Select Committee on Economic Affairs First Report


234. Globalisation has a macroeconomic and a financial dimension. A number of witnesses have linked national economic crises in many less developed countries to faults in the current international financial system and to the way it is administered by international economic institutions. The system is said to benefit developed countries at the expense of less developed countries. International economic institutions are accused of not doing enough to create a fairer financial system and of creating excessive capital mobility and exchange rate volatility thereby de-stabilising developing economies.

Development of the global capital market

235. The globalisation of capital markets is not a new phenomenon: "The figures tell a clear story about capital markets: they were highly integrated in the late nineteenth century, disintegrated during the inter-war period, and are only now recovering the levels of integration experienced in 1913."[138]

236. Following the Second World War, the Bretton Woods settlement saw the establishment of international institutions which sought to "re-create the international economy that had brought prosperity before the First World War while safeguarding against the dislocation of the 1930s that had led to the Second".[139] The post-Second World War international financial architecture was designed largely to promote the benefits of trade. Andrew Crockett, in his written evidence, observed that the post-war economic order was an attempt to avoid the "… negative experience with isolationism and the monetary disorder of the inter-war years …" (Ev I, p 155). The Bretton Woods system aimed to promote free trade through a set of mutually agreed "rules of the game". It embraced capital controls because it was thought this would " … make it easier to pursue the twin objective of full employment[140] and balance payments of equilibrium". In Andrew Crockett's view, trade liberalisation made it harder to maintain capital account restrictions with the result that " … countries liberalised capital flows as a means of 'leveraging' the benefits accruing from the trade side." (Ev I, p 156).

237. The Bretton Woods system was based on the US dollar. All exchange rates were pegged to it. As Professor Ronald McKinnon, Senior Fellow of the Stanford Institute of Economic Policy, explained in his evidence, much of the world's trade was invoiced in US dollars. The US provided the risk-free assets in the system and had an almost unlimited credit line with the rest of the world (Ev I, Q 528). Even today, the US dollar acts as the world's vehicle currency for trade, and the US must have a trade surplus in order to supply the world with currency and credit. The dominance of the US dollar - what Professor McKinnon describes as the "currency asymmetry" - was therefore built into the system from its inception, and it continues today.

238. In the early 1970s, the Bretton Woods system of fixed exchange rates broke down, flexible exchange rates re-emerged and capital market integration resumed. The reasons for the breakdown are still controversial. It is widely thought that a major factor was high domestic US inflation in the late 1960s, rather than the removal of capital controls. The rise in the real price of oil, accompanied by many governments' faulty response to it, also had an effect. High US inflation caused a loss of US competitiveness and so undermined the US trade balance and the value of dollar-denominated financial assets. Countries therefore sought a realignment of exchange rates. The easiest way for this to happen was for the US dollar to devalue against gold. This precipitated the general floating of exchange rates as countries searched for the most appropriate exchange rate level. Under Bretton Woods, monetary policy for all countries was, in effect, determined by the US due to the need to maintain the exchange rate parity with the dollar. Having a flexible exchange rate meant that a country could now determine its own monetary policy and compete for financial capital in world markets. It became increasingly apparent in the years immediately following that capital controls were no longer needed or desirable for most developed countries.

239. Although the broad level of capital market integration is not new, the composition of the capital flows differs markedly from that in pre-First World War globalisation. Andrew Crockett described the difference as follows: "In the more recent [phase of globalisation], short-term, notably bank flows are larger; foreign direct investment has become more important relative to portfolio flows; and within portfolio flows, the share of equity is higher." (Ev I, p 155). The character of current capital flows has been determined in part by advances in technology which has allowed the more efficient trading of traditional financial instruments and the development of more complex financial products.[141] It has also been affected by changes in the organisation of production of transnational corporations, with increased fragmentation of the production process leading to increased FDI. Whilst the increase in FDI has given rise to some concerns (see Chapter 5), the evidence we received suggests that the greater concern is short-term speculative capital flows and the consequent financial and exchange rate instability.

The effects of capital market liberalisation

Benefits of the removal of capital controls

240. The removal of capital controls resulted in more integrated world capital markets. This has tended to create cheaper and more plentiful international credit, thereby promoting economic development and trade. For example, Stephen King, Managing Director, Economics, HSBC, told us: "From a resource allocation perspective, if capital can flow to immobile - but potentially productive - labour, there should be benefits in terms of rising output … and greater social cohesion." (Ev I, p 70). George Soros argued that capital mobility was at the heart of globalisation. He suggested that globalisation of the financial markets had brought "great benefits": "… partly in helping to generate aggregate wealth and also in offering a degree of freedom that cannot be offered by any individual state." (Ev II, Q 1925). Not only did the evidence we receive suggest that capital market liberalisation has benefited developed countries but we also heard evidence that it had benefited some emerging developing economies as well. Tito Mboweni of the South Africa Reserve Bank told the Committee that the removal of capital controls had led to a massive participation by non-residents in their financial markets, which had quite clearly been a positive feature of the opening up of the economy after apartheid. Martin Wolf suggested that without reforms to exchange control liberalisation a number of developing countries would have grown more slowly than they did, particularly India and China (Ev II, Q 1588).

241. Capital market liberalisation may also help spread the financial risks that arise from increased trade specialisation. As Willem Buiter put it: "Access to global financial markets and international portfolio diversification makes it possible, in principle, to insure the residents of a nation against the risks (eg terms of trade shocks) associated with specialising in the production of a relatively narrow bundle of goods and services in an uncertain global environment." (Ev I, p 85).

242. There are also distinct disadvantages to having capital controls. By restricting outflows, they tend to reduce the domestic rate of return (because domestic residents having restricted, or no, access to higher returns in international markets are confined to lending at lower rates domestically). This may discourage savings and lead to thin domestic capital markets, although governments and other borrowers will be able to borrow more cheaply. Capital controls also discourage inflows, because investors fear that they will not be able to withdraw earnings. This discouragement of inwards investment constrains economic growth.

243. Furthermore, fears about the transitional effects of the removal of capital controls appear, to some extent, to be misplaced. Often when capital controls are removed, instead of capital fleeing, it flows in to take advantage of unexploited investment opportunities and this promotes economic growth and development. Indeed, even those witnesses who argued in favour of capital controls in some cases did not argue against their eventual removal. For example, Professor McKinnon noted that western Europe kept capital controls for a long time after the war, but "once a country fully industrialises and gets good internal financial markets, then it can ease the capital controls". He also pointed out that not everybody could have capital controls: "The post-war system could not have worked if the US also had capital controls, but given it is the central money, it is better to have capital controls in the peripheral countries. This is true for the emerging market economies (Asia, Latin America and much of Africa) at the present time." (Ev I, Q 547). Gerald Holtham, Chief Investment Officer, Morley Fund Management, thought that capital controls were a legitimate short-term instrument but argued that there should be "… a sharp distinction between capital controls as an occasional instrument of policy and capital controls as a continuing fact of life." Giving the examples of Malaysia (where capital controls were introduced in 1997) and Chile, he added that "[the] danger if you leave them on as a fact of life [is that] they will not only cause distortions in resource allocation, but just general rent-seeking behaviour. And there is an inducement to corruption."(Ev II, Q 1070).

The downsides of globalisation of the financial markets.


244. Whilst acknowledging the benefits of capital market liberalisation, a number of witnesses emphasised the problems it has created. It has been suggested to us that the advantages for trade and economic growth have been offset (even, perhaps, more than offset) by the disadvantages to macroeconomic stability and the management of national debt, and because of greatly increased financial instability caused by highly volatile short-term capital flows.[142]

245. Stephen King, for example, referred to capital flows being "a source of instability, particularly when they go into reverse". He gave the examples of Mexico and Thailand in the 1990s (Ev I, p 70). George Soros made the same point, giving Argentina's current predicament as an example (Ev II, Q 1925).

246. Professor Krugman emphasised financial instability as one of the downsides of globalisation: "The first thing is capital markets and financial crises. Those have been very severe. The nineties, I think, was the worst decade since the thirties for international financial crises." (Ev II, Q 1880). Andrew Crockett thought that there had been an increase in the number and severity of episodes of financial distress in recent years, and the costs of this financial turbulence "… in terms of output foregone ran into double digits as a percentage of GDP in a significant number of countries …" (Ev I, p 156).

247. Paul Volcker, former Chairman of the US Federal Reserve, whilst noting the "enormous benefits of open markets", commented: "The ironic thing is that financial markets really only opened up dramatically in the 1990s, following the break-up of the Soviet Union and the triumph of the doctrine of open markets and … with surprising enthusiasm, as I see it, the emerging markets joined in this opening and then they pretty promptly fell on their face." The effect was, and is, that: "The second half of the 1990s or the latter part of the 1990s and even extending to now has not matched the growth rate that they had before the markets were opened." (Ev II, Q 1757). Mr Volcker stressed that although large developed countries were able to be reasonably resilient in the face of financial and exchange rate volatility, this was not true of smaller economies:

"… my argument is that people do not realise how much … volatility affects a small open economy … you get a sharp fluctuation in exchange rates in those countries and you are talking about half the economy being knocked off course and the exchange rate and the interest rate going up and down in a wild swing in a way that is not very manageable." (Ev II, Q 1757).

248. Michael Kitson gave evidence about how technological developments had encouraged the use of new financial instruments for speculative purposes because of the speed at which they could be bought and sold. He noted the problems this had created. This "hot money", he said, "has led to volatility in exchange rates and asset prices and has deepened recent currency crises." (Ev I, p 111). The Royal Society of Edinburgh made a similar point: "As to the volatility of capital flows, if everything in the system is speeding up, in large part because technology is accelerating the process, then there will be increasing volatility as financial resources seek to flow to where the advantages are perceived to lie." (Ev II, p 378).

249. War on Want shared this concern. In their memorandum to the Committee, War on Want stated that "… systemic instability in global financial markets is a serious threat to any advance in human development." (Ev I, p 376). They continued: "Governments are finding it increasingly difficult to pursue independent policies which may be inconsistent with the interests of global capital, as the case of Brazil shows." (Ev I, p 378). The implication here seems to be that foreign capital flows are highly sensitive to certain domestic polices, and that there may therefore be a conflict of interest between lender and borrower.

250. The OECD argued that:

"The case for trade liberalisation is quite clear. In contrast, the benefits drawn from financial market deregulation are less obvious. Obviously, an open door to international financial flows is an important channel to utilise foreign savings and meet domestic investment needs. This can also spur competition in the financial sector and lead to efficiency gains. However, financial market volatility is large (although it is not clear whether it has increased in the recent past), and many countries have been subject to financial crises following the sudden withdrawal of foreign capital or the flight of domestic savings." (Ev I, p 173).[143]

251. Tito Mboweni identified the greater volatility in international capital movements as "… one of the most important challenges of globalisation to the South African economy …" (Ev I, p 236). The opening up of South African financial markets to international competition plus significant restructuring of the institutional arrangements in the South African capital markets had "… contributed to a large inflow of capital but also resulted in greater volatility in the capital movements between South Africa and the rest of world." (Ev I, p 235).

252. UNCTAD argued that capital market liberalisation had been damaging to both the poor developing countries and emerging economies:

"Financial liberalisation did bring greater capital flows to developing countries in the 1990s, albeit directed mainly to a handful of emerging markets. But even in these successful countries, the liberalisation of capital flows, particularly where it has been prompted by the need to finance growing external deficits, has actually made matters worse, further impeding investment in productive physical assets by favouring the short-term on financial assets. Higher interest payments have added to the difficulties caused by widening trade deficits, and even the strong growth of FDI flows to developing countries in the 1990s has been accompanied by an increased share of mergers and acquisitions as opposed to greenfield investment, and by investment in sectors characterised by boom-bust cycles.

On recent trends, the level and composition of net capital flows received by most developing countries are inadequate to meet their existing external financing requirements or to contribute to a higher target rate of growth. … The external financing needs of developing countries can be expected to exceed recent net capital inflows by a substantial amount. …

Thus globalisation is not working for many developing countries." (Ev I, p 363).

253. In recent years there has been a removal of capital controls on a scale which has led to a much greater reliance on borrowing from abroad. It appears that the problem described by UNCTAD is not financial liberalisation per se, but external deficits. These may have been caused by over-ambitious or faulty domestic policies accompanied by excessive external borrowing. If that is the case, then this is an argument, in certain cases, for greater, not lower, capital flows (albeit under favourable conditions). The problems for the domestic economy are magnified when the flows are denominated in foreign currency if there is an adverse movement in the exchange rate. This will require a large switch of resources to meet external debt obligations. In the short run, this can be extremely damaging and politically de-stabilising. Therefore, borrowing large amounts short term in a foreign currency is almost certainly inadvisable for a country. It is often done in countries where domestic financial markets are not sufficiently deep to meet a domestic fiscal crisis, and hence the long-run solution is a reform of domestic policy. This does not, of course, address the short-run problem.


254. Another cause for concern, related to financial instability, is the spread of financial crises from one country to other countries. Donald McKinnon commented that:

"Globalisation in international capital markets had resulted in far greater linkages between financial markets in economies which had liberalised their financial sectors but this had brought greater risks of financial contagion in a crisis.

A key lesson from the East Asian crisis is that capital flows, particularly short-term flows, can be extremely volatile. Furthermore, the herding instinct of investors actually accentuates crises and fuels contagion." (Ev I, p 303).

He concluded from this that it was important for developing countries to manage financial market liberalisation carefully with an appropriate sequence of policies in building deeper domestic capital markets (Ev I, p 302). Willem Buiter referred to contagion in financial markets, "manias and panics, irrational euphoria and despondency" as one of the elements of "pathological globalisation" (Ev I, p 84), and Sir Howard Davies, Chairman of the FSA, described how the ease of capital flows and technological advances meant that "… the financial shock waves of a major event now transmit to markets on a global basis virtually instantaneously." (Ev I, p 320). Gerald Holtham said, however, that he was interested in "how very little contagion there had been very recently, for example, from the Argentinian crisis" which has not "even affected Chile or Brazil to any significant extent" (Ev II, Q 1068). This appears to be a minority view.

255. Stanley Fischer, when he was First Deputy Managing Director of the IMF, wrote in 1998 in his analysis of the Asian crisis that: "Contagion to other economies in the region appeared relentless. Some of the contagion reflected rational market behaviour … 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 bath, the Indonesian rupiah, and the Korean won, among other currencies."[144] Professor Krugman spoke in terms of the current South and Latin American problems as having a strong element of contagion. This is particularly so in the case of Brazil, which, although it has inherited a large debt burden following fiscal deficits in the early 1990s, currently has a budget surplus, a floating exchange rate and a strong banking system. Contagion is seen as an important reason why international financial institutions like the IMF need to take an active role in crisis management in a country.

256. The evidence supports our view that there are advantages to capital market liberalisation. Economic theory and the evidence we have received show, in particular, that capital market liberalisation is broadly beneficial to the economic progress of developing countries. It is not without costs, however, and for developing countries to pursue it without adequate preparation of the right policies and institutions would be foolhardy. Our overall conclusion is that the international free flow of capital should be the aim, and become the norm. However, matching the timing of capital market liberalisation with the precise circumstances of the individual country is of the essence.

The international economic institutions

257. Although some blame for global financial instability and contagion is attributed to national economic policies, much of the evidence to the Committee tended to stress failures in the policies of the IMF, the main global economic institution involved actively in financial and macroeconomic management of countries. The World Bank was criticised to a lesser extent. We turn first to the World Bank briefly and then consider the IMF in more detail.

The World Bank

258. The World Bank was established as part of the Bretton Woods settlement to assist in financing the re-construction of war-damaged economies. It is now involved in financing development more generally. The evidence we received about the performance of the World Bank was largely positive (especially in comparison with the IMF), with indications that policy changes within the Bank in recent years were to be applauded.

259. Lord Desai, for example, said: "all through the 1990s the World Bank improved immensely in the way it understands growth, poverty and things like that. I would say that the World Bank has done much less harm than the IMF has done." (Ev II, Q 1741). Mathew Taylor MP suggested that although the World Bank had been "truly awful in the past", it was "undoubtedly improving" (unlike, Mr Taylor said, the IMF) (Ev II, Q 1385).

260. Professor Stiglitz, a former Chief Economist at the World bank, told us;

"As I have watched very carefully both the IMF and the World Bank, I think that there have been much more significant changes in the World Bank than in the IMF and it goes much deeper into the organisation, the change in mindset, the change in how they interact with developing countries. One thing about the World Bank is that it is very decentralised and the country directors and the regional vice-presidents have a lot of autonomy." (Ev II, Q 725).

Nicholas Stern, the current World Bank Chief Economist, confirmed this change in approach. We asked him about the allegation made against the World Bank, as well as the IMF, that it applies a "one-size-fits-all" approach:

"We have made a big effort, particularly in the last five or six years, to decentralise our activity and put our country directors in the field. The point of doing that is that they get closely involved with the real challenges in the country and they understand the particular environment. As part of that story of trying to support countries to make their own choices, we have been backing the approach called the poverty reduction strategy. There is a poverty reduction strategy paper which is a process which is built within the country." (Ev II, Q 1825).

261. Clare Short recognised this change within the World Bank: "The Bank has, in the last five years … , focused much, much more on the measurable reduction of poverty being the sign of success in development, empowering local people and governments to take control of the reform agenda against that kind of objective with more openness." (Ev II, Q 2022). We welcome this development.

262. While most of the evidence we received about the World Bank was positive, some criticisms were made. Dr Yilmaz Akyuz of UNCTAD, for example, suggested that unlike the IMF which, because of the Asian financial crisis in 1990s, had gone through a period of re-thinking, the Bank had failed to progress since the 1970s or 1980s. The Bank had, he said, "over-stretched itself" (Ev I, Q 975). It should consider focusing "on a few areas … maybe go back to project financing … maybe programme lending" (Ev I, Q 976). Paul Volcker shared the view that the World Bank was attempting to pursue too many objectives: "I do not criticise them … they are being asked to do too many things and very few of them are what is clearly within their grasp. It was quite different … 30 years ago: the World Bank lent on infrastructure." (Ev II, Q 1774).

263. Martin Wolf also alluded to the "extraordinarily multifarious" and "unbelievably wide-ranging" activities of the Bank. He suggested that the Bank should concentrate on two main functions: first, the provision of advice and knowledge not available from other sources (because the Bank "contains a vast repository of information and a great many very able people"); and secondly, the provision of funds to countries that have no access to capital markets to support programmes which those countries have decided to pursue (Ev II, QQ 1617-18).

264. We note that George Soros, in George Soros on Globalization, refers to the criticism of the World Bank by the International Finance Advisory Commission (the Meltzer Commission) Report: "… the Meltzer Commission criticises the World Bank for being a bureaucratic organisation with too large a staff and for engaging in lending activities that could be taken care of by the capital markets."[145] Although not wholly supportive of the Commission's recommendations in relation to the World Bank, Mr Soros endorses the view that the Bank lending operations should be reformed and should include, for example, an even greater emphasis on transparency and the fight against corruption.

265. We started our inquiry from a position highly critical of the World Bank in its role as an international financial institution. While acknowledging the criticisms of the Bank, the evidence has led us to a more balanced and supportive view. In addition to welcoming the Bank's more client-focused approach in its operations, we are especially impressed by the World Bank as a source of data and research which provides the basis for a sensible and valuable approach to the growth process.


266. The IMF was also created as part of the Bretton Woods settlement. The Articles of Agreement state that the IMF seeks to promote international monetary co-operation, facilitate the expansion of international trade, promote exchange-rate stability and avoid competitive depreciation.


267. A number of witnesses commented on the harmful effects that IMF policies had had on developing countries. It was seen by some as a major cause of the problems arising from globalisation, and by others as making economic crises in some developing countries worse. The crises in East Asia, Argentina and Brazil were frequently cited as examples.

268. Professor McKinnon told the Committee that he thought that the IMF had "lost its sense of mission". In the early days of Bretton Woods "… the strong dollar was at the centre while there was a lack of confidence in European currencies. … So the IMF very explicitly committed all the peripheral countries in Europe and Japan to maintain capital controls. … Today … countries on the periphery and emerging markets should be able to use capital controls (to stabilise their financial systems). The IMF's big sin of commission up to a year or two ago was to be a cheerleader for getting rid of capital controls. … Without capital controls, the stage is set for hot money flows, which are unnecessary."(Ev I, Q 541). He went on: "The leaders of the IMF have for the most part been in favour of free-floating and pushing countries despite these very strong neighbourhood effects, so that when country A devalues, it really hurts country B." (Ev I, Q 544).

269. John Grieve Smith, Fellow of Robinson College, Cambridge, argued in his memorandum to the Committee that "… the IMF should stop prescribing deflationary measures which increase the risk of massive increase in unemployment in countries in difficulties and instead help them to stabilise their economies in such a way as to maintain employment." (Ev I, p 63).

270. Professor Joseph Stiglitz thought that the main problems with the IMF arose from its governance: "the voices of all countries are not all equally heard…there is lot of unhappiness about the UN with five countries having veto power and in the IMF one country has effective veto power, and that particular country, I am embarrassed to say, tends to pursue a position which is increasingly best described as unilateralist and which itself is dictated by special corporate and financial interests within the United States" (Ev I, Q 711). Professor Stiglitz suggested that "basically countries are told [by the IMF] to adopt a neo-liberal agenda … and this is causing very severe problems in confidence in democracy and reforms in many developing countries"; he gave capital liberalisation as an example of "an agenda that was being pushed by the IMF and the US Treasury when there was no evidence that it promoted economic growth." (Ev I, Q 718). In his view "the IMF needs to focus on the one area of its supposed competence, that is crises". He went on: "They are beginning to talk about more use of bankruptcy and standstills and away from big bailouts. … Stan Fischer on this issue said if you default it is an abrogation of your debt contract, whereas my view was that bankruptcy has been a fundamental part of capitalism and we would not have the market economy we had if we did not have bankruptcy." (Ev I, Q 733).

271. George Monbiot of The Guardian similarly focused on governance issues. He said that he "would like to see the dissolution of the World Bank and the IMF", which he believed were "profoundly undemocratic organisations, that people who control them are exclusively the rich nations and the places in which they work are exclusively the poor nations, so the recipients of their policies have no effective influence over their policies" (Ev II, Q 1317). By way of example he said: "We saw this very clearly with Argentina where the government and certainly the people had a clear view of the sort of economic policies they thought would be appropriate. It was plain the IMF had a different view, the IMF's view prevailed and we all know what happened." (Ev II, Q 1334).

272. Professor Krugman, speaking about the Argentina, crisis said: "The sin of the IMF in 1997-98 was that of, essentially, adopting a crime and punishment point of view of financial crisis, that if you are having a crisis it must be because there is something terribly wrong with you and there can be no recovery without wrenching reform." (Ev II, Q 1883).


273. The current role of the IMF is very different from its original purpose. This is partly because the financial markets have much more influence. Andrew Crockett put it this way:

"Today, each of these features of the system - exchange rates, adjustments, and liquidity - are determined by decentralised decision taking in private financial markets. Concerns have shifted from traditional macroeconomic imbalances to the interaction between freer financial markets and the real economy. Addressing financial instability has risen to the top of the international policy agenda, both with regards crisis prevention and management. The effectiveness of the system relies not so much on whether governments take the right decisions, but on whether they provide the right framework to enable the private sector to make the right decisions. The IMF stills plays a key role, but the number of relevant players has increased including national standard setters in the financial sphere and their corresponding international bodies." (Ev I, pp 157-8).

He described the IMF's present role as follows:

"The [IMF and World Bank], while possibly playing a standard setting role in certain specific areas (eg, transparency of fiscal and monetary policies), are primarily involved in the monitoring of countries' policies, and in particular of their compliance with financial standards. They help countries upgrade their systems, set priorities among competing demands, and can be a vehicle for providing information to markets on the state of financial systems." (Ev I, p 158).

He referred to the constraints the Fund works under in one of the areas where it receives much criticism:

"The management of sovereign liquidity crises is one of the Fund's central tasks, but is greatly complicated by the fact that there is no international counterpart for insolvency and a lender of last resort in national financial systems. The IMF therefore has a delicate task in ensuring that private creditors are involved in crisis resolution in a way that does not exacerbate moral hazard, or choke off private sector flows for the future." (Ev I, p 158).

274. Willem Buiter was asked whether he thought the IMF should be the lender of last resort. He replied: "The lender of last of resort cannot be done internationally because it requires supranational institutions of the kind that we just do not have at a global level." (Ev I, Q 219). He went on to suggest that the IMF could not do it "because they do not have the resources or the power" (Ev I, Q 222). Martin Wolf took a similar view. He said that: "The really interesting questions [for the IMF] concern its role as a lender, and the difficulty here is I do not think we have worked out, and it is not even obvious in theory how we could work out, what precisely the lending function of such an institution is. It is clearly not there to save all the lenders. It is not there to ensure that all lenders get their money out. That would be highly undesirable. It cannot be a lender of last resort in runs because it does not have the resources and it is pretty clear it does not have the capacity to minimise the moral hazard that would be created by that. So it has a very limited function in that respect." (Ev II, Q 1628).

275. Referring to what he thought the IMF could do, Martin Wolf suggested that "… if this institution is to have any value, [it] is to make as clear as possible and ideally as publicly as possible when it believes countries are running into very serious difficulties, so that instead of financing growing crises, it forestalls them. This is an incredibly difficult thing for the IMF to do because it will be triggering the crisis it is supposed to avoid." He added that you have to be able to deal with a crisis without bailing everybody out. The Fund's job was to manage default while reducing the extent of the pain imposed upon the country concerned: "… the right package consists … of a default plus a willingness to lend to a country in arrears or in default provided that country is showing real signs of getting to grips with its problems." (Ev II, Q 1628).

276. Given that by definition all funds moved from one place must go somewhere else, it is at least worth considering whether the lender of last resort function could be undertaken by the leading central banks co-operating under the auspices of the IMF. The problem, of course, is how to cope with the moral hazard problem mentioned by Andrew Crockett and Martin Wolf (in paragraphs 273 and 274 above).

277. We were unable to arrange an evidence session with Horst Köhler, Managing Director of the IMF. We were interested to note, however, an article in the Financial Times[146] in which Kenneth Rogoff, Chief Economist at the IMF, explained the Fund's role as follows:

"Distressed emerging-market debtors typically come to the IMF precisely because its financial assistance, combined with the policies it supports, generally alleviates austerity rather than intensifying it. Emerging-market debtors typically come to the IMF only when their finances are under extreme duress - usually through imprudence and bad luck - and other creditors have turned their backs. These countries would otherwise have no choice but to tighten their belts. An IMF loan typically loosens the belt, both directly via added funds and indirectly by helping to stabilise markets."

Critics of the IMF, he said, thought that the Fund's main task was to fight recessions: "They claim that what the creditors really want is to see growth. Ergo, the best way to defend a currency is by cutting interest rates to expand the economy. Similarly, if a country wants to calm creditors, it should be borrowing more money, not less. They think the resulting growth would allow the country to carry proportionately more debt. Sadly, the clear weight of logic and evidence suggests the opposite." He admitted that "there is a real risk in any IMF programme that interest rates might be raised too sharply and the path of fiscal policy set too tight." When it became clear that the economic downturn in the Asian crisis of 1997-98 was worse than initially thought "not just by the IMF but also by just about everyone, the IMF changed its advice to allow fiscal policies to be less restrictive." He warned that "if the programme does not embody sufficiently ambitious targets, it will collapse for lack of credibility." He also drew attention to an important constraint that the IMF works under: its budget. If it lends to some countries for longer terms, it is unable to recycle the funds to other countries. There are, therefore, losers as well as gainers.

Tackling financial instability and crises

278. Central to our consideration of the role of the IMF in addressing problems of global financial instability, two distinctions must be made. The first is the distinction between the long and short term in setting policy; and, the second is between problems arising from faulty macroeconomic policy and those arising from forces outside the control of the government of the country concerned. On the one hand, the IMF can be helpful to countries in formulating a long-term policy strategy which is also connected with their short-term response to policy problems. On the other, the IMF itself can intervene in providing support when a short-term financial crisis emerges. This intervention might involve co-operation with the major central banks.

279. Our thoughts on the role of the IMF are based on the philosophy which underlies the whole of this report: namely, that it is for countries themselves to determine their objectives and means of achieving them. The role of outside bodies is not to take over the macroeconomic governance of a country. It is to be critical, advisory and supportive. Certainly, it is not to place obstacles in the path of a country trying to do the right thing in its own way at its own pace. We emphasise the word "critical". We see nothing wrong in the IMF saying from time to time, and, of course, on the basis of evidence, that such and such a policy on the part of country X has done harm rather than good in the other cases in which it has been tried. This is especially so when a good mark, so to speak, awarded by the IMF is likely to make it easier for a country (or firms in a country) to borrow both short and long term. To give a country a clean bill of health when it is not justified is damaging to international financial markets. Equally to the point, in encouraging poor policies it may lead to a postponement and magnification of disaster. Having said that, we reiterate the point that it is not true that only one policy model is right for all countries at all times. While our evidence has indicated that the IMF appeared to adopt this view at some time in the past, it no longer does so.

IMF as a "body for surveillance"

280. Gordon Brown, the Chancellor of the Exchequer, clearly sees an important role in the future both for prudent domestic economic management and for the IMF. He told us:

"I do believe that the new modus operandi around the world is for greater transparency, and in that context the IMF should see itself more as a body for surveillance which is reporting on whether codes and standards are being upheld and whether there is genuine monetary and fiscal transparency and there are good corporate standards being observed. … that is the way forward for the international institutions as well as the way in which the poorer countries can guarantee that they can get support, both in terms of international investment and support from the international institutions." (Ev II, Q 2092).

In his evidence, the Chancellor emphasised the importance of transparency several times. This is particularly important in establishing confidence in financial markets so that they are willing to make long-term, and not just short-term, loans.

281. Mervyn King of the Bank of England emphasised the need to accompany long-term borrowing with appropriate long-term macroeconomic policies:

"… if a government claims to be pursuing the right policies … the impact of that on capital markets will depend not just on what the government in control on the day is doing, but on what financial markets expect future governments to do as well … if the financial markets, taking a longer term view, feel that it is not sustainable … that is bound to affect the way [they] reach their judgement." (Ev II, Q 2051); and

"… lenders take a long-term view of what a country will do. ... It is difficult to borrow long term unless you have a framework for policy and an infrastructure in society which enables a country that is borrowing to make an equally long-term commitment to the lenders, and if it is not able to do that, perhaps it should not be looking to borrow quite so much long term from abroad." (Ev II, Q 2052).

Bail-outs and Bankruptcy

282. Bail-outs and bankruptcy provide mechanisms for re-structuring sovereign debt in the presence of an immediate crisis. Increased borrowing or lengthening the maturity structure of debt would resolve an immediate problem in most cases. It is, however, because a country is unable to do this that a problem becomes a crisis. Most of the debt obligations are to private sector banks and other financial institutions. They take the form of syndicated loans, or bonds in emerging market debt. Understandably, given the high-risk nature of additional loans, private investors are reluctant to commit additional resources, or re-schedule debts, without guarantees, or some way of spreading the risks.[147]

283. We have noted (in paragraphs 273-76 above) how the IMF might provide emergency finance by providing a lender of last resort facility, subject to the problem of moral hazard.[148] To some extent it does already but, as explained by Kenneth Rogoff , the main problem the IMF faces is that it has limited resources and these have to be re-cycled. The Treasury, in its supplementary evidence, endorsed Willem Buiter's view that the supranational institution of the kind needed to deal with the problem of lack of loanable funds did not exist. They wrote: "In a world of globalised financial markets, the official sector does not have sufficient resources to provide large-scale bail-out packages as a standard response to emerging market crises." (Ev II, p 270). The Committee acknowledges the constraints that the IMF works under in providing short-term finance.

284. There seems to be no good reason to rule out a free-market solution involving obtaining the additional funds from the world's capital markets. It is, however, the increasing reliance on international capital flows and the failure of the world's capital markets to come to the rescue of countries in crisis that lies at the heart of criticisms of global financial capitalism.

285. The key to a free-market solution is to deal with the legal problems arising from re-scheduling debt, to find a way to price default-risk and to develop insurance vehicles for creditors. A country's debt is not necessarily held by a single creditor, but is shared among several. A problem that can occur in re-scheduling debt arises from the fact that it may require a change in a legal contract which is difficult to obtain in some countries. As a result, even minor creditors can disrupt re-scheduling agreements.

286. Default is an extreme form of re-structuring debt. Its attraction for a country is that it immediately removes its debt service requirements as well as its long-term obligations. Debt-forgiveness is another way of removing long-term obligations. The UK government has been taking a leading role in advocating debt forgiveness as amongst other possible measures in debt re-scheduling. The Chancellor told the Committee that "a new international bankruptcy procedure to deal with unsustainable debt" was needed as part of a better framework for crisis prevention and resolution (Ev II, Q 2088).

287. Less extreme measures are standstills to suspend debt service payments and to write down debt obligations. Like debt-forgiveness, writing down debt, which reduces the size of the debt obligation but does not eliminate it, may be very beneficial in obtaining a sustainable long-run solution. As noted in paragraph 270 above, Professor Stiglitz has said that the IMF needs to give these types of solution closer consideration. In fact they are. The IMF and World Bank are currently examining the legal problems of re-structuring debt and the issue of default.

288. The Chancellor told the Committee that the IMF and the Group of 7 (G7) countries are actively engaged in finding new solutions to these pressing problems. In November 2001, the IMF proposed that a new Sovereign Debt Restructuring Mechanism (SDRM) be established. The Treasury's supplementary evidence to the Committee reports that there are four main components of this: (i) temporary protection from creditor litigation; (ii) establishing a mechanism to facilitate debtor-creditor negotiations; (iii) granting seniority to creditors during the restructuring period; and, (iv) a mechanism to bind minority creditors to the agreement. The Treasury states that: "The UK, along with the rest of the G7, has pledged its support for further work to develop this proposal." (Ev II, p 226).

289. Aside from that, part of the aim must be for financial markets to develop new ways to spread the risk to the lender arising from sovereign debt problems more widely across the world financial markets. Financial instruments are required that price default risk as they do other forms of risk. Instruments are also needed to provide the creditor with insurance in the case of default or non-performing assets. Credit derivatives, such as credit default swaps are an example of the latter. It would take a systemic failure of world capital markets on a large scale to prevent this type of risk-sharing from working. Even if these facilities were developed, the ultimate source of risk would still stem largely from individual country macroeconomic policies. This would be costly to a country as it would tend to create a country-specific risk premium.

290. This type of solution, whether it take the form of debt-forgiveness or debt-restructuring, again carries with it the problem of moral hazard: it increases the incentive to the borrower to incur more debt and to undertake more risky investments in the knowledge that it will be bailed out, or the lender has insurance. The problem of moral hazard makes it essential to write appropriate contracts and for them to be enforceable. This is an active area of research in international finance.

291. There is no doubt that the IMF has made mistakes in the past. It has admitted as much. We have noted that it is re-examining many of its policies, including whether it is always appropriate to recommend the removal, or non-imposition, of capital controls. And it is working on better mechanisms for sovereign debt re-structuring. The Committee was told by some witnesses that the IMF should be abolished, but we do not want to see the abolition of the IMF. We agree with the general view that were it not to exist, it would have to be re-invented. We believe that the IMF has a crucial role to play. We note the Chancellor's view that "[t]he role of the IMF is increasingly about surveillance and monitoring the transparency of individual national policies and publicising that surveillance. Where previously it used to be in secret rather than published, it is far better that it is out there and open and above board what the views of these experts are." (Ev II, Q 2108).

292. We believe that the IMF is the appropriate body to assist a country faced with an immediate financial crisis. We say this whilst recognising and sharing the criticism of some of the IMF's past interventions. We are aware that in the past the IMF has been seen as being part of the problem rather than the solution. We are glad to note that they have for some time been subjecting their procedures to internal scrutiny, especially as they pertain to dealing with short-term financial crises. In the short term, what is obviously required is immediate assistance to deal with impending sovereign debt default. We recognise that the resources of the IMF are limited and that, therefore, financial support from the United States and other developed countries will have to increase and the role of the main central banks be enhanced. We also recognise the advantages of involving the world's capital markets in providing the necessary short-term finance, and the important role that the IMF can play in sovereign debt re-scheduling. Finally, it is our general view the IMF should pursue an open-minded approach to these problems and one that is carefully tuned to the circumstances of individual countries.

Capital transactions tax

293. There is a view held by many economists that financial markets, national and international, show excess volatility even in the presence of sound macroeconomic policies.[149] One solution to this has been a capital transactions tax (CTT) or Tobin tax.

294. A CTT permits access to world capital markets but aims to limit their volatility by taxing movements in capital. War on Want stated that a Tobin tax "… is a pivotal issue for our times. The tax is both necessary, in order to deal with the risks of currency crises, and entirely possible, on a practical political level. It would make considerable sums available for global aid for sustainable development, which continues to suffer from chronic under-funding." (Ev I, p 381). They also said: "A CTT set at the right level should neatly discriminate between short-term investors - who typically undertake numerous currency speculations daily - and longer-term investors carrying out single foreign exchange transactions." (Ev I, p 379). War on Want do not, however, argue that "a CTT alone, even applied internationally, is an adequate measure to address global financial instability" (Ev I, p 379). Rob Cartridge, Campaigns Director for War on Want, told the Committee that "a Tobin tax is not a panacea", and added that War on Want was "not opposed to free and floating exchange rates" (Ev I, Q 995).

295. Rodney Schmidt, North South Institute, Canada, said that "the Tobin tax is relevant to a crisis which occurs by reason of an external shock, by reason of ad hoc movements in international foreign exchange markets." (Ev I, Q1008). Asked about how the tax would be collected, Mr Schmidt said by taxing all inter-bank and retail market foreign exchange transactions through the settlement system (Ev I, Q1027).

296. Demonstrating the size of capital flows, War on Want noted in their memorandum that currency market trading dwarfs trade, central bank reserves and FDI flows to developing countries (Ev I, p 376).[150] They also noted that "80 per cent of global forex transactions take place in seven cities around the world: London, New York, Hong-Kong, Singapore, Frankfurt and Berne. The City of London alone accounts for 32 per cent of the total." (Ev I, p 379).

297. There was no virtually no support from other witnesses for a CTT.[151] The Committee have various concerns about a Tobin tax: the consequences of it not being imposed simultaneously in all countries thereby allowing non-participating countries a huge advantage; the difficulty of collecting the tax; and, the potentially harmful effects on hedging foreign exchange risk through discouraging short-term positions. We also note that although capital flows are large relative to trade and reserves, the currency movements and the financial centres involved are almost entirely in countries with stable currencies for whom short-term capital volatility is not a problem.

298. Thus, if the main aim of the CTT is to stabilise world capital mobility and currencies, then it misses its target. If the aim is to apply it in countries that are particularly vulnerable to capital flight, then the danger is that it will make short-term borrowing, usually an emergency measure, much more difficult to acquire. If the aim is to generate aid for development purposes, then it is not at all clear that throwing sand into the financial system is the right way to do it. It is significant that Professor James Tobin, who originally proposed the tax, withdrew his support for the idea. The Chancellor put it this way: "Before he died Professor Tobin distanced himself from the apostles of the Tobin tax. The reason was that the Tobin tax was conceived in a different world of capital markets that were basically national and regulated. He thought, at the time, it was quite easy to impose a transactions tax. In actual fact, in a highly liberalised market, that is not regulated in the same way as it was by national governments in 1970s and 1980s, it is far more difficult to impose this anyway." (Ev I, Q 2105). Sir Edward George, Governor of the Bank of England, said that he was not an enthusiast of a Tobin tax in general. He said he thought some capital flows are good and some are bad and a Tobin tax could not distinguish between the two. He thought "the killer … on the Tobin tax is practicality, because foreign exchange markets can go anywhere in the world … [so] you would divert a lot of foreign exchange market activity to places that did not apply the tax. I think that is not a productive thing to do" (Ev II, Q 2054).

299. The Committee is not persuaded of the case for a Capital Transactions Tax as a mechanism for reducing capital market volatility. It would be difficult, if not impossible, to impose world-wide and could be very harmful to a country to do so on its own. We recognise that capital outflows can be damaging to an economy, but this is often a symptom of domestic macroeconomic problems, not the cause. Where, however, capital outflows are the result of excess volatility and the irrationality of international financial markets, the IMF, together with the major central banks, should assist in reducing that volatility. First, it could announce that it views market behaviour in the case in point not to be based on underlying reality; and, secondly, since by definition all outflows have corresponding inflows, the IMF - while lacking sufficient funds itself - could still help to organise a lender of last resort response on the part of the central banks acting jointly. Of course, all this depends on being able in practice to determine the cause of the outflows in the first place. But if we cannot distinguish sensible domestic economic management from what is unsound, there seems little value in having the IMF in the first place. In sum, the aim should be to address the cause, not the symptoms.

138   Centre for Economic Policy Research, Making Sense of Globalization: A Guide to the Economic Issues, Policy Paper No 8, July 2002, p 27. Back

139   Philippe Legrain, Open World: the Truth About Globalisation (2002), p 104. Back

140   The pursuit of full employment was central to Bretton Woods and post-war policy making up to the mid-1970s. The collapse of Bretton Woods was accompanied, coincidentally or otherwise, by rising unemployment for two decades, and the emergence of low inflation as a - or the - main macroeconomic objective. Back

141   European Commission, Responses to the Challenges of Globalisation: A Study on the International Monetary and Financial System and on Financing for Development, SEC (2002), 14 Feb 2002, p 25, and see Michael Kitson, Ev I, p 111. Back

142   In the cross-Departmental memorandum (Ev I, p 9), Departments were asked whether volatility had increased in the last 10 or 20 years. They suggested that there was "room for debate" and cited a number of studies which offered a complex comparative picture of the Bretton Woods and post-Bretton Woods level of volatility. For example, they referred to Bordo et al, "Is the Crisis Problem Growing More Severe?" Mimeo, December 2000, which demonstrates that crisis frequency since 1973 was double that during the Bretton Woods era and Gold Standard periods but that there was little evidence to suggest that crises were now more severe. Back

143   Footnote not included. George Soros was similarly ambivalent about the benefits of capital market liberalisation: liberalisation has benefits - wealth aggregation and empowering individual states - but it also has "great disadvantages": and one of these disadvantages is instability in the global financial markets (Ev II, Q 1925). Back

144   "The Asian Crisis", Address to the Midwinter Conference of the Bankers' Association for Foreign Trade, January 1998. Back

145   George Soros on Globalization (2002), p 101 (original footnote not included), referring to the report of the International Financial Institution Advisory Commission (The Melzer Commission), March 2000. Back

146   27 September 2002. Back

147   On 25 September 2002, in an after-dinner speech at Lancaster House, Dr Alan Greenspan spoke about the potential importance of using credit default swaps to insure against default risk. This is a new but rapidly emerging financial instrument.  Back

148   The question arises: what is the IMF to do when the source of the problem is the pursuit of erroneous policies on the part of a sovereign government? It is obvious that if a crisis occurs, the job of the IMF is not to make things worse. It is equally obvious that bail-outs should not be used to enable the country in question to continue with unsound policies or to encourage other countries to follow suit. In other words, the moral hazard problem needs to be resolved. Back

149   On excess volatility, the locus classicus is Robert J Shiller, "Do stock prices move too much to be justified by subsequent changes in dividends?" American Economic Review, 1981, vol 71, pp 421-35.. Back

150   War on Want, quoting the IMF World Outlook, October 2001, and the World Bank, Global Development Finance, 2000, state that while world exports were around US$7.7 trillion annually in 2001, daily turnover in currency markets is around US$1.2 trillion and FDI to developing countries in 2000 was US$178 billion. Back

151   We note, however, that Martin Hattersley, former President of the Economics Society of Northern Alberta and former Leader of the Social Credit Party of Canada, suggested that "the idea of a 'Tobin tax' to place a cost on [speculative] international financial transactions … is … very attractive" (Ev II, p 267). Also, Mr Jeremy Wright argued that a Tobin tax should be introduced in respect of all speculative currency transactions (Ev II, p 355). Back

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