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PubSkations
Tin; D i p j r t m e n t s
Features
Press Notices
21/09/98 Speech to New York Stock Exchange
Speaker: Prime Minister
Location: New York
I am sure you will want to talk about the British economy in the discussion that follows. But I
want to make a particular pitch to you first about investment in Northern Ireland. We have
made remarkable progress in the last year in the peace process. There is a new climate in
Northern Ireland. The Assembly will be up and running in the new year. The two communities
are working together.
If we are to make it work, we need economic prosperity, and that means private sector
investment. This will be the peace dividend.
Those of you who invest already in Northern Ireland - Ford, Du Pont, Seagate - know it is a
sound business decision. US companies invested half a billion dollars last year. Fourteen
thousand jobs have been created with 60 US companies.
I urge those of you who have not yet invested there to have a look. Northern Ireland offers a
highly educated and adaptable workforce. 40% go on to tertiary level education; good industrial
relations; a highly developed infrastructure.
We are going to mount a major campaign in October with an 11 city tour of North American
cities by Mo Mowlam, the new First Minister, David Trimble, and his deputy, Seamus Mallon. I
hope you and your colleagues will listen to them sympathetically.
However, any discussion of the new business opportunities opening up in Northern Ireland
takes place against the background of instability and uncertainty in the world economy.
In the past year we have seen a succession of financial crises in Thailand, Korea, Indonesia,
Malaysia, Russia and elsewhere. Around a quarter of the world economy is now in recession;
and many other countries in Latin America and Asia are facing financial market pressures.
Even in the US and the EU - which have so far remained islands of comparative stability - we
are now beginning to see the effects, as exporters face declining markets and stock markets
adjust.
In Britain, the full extent of the current problems in the global economy came home to us
recently with the closure in the North East of Fujitsu and Siemens. Two modern
semi-conductor plants. The loss of hundreds of jobs that were thought to be utterly secure. And
this has not just happened in Britain. As the financial crisis in Asia has accelerated, production
lines have been closed in Japan itself. Plants have closed in France and of course in the US,
where Mitsubishi, Matsushita and Hitachi have had to announce closures, and only last week
Motorola announced that they were halting work on a £3 billion investment in Virginia.
The vast capital flows that went to the emerging markets with such beneficial effects in the last
decade have gone into reverse with extraordinary speed and intensity. Asset prices have
gyrated wildly. Longstanding policy or institutional weaknesses have been dramatically
exposed. And the consistency and credibility of policy-makers have been rigorously tested.
In response, countries have had to cut domestic spending and reduce their trade deficits, often
very sharply. But some have also opted for short-term palliatives.
This has hastened the general "flight to quality", which risks undermining the efforts of those
countries conscientiously pursuing sound policies and far-reaching structural reform.
Amidst the turmoil and uncertainty we have to keep our nerve.
So how should we respond? The answer is in two parts.
Short-term measures to deal with the immediate crisis.
Long-run reforms to strengthen the international financial system.
The two must go hand in hand.
SHORT-TERM
In the short term it is crucial that emerging markets and developing countries press ahead with
reform. The lesson from the current crisis is not that market disciplines have failed, but that in a
global economy, with huge capital flows, the absence of such disciplines can have a
devastating effect. Countries must put in place the right policy framework - monetary policy
targeted at low inflation, sound and sustainable fiscal policies and structural reforms designed
to improve the supply side performance of the economy. Tax systems that work. Strong,
properly regulated and fully transparent banking and financial systems.
This applies with particular force to Russia. We must offer the new Russian government a clear
deal. If the process of reform resumes, we must of course continue to provide financial and
technical support, both bilaterally and through the IMF and the other international financial
institutions. We fully understand the domestic need to bring people along with the programme
of reform. There wi I no doubt be the occasional wrong turning on the way. But the essential
strategy and destination must be clear.
So it is a two-way deal, for Russia and for any other countries requiring short term help:
support but only in exchange for reform. •
And the developed world has other responsibilities, too, to help maintain confidence in the
short term.
1 of 3
10/1/98 4:11 PM
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IhforiTiation Centre - Releases
First macroeconomic policy. As G7 Finance Ministers and Governors made clear last week, the
balance of risk in the world economy has now shifted. Without interfering in any way with the
independence of central banks, we need to recognise that in an increasingly inter-dependent
global economy the policies of one country can have a major impact on the economies of
others and on the world economy as a whole. So the world's major economies must remain
vigilant and work closely together to ensure that growth is sustained.
The appropriate policy response will be different in each country. The US is in an advanced
stage of a long-term upswing. Recovery is gaining momentum in much of continental Europe
as countries prepare to launch the Euro. In the UK, we have seen a necessary slow-down in
growth as inf ationary pressures have been brought under control.
Japan is crucial to the world economy and has a special role to play in rebuilding confidence
and stability in Asia. It is by far the biggest economy in the region and a key export market of
the neighbouring economies.
I met the Japanese Prime Minister this morning, and welcomed the efforts that have been
made towards resolving the major problems in Japan's banking sector. Swift and strong fiscal
action to boost domestic demand in Japan and further decisive measures to strengthen the
financial system would provide the biggest single boost to investors' confidence in Asia and
beyond. I emphasised again today to Prime Minister Obuchi, the UK, with its G7 and EU
partners, will continue to support Japan as it seeks to meet these economic challenges.
Dialogue, co-ordination at least, of any information and where possible of any policy initiatives,
is going to be an important part of guiding the world economy through its present difficulties.
Secondly, in the industrialised world, we have a special responsibility to re ect protectionist
pressures. As Gordon Brown made clear in Tokyo last week, it is absolute y essential that we
keep the world trading system open. We must also start a new, comprehensive, round of trade
negotiations as soon as possible.
Third, we need to act swiftly to ensure that the IMF has the resources to ensure that where
countries are implementing the right economic policies they can be given sufficient financial
support. The IMF has lent $25 billion over the last year and it is important now to strengthen its
resources. The agreed Quota increase and the New Arrangements to Borrow must therefore
be implemented as soon as possible. It is important that you make clear to your legislators the
urgency of unblocking these measures rapidly.
Early action along these lines will help restore confidence. But I do not believe we can rest
there.
LONG TERM
The Bretton Woods institutions are now 54 years old. They were constructed for a world of
fixed exchange rates and capital controls, when international capital flows were much smaller.
The current crisis illustrates the weaknesses of the existing international financial system. It
needs to be modernised to meet the challenges of a new century.
There are five key priorities:
- first, greater openness and transparency. A key part of strengthening the global financial
system must be the implementation of codes of good practice. This year's G8 Summit in
Birmingham agreed that we must press ahead with the development of international
accounting standards. At the same time, I warmly welcome the fact that the IMF has developed
a code on fiscal transparency and is now working on a similar code on transparency in
monetary and financial policy. I would also strongly encourage the OECD to take forward its
parallel work on corporate governance. I have no doubt that promoting greater accountability
and openness will strengthen the incentives on governments to pursue sound policies, will
enable markets to price risk more accurately and should help all countries to manage more
effectively the risks of global integration;
- second, improving financial supervision and regulation. Recent developments have
underlined the vital importance of sound, properly regulated financial institutions. The IMF and
the World Bank need to give this issue much higher priority, working more closely together and
with the main international regulatory organisations. Over the next year I believe we need to
make more progress in three specific areas. First, it is essential to coordinate effectively the
supervision of internationally active financial institutions. The Joint Forum has produced
proposals on this. It should produce a further report for Finance Ministers next spring on how
far these have been implemented. Next, the New York Fed has established a Committee of
G10 and emerging market countries to monitor the implementation of the Basle principles on
banking supervision. I believe this process should now be given more teeth. For example each
country could be asked to provide an annual assessment of how far it meets the Basle
jrinciples. The UK would certainly be prepared to participate in such an exercise which could
lelp the international financial institutions and the private sector to identify weaknesses in the
current regulatory system. Finally, we must not lose sight of problems just round the corner.
Most obviously, the Year 2000 issue could pose real problems for the international financial
system. I believe that the IMF and the World Bank should focus on the actions countries are
taking to address this key problem.
- third, the ability of the international community to respond to short-term liquidity crises and to
help reforming countries maintain access to the international capital markets in times of
general financial turbulence. The banking systems of individual countries are typically
supported by a lender of last resort. The IMF does not and cannot play this role - the finance it
provides is strictly limited and is usually provided in return for specific policy demands
negotiated over a period of time. But it is vital that the international financial community has the
means to respond effectively to acute short-term liquidity crises, particularly those caused by a
generalised loss of market confidence rather than by economic policy failures in the countries
2 of 3
10/1/98 4:11 PM
�Information Centre - Releases
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concerned. This may require us to look imaginatively at the funding needed to support IMF
programmes, without in any way undermining the incentive countries have to pursue sound
policies;
- fourth, handling massive capital flows. The recent sharp movements in global capital flows
have provided a stark demonstration that while open capital markets do bring substantial
benefits, they also pose serious challenges. We need to ensure that the lessons of the last
year are properly learnt. For example it is vital that global investors assess more carefully the
risks associated with their lending decisions and price their loans appropriately. We need new
mechanisms to ensure close and regular contact between governments and the private sector
that can provide early warning of problems. And we need to approach the process of capital
account liberalisation with caution, ensuring that the right pre-conditions - in particular sound
financial systems - are in place.
- fifth, greater openness and accountability on the part of the international financial institutions
themselves. At a time when we are calling for greater accountability, transparency and
disclosure on the part of governments, it is essential that the international institutions apply
these principles themselves. Increased discussion of their programmes and explanation of their
advice will help to build a public consensus behind reform. I would therefore like to see
improved openness in procedures, and more systematic external evaluation of IMF policies. It
is important too that programmes should take full account of their impact on the poorest
sections of society.
Work is already going on in many of these areas. But it needs a broader vision and greater
political momentum, including the full support of Heads of Government. This is not a matter of
a few technical changes. We should not be afraid to think radically and fundamentally. We
need to commit ourselves today to build a new Bretton Woods for the next millennium.
As a first step, the G7 Finance Ministers and Central Bank bankers should take this initiative
forward as a matter of urgency when they meet in Washington next month, working closely
with the IMF and the other international financial institutions.
But this is not the 1940s, and the new Bretton Woods cannot be built just by Governments, or
by a handful of industrialised nations. We will have to reach out to a wider community - both
the developing nations, and outside experts - including financiers, economists and
businessmen.
/ believe we should set ourselves a deadline of one year in which this work should be done, so
that we can have the reformed institutions in place before the new Millennium. Firm proposals
should be put to the Heads of Government Summit next year and then to a wider forum next
September.
For in the end, if this process is to be successful, it will need to involve the Heads of
Government. Without the impetus they can provide we will not overcome the obstacles to
reform.
And given the gravity of the crisis we face, it is incumbent on all of us to provide the leadership
the world so desperately needs.
We live in a world economy hugely different from the one we grew up in. Crisis in one part of
the world affects economies in every other part of the world. As the impact is international, the
response must be international. So, together, we must design a new international financial
system for a new international financial age. Our prosperity, our stability, possibly our peace,
depends upon it.
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D E P A R T M E N T
202
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T R E VS V RV
NEWS
TREASURY
OFFICE OF PUBUC AFFAIRS * 1500 PENNSYLVANIA AVENUE, N.W. • WASHINGTON, D.C. • 20820 • (202) 622-2960
Po8t-it• Fax Note
7671
From
EMBARGOED UNTIL 1:00 p.m. EDT
Text as Prepared for Delivery
October 1, 1998
CoJOopl.
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FBX#
TREASURY SECRETARY ROBERT E. RUBIN REMARKS TO
THE DOW JONES/WALL STREET JOURNAL
ANNUAL CONFERENCE ON THE AMERICAS
NEW YORK, NY
I would to thank Peter Kann for that introduction, and Dow Jones and The Wall Street
Journal for hosting this conference, and for inviting me to speak with you today.
I would like to focus my remarks today on a topic of immense importance not only to the
nations of the Americas, but also the rest of the world: the urgent need to adapt and reform the
intemationalfinancialsystem for the 21st century. The backdrop for my discussion is the global
financial crisis, which erupted in Thailand over a year ago, spread throughout Asia, and to Russia,
and now threatens to spread to Latin America. This crisis has presented unprecedented and
enormously complex challenges to the internationalfinancialsystem created fifty years ago;
clearly the time has come to build a stronger system better suited for the challenges of the everchanging modem global economy. And it is a challenge that will be a focus of this weekend's
meetings of the Group of Seven industrialized nations, next week's meeting of the group of G-7
and emerging market economies, and next week's Annual Meetings of the World Bank and
Intemational Monetary Fund. Today I would like to discuss the approach of the United States to
these issues and areas where we believe we must take action.
Any discussion of changes to the globalfinancialsystem should be, from my perspective,
grounded in a fundamental belief that a market-based global economic system, based on the
relatively free flow of goods, services and capital between nations around the world, will best
promote global economic well being in the decades ahead. This system has been embraced by an
increasing number of nations over recent years, and has produced enormous gains in human
welfare. The enormous increases in trade and cross border capital flows have very much
contributed to our own economic well-being, and contributed even more to emerging markets, as
great flows of investment capital have helped lift millions of people out of poverty. Despite the
RR-2729
For press releases, speeches, public schedules and official biographies, call our 244iourfax line at (202) 622-2040
�•OCT-01-1998
15:24
202
6221999
P.02/03
recent crisis, most emerging markets across the globe - in Latin America, Asia and Eastern
Europe ~ are far better off today than before they embraced the global market-based system. For
example, even with the recent crisis, real per capita incomes in Korea and Thailand are-about 60%
higher than ten years ago.
However, I also believe that the global economy cannot live with the kinds of vast and
systemic disruptions that have occurred over the last year. We must address this challenge in
both the short and long-term.
In the short-term, the international community has worked aggressively to face the
immediate tasks of limiting the damagefromwhat is generally viewed as one of the most serious
financial challenges of the last 50 years and helping the affected emerging markets return to
stability and growth.
I believe the International Monetary Fund -r around which much of this effort has been
centered - has, on the whole, made sensible policy judgements in the face of complex and in
many ways unprecedented challenges. And the IMF has adjusted those judgements as
circumstances have warranted. The industrialized nations have worked in many ways to support
this strategy, in conjunction with the IMF and the World Bank, and bilaterally. The President has
now advocated in his recent speech moving forward in several other areas. Included in these is a
recognition that the balance of risk has shifted, as the G-7 Finance Ministers and Central Bank
Governors stated on the day the President spoke. He also emphasized there is no doubt that we
have much work to do in response to the current crisis. This crisis, as I have said, developed over
many years, and in my view the world is going to have to work through these problems for some
time to come.
For the long term, this crisis illustrates how, while free markets bring enormous benefits,
there are also accompanying problems that markets themselves cannot solve. Dealing with the
problems that markets alone cannot solve is essential to help maintain and expand thefreemarket
system. This was the logic behind the reforms andfinancialregulatory structure the United States
instituted for domestic markets in the 1930s: the Securities and Exchange Commission; laws
against manipulation; disclosure requirements; and a whole range of other measures, so that our
nation could receive the benefits of open capital markets with the accompanying problems greatly
moderated. At the same time, the United States began the introduction of deposit insurance,
which helped to strengthen confidence in our banking system.
Similarly, the intemational community is now working toward reforming the global
fmancial architecture to reduce the frequency and severity offinancialinstability in the future and,
when instability occurs, to deal with it more effectively. The intemational community launched a
renewed effort at the 1994 G-7 leaders meeting in Naples, At.that time, President Clinton,
recognizing that we needed a globalfinancialarchitecture commensurate with greatly changed
conditions, called for a review of the existing system. Out of that came a series of reforms
adopted at the 1995 G-7 leaders meetings which have been referred to as the Halifax initiatives.
�••CT-01-1998
15=25
202
6221999
P.03/03
Six months ago, we expanded on that effort to involve the Finance Ministers and Central Bank
Governors from the G-7 and key emerging markets to look toward broader and deeper measures.
At that time, the United States laid out a number of proposals in three broad areas forthe group
to consider. Now, in a meeting on October 5th, repons reflecting the work of 22 countries will
be presented suggesting concrete steps and proposals for future work to improve transparency,
strengthen country financial systems, and improve management of international financial crises
with private sector involvement.
Now we need to implement the recommendations, move forward on those complex issues
that have not been fully resolved, and, extend the reach of reform to other areas, as President
Clinton said in his speech last month. We must create a modern framework for the global markets
of the 21st century, though doing so will not be easy or quick, in order to improve and retain the
market-based system that will best promote future global economic well being.
To begin to accomplish these purposes, we need to understand that the responsibility for.
these crises does not lie in the emerging markets alone. A combination of factors underlie the
crisis of the last year: the dramatic changes in the global financial markets in recent decades; the
basic dynamics of markets; and the ill-discipline of creditors and investors in the industrial nations,
as well as the macroeconomic imbalances and theflawedfinancialsystems in a number of
emerging market economies.
First, the emerging market economies. Although circumstances differ in each of the
nations that have been enveloped in crisis, many shared a problem of underdeveloped and in some
cases badly flawed and poorly regulatedfinancialsystems and other structural problems. One key
problem was that banks and corporations in those countries borrowed too much in foreign
currency on a short term basis. In addition, banks in many cases extended credit on an unsound
basis, often as a result of government-directed lending or, non-arms length relationships between
creditors and borrowers. Moreover, many of these countries had very serious macroeconomic
imbalances and exchange rate problems. Thus these countries were more vulnerable to excess
injections of outside capital.
Second, the backdrop of dramatic changes in globalfinancialmarkets in the last three
decades. I began working in these markets in 1966 and I experiencedfirsthandthose changes.
Over the last 30 years, global capitalflowshave increased exponentially. The amount of money
that crosses a trader's desk is enormously greater today then when 1 left Wall Street six years ago
to say nothing of ten or twenty years ago, or fifty years ago when the Bretton Woods institutions
were created. The speed offlowsas a result of changes in technology has vastly increased. So
has the diversity of capital providers. Thirty years ago, providers were almost all banks; today
there are all sorts of providers, from mutual funds to endowments. There are also a great variety
of investment instruments, from plain vanilla bonds and stocks to immensely complex derivatives.
Moreover, a very large numbers of developing countries have more recently received large flows
of capital, while 20 or 30 years ago significant capital was going to far fewer emerging market
TOTAL P.03
�202
•CT-01-1998 15:26
D E P A R T M E N T
T
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6221999
P.01/09
T R E A S I' RV
INEWS
;
OFFICE OF PUBLIC AfTAIRS • 1500 PENNSYLVANIA AVENUE, N.W. • WASHINGTON, D.C- • 20220 • (202) 622-2S60
Post-lf Fax Note
7671
From
EMBARGOED UNTIL 1:00 p.m. EDT
Text as Prepared for Delivery
October 1, 1998
Co,/Dep..
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Co.
Phone#
F6X#
4-^'.^of
FaxK
TREASURY SECRETARY ROBERT E. RUB IN REMARKS TO
THE DOW JONESAVALL STREET JOURNAL
ANNUAL CONFERENCE ON THE AMERICAS
NEW YORK, NY
I would to thank Peter Kann for that introduction, and Dow Jones and The Wall Street
Journal for hosting this conference, and for inviting me to speak with you today.
I would like to focus my remarks today on a topic of immense importance not only to the
nations of the Americas, but also the rest of the world, the urgent need to adapt and reform the
internationalfinancialsystem for the 21st century. The backdrop for my discussion is the global
financial crisis, which erupted in Thailand over a year ago, spread throughout Asia, and to Russia,
and now threatens to spread to Latin America. This crisis has presented unprecedented and
enormously complex challenges to the international financial system created fifty years ago,
clearly the time has come to build a stronger system better suited for the challenges of the everchanging modern global economy. And it is a challenge that will be a focus of this weekend's
meetings of the Group of Seven industrialized nations, next week's meeting of the group of G-7
and emerging market economies, and next week's Annual Meetings of the World Bank and
International Monetary Fund. Today I would like to discuss the approach of the United States to
these issues and areas where we believe we must take action,
Any discussion of changes to the globalfinancialsystem should be, from my perspective,
grounded in a fundamental belief that a market-based global economic system, based on the
relatively free flow of goods, services and capital between nations around the world, will best
promote global economic well being in the decades ahead. This system has been embraced by an
increasing number of nations over recent years, and has produced enormous gains in human
welfare. The enormous increases in trade and cross border capitalflowshave very much
contributed to our own economic well-being, and contributed even more to emerging markets, as
great flows of investment capital have helped lift millions of people out of poverty. Despite the
RR-2729
For press releases, speeches, public schedules and official biographies, call our 24-hour fax line at (202) 622-2040
9
�.OCT-01-1998 15:26
202 6221999
P.02/09
recent crisis, most emerging markets across the globe ~ in Latin America, Asia and Eastern
Europe - are far better off today than before they embraced the global market-based system. For
example, even with the recent crisis, real per capita incomes in Korea and Thailand ar^-about 60%
higher than ten years ago.
However, I also believe that the global economy cannot live with the kinds of vast and
systemic disruptions that have occurred over the last year. We must address this challenge in
both the short and long-term.
In the short-term, the intemational community has worked aggressively to face the
immediate tasks of limiting the damagefromwhat is generally viewed as one of the most serious
financial challenges of the last 50 years and helping the aflfected emerging markets return to
stability and growth.
I believe the International Monetary Fund - around which much of this effort has been
centered - has, on the whole, made sensible policy judgements in the face of complex and in
many ways unprecedented challenges. And the IMF has adjusted those judgements as
circumstances have warranted. The industrialized nations have worked in many ways to support
this strategy, in conjunction with the IMF and the World Bank, and bilaterally. The President has
now advocated in his recent speech moving forward in several other areas. Included in these is a
recognition that the balance of risk has shifted, as the G-7 Finance Ministers and Central Bank
Governors stated on the day the President spoke. He also emphasized there is no doubt that we
have much work to do in response to the current crisis. This crisis, as I have said, developed over
many years, and in my view the world is going to have to work through these problems for some
time to come.
For the long term, this crisis illustrates how, while free markets bring enormous benefits,
there are also accompanying problems that markets themselves cannot solve. Dealing with the
problems that markets alone cannot solve is essential to help maintain and expand thefreemarket
system. This was the logic behind the reforms andfinancialregulatory structure the United States
instituted for domestic markets in the 1930s: the Securities and Exchange Commission; laws
against manipulation; disclosure requirements; and a whole range of other measures, so that our
nation could receive the benefits of open capital markets with the accompanying problems greatly
moderated. At the same time, the United States began the introduction of deposit insurance,
which helped to strengthen confidence in our banking system.
Similarly, the international community is now working toward reforming the global
financial architecture to reduce thefrequencyand severity offinancialinstability in the future and,
when instability occurs, to deal with it more effectively. The international community launched a
renewed effort at the 1994 G-7 leaders meeting in Naples. At.that time. President Clinton,
recognizing that we needed a global fmancial architecture commensurate with greatly changed
conditions, called for a review of the existing system. Out of that came a series of reforms
adopted at the 1995 G-7 leaders meetings which have been referred to as the Halifax initiatives.
�.OCT-01-1998 15:27
202 6221999
P.03/09
Six months ago, we expanded on that effort to involve the Finance Ministers and Central Bank
Governorsfromthe G-7 and key emerging markets to look toward broader and deeper measures.
At that time, the United States laid out a number of proposals in three broad areas forthe group
to consider. Now, in a meeting on October 5th, reports reflecting the work of 22 countries will
be presented suggesting concrete steps and proposals for future work to improve transparency,
strengthen country financial systems, and improve management of intemationalfinancialcrises
with private sector involvement.
Now we need to implement the recommendations, move forward on those complex issues
that have not been fully resolved, and, extend the reach of reform to other areas, as President
Clinton said in his speech last month. We must create a modernframeworkfor the global markets
of the 21st century, though doing so will not be easy or quick, in order to improve and retain the
market-based system that will best promote future global economic well being.
To begin to accomplish these purposes, we need to understand that the responsibility for
these crises does not lie in the emerging markets alone, A combination of factors underlie the
crisis of the last year: the dramatic changes in the globalfinancialmarkets in recent decades; the
basic dynamics of markets; and the ill-discipline of creditors and investors in the industrial nations,
as well as the macroeconomic imbalances and theflawedfinancialsystems in a number of
emerging market economies.
First, the emerging market economies. Although circumstances differ in each of the
nations that have been enveloped in crisis, many shared a problem of underdeveloped and in some
cases badlyflawedand poorly regulated financial systems and other structural problems. One key
problem was that banks and corporations in those countries borrowed too much in foreign
currency on a short term basis. In addition, banks in many cases extended credit on an unsound
basis, often as a result of government-directed lending or, non-arms length relationships between
creditors and borrowers. Moreover, many of these countries had very serious macroeconomic
imbalances and exchange rate problems. Thus these countries were more vulnerable to excess
injections of outside capital.
Second, the backdrop of dramatic changes in globalfinancialmarkets in the last three
decades. I began working in these markets in 1966 and I experiencedfirsthandthose changes.
Over the last 30 years, global capitalflowshave increased exponentially. The amount of money
that crosses a trader's desk is enormously greater today then when I left Wall Street six years ago
to say nothing of ten or twenty years ago, orfiftyyears ago when the Bretton Woods institutions
were created. The speed offlowsas a result of changes in technology has vastly increased. So
has the diversity of capital providers. Thirty years ago, providers were almost all banks; today
there are all sorts of providers,frommutual funds to endowments. There are also a great variety
of investment instruments,fromplain vanilla bonds and stocks to immensely complex derivatives.
Moreover, a very large numbers of developing countries have more recently received large flows
of capital, while 20 or 30 years ago significant capital was going to far fewer emerging market
�.001-01-1998
15:2?
202 6221999
P.04/09
countries. Any one of these changes would have been highly consequential, All together, they
have been revolutionary.
•
/
But the third major contributing factor was something that has not changed over time —
the basic dynamics of markets, and in particular their tendency to go to extremes. This has been a
subject of enormous attention back through the centuries during other famous global crises —
such as the Tulip Crisis in Holland in the 17th century, or the South Sea Bubble crisis of the 18th
century, and the Depression of the 1930s. The dynamics of markets, as a very wise man said to
me early in my years on Wall Street, are rooted in the human psyche.
Taken together, this combination offlawedeconomies, changes in the international
markets and the unchanging human psyche underlying markets helped produce the crisis of the
last year. The crisis did not begin in Thailand, as is often said; Thailand was simply the first
country in which these factors combusted.
I have seen this many times in the course of my career. As creditors and investors in
industrialized countries sought returns during a prosperous market era where spreads
progressively narrowed andriskpremium shrunk, they reached for yields and paid less and less
attention torisk— a common phenomenon during good times. As evidence, just look at the low
level ofriskpremiums across almost all assets going back a year or two. This included extending
more and more credit to, and investing more and more in, emerging markets in amounts not
justified by the underlying fundamentals.
When you look at all of this, one thing is clear; had the circumstances in the countries
been sounder, or capitalflowsbeen less excessive, there would have been problems, but not of the
size and scale that resulted in the current crisis.
From the first eruption in Thailand we said there was some chance that this crisis could
spread across the region and beyond, to envelop an ever increasing number of countries, which
has, of course, happened. We are now seeing this in Latin America, where while much remains to
be done, major nations have made great progress in the last ten years in dealing with
macroeconomic and structural issues. Just as capital onceflowedinto emerging market countries
without, in too many instances, due regard for proper analysis and weighting of risks, it is now
too often flowing out in a non-discriminatory, overly negative reaction to the fundamentals. And
that is leading to a contagion effect in Latin America that is, in my judgement, incommensurate
with the accomplishments of economic policy regimes in many Latin American nations.
A good example is Brazil, which has made important strides since President Cardoso
launched the real plan in 1994, helping to end inflation, privatizing key sectors of the economy,
and achieving many other structural reforms. While all countries have challenges they need to
meet. President Cardoso's commitment last week to accelerate reforms in this time of financial
market turbulence is a next critical step. As I said at the time, the United States believes that the
economic well-being of Brazil is critically important not only to our economy, but to the entire
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hemisphere. And we are in close consultation with Brazil and the international community about
what we can do to be helpful.
Let me now turn to the long-term - and the major foundation pieces for the architecture
of the globalfinancialsystem of the future. Before we consider these long term changes, we must
remember two critical points: first, that this subject be approached with great seriousness of
purpose, and second, that everyone with a stake in the process must do their part.
First, let me say a word about the need for seriousness. In recent months, there has been
no shortage of proposals that on the surface seem attractive. But what is needed with each
proposal is a rigorous analysis and evaluation of all so that serious judgments can be made and the
resulting blueprints and plans can stand the test of time. Moreover, as important as
accomplishing what needs to be done is avoiding what should not be done.
Second, going forward, everyone with a stake in the process - from governments in both
emerging markets and industrialized nations, to creditors and investors, and to the international
financial institutions must do their part. Each of these players will have different responsibilities.
For their part, as the internationalfinancialinstitutions help countries change, they must
also change themselves. I have no doubt that they will be very different institutions infiveyears
time: more transparent; more open; and more accountable. The IMF and the World Bank must
also examine their programs and policies and change them where needed. For example they must
work harder on providing adequate social support and on reinforcing good governance and
reinforcing political commitment to reform. And, I might add, we in the United States must
fulfill our responsibility ~ and provide the funding that the President has requested for the IMF.
The international community must have the resources that it needs to deal with this crisis that has
spread to so many emerging economies and threatens the economic well being of the American
people.
The industrialized nations, both individually and as a group, also have significant
responsibilities. Because policy shortcomings in the major industrial economies affect all nations
in the global economy, we must act to maintain stability and growth in our own economies as a
source of strength for the rest of the world. In the ^SO's and early 1990's, it was the enormous
fiscal deficit of the United States that posed the greatest danger to global economic growth.
Going forward today, Japan must urgently implement strong effective measures to lead to
strong, sustained demand led growth, critical not only for its own benefit, but also for recovery
from the global crisis. In the future, industrial nations must work together so that each country
fulfills its responsibilities to promote sound policies and sustain growth. The interdependence of
our economics, and of all members of our global economy, makes this imperative.
I also believe that it is in the enlightened self-interest of the industrial nations to greatly
increase international support to help build the foundations of private sector-based economies in
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Federal Reserve Board
Testimony of Chairman Alan Greenspan
Private-sector refinancing of the large hedge fund, Long-Term Capital Management
Before the Committee on Banking and Financial Services, U.S. House of
Representatives
October 1, 1998
Mr. Chairman and other members of the Committee, I thank you for this opportunity to
report on the Federal Reserve's role in facilitating the private-sector refinancing of the large
hedge fund, Long-Term Capital Management (LTCM). In my remarks this morning, I will
attempt to put into some perspective the events of the past few weeks and discuss some
questions of importance to public policy makers that they raise.
The Federal Reserve Bank of New York's efforts were designed solely to enhance the
probability of an orderly private-sector adjustment, not to dictate the path that adjustment
would take. As President McDonough just related, no Federal Reserve funds were put at
risk, no promises were made by the Federal Reserve, and no individual firms were
pressured to participate. Officials of the Federal Reserve Bank of New York facilitated
discussions in which the private parties arrived at an agreement that both served their
mutual self interest and avoided possible serious market dislocations. Financial market
participants were already unsettled by recent global events. Had the failure of LTCM
triggered the seizing up of markets, substantial damage could have been inflicted on many
market participants, including some not directly involved with the firm, and could have
potentially impaired the economies of many nations, including our own. With credit spreads
already elevated and the market prices of risky assets under considerable downward
pressure, Federal Reserve officials moved more quickly to provide their good offices to
help resolve the affairs of LTCM than would have been the case in more normal times. In
effect, the threshold of action was lowered by the knowledge that markets had recently
become fragile. Moreover, our sense was that the consequences of a fire sale triggered by
cross-default clauses, should LTCM fail on some of its obligations, risked a severe drying
up of market liquidity. The plight of LTCM might scarcely have caused a ripple in financial
markets or among federal regulators 18 months ago—but in current circumstances it was
judged to warrant attention.
What is remarkable is not this episode, but the relative absence of such examples over the
past five years. Dynamic markets periodically engender large defaults.
Events of the Past Few Weeks
LTCM is a hedge fund, or a mutual fund that is structured to avoid regulation by limiting its
clientele to a small number of highly sophisticated, very wealthy individuals and that seeks
high rates of return by investing and trading in a variety offinancialinstruments. Since its
founding in 1994, LTCM has had a prominent position in the community of hedge funds, in
part because of its assemblage of talent in pricing and trading financial instruments, as well
as its large initial capital stake. In its first few years of business, it earned an enviable
reputation by racking up a string of above-normal returns for its investors.
LTCM appears principally to have garnered those returns by making judgments on interest
rate spreads and the volatilities of market prices. In its search for high return, LTCM
levered its capital through securities repurchase contracts and derivatives transactions,
relying on sophisticated mathematical models of behavior to guide those transactions. As
long as the configuration of returns generally mimicked their historical patterns, LTCM's
mathematical models of asset pricing could be used to ferret out temporary market price
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anomalies. Their trading both closed such price gaps and earned an extra bit of return on
capital for them. But it is the nature of the competitive process driving financial innovation
that such techniques would be emulated, making it ever more difficult to find market
anomalies that provided shareholders with a high return. Indeed, the very efficiencies that
LTCM and its competitors brought to the overall financial system gradually reduced the
opportunities for above-normal profits. Indeed, LTCM acknowledged this when returning
$2-3/4 billion of capital to investors at the end of 1997. To counter these diminishing
opportunities, LTCM apparently reached further for return over time by employing more
leverage and increasing its exposure to risk, a strategy that was destined to fail.
Unfortunately for its shareholders, LTCM chose this exposure just as financial market
uncertainty and investor risk aversion began to rise rapidly around the world.
In that environment—so at variance with the experience built into its models—LTCM's
embrace of risk on a large scale produced stunning losses. As we now know, by the end of
August the firm had lost half its capital base. And as September unfolded, the bleeding
continued. The firm, however, apparently did not unwind its positions significantly.
In our dynamic market economy, investors and traders, at times, make misjudgments. When
market prices and interest rates adjust promptly to evidence of such mistakes, their
consequences are generally felt mostly by the perpetrators and, thus, rarely cumulate to
pose significant problems for the financial system as a whole. Indeed, the operation of an
effective market economy necessitates that investment funds committed to capital projects
that do not accurately reflect consumer and business preferences should incur losses and
ultimately be liquidated. What value is left needs to be redirected to profitable uses—those
that more accurately reflect market preferences. By such winnowing of inefficiencies,
productivity is enhanced and standards of livings expand over time.
Financial markets operate efficiently only when participants can commit to transactions
with reasonable confidence that the risk of nonpayment can be rationally judged and
compensated for. Effective and seasoned markets pass this test almost all of the time. On
rare occasions, they do not. Fear, whether irrational or otherwise, grips participants and they
unthinkingly disengage from risky assets in favor of those providing safety and liquidity.
The subtle distinctions that investors make, so critical to the effective operation of fmancial
markets, are abandoned. Assets, good and bad, are dumped indiscriminately in
circumstances of high uncertainty and fear that are not conducive to planning and
investment. Such circumstances, were they generalized and persistent, would be wholly
inconsistent with the functioning of sophisticated economies supported by long-term capital
investment.
Quickly unwinding a complicated portfolio that contains exposure to all manner of risks,
such as that of LTCM, in such market conditions amounts to conducting a fire sale. The
prices received in a time of stress do not reflect longer-run potential, adding to the losses
incurred. Of course, a fire sale that transfers wealth from one set of sophisticated market
players to another, without any impact on the financial system overall, should not be a
concern for the central bank. Moreover, creditors should reasonably be expected to put
some weight on the possibility of a large market swing when making their risk assessments.
Indeed, when we examine banks we expect them to have systems in place that take account
of outsized market moves. However, a fire sale may be sufficiently intense and widespread
that it seriously distorts markets and elevates uncertainty enough to impair the overall
functioning of the economy. Sophisticated economic systems cannot thrive in such an
atmosphere.I
The scale and scope of LTCM's operations, which encompassed many markets, maturities,
and currencies and often relied on instruments that were thinly traded and had prices that
were not continuously quoted, made it exceptionally difficult to predict the broader
ramifications of attempting to close out its positions precipitately. That its mistakes should
be unwound and losses incurred was never open to question. How they should be unwound
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and when those losses incurred so as to foster the continued smooth operation of financial
markets was much more difficult to assess. The price gyrations that would have evolved
from a fire sale would have reflected fear-driven judgments that could only impair effective
market functioning and generate losses for innocent bystanders.
While the principle that fire sales undermine the effective functioning of markets may be
clear, deciding when a potential market disruption rises to a level of seriousness warranting
central bank involvement is among the most difficult judgments that ever confronts a
central banker. In situations like this, there is no reason for central bank involvement unless
there is a substantial probability that a fire sale would result in severe, widespread, and
prolonged disruptions to financial market activity.
It was the judgment of officials at the Federal Reserve Bank of New York, who were
monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in
a forced liqudiation would not only have a significant distorting impact on market prices
but also in the process could produce large losses, or worse, for a number of creditors and
counterparties, and for other market participants who were not directly involved with
LTCM. In that environment, it was the FRBNY's judgment that it was to the advantage of
all parties—including the creditors and other market participants—to engender ifat all
possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation
following a set of cascading cross defaults.
As President McDonough has detailed, officers of the Federal Reserve Bank of New York
contacted a number of creditors and asked if there were alternatives to forcing the firm into
bankruptcy. At the same time, FRBNY officers informed some of their colleagues at the
Federal Reserve Board, the Treasury, and other financial regulators of their ongoing
activities. The troubles of LTCM were not a complete surprise to its counterparties. After
all, LTCM's earlier statements regarding its August losses were well known, and
sophisticated counterparties understood the difficulties in closing out large losing positions.
In addition, the commercial banks among its creditors had already begun taking normal
precautionary measures associated with exposure to counterparties whose condition is
deteriorating. Still, creditors as a whole most likely underestimated the size and scope of the
market bets that LTCM was undertaking, an issue that is currently under review.
On September 23, the private sector parties arrived at an agreement providing a capital
infusion of about $3-1/2 billion in return for substantially diluting existing shareholders'
stake in LTCM. Control of the firm passed from the current management to a committee
determined from the outside by the new investors. Those investors intend to shrink LTCM's
portfolio so as to reduce risk of loss and return the remaining capital to the investors as soon
as practicable. I do not rule out the possibility that the new owners of what is left of LTCM
may decide to keep part of it in business. That is their judgment to make.
This agreement was not a government bailout, in that Federal Reserve funds were neither
provided nor ever even suggested. Agreements were not forced upon unwilling market
participants. Creditors and counterparties calculated that LTCM and, accordingly, their
claims, would be worth more over time if the liquidation of LTCM's portfolio was orderly
as opposed to being subject to a fire sale. And with markets currently volatile and investors
skittish, putting a special premium on the timely resolution of LTCM's problems seemed
entirely appropriate as a matter of public policy.
Of course, any time that there is public involvement that softens the blow of private-sector
losses—even as obliquely as in this episode—the issue of moral hazard arises. Any action by
the government that prevents some of the negative consequences to the private sector of the
mistakes it makes raises the threshold of risks market participants will presumably
subsequently choose to take. Over time, economic efficiency will be impaired as some
uneconomic investments are undertaken under the implicit assumption that possible losses
may be borne by the government.
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But is much moral hazard created by aborting fire sales? To be sure, investors wiped out in
a fire sale will clearly be less risk prone than if their mistakes were more orderly unwound.
But is the broader market well served if the resulting fear and other irrational judgments
govern the degree of risk participants are subsequently willing to incur? Risk taking is a
necessary condition for wealth creation. The optimum degree of risk aversion should be
governed by rational judgments about the market place, not the fear flowing from fire sales.
The Federal Reserve provided its good offices to LTCM's creditors, not to protect LTCM's
investors, creditors, or managers from loss, but to avoid the distortions to market processes
caused by afire-saleliquidation and the consequent spreading of those distortions through
contagion. To be sure, this may well work to reduce the ultimate losses to the original
owners of LTCM, but that was a byproduct, perhaps unfortunate, of the process.
I should add that, in order to keep incentives working in their favor, the creditors of LTCM
apparently also understood the importance of some cushioning of the losses to the owners
and managers of the firm. The private creditors and counterparties in the rescue package
chose to preserve a sliver of equity for the original owners-one tenth—so that some of the
management would have an incentive to stay with the firm to assist in the liquidation of the
portfolio. Regrettably, the creditors felt that, given the complexity of market bets woven
into a bewildering arrray of fmancial contracts, working with the existing management
would be far easier than starting from scratch.
Some Questions for Policy Makers
Without doubt, extensive study will be required to put the events of the past few weeks into
proper perspective. As a member of the President's Working Group on Financial Markets, I
support Secretary Rubin's call for a special study on the public policy implications of hedge
funds. While the affairs of LTCM are by no means settled, I would like to pose some
tentative questions that may have to be addressed.
First, how much dependence should be placed on financial modeling, which, for all its
sophistication, can get too far ahead of human judgment? This decade is strewn with
examples of bright people who thought they had built a better mousetrap that could
consistently extract an abnormal return from fmancial markets. Some succeed for a time.
But while there may occasionally be misconfigurations among market prices that allow
abnormal returns, they do not persist. Indeed, efforts to take advantage of such
misalignments force prices into better alignment and are soon emulated by competitors,
further narrowing, or eliminating, any gaps. No matter how skillful the trading scheme, over
the long haul, abnormal returns are sustained only through abnormal exposure to risk.
Second, what steps could counterparties have taken to ensure that they had properly
estimated their exposure, particularly in markets that are volatile? To an important degree,
the creditors of LTCM were induced to infuse capital into the firm because they failed to
stress test their counterparty exposures adequately and therefore underestimated the size of
the uncollateralized exposure that they could face in volatile and illiquid markets. In part,
this also reflected an underappreciation of the volume and nature of the risks LTCM had
undertaken and its relative size in the overall market. By failing to make those
determinations, its fellow market participants failed to put an adequate brake on LTCM's
use of leverage. To be sure, sometimes decisions are based on judgments about the
soundness of borrowers that are accepted from third parties or, possibly in this case, that are
founded on the impressive qualifications of LTCM's principals. In some cases, such
truncated risk appraisals may be accurate, but they are not a substitute for a rigorous
analysis by the lender of the borrower's overall credit worthiness and risk profile.
Third, in this regard what lessons are there for bank regulators? Domestic commercial bank
exposure to LTCM included both direct lending and acting as counterparties to the firm in
derivatives contracts. A preliminary review of bank dealings with LTCM suggests that the
banks have collateral adequate to cover most of their current mark-to-market exposures
with LTCM. The unexpected surge in risk aversion and the dramatic opening up of interest
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rate spreads in August obviously caught LTCM wrong footed. Counterparties, including
banks, continued to collect collateral for marks to market. What they were not collateralized
against was the losses that might have occurred when prices moved even further and market
liquidity dried up in a fire sale.
Supervisors of banks and security firms must assess whether current procedures regarding
stress testing and counterparty assessment could have been improved to enable
counterparties to take steps to insulate themselves better from LTCM's debacle. More
important will be the assessment of whether those procedures are adequate for the future.
But this is an area in which much work has been ongoing. During the fourth quarter of 1997
and the first quarter of 1998, supervision staff of the Federal Reserve Bank of New York
and the Board met with managers at several major New York banking institutions to discuss
their current relationships with hedge funds, updating a similar study conducted 3-1/2 years
earlier.
Fourth, does the fact that investors have lost most of their capital and creditors may take
some losses on their exposure to LTCM call for direct regulation of hedge funds? It is
questionable whether hedge funds can be effectively directly regulated in the United States
alone. While their financial clout may be large, hedge funds' physical presence is small.
Given the amazing communication capabilities available virtually around the globe, trades
can be initiated from almost any location. Indeed, most hedge funds are only a short step
from cyberspace. Any direct U.S. regulations restricting their flexibility will doubtless
induce the more aggressive funds to emigrate from under our jurisdiction. The best we can
do in my judgment is what we do today: Regulate them indirectly through the regulation of
the sources of their funds. We are thus able to monitor far better hedge funds' activity,
especially as they influence U.S financial markets. If the funds move abroad, our oversight
will diminish.
In the first line of risk defense, if I may put it that way, are hedge funds' lenders and
counterparties. Commercial and investment banks especially have the analytic skills to
judge the degree of risk to which the funds are exposed. Their sel f interest has, with few
exceptions but including the one we are discussing today, controlled the risk posed by
hedge funds. Banking supervisors are the second line of risk defense in their examination of
lending procedures for safety and soundness. We neither try, nor should we endeavor, to
micro-manage bank lending activity. We have nonetheless built up significant capabilities
in evaluating the complex lending practices in OTC derivatives markets and hedge funds.
If, somehow, hedge funds were barred worldwide, the American financial system would
lose the benefits conveyed by their efforts, including arbitraging price differentials away.
The resulting loss in efficiency and contribution to financial value added and the nation's
standard of living would be a high price to pay—to my mind, too high a price.
Fifth, how much weight should concerns about moral hazard be given when designing
mechanisms for governmental regulation of markets? By way of example, we should note
that were banks required by the market, or their regulator, to hold 40 percent capital against
assets as they did after the Civil War, there would, of course, be far less moral hazard and
far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would
be profitable, the degree of financial intermediation less, capital would be more costly, and
the level of output and standards of living decidely lower. Our current economy, with its
wide financial safety net, fiat money, and highly leveraged financial institutions, has been a
conscious choice of the American people since the 1930s. We do not have the choice of
accepting the benefits of the current system without its costs.
Conclusion
For so long as there have been fmancial markets, participants have had on occasion to
weigh the costs and, especially, the externalities associated with fire-sale liquidations of
troubled entities against short-term assistance to tide the firms over for a time. It was such a
balancing of near-term costs and longer-term benefits that presumably led J.P. Morgan to
convene the leading bankers ofhis age—both commercial and investment—in his library in
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1907 to address the severe panic of that year. Such episodes were recognized as among
those rare occasions when otherwise highly effective markets seize up and temporary ad
hoc responses were required. The convening of LTCM investors and lenders last week at
the Federal Reserve Bank of New York could be viewed in that long tradition. It should
similarly be viewed as a rare occasion, warranted because of the potential for serious
disruptions to markets. We must also remain mindful where to draw the line at which
public-sector involvement ends. The efforts last week were limited to facilitating a
private-sector agreement and had no implications for Federal Reserve resources or policies.
Testimony of William J. McDonough
Footnotes
At the same time, not all fire sales are without merit. The Resolution Trust Corporation
earlier this decade chose to offer commercial real estate in what might be termed a fire sale
because it was the only way an otherwise seized-up market could be galvanized. Some level
of market prices had to be established-even if below "intrinsic" or longer-run value in order
to re-establish a two-way market. This was a special case.
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Federal Reserve Board
Testimony of Chairman Alan Greenspan
The crisis in emerging market economies
Before the Committee on the Budget, U.S. Senate
September 23,1998
The crisis in emerging market economies that began in Thailand a little over a year ago,
spread to other economies in East Asia and Russia, and has most recently been pressuring a
number of economies in Latin America. There is little evidence to suggest that the
contagion has subsided.
Moreover, the declines in Asian export markets only added to the difficulties in Japan,
which was struggling with a preexisting set of corrosive banking problems. Those
difficulties have contributed to that economy's most protracted recession in the postwar era.
As I indicated several weeks ago to a university audience, it is just not credible that the
United States, or for that matter Europe, can remain an oasis of prosperity unaffected by a
world that is experiencing greatly increased stress.
With few signs that the financial crisis that started in Asia last year has subsided, or is about
to do so, policymakers around the world have to be especially sensitive to the deepening
signs of global distress, which can impact their own economies.
In emerging markets, after about six months of relative stability, heightened perceptions of
credit risk erupted in mid-August when Russia, which seemed to have been making
progress toward greater stability, fell into renewed crisis.
Russia is not large in the world's trade accounts or critical to the stability of the
international financial system. Nevertheless, the severity of its crisis and the authorities'
inability to contain it reflected a significant jump of contagion out of East Asia, which, until
then, had been assumed to have gone into remission.
The shock drove yields on dollar-denominated debt securities of emerging market
economies sharply higher across the globe, engulfing economies that are as radically
different as Korea, Brazil, Poland, South Africa, and China. To be sure, some yields have
increased only one to two percentage points, while others have risen ten points or more. But
all these economies have experienced stress. The flight to safety has significantly
augmented the demand for U.S. Treasury securities, whose yields have declined in tandem
with the increases in yields on most dollar-denominated sovereign debt in international
bond markets.
In recent weeks, that shift internationally has also been accompanied by a rising concern for
risk in the United States, presumably reflecting the fear that the contagion would adversely
affect our economy.
When I testified before the Congress in July, I noted that some of the effects of the
international crisis had actually been positive for the U.S. fmancial markets and economy,
for example, by lowering long-term interest rates paid by our households and businesses.
However, the most recent more virulent phase of the crisis has infected our markets as well.
Concerns about business profits and a general pulling back from risk-taking in the midst of
great uncertainty around the globe have driven down stock prices and pushed up rates on
the bonds of lower-rated borrowers. Flows of funds through financial markets have been
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disrupted, at least temporarily. Issuance of equity, and of bonds by lower-rated
corporations, has come virtually to a halt; even investment-grade companies have cut back
substantially on their borrowing in capital markets. Banks also are reportedly becoming
more cautious and more expensive lenders to many companies.
There is little evidence to date, however, that foreign problems or the tightening in financial
conditions in domestic markets have produced any significant underlying weakness in the
American economy as a whole. Moreover, labor markets remain tight and hourly
compensation has continued to grow more rapidly. Nonetheless, the increases in overall
costs and the CPI have been held to modest levels by reasonably good productivity
advances, lower oil prices, and foreign competition.
However, looking forward, the restraining effects of recent developments on the U.S.
economy are likely to intensify. As I noted in congressional testimony last week, we can
already see signs of the erosion of production around the edges, especially in
manufacturing. Disappointing profits in a number of industries and less rapid expansion of
sales suggest some stretching out of capital investment plans in the months ahead. Lower
equity prices and higher financing costs should damp household and business spending, and
greater uncertainty and risk aversion may also lead to more cautious spending behavior.
When I testified on monetary policy in July, I explained that the Federal Open Market
Committee was concerned that high-indeed rising-demand for labor could produce cost
pressures on our economy that would disrupt the ongoing expansion. I also noted that a
high real federal funds rate was a necessary offset to expansionary conditions elsewhere in
financial markets. By mid-August the Committee believed that disruptions abroad and more
cautious behavior by investors at home meant that the risks to the expansion had become
evenly balanced. Since then, deteriorating foreign economies and their spillover to domestic
markets have increased the possibility that the slowdown in the growth of the American
economy will be more than sufficient to hold inflation in check.
As I have indicated in earlier presentations, the dramatic advances in computer and
telecommunications technologies over the last decade have fostered a marked increase in
the degree of sophistication of financial products. A vast new array of debt, equity and
hybrid instruments, as well as newly crafted derivative products have fostered an
unbundling of risks, which, in turn, has enabled investors to optimize (as they see it) their
portfolios of fmancial assets. This has engendered a set of market prices and interest rates
that have guided business organizations increasingly toward producing those capital
investments that offer the highest long-term rates of return, that is, those investments that
most closely align themselves with the prospective value preferences of consumers. This
process has effectively directed scarce savings into our most potentially valuable productive
capital assets. The result, especially in the United States, where financial innovations are
most advanced, has been an evident acceleration in productivity and standards of living,
and, owing to the financial sector's increased contribution to the process, a greater share of
national income earned by it over the past decade.
The new financial innovations, which have spread at a quickened pace, have facilitated a
rapid expansion of cross-border investment and trade, and almost surely, as a consequence,
a significant increase in standards of living for those nations that have chosen to participate
in what can appropriately be called our new international financial system. The system is
new in the sense that its dynamics appear somewhat more accelerated relative to the
international financial structure of, say, fifteen or twenty years ago. Owing to the newer
technologies, market prices have become more sensitively tuned to subtle changes in
preferences and, hence, react to those changes far faster than in previous generations. The
system is productive of increased standards of living and more sensitive to capital misuse. It
is a system more calibrated than before to not only reward innovation but also to discipline
the mistakes of private investment or public policy.
Thus, the crises that have emerged out of this new financial structure, while sharing most of
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the characteristics of past episodes, nonetheless, appear different in important ways. It is not
yet clear whether recent crises are deeper than in the past, or just triggered more readily.
In early 1995,1 characterized the Mexican crisis as the first crisis of this new international
financial system. The crisis that started in East Asia more than a year ago, is its second.
Since the Mexican crisis, policymakers have been engaged in an accelerated learning
process of how this new system works.
There are certain elements that are becoming evident.
The sensitivity of market responses under the new regime has been underscored by the
startling declines of exchange rates of some emerging market economies against the dollar,
and most other major currencies, of 50 percent or more in response to what at first appeared
to be relatively modestfinancialdifficulties. Market discipline appears far more draconian
and less forgiving than twenty or thirty years ago.
Capital, which in an earlier period may have flowed to a "merely adequate" profit
environment, owing to a lack of information or opportunity, now shifts predominantly to
those ventures or economies that appear to excel. This capital, in times of stress, also flees
more readily to securities and markets of unquestioned quality and liquidity.
It has taken the longstanding participants in the international financial community many
decades to build sophisticatedfinancialand legal infrastructures that buffer shocks. Those
infrastructures discourage speculative attacks against a well entrenched currency because
financial systems are robust and are able to withstand vigorous policy responses to such
attacks. For the more recent participants in globalfinance,their institutions, until recently,
had not been tested against the rigors of major league pitching, to use a baseball analogy.
The situation in many emerging market economies is illustrative. Under stress, fixed
exchange rate arrangements have failed from time to time. Consequently, domestic
currency interest rates, reflecting devaluation probability premiums, are almost always
higher in emerging market economies with fixed exchange rates than in the economy of the
major currency to which the emerging economy has chosen to peg. That currency is often
the dollar.
This phenomenon, and its risky exploitation, is one important element in the current crisis
and a symptom of what has gone wrong generally. What appeared to be a successful
locking of currencies onto the dollar over a period of years in East Asia and elsewhere, led,
perhaps inevitably, to large borrowings of cheaper dollars to lend at elevated domestic
interest rates, with the intermediary pocketing the devaluation risk premium. When the
amount of unhedged dollar borrowings finally became excessive, as was almost inevitable,
the exchange rate broke. Incidentally, it also broke in Sweden in 1992 when large
borrowings of DM to lend in krona at higher interest rates met the same fate. Such episodes
are not uncommon, suggesting that investors, even sophisticated ones, are prone to this type
of gambling.
This heightened sensitivity of exchange rates of emerging economies under stress would be
of less concern if banks and other fmancial institutions in those economies were strong and
well capitalized. Developed countries' banks are highly leveraged, but subject to sufficiently
effective supervision so that, in most countries, banking problems do not escalate into
internationalfinancialcrises. Most banks in emerging nations are also highly leveraged, but
their supervision often has not proved adequate to forestall failures and a general financial
crisis. The failure of some banks is highly contagious to other banks and businesses that
deal with them.
This weakness in banking supervision in emerging market economies was not a major
problem for the rest of the world prior to those economies' growing participation in the
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international financial system over the past decade or so. Exposure of an economy to
short-term capital inflows, before its financial system is sufficiently sturdy to handle a large
unanticipated withdrawal, is a highly risky venture.
It, thus, seems clear that some set of standards for participation in the new highly sensitive
international financial system is essential to its effective functioning. There are many ways
to promulgate such standards without developing an inappropriately exclusive and
restrictive club of participants.
One is far greater transparency in the way domesticfinanceoperates and is supervised. This
is essential if investors are to make more knowledgeable commitments and supervisors are
to judge the soundness of such commitments by their financial institutions. A better
understanding of financial regimes as yet unseasoned in the vicissitudes of our international
financial system also will enable counterparties to more appropriately evaluate the credit
standing of institutions investing in such financial systems. There is no mechanism,
however, to insulate investors from making foolish decisions, but some of the ill-advised
investing of recent years can be avoided in the future if investors, their supervisors, and
counterparties, are more appropriately forewarned.
To the extent that policymakers are unable to anticipate or evaluate the types of complex
risks that the newer financial technologies are producing, the answer, as it always has been,
is less leverage, i.e. less debt, more equity, and, hence, a larger buffer against adversity and
contagion.
I must also stress the obvious necessity of sound monetary and fiscal policies whose
absence was so often the cause of earlier international financial crises. With increased
emphasis on private international capital flows, especially interbank flows, private
misjudgments within flawed economic structures have been the major contributors to recent
problems. But inappropriate macropolicies also have been a factor for some emerging
market economies in the current crisis.
Improvements in transparency, commercial and legal structures, as well as supervision that
I, and my colleagues, have supported in recent months cannot be implemented quickly.
Such improvements and the transition to a more effective and stable international financial
system will take time. The current crisis, accordingly, will have to be addressed with ad hoc
remedies. It is essential, however, that those remedies not conflict with a broader vision of
how our new international financial system will function as we enter the next century.
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���I
N The Philosophy
of History, Hegel
discerned a disturbing historical pattern—the crack and fall
of civilizations owing to
a morbid intensification
of their own first principles. Although I have
made a fortune in the financial markets, I now
fear that the untrammeled
intensification of laissezfaire capitalism and the
spread of market values
into all areas of life is endangering our open and
democratic society. The
main enemy of the open
society, I believe, is no
longer the communist but
the capitalist threat.
The term "open society" was coined by Henri
Bergson, in his book The
Two Sources of Morality
and Religion (1932), and
given greater currency by
the Austrian philosopher
Karl Popper, in his book
The Open Society and Its
Enemies (1945). Popper
showed that totalitarian
ideologies like communism and Nazism have a
common element: they
THE
ATLANTIC
MONTHLY
THE
CAPITALIST
THREAT
by GEORGE SOROS
What
do
kind
we want?
market
of
society-
"Let
the
decide!"
the
often-heard
That
response,
on which
is
response.
a
capitalist
undermines
free
prominent
argues,
the very
open
societies
and
values
democratic
depend
I l l u s t r a t i o n s by B r i a n C r o n i n
claim to be in possession
of the ultimate truth.
Since the ultimate truth
is beyond the reach of
humankind, these ideologies have to resort to
oppression in order to impose their vision on society. Popper juxtaposed
with these totalitarian
ideologies another view
of society, which recognizes that nobody has a
monopoly on the truth;
different people have different views and different
interests, and there is a
need for institutions that
allow them to live together in peace. These institutions protect the rights
of citizens and ensure
freedom of choice and
freedom of speech. Popper called this form of social organization the
"open society." Totalitarian ideologies were its
enemies.
Written during the
Second World War, The
Open Society and Its
Enemies explained what
the Western democracies
stood for and fought for.
The explanation was
45
�highly abstract and philosophical, and the term "open society" never gained wide recognition. Nevertheless, Popper's
analysis was penetrating, and when I read it as a student in
the late 1940s, having experienced at first hand both Nazi
and Communist rule in Hungary, it struck me with the force
of revelation.
I was driven to delve deeper into Karl Popper's philoso46
phy, and to ask, Why does nobody have access to the ultimate truth? The answer became clear: We live in the same
universe that we are trying to understand, and our perceptions can influence the events in which we participate. If our
thoughts belonged to one universe and their subject matter
to another, the truth might be within our grasp: we could formulate statements corresponding to the facts, and the facts
FEBRUARY
1997
�would serve as reliable criteria for deciding whether the
statements were true.
There is a realm where these conditions prevail: natural
science. But in other areas of human endeavor the relationship between statements and facts is less clear-cut. In social
and political affairs the participants' perceptions help to determine reality. In these situations facts do not necessarily
constitute reliable criteria forjudging the truth of statements.
There is a two-way connection—a feedback mechanism—
between thinking and events, which I have called "reflexivity." I have used it to develop a theory of history.
After the collapse of communism, the mission of the
foundation network changed. Recognizing that an open society is a more advanced, more sophisticated form of social
organization than a closed society (because in a closed society there is only one blueprint, which is imposed on society,
whereas in an open society each citizen is not only allowed
but required to think for himself), the foundations shifted
from a subversive task to a constructive one—not an easy
thing to do when the believers in an open society are accustomed to subversive activity. Most of my foundations did a
good job* but unfortunately, they did not have much company. The open societies of the West did not feel a strong urge
to promote open societies in the former Soviet empire. On
the contrary, the prevailing view was that people ought to be
left to look after their own affairs. The end of the Cold War
brought a response very different from that at the end of the
Second World War. The idea of a new Marshall Plan could
not even be mooted. When I proposed such an idea at a conference in Potsdam (in what was then still East Germany), in
the spring of 1989,1 was literally laughed at.
Whether the theory is valid or not, it has turned out to be
very helpful to me in the financial markets. When I had
made more money than I needed, I decided to set up a foundation. I reflected on what it was I really cared about. Having lived through both Nazi persecution and Communist oppression, I came to the conclusion that what was paramount
for me was an open society. So I called the foundation the
Open Society Fund, and I defined its objectives as opening
up closed societies, making open societies more viable, and
promoting a critical mode of thinking. That was in 1979.
The collapse of communism laid the groundwork for a
My first major undertaking was in South Africa, but it was universal open society, but the Western democracies failed
not successful. The apartheid system was so pervasive that
toriseto the occasion. The new regimes that are emerging in
whatever I tried to do made me part of the system rather than
the former Soviet Union and the former Yugoslavia bear lithelping to change it. Then I turned my attention to Central
tle resemblance to open societies. The Western alliance
Europe. Here I was much more successful. I started supportseems to have lost its sense of purpose, because it cannot deing the Charter 77 movement in Czechoslovakia in 1980 and
fine itself in terms of a Communist menace. It has shown litSolidarity in Poland in 1981.1 established separate foundatle inclination to come to the aid of those who have defendtions in my native country, Hungary, in 1984, in China in
ed the idea of an open society in Bosnia or anywhere else.
1986, in the Soviet Union in 1987, and in Poland in 1988.
As for the people living in formerly Communist countries,
My engagement accelerated with the collapse of the Soviet
they might have aspired to an open society when they sufsystem. By now I have established a network of foundations
fered from repression, but now that the Communist system
that extends across more than twenty-five countries (not inhas collapsed, they are preoccupied with the problems of
cluding China, where we
shutdown in 1989).
A I S S E Z - F A I R E C A P I T A L I S M H O L D S THAT THE C O M Operating under Communistregimes,I never felt
MON G O O D IS BEST S E R V E D B Y THE UNINHIBITED
the need to explain what
"open society" meant;
P U R S U I T O F S E L F - I N T E R E S T . U N L E S S IT I S T E M P E R E D
those who supported the
BY THE R E C O G N I T I O N OF A C O M M O N INTEREST
objectives of the foundations understood it better
THAT O U G H T TO T A K E P R E C E D E N C E O V E R P A R T I C U L A R I N T E R E S T S ,
than I did, even if they
were not familiar with the
OUR PRESENT SYSTEM IS LIABLE TO BREAK D O W N .
expression. The goal of
my foundation in Hungary, for example, was to support alternative activities. I
survival. After the failure of communism there came a genknew that the prevailing Communist dogma was false exeral disillusionment with universal concepts, and the open
actly because it was a dogma, and that it would become unsociety is a universal concept.
sustainable if it was exposed to alternatives. The approach
These considerations have forced me to re-examine my
proved effective. The foundation became the main source of belief in the open society. Forfiveor six years following the
support for civil society in Hungary, and as civil society
fall of the Berlin Wall, I devoted practically all of my enerflourished, so the Communist regime waned.
gies to the transformation of the formerly Communist world.
THi:
ATLANTIC
MONTHLY
47
�I
More recently I have redirected my attention to our own society. The network of foundations I created continues to do
good work; nevertheless, I felt an urgent need to reconsider
the conceptual framework that had guided me in establishing them. This reassessment has led me to the conclusion
that the concept of the open society has not lost its relevance. On the contrary, it may be even more useful in understanding the present moment in history and in providing
a practical guide to political action than it was at the time
Karl Popper wrote his book—but it needs to be thoroughly
rethought and reformulated. If the open society is to serve as
an ideal worth striving for, it can no longer be defined in
terms of the Communist menace. It must be given a more
positive content.
THE IVEW ENEMY
P
OPPER showed that fascism and communism had
much in common, even though one constituted the
extreme right and the other the extreme left, because
both relied on the power of the state to repress the freedom
of the individual. I want to extend his argument. I contend
that an open society may also be threatened from the opposite direction—from excessive individualism. Too much
competition and too little cooperation can cause intolerable
inequities and instability.
Insofar as there is a dominant belief in our society today,
it is a belief in the magic of the marketplace. The doctrine of
laissez-faire capitalism holds that the common good is best
served by the uninhibited pursuit of self-interest. Unless it is
tempered by the recognition of a common interest that ought
to take precedence over particular interests, our present system—which, however imperfect, qualifies as an open society—is liable to break down.
I want to emphasize, however, that I am not putting laissez-faire capitalism in the same category as Nazism or communism. Totalitarian ideologies deliberately seek to destroy
the open society; laissez-faire policies may endanger it, but
only inadvertently. Friedrich Hayek, one of the apostles of
laissez-faire, was also a passionate proponent of the open society. Nevertheless, because communism and even socialism
have been thoroughly discredited, I consider the threat from
the laissez-faire side more potent today than the threat from
totalitarian ideologies. We are enjoying a truly global market
economy in which goods, services, capital, and even people
move around quite freely, but we fail to recognize the need
to sustain the values and institutions of an open society.
The present situation is comparable to that at the turn of
the past century. It was a golden age of capitalism, characterized by the principle of laissez-faire; so is the present.
The earlier period was in some ways more stable. There
was an imperial power, England, that was prepared to dispatch gunboats to faraway places because as the main ben-
48
eficiary of the system it had a vested interest in maintaining
that system. Today the United States does not want to be
the policeman of the world. The earlier period had the gold
standard; today the main currencies float and crush against
each other like continental plates. Yet the free-market
regime that prevailed a hundred years ago was destroyed by
the First World War. Totalitarian ideologies came to the
fore, and by the end of the Second World War there was
practically no movement of capital between countries. How
much more likely the present regime is to break down unless we leam from experience!
Although laissez-faire doctrines do not contradict the
principles of the open society the way Marxism-Leninism or
Nazi ideas of racial purity did, all these doctrines have an
important feature in common: they all try to justify their
claim to ultimate truth with an appeal to science. In the case
of totalitarian doctrines, that appeal could easily be dismissed. One of Popper's accomplishments was to show that
a theory like Marxism does not qualify as science. In the
case of laissez-faire the claim is more difficult to dispute,
because it is based on economic theory, and economics is
the most reputable of the social sciences. One cannot simply
equate market economics with Marxist economics. Yet laissez-faire ideology, I contend, is just as much a perversion of
supposedly scientific verities as Marxism-Leninism is.
The main scientific underpinning of the laissez-faire ideology is the theory that free and compedtive markets bring
supply and demand into equilibrium and thereby ensure the
best allocation of resources. This is widely accepted as an
eternal verity, and in a sense it is one. Economic theory is an
axiomatic system: as long as the basic assumptions hold, the
conclusions follow. But when we examine the assumptions
closely, we find that they do not apply to the real world. As
originally formulated, the theory of perfect competition—of
the natural equilibrium of supply and demand—assumed
perfect knowledge, homogeneous and easily divisible products, and a large enough number of market participants that
no single participant coulee-influence the market price. The
assumption of perfect knowledge proved unsustainable, so it
was replaced by an ingenious device. Supply and demand
were taken as independently given. This condition was presented as a methodological requirement rather than an assumption. It was argued that economic theory studies the relationship between supply and demand; therefore it must
take both of them as given.
As I have shown elsewhere, the condition that supply and
demand are independently given cannot be reconciled with
reality, at least as far as thefinancialmarkets are concerned
—andfinancialmarkets play a crucial role in the allocation
of resources. Buyers and sellers infinancialmarkets seek to
discount a future that depends on their own decisions. The
shape of the supply and demand curves cannot be taken as
given because both of them incorporate expectations about
FEBRUARY
1997
�events that are shaped by those expectations. There is a twoway feedback mechanism between the market participants'
thinking and the situation they think about—"reflexivity." It
accounts for both the imperfect understanding of the participants (recognition of which is the basis of the concept of the
open society) and the indeterminacy of the process in which
they participate.
If the supply and demand curves are not independently
given, how are market prices determined? If we look at the
behavior offinancialmarkets, wefindthat instead of tending
toward equilibrium, prices continue tofluctuaterelative to
the expectations of buyers and sellers. There are prolonged
periods when prices are moving away from any theoretical
equilibrium. Even if they eventually show a tendency to return, the equilibrium is not the same as it would have been
without the intervening period. Yet the concept of equilibrium endures. It is easy to see why: without it, economics
could not say how prices are determined.
In the absence of equilibrium, the contention that free
markets lead to the optimum allocation of resources loses its
justification. The supposedly scientific theory that has been
used to validate it turns out to be an axiomatic structure
whose conclusions are contained in its assumptions and are
not necessarily supported by the empirical evidence. The resemblance to Marxism, which also claimed scientific status
for its tenets, is too close for comfort.
I do not mean to imply that economic theory has deliberately distorted reality for polidcal purposes. But in trying to
imitate the accomplishments (and win for itself the prestige)
of natural science, economic theory attempted the impossible. The theories of social science relate to their subject matter in a reflexive manner. That is to say, they can influence
events in a way that the theories of natural science cannot.
subject matter and laid itself open to exploitation by laissezfaire ideology.
What allows economic theory to be converted into an ideology hostile to the open society is the assumption of perfect
knowledge—at first openly stated and then disguised in the
form of a methodological device. There is a powerful case
for the market mechanism, but it is not that markets are perfect; it is that in a world dominated by imperfect understanding, markets provide an efficient feedback mechanism
for evaluating the results of one's decisions and correcting
mistakes.
Whatever its form, the assertion of perfect knowledge
stands in contradiction to the concept of the open society
(which recognizes that our understanding of our situation is
inherently imperfect). Since this point is abstract, I need to
describe specific ways in which laissez-faire ideas can pose
a threat to the open society. I shall focus on three issues: economic stability, social justice, and international relations.
ECONOMIC STABILITY
E
CONOMIC theory has managed to create an artificial
world in which the participants' preferences and the
opportunities confronting participants are independent
of each other, and prices tend toward an equilibrium that
brings the two forces into balance. But infinancialmarkets
prices are not merely the passive reflection of independently
given demand and supply; they also play an active role in
shaping those preferences and opportunities. This reflexive
interaction rendersfinancialmarkets inherently unstable.
Laissez-faire ideology denies the instability and opposes any
form of government intervention aimed at preserving stability. History has shown thatfinancialmarkets do break down,
causing economic depression and social unrest. The
HERE HAS BEEN AN O N G O I N G CONFLICT BETWEEN
breakdowns have led to
the evolution of central
MARKET VALUES AND OTHER, MORE TRADITIONAL
banking and other forms
V
of regulation. Laissez-faire
ideologues like to argue
VALUE SYSTEMS, WHICH HAS AROUSED STRONG
that the breakdowns were
PASSIONS AND A N T A G O N I S M S . UNSURE OF WHAT
caused by faulty regulaTHEY T H E M S E L V E S STAND F O R , P E O P L E HAVE COME TO RELY
tions, not by unstable markets. There is some vaI N C R E A S I N G L Y ON M O N E Y A S THE C R I T E R I O N OF V A L U E .
lidity in their argument,
because if our understandHeisenberg's famous uncertainty principle implies that the
ing is inherently imperfect, regulations are bound to be deact of observation may interfere with the behavior of quanfective. But their argument rings hollow, because it fails to
tum particles; but it is the observation that creates the effect, explain why the regulations were imposed in the first place.
not the uncertainty principle itself. In the social sphere, theIt sidesteps the issue by using a different argument, which
ories have the capacity to alter the subject matter to which
goes like this: since regulations are faulty, unregulated marthey relate. Economic theory has deliberately excluded rekets are perfect.
flexivity from consideration. In doing so, it has distorted its
The argument rests on the assumption of perfect knowl50
FEBRUARY
1997
�edge: if a solution is wrong, its opposite must be right. In
the absence of perfect knowledge, however, both free markets and regulations are flawed. Stability can be preserved
only if a deliberate effort is made to preserve it. Even then
breakdowns will occur, because public policy is often
faulty. If they are severe enough, breakdowns may give rise
to totalitarian regimes.
THE
ATLANTIC
MONTHLY
Instability extends well beyond financial markets: it affects the values that guide people in their actions. Economic theory takes values as given. At.the time economic theory was bom, in the age of Adam Smith, David Ricardo, and
Alfred Marshall, this was a reasonable assumption, because people did, in fact, have firmly established values.
Adam Smith himself combined a moral philosophy with
51
�his economic theory. Beneath the individual preferences
that found expression in market behavior, people were
guided by a set of moral principles that found expression in
behavior outside the scope of the market mechanism.
Deeply rooted in tradition, religion, and culture, these principles were not necessarily rational in the sense of representing conscious choices among available alternatives. Indeed, they often could not hold their own when alternatives
became available. Market values served to undermine traditional values.
There has been an ongoing conflict between market values and olher. more traditional value systems, which has
aroused strong passions and antagonisms. As the market
mechanism has extended its sway, the fiction that people act
on the basis of a given set of nonmarket values has become
progressively more difficult to maintain. Advertising, marketing, even packaging, aim at shaping people's preferences
rather than, as laissez-faire theory holds, merely responding
to them. Unsure of what they stand for, people increasingly
rely on money as the criterion of value. What is more expensive is considered better. The value of a work of art can
be judged by the price it fetches. People deserve respect and
admiration because they are rich. What used to be a medium
T II K
of exchange has usurped the place of fundamental values,
reversing the relationship postulated by economic theory.
What used to be professions have turned into businesses.
The cult of success has replaced a belief in principles. Society has lost its anchor.
S O C I A L DARWINISM
B
Y taking the conditions of supply and demand as
given and declaring government intervention the ultimate evil, laissez-faire ideology has effectively
banished income or wealth redistribution. I can agree that
all attempts at redistribution interfere with the efficiency of
the market, but it does not follow that no attempt should be
made. The laissez-faire argument relies on the same tacit appeal to perfection as does communism. It claims that if redistribution causes inefficiencies and distortions, the problems can be solved by eliminating redistribution—just as the
Communists claimed that the duplication involved in competition is wasteful, and therefore we should have a centrally planned economy. But perfection is unattainable. Wealth
does accumulate in the hands of its owners, and if there is no
mechanism for redistribution, the inequities can become in-
CHANGE
Those yews at winter's end,
and change. Without a word
near-black on snow—she said
they watched the sky, blank now,
as they walked—are the proper green
muzzled in iron gray
for the shutters of a house.
as if some brighter world
He wondered, walking there
had sealed its doors on theirs.
watching the feint and dart
He wondered how the season
of sparrows returned to stark
with this imperious pause
hedgerows, alighting on canes
changed imperceptibly
of blackberry thorned and bare.
and answered her—now half
As they walked they thought how quiet
a mile beyond those yews—
this end of winter was,
that their winter hue was right
how long, both of them watching
for the shutters of a house
the neutral tones of March,
bul lhat the yews would change:
the slow, ferocious patience
an emerald rise from earth's
of air and plant and bird
dark core, needles leaden
slowly squaring with change
with cold, soon brightening.
— STF.PMEN S A N D Y
F K 1 II L \ B V
1
19 9 7
�tolerable. "Money is like muck, not good except it be spread."
Francis Bacon was a profound economist.
The laissez-faire argument against income redistribution
invokes the doctrine of the survival of thefittest.The argument is undercut by the fact that wealth is passed on by inheritance, and the second generation is rarely as fit as the first.
In any case, there is something wrong with making the
survival of thefittesta guiding principle of civilized society.
This social Darwinism is based on an outmoded theory of
evolution, just as the equilibrium theory in economics is taking its cue from Newtonian physics. The principle that
guides the evolution of species is mutation, and mutation
works in a much more sophisticated way. Species and their
environment are interactive, and one species serves as part
of the environment for the others. There is a feedback mechanism similar to reflexivity in history, with the difference being that in history the mechanism is driven not by mutadon
but by misconceptions. I mention this because social Darwinism is one of the misconcepdons driving human affairs
today. The main point I want to make is that cooperadon is
as much a part of the system as competition, and the slogan
"survival of thefittest"distorts this fact.
INTERNATIONAL RELATIONS
I
AISSEZ-FAIRE ideology shares some of the deficiencies of another spurious science, geopolitics.
States have no principles, only interests, geopoliticians argue, and those interests are determined by geographic location and other fundamentals. This deterministic
approach is rooted in an outdated nineteenth-century view
of scientific method, and it suffers from at least two glaring
defects that do not apply with the same force to the economic doctrines of laissez-faire. One is that it treats the state
as the indivisible unit of analysis, just as economics treats
the individual. There is something contradictory in banishing the state from the economy while at the same time enshrining it as the ultimate source of authority in intemational relations. But let that pass. There is a more pressing
practical aspect of the problem. What happens when a state
disintegrates? Geopolitical realists find themselves totally
unprepared. That is what happened when the Soviet Union
and Yugoslavia disintegrated. The other defect of geopolitics is that it does not recognize a common interest beyond
the national interest.
With the demise of communism, the present state of affairs, however imperfect, can be described as a global open
society. It is not threatened from the outside, from some totalitarian ideology seeking world supremacy. The threat
comes from the inside, from local tyrants seeking to establish internal dominance through external conflicts. It may
also come from democratic but sovereign states pursuing
their self-interest to the detriment of the common interest.
THE
ATLANTIC
MONTHLY
The intemational open society may be its own worst enemy.
The Cold War was an extremely stable arrangement. Two
power blocs, representing opposing concepts of social organization, were struggling for supremacy, but they had to respect each other's vital interests, because each side was capable of destroying the other in an all-out war. This put a
firm limit on the extent of the conflict; all local conflicts
were, in turn, contained by the larger conflict. This extremely stable world order has come to an end as the result of the
internal disintegration of one superpower. No new world order has taken its place. We have entered a period of disorder.
Laissez-faire ideology does not prepare us to cope with
this challenge. It does not recognize the need for a world order. An order is supposed to emerge from states' pursuit of
their self-interest. But, guided by the principle of the survival of thefittest,states are increasingly preoccupied with
their competitiveness and unwilling to make any sacrifices
for the common good.
There is no need to make any dire predictions about the
eventual breakdown of our global trading system in order to
show that a laissez-faire ideology is incompatible with the
concept of the open society. It is enough to consider the free
world's failure to extend a helping hand after the collapse of
communism. The system of robber capitalism that has taken
hold in Russia is so iniquitous that people may well turn to a
charismatic leader promising national revival at the cost of
civil liberties.
If there is any lesson to be learned, it is that the collapse
of a repressive regime does not automatically lead to the establishment of an open society. An open society is not merely the absence of government intervention and oppression. It
is a complicated, sophisticated stracture, and deliberate effort is required to bring it into existence. Since it is more sophisticated than the system it replaces, a speedy transition
requires outside assistance. But the combination of laissezfaire ideas, social Darwinism, and geopolitical realism that
prevailed in the United States and the United Kingdom
stood in the way of any ho£p for an open society in Russia.
If the leaders of these countries had had a different view of
the world, they could have established firm foundations for a
global open society.
At thetimeof the Soviet collapse there was an opportunity to make the UN function as it was originally designed to.
Mikhail Gorbachev visited the United Nations in 1988 and
outlined his vision of the two superpowers cooperating to
bring peace and security to the world. Since then the opportunity has faded. The UN has been thoroughly discredited
as a peacekeeping institution. Bosnia is doing to the UN
what Abyssinia did to the League of Nations in 1936.
Our global open society lacks the institutions and mechanisms necessary for its preservation, but there is no political
will to bring them into existence. I blame the prevailing attitude, which holds that the unhampered pursuit of self-inter53
�est will bring about an eventual intemational equilibrium. I
believe this confidence is misplaced. I believe that the concept of the open society, which needs institutions to protect
it, may provide a better guide to action. As things stand, it
does not take very much imagination to realize that the global open society that prevails at present is likely to prove a
temporary phenomenon.
54
TH K PROMISE OF FALLIBILITY
I
T is easier to identify the enemies of the open society
than to give the concept a positive meaning. Yet without
such a positive meaning the open society is bound to fall
prey to its enemies. There has to be a common interest to
hold a community together, but the open society is not a
FEBRUARY
1 9 S7
�^ ^ ^ ^ i t y in the traditional sense of the word. It is an ab^ i d i i , a universal concept. Admittedly, there is such a
^ S ^ ' a global community; there are common interests on
Jllyievel, such the preservation of the environment
lliilp|revention of war. But these interests are relatively
llfComparison with special interests. They do not have
[ M c l f l a constituency in a world composed of sovereign
H^llloreover, the open society as a universal concept
^ m ^ | i d s all boundaries. Societies derive their cohesion
" """"""
values. These values are rooted in culture, reliIhistory, and tradition. When a society does not have
|ies, where are the shared values to be found? I beis only one possible source: the concept of the
iety itself.
a s
1
gard their own values as absolute, an open society, which is
aware of many cultures and religions, must regard its own
shared values as a matter of debate and choice. To make the
debate possible, there must be general agreement on at least
one point: that the open society is a desirable form of social
organization. People must be free to think and act, subject
only to limits imposed by the common interests. Where the
limits are must also be determined by trial and error.
The Declaration of Independence may be taken as a pretty good approximation of the principles of an open society,
but instead of claiming that those principles are self-evident,
we ought to say that they are consistent with our fallibility.
Could the recognition of our imperfect understanding serve
to establish the open society as a desirable form of social organization? I believe it could, although there are formidable
difficulties in the way. We must promote a belief in our own
fallibility to the status that we normally confer on a belief in
ultimate truth. But if ultimate truth is not attainable, how can
we accept our fallibility as ultimate truth?
Ifill this role, the concept of the open society needs
ifined. Instead of there being a dichotomy between
closed, I see the open society as occupying a mid^ d , where therightsof the individual are safeguard^ j ^ ^ ^ p h w e there are some shared values that hold society
^This middle ground is threatened from all sides. At
This is an apparent paradox, but it can be resolved. The
i ' i 1 'ft|Sft ' ^ '
» and nationalist doctrines would
first proposition, that our understanding is imperfect, is
Wl^^^l^raTO^state domination. At the other extreme, laissez-faire
consistent with a second proposition: that we must accept
would lead to great instability and eventual breakthe first proposition as an article of faith. The need for artiare other variants. Lee Kuan Yew, of Singapore,
cles of faith arises exactly because our understanding is
ss a so-called Asian model that combines a market
imperfect. If we enjoyed perfect knowledge, there would
ioiiiy with a repressive state. In many parts of the world be no need for beliefs. But to accept this line of reasoning
^ontrol'pf the state is so closely associated with the creation
requires a profound change in the role that we accord our
wealth that one might speak of robber capitalism,
beliefs.
i^^-SSSrSijie^"gangster state," as a new threat to the open society.
Historically, beliefs have served to justify specific rules
envisage the open society as a society open to improveof conduct. Fallibility ought to foster a different attitude. Be^Ve start with the recognition of our own fallibility,
liefs ought to serve to shape our lives, not to make us abide
icfi^xtends not only to our mental constructs but also to
by a given set of rules. If we recognize that our beliefs are
S&MBW^titutions. What is imperfect can be improved, by a
expressions of our choices, not of ultimate truth, we are
s'of trial and error.
society not only
N A N Y C A S E , THERE IS S O M E T H I N G W R O N G WITH
gthis process but ac|ncourages it, by
M A K I N G THE S U R V I V A L OF THE FITTEST A G U I D I N G
>£i3JpHn;g on freedom of
ion and protecting
P R I N C I P L E O F C I V I L I Z E D S O C I E T Y . THE M A I N
S-The open society
POINT I WANT TO M A K E IS THAT C O O P E R A T I O N I S
a vista of limitless
jss. In this respect it
AS MUCH A PART OF THE S Y S T E M AS C O M P E T I T I O N , AND THE
with the
jfib method. ButsciS L O G A N ' S U R V I V A L OF THE F I T T E S T " DISTORTS THIS FACT.
jpias at its disposal
e criteria
namemore likely to tolerate other beliefs and to revise our own in
' i f ^ | | f a c t s by which the process may be judged. Unfortuthe light of our experiences. But that is not how most people
y human affairs the facts do not provide reliable critreat their beliefs. They tend to identify their beliefs with ulof truth, yet we need some generally agreed-upon
timate truth. Indeed, that identification often serves to define
! I | | | ^ | 5 by which the process of trial and error can be
their own identity. If their experience of living in an open soEj^All cultures and religions offer such standards; the
ciety obliges them to give up their claim to the ultimate
>?iety cannot do without them. The innovation in an
truth, they feel a sense of loss.
s|9iety is that whereas most cultures and religions rev
v
*Jir
me
c o m m u n
s t
"
1
S
<
i
| S ? ^ I ^ ANTIC MONTHLY
55
�The idea that we somehow embody the ultimate truth is
deeply ingrained in our thinking. We may be endowed with
critical faculties, but we are inseparably tied to ourselves.
We may have discovered truth and morality, but, above all,
we must represent our interests and our selves. Therefore, if
there are such things as truth and justice—and we have
come to believe that there are—then we want to be in possession of them. We demand truth from religion and, recently, from science. A belief in our fallibility is a poor substitute. It is a highly sophisticated concept, much more difficult
to work with than more primitive beliefs, such as my country (or my company or my family), right or wrong.
specific objectives by twisting or denying the truth, and people may be more interested in attaining their specific objectives than in attaining the truth. Only at the highest level of
abstraction, when we consider the meaning of life, does
truth take on paramount importance. Even then, deception
may be preferable to the truth, because life entails death and
death is difficult to accept. Indeed, one could argue that the
open society is the best form of social organization for making the most of life, whereas the closed society is the form
best suited to the acceptance of death. In the ultimate analysis a belief in the open society is a matter of choice, not of
logical necessity.
If the idea of our fallibility is so hard to take, what makes
it appealing? The most powerful argument in its favor is to
be found in the results it produces. Open societies tend to be
more prosperous, more innovative, more stimulating, than
closed ones. But there is a danger in proposing success as
the sole basis for holding a belief, because if my theory of
reflexivity is valid, being successful is not identical with being right. In natural science, theories have to be right (in the
sense that the predictions and explanations they produce correspond to the facts) for them to work (in the sense of producing useful predictions and explanations). But in the social sphere what is effective is not necessarily identical with
what is right, because of the reflexive connection between
thinking and reality. As I hinted earlier, the cult of success
can become a source of instability in an open society, because it can undermine our sense of right and wrong. That is
what is happening in our society today. Our sense of right
and wrong is endangered by our preoccupation with success,
as measured by money. Anything goes, as long as you can
get away with it.
If success were the only criterion, the open society would
lose out against totalitarian ideologies—as indeed it did on
many occasions. It is much easier to argue for my own interest than to go through the whole rigmarole of abstract reasoning from fallibility to the concept of the open society.
The concept of the open society needs to be more firmly
grounded. There has to be a commitment to the open society
because it is the right form of social organization. Such a
commitment is hard to come by.
I believe in the open society because it allows us to develop our potential better than a social system that claims to
be in possession of ultimate truth. Accepting the unattainable character of truth offers a better prospect for freedom
and prosperity than denying it. But I recognize a problem
here: I am sufficiently committed to the pursuit of truth to
find the case for the open society convincing, but I am not
sure that other people will share my point of view. Given the
reflexive connection between thinking and reality, truth is
not indispensable for success. It may be possible to attain
That is not all. Even if the concept of the open society
were universally accepted, that would not be sufficient to
ensure that freedom and prosperity would prevail. The open
society merely provides a framework within which different
views about social and political issues can be reconciled; it
does not offer a firm view on social goals. If it did, it would
not be an open society. This means that people must hold
other beliefs in addition to their belief in the open society.
Only in a closed society does the concept of the open society
provide a sufficient basis for political action; in an open society it is not enough to be a democrat; one must be a liberal democrat or a social democrat or a Christian democrat or
some other kind of democrat. A shared belief in the open society is a necessary but not a sufficient condition for freedom and prosperity and all the good things that the open society is supposed to bring.
It can be seen that the concept of the open society is a
seemingly inexhaustible source of difficulties. That is to be
expected. After all, the open society is based on the recognition of our fallibility. Indeed, it stands to reason that our ideal of the open society is unattainable. To have a blueprint for
it would be self-contradictory. That does not mean that we
should not strive toward it. In science also, ultimate truth is
unattainable. Yet look at the progress we have made in pursuing it. Similarly, the open society can be approximated to
a greater or lesser extent.^
To derive a political and social agenda from a philosophical, epistemological argument seems like a hopeless undertaking. Yet it can be done. There is historical precedent. The
Enlightenment was a celebration of the power of reason, and
it provided the inspiration for the Declaration of Independence and the Bill of Rights. The belief in reason was carried to excess in the French Revolution, with unpleasant side
effects; nevertheless, it was the beginning of modernity. We
have now had 200 years of experience with the Age of Reason, and as reasonable people we ought to recognize that
reason has its limitations. The time is ripe for developing a
conceptual framework based on our fallibility. Where reason has failed, fallibility may yet succeed.
58
FEBRUARY
1997
�T E EC
M
Y
tries are intimately interconnected. In
this respect the character of the financial
markets has changed out of all recognition during the forty years that I have
been involved in them. So the global
economy should really be thought of as
the global capitalist system.
Toward a Global
Open Society
A billionaire
financier,
being a hypocritical
his February
Atlantic
Threat,"
wrongly
capitalist
cover story,
returns
accused
to the
of
for
"The
Capitalist
fray
L
ET me start with the obvious. We
do live in a global economy. But it
is important to be clear about what
we mean by that. A glob-
investments and tofinancialtransactions.
Though both have been gaining in importance since the end of the Second World
War, the globalization
al economy is characby George Soros
of financial markets in
terized not only by the
particular has acceleratfree movement of goods and services but, ed in recent years to the point where
more important, by the free movement of movements in exchange rates, interest
ideas and of capital. This applies to direct rates, and stock prices in various coun-
Global integration has brought tremendous benefits: the benefits of the intemational division of labor, which are
so clearly proved by the theory of comparative advantage; dynamic benefits
such as economies of scale and the rapid
spread of innovations from one country
to another, which are less easy to demonstrate by static equilibrium theory;
and such equally important noneconomic benefits as the freedom of choice associated with the international movement of goods, capital, and people, and
the freedom of thought associated with
the intemational movement of ideas.
But global capitalism is not without
its problems, and we need to understand
these better i f we want the system to
survive. By focusing on the problems
I'm not trying to belittle the benefits that
globalization has brought, as some readers of my previous Atlantic article assumed. The benefits of the present global capitalist system, I believe, can be
sustained only by deliberate and persis-
IP
20
I l l u s l r a l i o n s by B a r i o n S t a b l e r
J * N I! \ R V
19»8
�much more easily than labor can. Capital will tend to avoid countries where
employment is heavily taxed or heavily
protected, leading to a rise in unemployment. That is what has happened in continental Europe. I am not defending the
antiquated European social-security systems, which are badly in need ol" reform:
but 1 am expressing concern about the reduction in social provisions both in Europe and in America.
This is a relatively new phenomenon,
and it has not yet had its full effect. Until
recently the siate"s share of GNP in the
industrialized countries taken as a group
was increasing; it had almost doubled
since the end of the Second World War.
Although the ratio peaked in the I98()s, it
has not declined perceptibly. The Thatcher and Reagan governments embarked on
a program of reducing the state's role in
the economy. What has happened instead
is that the taxes on capital have come
down while the taxes on labor have kept
increasing. As the international economist Dani Rodrik has argued, globalization increases the demands on the state
to provide social insurance while reducing its ability to do so. This carries the
seeds of social conflict. If social services
are cut too far while instability is on the
rise, popular resentment could lead to a
new wave of protectionism both in the
United States and in Europe, especially
if (or when) the current boom is fol-
Markets
thing
reduce
to
commodities.
We can have
economy
cannot
every-
a
market
but we
have
a
market
society.
lowed by a bust of some seventy. This
could lead to a breakdown in the global
capitalist system, just as it did in the
1930s. With the influence of the state declining, there is a greater need for international cooperation. Hut such cooperation is contrary to the prevailing ideas of
laissez-faire on the one hand and nation24
alism and fundamentalism on the other.
The state has played another role in
economic development: in countries deficient in local capital it has allied itself
with local business interests and helped
them to accumulate capital. This strategy
has proved successful in Japan, Korea,
and the now wounded tigers of Southeast
Asia. Although the model has worked, it
raises some important questions about
the relationship between capitalism and
democracy. Clearly, an autocratic regime
is more favorable to the rapid accumulation of capital lhan a democratic one. and
a prosperous country is more favorable
to the development of democratic institutions than a destitute one. So it is reasonable to envisage a pattern of development that goes from autocracy and
capital accumulation to prosperity and
democracy. But the transition from autocracy to democracy is far from assured:
those who are in positions of power cling
tenaciously to their power.
Autocratic regimes weaken themselves by restricting free speech and allowing corruption to spread. Eventually
they may collapse of their own weight.
The moment of truth comes when they
fail to sustain prosperity. Unfortunately,
economic dislocation and decline do not
provide a good environment for the development of democratic institutions. So
the political prospects for the Asian economic miracle remain cloudy at best.
5. This brings me to the most nebulous
problem area, the question of values and
social cohesion. Every society needs
some shared values to hold it together.
Market values on their own cannot serve
that purpose, because they reflect only
what one market participant is willing to
pay another in a free exchange. Markets
reduce everything, including human beings (labor) and nature (land), to commodities. We can have a market economy but we cannot have a market society.
In addition to markets, society needs
institutions to serve such social goals
as political freedom and social justice.
There are such institutions in individual
countries, but not in the global society.
The development of a global society has
lagged behind the growth of a global
economy. Unless the gap is closed, the
global capitalist system will not survive.
When I speak of a global society. I do
not mean a global state. States are notoriously imperfect even al the national
level. We need to find new solutions for
a novel situation, although this is not the
first time that a global capitalist system
has come into being. Similar conditions
prevailed at the turn of the century. Then
the global capitalist system was held together by the imperial powers. Eventually, it was destroyed by a conflict between those powers. But the days of the
empires are gone. For the current global capitalist system to survive, it must
satisfy the needs and aspirations of its
participants.
Our global society contains many different customs, traditions, and religions;
where can it find the shared values that
would hold it together? I should like to
put forward the idea of what I call the
open society as a universal principle that
recognizes the diversity inherent in our
global society, yet provides a conceptual
basis for establishing the institutions we
need. I realize that gaining acceptance for
a universal principle is a tall order, but 1
cannot see how wc can do without it.
W
HAT is the open society * Superficially, it is a way to describe the
positive aspects of democracy: the greatest degree of freedom compatible with
social justice. It is characterized by the
rule of law: respect for human rights,
minorities, and minority opinions; the
division of power; and a market economy. The principles of the open society
are admirably put forth in the Declaration of Independence. But the Declaration states, "We hold these truths to be
self-evident," whereas the principles of
the open society are anything but selfevident: they need to be established by
convincing arguments.
There is a strong epistemological argument, elaborated by Karl Popper, in
favor of the open society: Our understanding is inherently imperfect: the ultimate truth, the perfect design for society,
is beyond our reach. We must therefore
content ourselves with the next best
thing—a form of social organization that
falls short ol" perfection but holds itself
open to improvement. That is the concept of the open society: a society open
to improvement. The more conditions
are changing—and a global economy
fosters change—the more important the
concept becomes.
But the idea of the open society is not
(Continued on page 32)
j \ \ I v it \
i » •) II
�a
e2 4
^ fro*
(Continued^ P^S ^ )
^
c o n t r a r y :
a c C
widely
• \ argument has not even
epistemolog
^ ^
been proper y ^ . ^
, _
a global ope ^
^^^^
a
c o n s i d e r e d
i d e a
j s o f t e n e x p l i c i t
y
f o r
jected. The
argue that
o f
re
w h o
^ iff ent in Asia. Of
^
^
d
er
g l o b a l
course ^ ^ e d by diversity. But falety is ch
j
i human condition;
^owledge it, we have found
once we "
^
u n
l i b i l i t y
v e r s a
, S
a C )
o u n d
a c o m m
°
which
n
f o r
o p c n
s o c i e t y j
S
e s this diversity.
f our fallibility is necesn o t sufficient to establish the
sary but ^ ^
concept
^
degjgg f altruism,
combine
b
r a t
c e , e
0
ReCOgn
o p e n
s o c i e t y
s o m e
W
e
r n u s t
0
f o r o u r
fcllow
h u m a n
b e
some co
^ principle of reciprocity,
ings based
.
variety
fit into a glo P society. P'oI m e universal values reflectvided that soi"
viucu u .jjbility and our concern for
ing o ' H j " ^ the freedom of expresothers—su ^ ^ ^
.
_
sion and ^
democracy is
also ^
that an open society
^ I in fact, that the open society
o f A s
a n > o r
v a l u e s
1
bal 0
en
W 0 U l
an ideal world that has little resemblance
to reality. Markets do not operate in a
vacuum and do not tend toward equilibrium. They operate in a political setting,
and they evolve in a reflexive fashion.
The open society is a more comprehensive framework. It recognizes the
merits of the market mechanism without idealizing it, but it also recognizes
the roles of other than market values in
society. At the same time, it is a much
vaguer, less determinate concept. It cannot define how the economic, political,
social, and other spheres should be separated from and reconciled with one another. Opinions may differ on where the
dividing line between competition and
cooperation should be drawn. Karl Popper and Friedrich Hayek, two champions of the open society, parted company over just this point.
Let me summarize my own views on
the specific requirements of our global
open society at this moment of history.
We have a global economy that suffers
from some deficiencies, the most glaring
of which are the instability of financial
markets, the asymmetry between center
and periphery, and the difficulty in taxfre a
y
should t
i gi
argument xhis
ing capital. Fortunately, we have some
^die strength and the weakness of intemational institutions to address these
> provides a conceptual frame- issues, but they will have to be strength' *l
e ds to be filled with specific ened and perhaps some new ones creatwork tha ^
j y
historical
ed. The Basle Committee on Banking
- .^t decide on the specifics,
Supervision has established capitalperiod, rt
adequacy requirements for the international banking
system, but these
did not prevent the
current banking
crisis in Southeast
Asia. There is no
international regulatory authority
for financial markets, and there is
not enough international cooperation for the taxation of capital.
But the real deficiencies are out„ ntual framework, the open side the economic field. The state can no
As a cow-w
ilonger play the role it played previousj bett than any bluepnnt, in^
concept of perfect competi- ly. In many ways that is a blessing, but
cluding
mpetition presupposes a some of the state's functions remain unof knoW g that is beyond the fulfilled. We do not have adequate inter'
c market participants. It describesnational institutions for the protection of
reach of to**
a s
h t
a
f a
r
t r i a l
w e r e
W e s t e r n
r e s p
f o r m
n 0 t
C 0 U l d
v a r i e t
e m o
o f
0
f o r m s
c a l
f r 0 m
15 b 0 t h
lde
a
n
e
s o c
e t
c o n t e n t
ius
re
er
s
S0Ciet
c0
t i 0 n
c i n c l 0
led
e
j
e a c h
f o l l o w s
individual freedoms, human rights, and
the environment, or for the promotion
of social justice—not to mention the
preservation of peace. Most of the institutions we do have are associations of
states, and states usually put their own
interests ahead of the common interest.
The United Nations is constitutionally incapable of fulfilling the promises
contained in the preamble of its charter.
Moreover, there is no consensus on the
need for better intemational institutions.
What is to be done? We need to establish certain standards of behavior to contain corruption, enforce fair labor practices, and protect humanrights.We have
hardly begun to consider how to go
about it.
As regards security and peace, the liberal democracies of the world ought to
take the lead and forge a global network
of alliances that could work with or without the United Nations. NATO is a case
in point. The primary purpose of these
alliances would be to preserve peace;
but crisis prevention cannot start early
enough. What goes on inside states is of
consequence to their neighbors and to the
world at large. The promotion of freedom
and democracy in and around these alliances ought to become an important
policy objective. For instance, a democratic and prosperous Russia would make
a greater contribution to peace in the region than would any amount of military
spending by NATO. Interfering in other
countries' internal affairs is fraught with
difficulties—but not interfering can be
even more dangerous.
Right now the global capitalist system
is vigorously expanding in both scope
and, intensity. It exerts a tremendous attraction through the benefits it offers and,
at the same time, it imposes tremendous
penalties on those countries that try to
withdraw from it. These conditions will
not prevail indefinitely, but while they do,
they offer a wonderful opportunity to lay
the groundwork for a global open society.
With the passage of time the deficiencies are likely to make their effect felt,
and the boom is likely to turn into a bust.
But the ever-looming breakdown can
be avoided if we recognize theflawsin
time. What is imperfect can be improved. For the global capitalist system
to survive, it needs a society that is constantly striving to correct its deficiencies: a global open society. ^
JANUARY
32
1998
��•••«|t»VIHmiW»fi»»:tetf..-. •
How Washington worsened Asia'slcrash.
1 HE C N I E C G M
O FD N E A E
; : • !; '
• .<
. '
By Paul Krugman
E
if
i
ven in private, officials at the International
Monetary Fund and the U.S. Treasury Department still think that they did the right thing
on Asia and that their medicine will eventually work. And they do have some favorable numbers
to cling to: interest rates in South Korea and Thailand
have been dropping, and, with the exception of
Indonesia, the collapse in output—devastating as it has
been—is no worse than that of Mexico in 1995. But
most people outside Washington's corridors of power
are far less sanguine: they are all too aware that, at
every point in this crisis, the real consequences of
fmancial turmoil have been worse than anyone anticipated and that, in recent weeks, the crisis, far from
being contained, has appeared to be spreading, especially to the hitherto largely immune economies of
Latin America.
The human and economic costs of the slump are selfevident, as is the damage to Western influence. Less
attention, however, has been paid to the effects of this
crisis on the credibility of America's economic policymaking establishment. So it is not too soon to make sure
diat the story of what went wrong is told the right way.
Here is how I fear the story will get told: The best and
the brightest—the smartest economists in America—
went to Washington; they applied orthodox economic
analysis to Asia; and the result was disaster. So, from now
on, let's ignore the advice of economists and rely on
businessmen, or journalists, or, at least, somebody without intellectual pretensions to make economic policy.
This story is half-right. The best and the brightest did
indeed go to Washington. Never before in history, as
far as I can tell, have so many first-rate academic
economists held so many high policy positions. (Deputy
Treasury Secretary Lawrence Summers and his team; in
particular, are an unprecedented group of all-stars.) But
they did not apply orthodox economic analysis. On the
contrary, from the very beginning of the crisis, the
response from Washington has beenito throw away the
textbooks. If orthodoxy has been applied, it has been
that of bankers, not economists.
r
Why? Because, from the beginning, Washington's
preoccupation has been not economic fundamentals
PAUL KRUGMAN is professor of economics at MIT.
'•-••'.v-V'.i
,:....:. j
but market confidence. And what does it take to restore
confidence? Policies that may not make sense in and of
themselves but that policymakers believe will appeal
to the prejudices of investors—or, in some cases, that
diey believe will appeal to what investors believe are the
prejudices of their colleagues.
Whatever one's views about the uldmate causes of the
Asian crisis, the proximate cause—the shock that turned
miracle into debacle—is not in dispute: the global capital market did it. Right up to the eve of the crisis, Asian
economies could, in the eyes of people with money to
invest, do no wrong. In 1996 alone, foreign banks lent
the countries now in crisis more than $100 billion, and
nonbank investors poured in tens of billions more.
These enormous inflows of capital allowed Asian countries to spend far more than their incomes. In the second half of 1997, however, those same banks called in
more than $50 billion worth of loans.
Now suppose that you were to buy a copy of the bestselling textbook . on international economics. What
would it tell you about how to cope with such a sudden
loss of confidence by international investors? Well, not
much. (Trust me—I'm the coauthor of that textbook.)
But, to the extent that it does offer an answer, it suggests that the affected country should try to roll with
the punch: let its currency decline, maybe even cut
interest rates to keep the economy from slumping.
That, after all, is what the United States did in. 1985,
when markets finally began to wonder whether the
mounting trade deficits of the early Reagan years could
be sustained forever. We cheerfully let the dollar slide
from 240 yen to 140, from three Deutsche marks to 1.8;
the Fed even helped the process along by cutting interest rates; and the U.S. economy continued to expand.
When the Asian crisis struck, however, the response
that Washington urged on the afflicted nations—and
demanded as a condition for emergency JMF.loanswas very different. True, countries were;Jiot told to
defend their exchange rates at all costs:! the.baht^the
won, and the: rupiah were allowed/to: slide-.agaihst 'the
dollar. But countries were: told tcnraise iinterest^rates,
not cut them,; in\.iorder. to rpersuadeijsoi^e^foreigh
investors to keep .^eir <moh<^i]^p^
die exchange-rate plunge.- ^
to accept the resulting recessibns^recess^
;
(
�adniiitedly to everyone's surprise, turned out to be the
world's worst since the 193()s. In dlect, countries were
lold to forget about macroeconomic: policy; instead of
trying to prevent or even alleviate the looming slumps
in their economies, they were told to follow policies that
would actually deepen those slumps.
So where was recovery supposed to come from? Well,
reform—closing the bad banks, getting rid of the
cronies—was supposed to bring about a restoration of
confidence. Do the right thing, countries were told, and
inlernational capital will evenluallv come Hooding back.
It is still possible that this was the right policy—that
the alternatives would have been eve n worse. But, right
or wrong, Washington's response to the Asian crisis represented a break with, even a ben aval of, a sort of deal
that capitalism and its economists made with the public
two generations ago.
C
all this deal the "Keynesian compact." Its origins lie in the 19.3()s, when it was natural for
even moderate observers to conclude that free
markets had failed and thai only a highly regulated economy, perhaps even a cenirally planned system, could avoid devastating economic slumps. What
restored faith in free markets was not just the recovery
from the Depression but the assurance that macroeconomic intervention—culling interest rates or increasing
budget deficits to fight recessions—could keep a freemarket economy more or less stable at more or less full
employment. And, in the United States, that compact
has been honored. Oh, there are recessions now and
then. However, when they occur, everyone expects the
Fed io do what it did in 1975, 1982, and 1991: cut interest rates to perk up the economy.
But, when it comes to "emerging market" economies, suddenly the deal is off. Look at what i.s happening right now in Brazil—a country which has carried
out substantial economic reforms, moving toward
much freer markets, but whose unemployment rate has
been steadily rising for the pasi few years. Inflation in
Brazil is low; by rights, one might expect the country to
be able to cut interest rales and get some job creation
under way. Instead, Brazil is being urged to avoid a
devaluation of its currency, the real, al all costs. And to
keep the real stable, it is told, it must raise interest rates
to punitive levels and slash the budget deficit. In other
words, far from fighting the slowdown in its economy,
Brazil—like Thailand and South Korea—is being
instructed to take steps that will clearly ensure a nasty,
perhaps disastrous, recession.
Again, maybe this is the right advice. But why did the
high-powered economists near the top ol the IMF and
die Treasury, as soon as they encountered a crisis, throw
away the textbooks—indeed, do almost the opposite of
what the textbooks would have suggested?
Of course, Thailand is not the United States. Imports
are a much larger share of consumption, so that too
large a currency depreciation could produce a surge in
inflation—perhaps even a runaway wage-price spiral.
Also, many corporations and banks in Asia have large
24 THE NEW REPUBLIC OCTOBER S, 1998
dollar debts; a sharp drop in their currencies, which
would make those debts suddenly far larger in baht or
won or rupiah, might push those borrowers into insolvency. So even economists who strongly believe in
benign neglect when it comes to the dollar become
more cautious when it comes to the currencies of small
developing countries.
But there i.s a deeper reason why the policies Washington urges on developing countries are so different
from those it follows at home: fear of speculators.
^
I
magine an economy that isn't perfect. (What economy is?) Maybe the government is running a budget deficit that, while not really threatening its
solvency, is coming down more slowly than it
should, or maybe banks with political connections have
made too many loans to questionable borrowers. But, as
far as anyone can tell by going over the numbers, there
are no problems that cannot be dealt with given goodwill and a few years of stability.
Then, for some reason—perhaps an economic crisis
on the other side of the world—investors become jittery
and start pulling their money out en masse. Suddenly
the country is in trouble, its slock market plunging, its
interest rates soaring. You might think that savvy
investors would see this as an opportunity to buy. After
all, if the fundamentals haven't changed, doesn't this
mean that assets are now undervalued? Not necessarily.
The crash in asset values may cause previously sound
banks to collapse; an economic slump plus high interest
rates ma)' cause sound companies to go bankrupt; and,
at worst, economic distress may cause political instability. Maybe buying when everyone else is rushing for the
exits isn't such a good idea after all; maybe it's better to
run for the exit yourself.
Thus it is possible in principle that a loss of confidence in a country can produce an economic crisis that
justifies that loss of confidence—that countries may be
vulnerable to what economists call "self-fulfilling speculative attacks." And, while many economists, myself
included, used to be skeptical about the importance of
such self-fulfilling crises, the experience of the '90s in
Latin America and Asia has settled those doubts, at least
as a practical matter.
True, many of the investments made in Asia in recent
years now look extremely foolish, and it seems only natural to conclude that they were the product of a deeply
corrupi "crony" system—and that the massive loss of
investor confidence in Asia was therefore wholly justified on that basis. But how sound would our own fmancial institutions look if we experienced a comparable
loss of investor confidence? Scaling up Thailand's experience to the size of the U.S. economy, it would be as if
the roughly $200-bil]ion-per-year net inflow of foreign
investment that currently helps stabilize our financial
markets were next year to become an outflow, not of
$200 billion, but of a trillion dollars. How many loans
that looked reasonable at the time would suddenly
become "nonperforming"? How many seemingly sound
banks would be defunct? In short, whatever the sins of
�the Asian economies, it's important to understand that
J most of what is now wrong with them is the consefcqiience, noi die cause, of their crisis.
^ ) \ ' Big, rich countries like the United States are gener^ a l l y invulnerable to such a self-ratifying loss of market
confidence and can still operate on the assumption that
the financial markets will more or less appropriately
reward good policies. But smaller counlries, wilh a
shorter record of economic success, are always at risk—
and avoiding such collapses of confidence becomes a
central concern of economic policy.
The peculiar thing is lhat, because speculative attacks
can be self-justifying, following an economic policy lhat
makes sense in terms of the fundamentals is not
enough to assure market confidence. In fact, the need
to win thai confidence can actually prevem a country
from following otherwise sensible policies and force il
lo follow policies lhat would normally seem perverse.
Consider again lhe plight of Brazil. Many economists
believe Brazil's currency is overvalued—that is, if one
could ignore the question of market confidence, the
country would benefit from a devaluation that would
make its exports more competitive on world markets.
Examples of successful devaluation abound: the drop in
the value of Britain's pound in 1992, while a humiliation for the governmenl, led to a rapid economic recovery lhat was the envy of continental Europe. Bul Brazil's
leaders (and Washington officials) fear, with good reason, lhal investors hold developing countries to a different siandard: thai any comparable move in Brazil would
be the signal for a massive run on the currency and
would be an economic catastrophe. It's not that devaluation is a terrible thing per se, but investors believe that
it would be, and, in a world of self-fulfilling crises,
believing makes it so.
The same logic applies to Brazil's interest rate and
budget policy. Raising interest rates to defend the currency may be a destructive policy from a strict economic
viewpoint; so i.s reducing spending and raising taxes in
the lace of a recession. But investors believe that, if
Brazil does nol do these things, there will be a terrible
crisis, and ihey are surely right, because they themselves
will generate lhat c risis.
ow consider the situation from the point of view
of those smart economists who are making
policy in Washington. They find themselves
dealing with economies whose hold on investor
confidence is fragile; almost by definition a country that
has come to the United Slates and/or the IMF for help
is one thai has already experienced a devastating run on
ils currency and is al risk of anolher. The overriding
objective of policy must therefore be to mollify market
sentiment. But, because crises can be self-fulfilling, sound
economic policy is not sufficient to gain market confidence; one must cater to the perceptions, the prejudices,
and ihe whims of ihe market. Or, rather, one musl cater
to what one hopes will be the perceptions of the market.
I ^ i / ^ s i " , inlernational economic policy ends up
|l|&;.h
g very little to do with economics. It becomes an
N
1 0
a v i n
exercise in amateur psychology, -inswhich the IMF—
whose top economist, Stanley Fischei^bpasts credentials
just as impressive as those of Summerafan'd his crew—
and the Treasury Department try to convince countries
to do things they hope will be perceived by the market
as favorable. No wonder the economics textbooks went
right out the window as soon as the crisis hit.
Unfortunately, the textbook issues do not go away.
Suppose that Washington is right, that a country threatened with an investor panic must raise interest rates, cut
spending, and defend its currency to avoid devastating
crisis. It still remains true that tight monetary and fiscal
policies, together with an overvalued currency, produce
recessions. What remedy does Washington offer? None.
The perceived need to play the confidence game supersedes the normal concerns of economic policy. It
sounds pretty crazy, and it is.
D
uring the past four years, seven countries—
Mexico, Argeniina, Thailand, South Korea,
Indonesia, Malaysia, and Hong Kong—have
experienced severe economic recessions, worse
than anything the United States has seen since the '30s,
essentially because playing the confidence game forced
them into macroeconomic policies that exacerbated
slumps instead of relieving them. It now looks extremely
likely that Brazil will be forced down the same route and
that much of the rest of Latin America will follow. This
is a truly dismal, even tragic, record. Isn't there a better way?
Well, as long as countries are wide open to massive
movements of hot money—to huge inflows when the
markets like them, then to equally large outflows when
confidence is shaken for some reason—the answer is
no. As long as capital flows freely, nations will be vulnerable to self-fulfilling speculative attacks, and policymakers will be forced to play the confidence game. And
so we come to the question of whether capital should
really be allowed to flow so freely.
Of course, it is not easy to limit the international
movement of capital—at least not without threatening
to strangle international trade as well. Discuss the issue
with the experts in Washington, and they will raise
many pointed technical objections. They will also
remind you that, in 1995, the IMF and the Treasury
Department played the confidence game on behalf of
Mexico and Argeniina and won it.
But they do not seem to be winning this time. And
even if, miraculously, Asia recovers and Latin America
avoids disaster, and even if another crisis does not materialize a couple of years later, the Keynesian compact
will still remain broken: developing countries will consistently find that, when a recession strikes, financial
markets force them to act in a way that makes that
recession even worse.
Maybe such a system can survive, but I doubt it. If
allowing free capital movement means that economic
policy must play by the rules of the confidence game,
sooner or later the world is going to decide that it is a
game not worth playing. •
OCTOBER 5,1998 THE NEW REPUBLIC 25
��http://www.nyu.edu:80/globalbeat/asia/fischer012298. html
Global Beat: The Asian Crisis: A View from the IMF
ifJpfiriiefMqrgu e>•
East Asian Security
Experts and Links
The Asian Crisis: A View from the
IMF
By Stanley Fischer, First Deputy Managing Director of
the International Monetary Fund
January 22, 1998
Address at the Midwinter Conference of the Bankers'
Association for Foreign Trade, Washington, D.C.
As the crisis has unfolded in Asia, the IMF has become,
at least for this brief moment in history, almost a
household name. But even if the institution has become
more well known, its role in Asia and more broadly in
the world economy is not widely understood. Thus, I am
very pleased to have this opportunity to discuss the
Asian crisis, what the IMF is doing to help contain it,
and the institution's wider role in the international
monetary system.
Asia's economic success
The crisis in Asia has occurred after several decades of
outstanding economic performance. Annual GDP
growth in the ASEAN-5 (Indonesia, Malaysia, the
Philippines, Singapore, and Thailand) averaged close to
8 percent over the last decade. Indeed, during the 30
years preceding the crisis per capita income levels had
increased tenfold in Korea, fivefold in Thailand, and
fourfold in Malaysia. Moreover, per capita income levels
in Hong Kong and Singapore now exceed those in some
industrial countries. Until the current crisis, Asia
attracted almost half of total capital inflows to
developing countries—nearly $100 billion in 1996. In the
last decade, the share of developing and emerging
market economies of Asia in world exports has nearly
doubled to almost one fifth of the total.
This record growth and strong trade performance is
unprecedented, a remarkable historical achievement.
Moreover, Asia's success has also been good for the rest
of the world. The developing and emerging market
economies of Asia have not just been major exporters;
they have been an increasingly important market for
other countries' exports. For example, these countries
bought about 19 percent of U.S. exports in 1996, up
from about 15 percent in 1990. Likewise, the dynamism
of these economies helped cushion the impact of
successive downturns in industrial economies on the
world economy during 1991-93. In recent years, they
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have also been a source of attractive investment returns.
For all these reasons, the developing and emerging
market economies of Asia have been a major engine of
growth in the world economy.
So what went wrong? Let me start with the common
underlying factors.
The origins of the crisis
The key domestic factors that led to the present
difficulties appear to have been: first, the failure to
dampen overheating pressures that had become
increasingly evident in Thailand and many other
countries in the region and were manifested in large
external deficits and property and stock market bubbles;
second, the maintenance of pegged exchange rate
regimes for too long, which encouraged external
borrowing and led to excessive exposure to foreign
exchange risk in both the financial and corporate sectors;
and third, lax prudential rules and financial oversight,
which led tb a sharp deterioration in the quality of banks'
loan portfolios. As the crises unfolded, political
uncertainties and doubts about the authorities'
commitment and ability to implement the necessary
adjustment and reforms exacerbated pressures on
currencies and stock markets. Reluctance to tighten
monetary conditions and to close insolvent financial
institutions has clearly added to the turbulence in
financial markets.
Although the problems in these countries were mostly
homegrown, developments in the advanced economies
and global financial markets contributed significantly to
the buildup of the imbalances that eventually led to the
crises. Specifically, with Japan and Europe experiencing
weak growth since the beginning of the 1990s, attractive
domestic investment opportunities have fallen short of
available saving; meanwhile, monetary policy has
remained appropriately accomodative, and interest rates
have been low. Large private capital flows to emerging
markets, including the so-called "carry trade," were
driven, to an important degree, by these phenomena and
by an imprudent search for high yields by international
investors without due regard to potential risks. Also
contributing to the buildup to the crisis were the wide
swings of the yen/dollar exchange rate over the past
three years.
The crisis erupted in Thailand in the summer. Starting in
1996, a confluence of domestic and external shocks
revealed weaknesses in the Thai economy that until then
had been masked by the rapid pace of economic growth
and the weakness of the U.S. dollar to which the Thai
currency, the baht, was pegged. To an extent, Thailand's
difficulties resulted from its earlier economic success.
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Strong growth, averaging almost 10 percent per year
from 1987- 95, and generally prudent macroeconomic
management, as seen in continuous public sector fiscal
surpluses over the same period, had attracted large
capital inflows, much of them short-term—and many of
them attracted by the establishment of the Bangkok
International Banking Facility in 1993. And while these
inflows had permitted faster growth, they had also
allowed domestic banks to expand lending rapidly,
fueling imprudent investments and unrealistic increases
in asset prices. Past success also may also have
contributed to a sense of denial among the Thai
authorities about the severity of Thailand's problems and
the need for policy action, which neither the IMF in its
continuous dialogue with the Thais during the 18 months
prior to the floating of the baht last July, nor increasing
exchange market pressure, could overcome. Finally, in
the absence of convincing policy action, and after a
desperate defense of the currency by the central bank,
the crisis broke.
Contagion to other economies in the region appeared
relentless. Some of the contagion reflected rational
market behavior. The depreciation of the baht could be
expected to erode the competitiveness of Thailand's
trade competitors, and this put some downward pressure
on their currencies. Moreover, after their experience in
Thailand, markets began to take a closer look at the
problems in Indonesia, Korea, and other neighboring
countries. And what they saw to different degrees in
different countries were some of the same problems as in
Thailand, particularly in the financial sector. Added to
this was the fact that as currencies continued to slide, the
debt service costs of the domestic private sector
increased. Fearful about how far this process might go,
domestic residents rushed to hedge their external
liabilities, thereby intensifying exchange rate pressures.
But the amount of exchange rate adjustment that has
taken place far exceeds any reasonable estimate of what
might have been required to correct the initial
overvaluation of the Thai baht, the Indonesian rupiah,
and the Korean won, among other currencies. In this
respect, markets have overreacted.
So, in many respects, Thailand, Indonesia and Korea do
face similar problems. They all have suffered a loss of
confidence, and their currencies are deeply depreciated.
Moreover, in each country, weak financial systems,
excessive unhedged foreign borrowing by the domestic
private sector, and a lack of transparency about the ties
between government, business, and banks have both
contributed to the crisis and complicated efforts to
defuse it.
But the situations in these countries also differ in
important ways. One notable difference is that Thailand
was running an exceptionally large (8 percent of GDP)
current account deficit, while Korea's was on a
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downward path, and Indonesia's was already at a more
manageable level (3 1/4 percent of GDP). These
countries also called in the IMF at different stages of
their crises. Thailand called on the IMF when the central
bank had nearly run out of usable reserves. Korea came
still closer to catastrophe, a situation which has
improved following the election of Kim Dae-Jung, the
forceful implementation of the IMF-supported program
even before he takes office, and the start of discussions
with commercial banks on the rollover of Korea's
short-term debt.
Indonesia, on the other hand, requested IMF assistance
at an earlier stage, and at the start—in early
November—the reform program seemed to be working
well. But questions about the implementation of the
program and the President's health, as well as contagion
from Korea, all took their toll. Last week, after intense
consultations and negotiations with the IMF, President
Suharto decided to accelerate the reform program.
Important measures to deal with banking sector
difficulties and to increase confidence in the banks
should be announced in the next few days. Corporate
sector debt difficulties will have to be dealt with in a
way that preserves the principle that the solution is
primarily up to individual debtors and their creditors.
The Philippines, for its part, has not escaped the turmoil,
but its decision to extend the IMF-supported program
that it had already been implementing successfully for
several years has helped mitigate the effects of the crisis.
IMF-supported Programs in Asia
The design of the IMF-supported programs in these
countries reflects these similarities and differences. All
three programs have called for a substantial rise in
interest rates to attempt to halt the downward spiral of
currency depreciation. And all three programs have
called for forceful, up-front action to put the fmancial
system on a sounder footing as soon as possible.
To this end, non-viable institutions are being closed
down, and other institutions are required to come up
with restructuring plans and comply—within a
reasonable period that varies according to country
circumstances—with internationally accepted best
practices, including the Basle capital adequacy standards
and internationally accepted accounting practices and
disclosure rules. Institutional changes are under way to
strengthen financial sector regulation and supervision,
increase transparency in the corporate and government
sectors, create a more level playing field for private
sector activity, and open Asian markets to foreign
participants. Needless to say, all of these reforms will
require a vast change in domestic business practices,
corporate culture, and government behavior, which will
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take time. But the process is in motion, and already
some dramatic steps have been taken.
The fiscal programs vary from country to country. In
each case, the IMF asked for a fiscal adjustment that
would cover the carrying costs of financial sector
restructuring—the full cost of which is being spread over
many years-and to help restore a sustainable balance of
payments. In Thailand, this translated into an initial
fiscal adjustment of 3 percent of GDP; in Korea, 1 1/2
percent of GDP; and in Indonesia, 1 percent of GDP,
much of which will be achieved by reducing public
investment in projects with low economic returns.
Some have argued that these programs are too tough,
either in calling for higher interest rates, tightening
government budget deficits, or closing down financial
institutions. Let's take the question of interest rates first.
By the time these countries approached the IMF, the
value of their currencies was plummeting, and in the
case of Thailand and Korea, reserves were perilously
low. Thus, the first order of business was, and still is, to
restore confidence in the currency. Here, I would like to
dispel the notion that the deep currency depreciations
seen in Asia in recent months have occurred by IMF
design. On the contrary, as I noted a moment ago, we
believe that currencies have depreciated far more than is
warranted or desirable. Moreover, without IMF support
as part of an international effort to stabilize these
economies, it is likely that these currencies would have
lost still more of their value. To reverse this process,
countries have to make it more attractive to hold
domestic currency, and that means temporarily raising
interest rates, even if this complicates the situation of
weak banks and corporations. This is a key lesson of the
"tequila crisis" in Latin America 1994-95, as well as
from the more recent experience of Brazil, Hong Kong,
and the Czech Republic, all of which have fended off
attacks on their currencies over the past few months with
a timely and forceful tightening of interest rates along
with other supporting policy measures. Once confidence
is restored, interest rates should return to more normal
levels.
Let me add that companies with substantial foreign
currency debts are likely to suffer far more from a long,
steep slide in the value of their domestic currency than
from a temporary rise in domestic interest rates.
Moreover, when interest rate action is delayed,
confidence continues to erode. Thus, the increase in
interest rates needed to stabilize the situation is likely to
be far larger than if decisive action had been taken at the
outset. Indeed, the reluctance to tighten interest rates in a
determined way at the beginning has been one of the
factors perpetuating the crisis. Higher interest rates
should also encourage the corporate sector to restructure
its financing away from debt and toward equity, which
will be most welcome in some cases, such as Korea.
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Other observers have advocated more expansionary
fiscal programs to offset the inevitable slowdown in
economic growth. The balance here is a fine one. As
already noted, at the outset of the crisis, countries need
to firm their fiscal positions, to deal both with the future
costs of financial restructuring and-depending on the
balance of payments situation-the need to reduce the
current account deficit. Beyond that, if the economic
situation worsens, the IMF generally agrees with the
country to let automatic stabilizers work and the deficit
to widen somewhat. However, we cannot remain
indifferent to the level of the fiscal deficit, particularly
since a country in crisis typically has only limited access
to borrowing and since the alternative of printing money
would be potentially disastrous in these circumstances.
Likewise, we have been urged not to recommend rapid
action on banks. However, it would be a mistake to
allow clearly bankrupt banks to remain open, as this
would be a recipe for perpetuating the region's financial
crisis, not resolving it. The best course is to recapitalize
or close insolvent banks, protect small depositors, and
require shareholders to take their losses. At the same
time, banking regulation and supervision must be
improved. Of course, we take individual country
circumstances into account in deciding how quickly all
of this can be accomplished.
In short, the best approach is to effect a sharp, but
temporary, increase in interest rates to stem the outflow
of capital, while making a decisive start on the
longer-term tasks of restructuring the financial sector,
bringing financial sector regulation and supervision up
to international standards, and increasing domestic
competition and transparency. None of this will be easy,
and unfortunately, the pace of economic activity in these
economies will inevitably slow. But the slowdown
would be much more dramatic, the costs to the general
population much higher, and the risks to the
international economy much greater without the
assistance of the international community, provided
through the IMF, the World Bank, and bilateral sources,
including the United States.
Most major industrial countries appear well positioned
to absorb the adverse effects of the Asian crisis. In the
United States, consumer spending and investment
remain strong and incoming data for the fourth quarter
point to further robust growth in output and household
spending. Consumer confidence remains at or near
all-time highs, and the unemployment rate stood at 4.7
percent in December, only slightly above the November
rate of 4.6 percent, which was the lowest rate in 24
years. Direct measures of prices indicate that inflationary
pressures are receding, and the strong dollar and weak
import and commodity prices suggest that this trend will
continue for a while longer. Nevertheless, it does not
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take a great deal of imagination to see how the problems
in Asia could take on larger proportions, with more
profound effects on global growth and financial market
stability. That is why the international community has
decided to work together through the IMF to try to
overcome the crisis in a way that does the least damage
to the global economy.
Moral Hazard
Of course, not everyone agrees with the international
community's approach of trying to cushion the effects of
such crises. Some say that it would be better simply to
let the chips fall where they may, arguing that to come to
the assistance of countries in crisis will only encourage
more reckless behavior on the part of borrowers and
lenders. I do not share the view that we should step aside
in these cases. To begin with, the notion that the
availability of IMF programs encourages reckless
behavior by countries is far-fetched: no country would
deliberately court such a crisis even if it thought
international assistance would be forthcoming. The
economic, financial, social, and political pain is simply
too great; nor do countries show any great desire to enter
IMF programs unless they absolutely have to.
On the side of the lenders, despite the constant talk of
bailouts, most investors have made substantial losses in
the crisis. With stock markets and exchange rates
plunging, foreign equity investors have lost nearly
three-quarters of the value of their equity holdings in
some Asian markets. Many firms and fmancial
institutions in these countries will go bankrupt, and their
foreign and domestic lenders will share in the losses.
International banks are also sharing in the cost of the
crisis. Some lenders may be forced to write down their
claims, especially against corporate borrowers. In
addition, foreign commercial banks are having to roll
over their loans at a time when they would not normally
choose to do so. And although some banks may benefit
from higher interest rates on their rollovers than they
would otherwise receive, the fourth quarter earnings
reports now becoming available indicate that, overall,
the Asian crisis has indeed been costly for foreign
commercial banks.
In effect, we face a trade-off. Faced with a crisis, we
could allow it to deepen and possibly teach international
lenders a lesson in the process; alternatively, we can step
in to do what we can to mitigate the effects of the crisis
on the region and the world economy in a way that
places some of the burden on borrowers and lenders,
although possibly with some undesired side effects. The
latter approach—doing what we can to mitigate the
crisis-makes more sense. The global interest, and
indeed the U.S. interest, lies in an economically strong
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Asia that imports as well as exports and thereby supports
global growth.
Simply letting the chips fall where they may would
surely cause more bankruptcies, larger layoffs, deeper
recessions, and even deeper depreciations than would
otherwise be necessary to put these economies back on a
sound footing. The result would not be more prosperity,
more open markets and faster adjustment, but rather
greater trade and payments restrictions, a more
significant downturn in world trade, and slower world
growth. That is not in the interest of the United States,
nor of any other IMF member.
Role of the IMF
If I am emphatic on that point, it is because the IMF was
founded in the hope that establishing a permanent forum
for cooperation on international monetary problems
would help avoid the competitive devaluations,
exchange restrictions, and other destructive economic
policies that had contributed to the Great Depression and
the outbreak of war. The international economy has
changed considerably since then, and so has the IMF.
But its primary purposes remain the same; they are (and
here I quote from the IMF's Articles of Agreement):
• "to facilitate...the balanced growth of international
trade, and to contribute thereby to...high levels of
growth and real income"~and we have
consistently promoted trade liberalization;
• "to promote exchange rate stability, to maintain
orderly exchange arrangements among members,
and to avoid competitive exchange depreciation";
and
• to provide members "with opportunities to correct
maladjustments in their balance of payments,
without resorting to measures destructive of
national or international prosperity."
Our approach to these tasks is straightforward: it is to
encourage all members to pursue sound economic
policies and to open their economies to trade and
investment. It is also to seek to avert crises by keeping
close watch on member countries' economies and to
warn them when trouble threatens. Sometimes we
succeed, in that we warn countries and they take action.
Sometimes we warn, but our advice is not followed,
even when it is timely and on the mark. And sometimes
despite our continuous efforts to strengthen our
surveillance over member policies and performance, we
might see some of the key elements of an emerging
crisis, but fail to draw their full implications. We will
continue to seek to strengthen surveillance~but it would
be unrealistic to expect that every crisis can be
anticipated.
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When crisis does strike, the IMF has been willing to act
in accordance with its purposes to deal with major
problems confronting the international economy. On
numerous occasions, the IMF has helped provide the
expertise and vision needed to come up with pragmatic
solutions to important international monetary problems,
and it has helped mobilize the international resources to
make them work. This was true during the energy crisis
in 1973-74, when the IMF established a mechanism for
recycling the surpluses of oil exporters and helping to
finance the oil-related deficits of other countries. It was
true in the mid-1980s, when the IMF played a central
role in the debt strategy. It was true in 1989 and after,
when the IMF helped design and finance the massive
effort to help the 26 transition countries cast off the
shackles of central planning. And it was true in 1994-95,
when the IMF came forward to help avert Mexico's
financial collapse—and to prevent the crisis from spilling
over into the markets, forcing other countries to resort to
exchange controls and debt moratoria, and possibly
causing a dramatic disruption in private capital flows to
developing countries. Because of the authorities' efforts
and IMF support, Mexico's markets remained open and
capital continued to flow.
There is no denying that each of these crises has been
difficult-especially for the IMF members most
adversely affected. In each case we, the IMF and the
international community as a whole, learned from our
experiences. And in each case, it is clear that without
Fund assistance, things would have been much worse.
The IMF's effectiveness derives from the fact that as an
international institution with a nearly global
membership, it can carry on a policy dialogue with
member countries and make policy recommendations in
situations where a bilateral approach would not be
accepted. At the same time, the IMF provides a
mechanism for sharing the responsibility of supporting
the international monetary system among the entire
international community.
IMF Resources
Part of that shared responsibility is to provide resources
to the IMF. Let me emphasize that the IMF is not a
charitable institution, nor does it carry out its operations
at taxpayers' expense. On the contrary, it operates much
like a credit union. On joining the IMF, each member
country subscribes a sum of money called its quota.
Members normally pay 25 percent of their quota
subscriptions out of their foreign reserves, the rest in
their national currencies. The quota is like a deposit in
the credit union, and the country continues to own it.
The size of the quota determines the country's voting
rights, and the United States, with over 18 percent of the
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shares, is the largest shareholder. Many key issues
require an 85 percent majority, so that the United States
effectively has a veto over major Fund decisions.
When a member borrows from the Fund, it exchanges a
certain amount of its own national currency for the use
of an equivalent amount of currency of a country in a
strong external position. The borrowing country pays
interest at a floating market rate on the amount it has
borrowed, while the country whose currency is being
used receives interest. Since the interest received from
the IMF is broadly in line with market rates, the
provision of financial resources to the Fund has involved
little cost, if any, to creditor countries, including the
United States.
As you are no doubt aware, the Fund's membership has
recently agreed to increase IMF quotas by 45 percent,
about $88 billion, which will raise the capital base of the
institution to some $284 billion. The United States' share
of this increase would be nearly $16 billion. In addition,
the Fund has taken steps to augment its financial
resources through the agreement on the New
Arrangements to Borrow (NAB). Under the NAB,
participants would be prepared to lend up to about $45
billion when additional resources are needed to forestall
or cope with an impairment of the international
monetary system, or to deal with an exceptional
situation that poses a threat to the stability of the system.
These are large sums. They are often described as an
expense to the taxpayer. We are deeply aware in the IMF
that our support derives ultimately from the legislatures
that vote to establish their countries' quotas—their
deposits-in the IMF. We must justify that support. But
it must also be recognized that contributions to the IMF
are not fundamentally an expense to the taxpayer; rather,
they are investments. They are an investment in the
narrow sense that member countries earn interest on
their deposits in the IMF. Far more important, they are
also an investment in a broader sense, an investment in
the stability and the prosperity of the world economy.
Thank you.
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Dublin Core
The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/.
Title
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Michael Waldman
Description
An account of the resource
<p>Michael Waldman was Assistant to the President and Director of Speechwriting from 1995-1999. His responsibilities were writing and editing nearly 2,000 speeches, which included four State of the Union speeches and two Inaugural Addresses. From 1993 -1995 he served as Special Assistant to the President for Policy Coordination.</p>
<p>The collection generally consists of copies of speeches and speech drafts, talking points, memoranda, background material, correspondence, reports, handwritten notes, articles, clippings, and presidential schedules. A large volume of this collection was for the State of the Union speeches. Many of the speech drafts are heavily annotated with additions or deletions. There are a lot of articles and clippings in this collection.</p>
<p>Due to the size of this collection it has been divided into two segments. Use links below for access to the individual segments:<br /><a href="http://clinton.presidentiallibraries.us/items/browse?advanced%5B0%5D%5Belement_id%5D=43&advanced%5B0%5D%5Btype%5D=is+exactly&advanced%5B0%5D%5Bterms%5D=2006-0469-F+Segment+1">Segment One</a><br /><a href="http://clinton.presidentiallibraries.us/items/browse?advanced%5B0%5D%5Belement_id%5D=43&advanced%5B0%5D%5Btype%5D=is+exactly&advanced%5B0%5D%5Bterms%5D=2006-0469-F+Segment+2">Segment Two</a></p>
Creator
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Michael Waldman
Office of Speechwriting
Date
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1993-1999
Identifier
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2006-0469-F
Extent
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Segment One contains 1071 folders in 72 boxes.
Segment Two contains 868 folders in 66 boxes.
Provenance
A statement of any changes in ownership and custody of the resource since its creation that are significant for its authenticity, integrity, and interpretation. The statement may include a description of any changes successive custodians made to the resource.
Clinton Presidential Records: White House Staff and Office Files
Publisher
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William J. Clinton Presidential Library & Museum
Format
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Adobe Acrobat Document
Text
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Original Format
The type of object, such as painting, sculpture, paper, photo, and additional data
paper
Dublin Core
The Dublin Core metadata element set is common to all Omeka records, including items, files, and collections. For more information see, http://dublincore.org/documents/dces/.
Title
A name given to the resource
IMF Spch. [International Monetary Fund Speech]- Briefing Book [4]
Creator
An entity primarily responsible for making the resource
Office of Speechwriting
Michael Waldman
Is Part Of
A related resource in which the described resource is physically or logically included.
Box 64
<a href="http://clinton.presidentiallibraries.us/items/show/36404"> Collection Finding Aid</a>
<a href="https://catalog.archives.gov/id/7763296">National Archives Catalog Description</a>
Identifier
An unambiguous reference to the resource within a given context
2006-0469-F Segment 2
Provenance
A statement of any changes in ownership and custody of the resource since its creation that are significant for its authenticity, integrity, and interpretation. The statement may include a description of any changes successive custodians made to the resource.
White House Staff and Office Files
Publisher
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William J. Clinton Presidential Library & Museum
Format
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Adobe Acrobat Document
Medium
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Preservation-Reproduction-Reference
Date Created
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6/3/2015
Source
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7763296
42-t-7763296-20060469F-Seg2-064-006-2015