July 2, 2001
 

Reviewed by Gene Epstein
This book is the proverbial tall drink of water after a long trek through an intellectual desert. The currency and emerging-market meltdowns of the past decade have been shocking events that cry out for thoroughgoing analysis and explanation.

But apart from generating a few fleeting insights on these urgent issues, mainstream economists and commentators have served up the usual wasteland of airy musings, usually punctuated by the proposal that international regulatory bodies get beefed up, possibly with said economists and commentators in charge, to curb market excesses.

A pretentious work by Princeton economist Paul Krugman (The Return of Depression Economics, 1999), and the literary ravings of billionaire hedge-fund manager George Soros (Open Society: Reforming Global Capitalism, 2000) are prominent examples.

Now comes In Defense of Free Capital Markets: The Case Against a New International Financial Architecture, a book that, for the sake of its sales, should have had a different title, since its unique achievement is to explain to anyone of any ideological stripe the real causes and cures of these tragic happenings.

For sure, Ph.D. economist David F. DeRosa (a Yale School of Management Adjunct Professor and head of DeRosa Research & Trading) lays the responsibility squarely at the feet of government; at local governments for instituting ruinous fixed exchange-rate regimes; but most especially those two governing institutions, the U.S. Treasury Department and the International Monetary Fund.

His story even includes a villain or two, if (like me) you're willing to call former Treasury Secretary Robert Rubin villainous for helping to set in motion the forces that punished the innocent and rewarded the guilty.

For DeRosa, the key combustible material present in Mexico's unraveling of '94, and in the subsequent crises in Asia through 1998-99, was the practice of pegging the local currency to the dollar, yen and mark, together with the policy of protecting investors from their losses. If that thesis sounds odd, then consider how these policies can lead to behavior destructive enough to lay these economies low.

Although no brief sketch can do justice to DeRosa's analysis, here's one storyline: Say the Mexican peso is pegged at 3.0 to the dollar. What invariably occurs is that the returns on a dollar's worth of pesos will exceed the cost of borrowing that dollar by a wide margin.

In January '94, for example, the short-term peso-denominated interest rate on Treasury bills issued by the Mexican government exceeded comparable U.S. dollar rates by more than 6%. This kind of spread not only gives rise to the "carry-trade" speculators going short dollars and long the local currency. It also motivates domestic banks and businesses to borrow heavily in dollars from foreign investors and then convert those dollars to the local currency to transact their business.

What happens, then, is that pegging motivates virtually everyone to be long the local currency and short dollars -- a "bomb in the making," as DeRosa writes. For if and when the peg is abandoned, the local currency will plunge in value as the carry-trade rushes for the exits, and the dollars owed by government and business become ever more expensive to repay. Then come the U.S. Treasury and IMF to make matters worse.

When the peso was devalued in 1995, pushing Mexico into default, Treasury Secretary Rubin engineered a financial bailout. The result was that foreign investors and institutions were made whole, while Mexico slid into recession. And armed with the knowledge that the U.S. Treasury or IMF would come to the rescue if trouble arose, foreign investment flowed at an accelerating pace into the economies of Southeast Asia, where exactly the same preconditions for disaster were present. Among plausible cures, DeRosa rightly favors flexible exchange rates, plus the complete abandonment of the lethal practice of no-fault capitalism.

Many nonfiction books are basically padded versions of 30-page articles. But the 230 pages of In Defense of Free Capital Markets, while readable and clear, should have run 400-500. The book often covers far too much territory in too short a space, as when it tries to lay out the story of Japan's decline and fall. Its thesis would be more persuasive if placed within the context of the Austrian theory of business cycles.

On the other hand, what a pleasure to read any book that one wishes were longer.

Gene Epstein is Barron's economics editor
E-mail comments to editors@barrons.com

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