TCS Daily

Bad Architects Destabilize Global Markets

By Christopher Lingle - April 28, 2005 12:00 AM

After widespread economic and financial turmoil in much of East Asia in 1997 and 1998, there was a widespread perception that global markets were in a state of crisis and that emerging markets were victimized by short-term capital flows. This brought denunciation of capital owners as owing no national loyalty to tales of treachery and conspiracy. A consensus began to form that justified imposing restraints and regulations on capital markets. Even members of the G7 joined the chorus.

In turns, there were references to the need for a new "global financial architecture". Unfortunately, the proposed economic engineering was based upon faulty premises. Lets review the assumptions that financial crises stem from (1) inherent market instability that are (2) aggravated by short-term capital flows.


Concerning the question of market instability, despite claims to the contrary, markets tend to be inherently stable due to a balance between risk seekers and those who avoid risk. If market outcomes become skewed in one direction or if one set of opinions dominates, the result is excessive pessimism and panics or excessive optimism and bubbles. While rare, there are some dramatic historical examples where over-speculation occurred, as recently seen in parts of East Asia.


Then how do market outcomes become unstable? That these events are rare suggests that market have few inherent defects. There must be pervasive signals to induce most market players to undertake a course that proves to be so disastrously wrong. This is because markets are made up of many independent players, who may never discuss plans with anyone else. When most players consistently make the wrong guess about the future, a dominant source must have generated distorting influences to induce otherwise autonomous decisions to be made in a similar manner.


Market choices are made within incentive structures that emerge from existing institutional arrangements. Of course, governments have the most extensive control over the institutional framework. In particular, governments control the supply of money. Money is the single most important conveyor of information in a modern market economy since its amount and value convey information about individual values, income and prices.


Imposed credit expansions are perhaps the greatest destabilizing force for a market economy. When governments expand credit through artificially low interest rates or directed credit policy, consumers and businesses experience increases in income streams as measured in monetary terms. However, the increase in incomes reflects only the inflow of new paper money rather than increases in the availability of real goods and services. This illusory increase in income inspires investments that cannot be supported by the real sector of the economy. Effectively, entrepreneurs mistakenly believe that more savings were available then actually existed so they undertake investments for which there is insufficient real demand to make them profitable.


The rush to invest and consume creates distorted price signals that encourage misdirected investments and perhaps speculative fever. Eventually the illusory boom stops either because governments must curb the inflationary outcome of their loose credit policies or because self-correcting forces triggered by inflation begin to reverse the expansion.


Concerning the need for constraining short-term capital, this is an elusive and perhaps counter-productive proposition. In the first instance, some capital intended to be transient might become committed for longer periods under appropriate conditions or opportunities. And some long-term commitments might be cancelled if conditions change. In all events, it is seldom important to make such distinctions since capital outflows are normally offset by inflows.


Under this interpretation, the exodus of capital from East Asia and other emerging markets in 1997 was only the messenger or an effect rather than the cause of financial and economic crises. There was a crisis of confidence causing a net outflow of capital funds regardless of investors prior intent.


The crisis of confidence arose from a reassessment of the reliability of economic and political institutions of the afflicted countries. As such, there are no quick resolutions of the systemic and structural problems exposed by capital outflows. Indeed, proposed capital controls may worsen matters by delaying the necessary steps towards stabilization of the regions economies that must precede recovery.


Policy makers should avoid temptations for politically-expedient quick fixes. Instead, they should attack the fundamental problems that thwart stability in their economies. Unfortunately, stabilization requires a painfully long period of adjustments. The crisis of confidence can only be resolved through radical institutional reforms. Return inflows of capital await assurances of greater transparency and accountability on the part of both commercial and political actors.


In short, markets best serve the interest of the general public when their operations are de-politicized. Thus, the key to resolving East Asias problems is through adjustments in the supply side of their economies. This will require greater efficiency in financial market that can be brought about through accelerating liberalization. For stability and growth, sound monetary policy is needed while political patronage in the form of subsidies or monopoly grants is eliminated or minimized.


At the same time, removal of export subsidies and elimination of tariffs and monopoly concessions can reduce distortions in their domestic economies. There is evidence that East Asia has an ample supply of private entrepreneurs. Tax reform should be undertaken to place greater control over resources back into their able hands. Stabilization and recovery in East Asia awaits the political will to de-politicize markets.


The notion of a need for a "financial architecture" with regulatory steps to introduce stability into the global economy is based upon flawed premises. It would lead to greater politicization of the global economy and shift bureaucratic involvement to an international level overseen by architects that have not proven themselves to be competent. After all, none of them foresaw the problems that they now claim to understand how to fix.


Christopher Lingle is Global Strategist for eConoLytics.


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