Summer 2001-02

The Market for Capital Book Reviews Reviewed by Wolfgang Kasper

In Defense of Free Capital Markets: The Case Against a New International Financial Architecture
By David F. DeRosa
Princeton, New Jersey, Bloomberg Press, 2001, US$27.95  230 pp, ISBN 1 57660 036 X

The Volatility Machine: Emerging Economies and the Threat of Financial Collapse
By Michael Pettis
Oxford-New York, Oxford University Press, 2001, US$45.00, 245 pp, ISBN  0 19 514330 2

IT IS FASCINATING to see what two different authors-with different professional backgrounds, networks and different bodies of knowledge-discover when they examine the same problem. The two authors come up with differing conclusions, which are, I believe, compatible. David DeRosa and Michael Pettis looked at the increasing crises in international financial markets, from the Mexican crisis of 1994-95, the Asian 'meltdown' of 1997 to Russia's end-of-millennium debt default. DeRosa argues that national economies must not be squeezed into regulatory corsets, whereas Pettis advocates an internal bone structure that keeps national economic corpuses in crisis-resilient shape. Let me explain.

DeRosa, academic and journalist with the gilt-edged Bloomberg news service, also looked at the crises that shocked Europe's Exchange Rate Mechanism in the 1980s and at the financial side of Japan's protracted 'economic torpor'. He asked what might be achieved by regulation of international financial and capital markets (dubbed 'The New Financial Architecture'), which anti-market observers, ranging from Fred Bergsten , Eisuke Sasikabara and George Soros to UN bodies, and meddle-happy politicians, such as Clinton, Schröder and Mahathir, have been demanding, as before them dirigiste politicians such as Roosevelt.

DeRosa shows through well-documented, insightful case studies that all monetary crises started with wrong-headed policies and mismanagement at home. Capital market interventions and exchange-rate fixes postpone gradual adjustment, so that the unravelling of politically-created market disequilibria comes as an abrupt crisis. Politicians then blame foreign exchange markets rather than their own blunders and market interventions. DeRosa also spells out that there is no such thing as 'contagion' from currency crises, except among mismanaged regimes. Surprisingly, he makes little in this context of how well Taiwan and Singapore weathered 1997.

The Japanese sclerosis is analysed from a monetary angle, but-for my money-too little is made of the long tradition of 'guided' industry policy and interventionism in misdirecting capital investments. Neither does he acknowledge underlying factors, such as the ageing of the population. Mahathir's Malaysia comes in for particular criticism-for my money deservedly! In this case, DeRosa shows how megalomania, protectionism and the blatant cronyism of 'Mahathir Incorporated' (p. 108) saddled Malaysia with excessive foreign borrowing costs. They far exceeded the returns of the investments, which can over the long run be earned in a regulation-corrupted economy. Having myself served as an advisor to the Malaysian Treasury, I would also have spoken of the corruptive poison of 'positive' racial discrimination as the root cause of Malaysia's opportunistic interventionism. The initiators of a redistributionist 'New Economic Policy' (in the early 1970s) had floated the currency and liberalised capital flows, among other things to provide a 'safety brake' on excesses of political redistribution and interventionism. The brake had worked well in the late 1970s and early 1980s, when capital outflows and devaluation forced politicians to deregulate the economy and moderate redistribution. This paved the way for fast growth during the 1980s.

But, by the late 1990s, excessive debt, combined with growing interventionism and party-political cronyism, threatened a repeat of instability of the late 1970s/early 1980s. This time, Mahathir imposed capital controls and fixed the exchange rate, because he and his cronies were not going to accept external discipline. His egotistic power play was covered up by vituperative attacks on foreigners and capital markets, as well as internal witch hunts. In the process, economic freedom, the rule of law and much political freedom were destroyed, which will have dire long-term consequences. DeRosa appears oddly agnostic about this outcome of Mahathir's interventionism.

The policy conclusions of this well-informed and fluently written book are straightforward and compelling: no bunch of politicians or bureaucrats can handle the relevant knowledge about a dynamically changing, complex world as well as free currency markets do. DeRosa argues against all sorts of controls (which he, somewhat irritatingly, calls 'reforms' throughout the book). No bandwidths for currency movements. No prohibition of derivatives and hedge funds. No Tobin taxes on currency transactions. Above all, no fixing of the exchange rate! He shows that such devices are not workable in international markets and lead to costly subsequent crises.He sees a very small role for the IMF whose 'central planning from Washington' has aggravated various crises. Only free capital markets can give self-seeking politicians and their cronies the feedback necessary to inform them what institutions and policies are needed for stable growth.

Michael Pettis' book has a different thrust. Pettis, bond trader and Columbia University lecturer, argues that many emerging countries unwittingly acquire national balance sheets which expose them to financial market volatility, so that crises become inevitable. He applies the framework of corporate finance (summarised in Chapter 6, a gem!) to nations and shows that aggregate assets and liabilities of developing countries are often asymmetrically affected by reductions in global liquidity or exchange-rate fluctuations. Different from DeRosa, he takes free capital markets as given. Pettis argues that emerging economies should hedge against aggregate risks. For example exporters to the US dollar area should issue US dollar debt, so that a US dollar depreciation (which cuts export revenue in home-currency terms) is countered by an easing of the US dollar debt burden. This is sound advice, and I hope that an Australian PhD student or Treasury researcher analyses Australia's balance sheet on those terms. The real problems, which Pettis does not address, of course arise when countries no longer have the credit to borrow at almost any cost-such as Argentina at the time of writing-so that they cannot hedge by balancing assets and liabilities.

Pettis bases the analysis on Charlie Kindleberger's plausible insight that capital flows to and from peripheral economies are driven by the liquidity situation in the core of the global network-New York, London and Tokyo. He also bases his theory on an account of financial crises going back to 1820 in Chapter 4, another gem!

Abundant liquidity in the system as of 2001-02 makes financial crises less likely and is helping Latin American and East Asian countries, as well as Russia, to avoid serious reform and restructuring. But he rightly warns (in Chapter 10) that countries, which do not rid themselves of a liquidity trap in their balance-sheet structures, may face more serious collapses further down the track.

Pettis is at times oddly sceptical of the need for economic freedom and has the occasional stab at what he calls 'neoliberal policies'. But unfree economies rigidify and expose assets in the national balance sheet to risks when circumstances change. This detracts to my mind from an otherwise excellent book. Pettis also seems at times a bit starry-eyed about what bureaucracies can do, for example when he advocates that the IMF should evaluate a nation's sovereign risk management along his lines. This will certainly do some good, but it would be better if thousands of market participants adopted his analysis, incidentally also for the sales of his book!