics of the Fund argue that such measures are based on the North American market ideology and are not directly related to the financial crises. Even if such reforms are necessary (and not everyone agrees that they are) the middle of a financial crisis is the worst possible time to introduce far-reaching microeconomic reforms. There is also a contradiction in that IMF packages generally require further liberalization of capital controls, while the Fund criticizes LDCs for the inadequacy of their financial regulations. The implication would seem to be that liberalization should be put on hold until such regulations are in place and working effectively.
(3) The IMF favors private lenders at the expense of its member governments. At least part of the crisis is the result of private sector agents making risky loans but the IMF appears to believe that the burden of adjustment should be borne as much as possible by the debtors. The Fund has made little effort to pressure the western commercial banks into writing off debts but has instead mobilized IMF resources and taxpayer funds in the rich countries to bail out the banks and other private lenders. According to the Fund’s critics this is not only inequitable but also creates a “moral hazard” problem by encouraging risky behavior by lenders (who know that if worst comes to worst they will be bailed out).
Critics of the IMF have proposed the following policies:
(1) They agree with the Fund that improvements in financial sector supervision and regulation are desirable but believe that undue haste in liberalization has increased the dangers inherent in the existing inadequate regulatory institutions. There should therefore be a slower more cautious approach to deregulation than is currently being advocated by the IMF and western governments. In any event stronger financial supervision by itself would not be sufficient to prevent future crises. Even the United States, which has considerable experience in prudential regulation, was rocked by the savings and loans scandals in the 1980s.
(2) There should be less official financing and more bank financing. This would force the lenders to bear a greater proportion of the cost of their actions and in the long run this would encourage greater responsibility on their part. The IMF and G7 governments can launch negotiations to force debt reductions. This occurred in the 1980s as a result of the Latin American debt crisis but it took seven years of considerable hardship in the LDCs before action was taken.
(3) When IMF assistance is provided it should be less conditional. The IMF and the World Bank were originally set up to serve the interests of member countries not those of conservative banking and business interests.