IN DEFENSE OF FREE CAPITAL MARKETS The Case Against a New International Financial Architecture By David DeRosa Date Published: January 2001 ISBN 1-57600-036-X Suggested Retail Price: $27.95

Excerpt
A compelling argument for less regulation of the global markets.

Advocates of financial reform say that the 1990s and earlier periods teach that the foreign exchange market is episodically out of control and that capital flows can destabilize world markets, behaving more like wrecking balls than pendulums, in Soros's words. Consequently, the whole international monetary system needs redesign and supranational institutions like the IMF must be permanently and deeply involved with running the world economy.

These positions must be tempered by the study of the countries that have suffered the sharpest reversals of fortune in the 1990s. These same nations had dangerous domestic financial policies in place for a significant time before they descended into crisis. Moreover, when crisis did erupt, the government's response often exacerbated their problems.

The picture of history that is being told by most, but not all, of the would-be reformers lacks the essential recognition that financial crisis is mostly homegrown, not imported, and that it is usually preventable with modification of bad financial policies. By analogy, one could imagine a large, complex telephone network that is subject to intermittent failures. The reformers have concluded that the problem must be with the master switching circuitry, the analogue of the international capital market, before having taken a close look at the subscriber's kitchen wall phone, the parallel for domestic financial policies.

The common denominator in practically every crisis in the 1990s was an experiment with a fixed foreign exchange rate regime. Fixed foreign exchange regimes are founded on the promise of currency stability. Some of them have survived for years and have basked in their apparent success. Yet so many have ended in spectacular turmoil that one has to wonder if there isn't an inevitable day of reckoning for all pegged exchange rate currencies. What is often misunderstood is that fixed exchange rate systems, in and of themselves, have the power to attract foreign capital, provided that they reflect an appearance of permanence. They incubate the buildup of massive disequilibrium positions in the foreign exchange and fixed income markets. The famous carry trade, in which investors have taken leveraged positions in stabilized, high-yielding foreign currencies, is one example. Another is the phenomenon of foreign currency denominated debt accumulation in countries with fixed exchange rates. Both are motivated by the illusion that the fixed exchange rate regime will be permanent. If the day comes when the market suspects otherwise, a ferocious adjustment process can take place at a moment's notice when practically everyone inside and outside of the country tries to dump their exposure to the local currency.

The '90s, far from being an indictment of the international financial system, are a striking reminder of how potentially destructive fixed exchange rate regimes can be. Equally striking is the fact that once broken fixed exchange rate systems were replaced with floating regimes, no further disruptions occurred.

From In Defense of Free Capital Markets ©2001 Bloomberg Press