January 25, 2006

Global Capital Flows and Financial Crises

Drawing lessons from recent and historical financial crises, Charles Calomiris offers policy recommendations for managing risk in global financial markets.

Your essay in Globalization: What’s New? mentions two financial crises that took place roughly a century ago in Russia and Mexico. How did those events differ from more recent crises?

Those were examples of problems in the private part of the financial system, not the government accounts. What was interesting is that the governments of Russia and Mexico had uninterrupted access to international capital markets even during the crises, and they were able to provide support to their domestic financial systems in the form of liquidity. They were able to access the international capital markets as sovereign borrowers because they were on the gold standard. And because they were controlling their own fiscal affairs they were able to help their banking systems.

What we learned is that if the sovereign has fiscal control, then you don’t really need an IMF to assist the domestic financial system because the sovereign can do it. The reason we can’t do that today is because the sovereigns collapse alongside the banks. That happens either because the sovereigns’ fiscal problems are the cause of the financial crisis or because the banks are so protected during the crisis that the cost of bailing out the banks undermines the fiscal discipline of the government. If you do a comparison of what emerging market crises looked like 100 years ago as opposed to today, the ultimate lesson you get is we didn’t used to have “twin crises” — the simultaneous collapse of a country’s banking system and its currency.

Are the frequent financial crises of the past 25 years an inevitable byproduct of an integrated global financial system?

In a sense, yes, because those crises come about from the inconsistency between membership in a globally competitive environment and local crony capitalism. If you use the banks to create insider-connected lending to inefficient firms, the firms still have to compete in a global marketplace. So if you combine international trade with a crony banking system, that brings these two different mindsets together, and something’s got to give. If you add capital flows into the mix, you may accelerate that process because — especially if the local banks are accessing the capital in the form of short-term dollar-denominated debt — the banks may take enormous risks as part of their attempt to desperately prop themselves up and prop up their favored insider borrowers.

Research has shown that access to global capital helps countries with moderately developed economic and financial systems but may hurt countries with rudimentary systems. Should some countries limit foreign capital flows, and if so, how?

I think the answer is you should try to reform the domestic financial system to get rid of the perverse incentives toward taking risk and subsidizing crony capitalists. That’s the proximate source of the problem, so the solution is obviously to address the real problem. What if you can’t address that problem? Then I think there’s a legitimate argument for trying to limit short-term, hard-currency-denominated capital flows, but not to shut out all forms of foreign capital. So I would come to it as a last resort.

What lessons should investors and policymakers draw from the 2001 Argentine crisis?

The Argentine crisis was a failure to fulfill the promise of reform. Argentina established a sword of Damocles — something hanging from a thread over its head — in the form of the convertibility system and complete openness of capital markets and a whole variety of things that only made sense as policies if other changes were going to happen. One of the other changes was fiscal reform. Argentine labor laws also made the country very noncompetitive. The problem was that the government never completed the most important parts of the reform program. What that meant was that as time wore on, capital was no longer willing to come to Argentina.

The real lesson is that you can’t do things in pieces. In an emerging market country, fiscal reform is the sine qua non — you can’t have liberalization without it. Argentina fixed its banking system, but then at the same time it forced the banks to stuff themselves with government debt — because no one would buy the government debt outside the country — so the government twisted the arms of the pension funds and the banks and of course brought the banks down with the currency. The fiscal problem is the central problem because if you don’t fix it, it contaminates even the things you have fixed.

What steps should the IMF take to restore proper risk management to global financial markets?

The IMF needs to become a source of liquidity to mitigate the fallout that comes from financial crises. In particular, if country #1 has a major fiscal problem that makes it suffer a twin crisis, the IMF’s main obligation should be to look at what the ramifications are going to be for other countries. One of the things the IMF needs to do is to provide a rapid liquidity infusion on a coordinated basis to prevent the non-crisis-starting countries from suffering their own crises.

There are going to be some crises that might not be ultimately from insolvency. In those cases, being able to provide liquidity in a way that doesn’t encourage the use of IMF lending for bailouts could also be very helpful in preventing crises, not just in third-party countries but also in the country that’s experiencing the fundamental problem.

So my emphasis has been on creating mechanisms at the IMF that are geared toward that kind of liquidity provision. Banks in the United States do this with lines of credit, and we have ways of giving a borrower access to a line of credit but still making sure that the circumstances are appropriate for the use of that line of credit. I believe we could do that with a sovereign, and I think that’s what the IMF really should be thinking about.

You also need to have the right internal governance so that the IMF abides by the rules it establishes. My view is that the IMF as it’s currently constituted is simply too politically motivated. We used to think we wanted the IMF to be an agent of coercion to enforce something called the Washington Consensus of the G7. Well, we don’t have a Washington Consensus, really. If you start looking around the world, Korea’s a pretty important country, India’s a pretty important country, China’s a pretty important country, Russia’s a pretty important country, Mexico’s a pretty important country, Brazil’s a pretty important country. But none of them is in the G7.

The whole model of the slush-fund entity that we use as our agent to achieve our political objectives doesn’t make much sense if our political objectives are so heterogeneous. So we really have to change our mindset to make the IMF an effective mechanism, because, first of all, I don’t think it should be a political tool. But I would also say it can’t be a political tool, because the G7 no longer has a monopoly over political will.


Charles Calomiris is the Henry Kaufman Professor of Financial Institutions and academic director of the Jerome A. Chazen Institute of International Business at Columbia Business School and academic director of the Columbia University Center for International Business Research and Education (CIBER).

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Charles Calomiris

"Capital Flows, Financial Crises, and Public Policy"

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