Jagdish Bhagwati is arguably the most prominent proponent of trade liberalization and globalization, and so he caused a bit of a stir when he came out against the complete liberalization of capital in 1998. In a Foreign Affairs essay entitled the "Capital Myth: The Difference between Trade in Widgets and Dollars" he criticized the push to liberalize financial markets and remove all restrictions on capital flows, something he would later call 'Gung-ho International Financial Capitalism.' [Bhagwati has made this essay, along with other writings on the subject, available in PDF form on his faculty website] Talking about the push for free international capital flows, he says:
This is a seductive idea: freeing up trade is good, why not also let capital move freely across borders? But the claims of enormous benefits from free capital mobility are not persuasive. Substantial gains have been asserted, not demonstrated, and most of the payoff can be obtained by direct equity investment. And even a richer IMF with attendant changes in its methods of operation will probably not rule out crises or reduce their costs significantly. The myth to the contrary has been created by what one might christen the Wall Street-Treasury complex, following in the footsteps of President Eisenhower, who had warned of the military- industrial complex. (Bhagwati, 1998)
With regard to the problems associated with unfettered capital mobility, Bhagwati argues that capital flows, especially short term credit, are more prone to (in Kindleberger's terms) panics and manias than trade in goods and services. That is, that financial investors, working with incomplete information and subject to herding influences, are more likely to overestimate the returns and stability of a nation capital market (which producing a mania of capital inflows) and/or to underestimate the strength of a market when confronted with adverse news (which produces a panic in the form of sudden and massive capital outflows).
Writing on this in The Defense of Globalization, Bhagwati contrasted the Mexican Peso crisis with the Asian financial crisis. He argued, while that the Mexican crisis exposed fundamental problems in the Mexican financial system that may have warranted reactions from investors, the same was not true of the Asian crisis. The fundamentals of the Asians were fairly strong in comparison to other nations. While problems such as cronyism existed, these problems were generally previously known to exist and there was nothing in the crisis that suggested they had suddenly become acute.
The problem in Asia in the 1990s, as Bhagwati (2004) sees it was that Asian banks were using short term capital inflows to finance long term domestic loans. When the short term inflows suddenly turned into outflows, there was simply not enough cash (in foreign currency) to cover the outflow even though the long term loans were generally sound. Note that, in such a case, it makes sense for a lender of last resort to loan banks money to cover the short term outflows based on the strength of the long term loans. In fact, in the case of a panic, one can make money doing so (think Old Man Potter backing the bank during the panic in It's A Wonderful Life).
However, unlike the US, where the Federal Reserve can print all the dollars it wants and act as lender of last resort, the central banks of the Asian countries could not do so to the same extent as they print domestic currency, not dollars. So, once their supply of foriegn reserves was expended, central banks and their governments had to beg the dollars they could from the IMF and other countries. More importantly, they had to implement severe macroeconomic measures, notably raising interest rates and selling assets. These measures rippled through their economies undercutting its fundamental strength. Businesses, which carried debt and depended on access to credit to operate, were decimated (and those, formerly sound, long term longs to them were no longer quite so sound). Owners of assets were forced to sell to foreign purchasers at greatly reduced prices.
In general, Bhagwati argues that the gains of financial liberalization, in terms of economic growth, are questionable. Many other countries, such as China, have grown without open capital markets (though this is eerily similar to claims by opponents of trade liberalization). Furthermore, if there are benefits, the results can be achieved by opening markets to foreign direct investment, which is inherently longer term and less mobile in nature, and, therefore, not as susceptible to panics.
In the end, Bhagwati attributes much of the push for unfettered financial flows to interest groups in the developed nations, particularly the financial sector in the US. This sector directly benefits from expansion of global credit markets and exerts great influence on the US government and the IMF. Bhagwati notes that US economists frequently move back and forth between the US financial sector and government positions. This elite network, along with the financial sector lobbying efforts, creates what he calls the Wall Street-Treasury Complex, whose effect describes as follows:.
This powerful network, which may aptly, if loosely, be called the Wall Street-Treasury complex, is unable to look much beyond the interest of Wall Street, which it equates with the good of the world. Thus the IMF has been relentlessly propelled toward embracing the goal of capital account convertibility. The Mexican bailout of 1994 was presented as necessary, which was true. But so too was the flip side, that the Wall Street investors had to be bailed out as well, which was not. Surely other policy instruments, such as a surcharge, could have been deployed simultaneously to punish Wall Street for its mistakes. Even in the current Asian crisis, particularly in South Korea, U.S. banks could all have been forced to the bargaining table, absorbing far larger losses than they did, but they were cushioned by the IMF acting virtually as a lender of first, rather than last, resort.
The last sentence suggests an argument that Bhagwati doesn't explicitly develop, i.e., that the IMF is not a good lender of last resort because of its motivation. The obvious the limiting factor on the IMF serving as lender of last resort is its limited supply of funds (remember that when the Federal Reserve acts as lender of last resort in the US, it theoretically has an infinite supply of dollars). Here, Bhagwati suggests that IMF is biased towards insulating foreign creditors from the downside of the crisis; whereas an ideal lender of last resort would focus on minimizing the crisis in total (especially its long term impact n the economy) and remain neutral with regard to the distribution of losses.
References:
Bhagwati, Jagdish. (1998, May 1). "The Capital Myth: The Difference between Trade in Widgets and Dollars." Foreign Affairs. Retrieved February 4, 2014, from http://www.foreignaffairs.com/articles/54010/jagdish-n-bhagwati/the-capital-myth-the-difference-between-trade-in-widgets-and-dol
Bhagwati, Jagdish. (2004) "Chapter 13: The Perils of Gung-ho International Financial Capitalism." In Defense of Globalization. New York, NY: Oxford University Press.
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