Fallout from the Global Financial Crisis

Abstract

WHEN THE SECURITY THREAT of the cold war ended it was commonly thought that the world would be a safer place. Yet the forces unleashed with the collapse of communism brought forth new economic competitors and 'marketization' at the same time that information technology innovation was transforming entire industries, making global markets possible. The international financial system has been in the forefront of these changes. With capital now moving in large amounts at the speed of an electron, a new concern has appeared - the dangers of unfettered market forces.The near meltdown in financial markets in 1998, the widespread and chaotic nature of the crisis, and the high casualty toll among innocent bystanders - particularly in poor countries - and knowledgeable market participants alike has spurred new calls for curbs on capitalism. Yet the international community's response over the past year demonstrates that the system can and is being made safer, both by improving how markets operate and by devising strategies for small open economies to integrate more safely into the system. Indeed, in mid-1999 concern about the crisis is being replaced with concern that the speed of recovery will blunt the will to change.While technology (as well as deregulation and removal of capital controls by governments) has made it possible for capital to flow freely and quickly across national borders, the flows themselves respond to shifts in economic growth, production, and rates of return, which have risen in developing countries relative to those in the mature industrial countries (that is, those countries which are members of the Organisation for Economic Co-operation and Development - OECD). Both groups of countries stand to benefit, but the challenge is to balance the obvious benefits of financial liberalization and open markets with the risks of possible financial instability. International financial markets that are free, open, and large channel capital into its most productive international uses. Cross-border capital flows contribute to more rapid economic growth for borrowing countries than if they were to rely on domestic savings alone (as Canadians know from their own history). Investors can realize higher returns.Yet the recent crisis underlines the potentially catastrophic costs of financial instability. By some estimates, the Asian crisis countries (Indonesia, Malaysia, the Philippines, South Korea, and Thailand) received capital inflows in 1995-6 equal to about 6.6 per cent of gross domestic product (GDP), while the subsequent reversal of these flows in 1996-7 amounted to a swing of about 11 per cent of GDP. Such a dramatic reversal is bound to create a backlash against market forces as arbitrary and unfair. Indeed, some argue that if this is 'normal' operation of the system, why participate in it? It is significant, however, that nearly two decades after the Third World debt crisis began in Latin America, almost no government has chosen to withdraw from the international financial system. Indeed, Latin American governments have increased their economic openness by replacing inward-looking import substitution policies with outward-looking export policies and by removing barriers to foreign direct investment. In the wake of the east Asian financial crisis, which occurred in a benign international policy environment and among economies already very open, both South Korea and Japan have responded by increasing their openness to foreign direct investment and by opening their financial markets further.At the outset, it is important to remind ourselves that the very nature of finance means that financial crises have always been, and will always be, with us. Panics, manias, and other frenzied problems occur in even the strongest financial systems because of asymmetric information. Information is not perfectly available to borrowers and lenders alike. Frequently lenders do not know the full risks of their lending decisions; in the absence of full information, they react to each other and to rumours, moving in herds and causing financial markets to overshoot. …