Redesigning World Markets

This has not been a good week for Michael Mussa, the economic counselor for the International Monetary Fund.

Critics have repeatedly accused Mr. Mussa and his colleagues at the IMF's annual meeting of fueling rather than halting the firestorm in world financial markets.

"We are virtually in depression in much of the emerging world," said Jeffrey Sachs, director of the Harvard Institute for International Development, before a gathering here of economists and officials, including Mussa. "This was a predictable consequence of Draconian [IMF] measures that increase panic rather than reduce panic."

A look at the obstacles to restoring world financial order suggests, however, that Mussa and other IMF technocrats are not scoundrels but scapegoats.

IMF officials admit they were caught flatfooted and that the "international financial architecture" needs an overhaul, but first governments must repair the political foundation for global finance. Ultimately, the world financial system is shaky because it cannot cope with the surge in capital flows.

Investment and private loans in emerging markets exploded more than fivefold between 1990 and 1996 to roughly $300 billion. World institutions sped the flood of capital, helping to bring to both wealthy and developing nations unprecedented free market riches. Those same institutions, though, have proven incapable of containing free-market risks. In East Asia especially, poorly supervised banks went on a spree of lending to unprofitable companies. Mounting business losses and debt helped trigger the financial tumult last year.

The resulting costs today in well-being and social order are high; the possible future costs are enormous. Financial-market mayhem has spread within 15 months from several countries in East Asia, to Russia, and to the doorstep of Latin America.

Now, one-fourth of the world economy is in recession. The IMF estimates lost output has so far equaled the annual gross domestic product of Canada. The monetary fund last week warned of global recession, drastically cutting its forecast for economic growth this year to 2 percent.

Of more historical weight, the laissez faire ethos that sprouted in Britain in the late 1970s and took root in the United States and much of the world is in retreat. Several governments in the past several weeks have either proposed or instituted capital controls. Thailand and South Korea, have made the most progress in strengthening their currencies by following IMF remedies, but at a great cost of lost jobs and bankruptcies.

The crisis has prompted the major industrialized countries to pitch a cacophony of solutions. The clashing proposals underscore how the leaders, pulled apart by pressing domestic needs, have failed to hatch a decisive, unified plan to calm financial markets.

"At the end of the day, all of the world's problems are individual problems," says Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y. Governments "will be hard pressed to come up with any coordinated" solutions, he says.

Billionaire financier George Soros on Oct. 5 criticized financial leaders from industrial nations for not overcoming their differences and devising a concrete plan for calming markets. Referring to a meeting of finance officials from major economies, Mr. Soros said, "Those people should have been shut into a room and hammered this thing out and come out with a decision."

Japan's leaders exemplify how politicians put domestic concerns before the need to make sacrifices for a multilateral campaign to restore financial order. Tokyo has been paralyzed for years by factionalism and fiscal conservatism. It has shrugged off foreign pressure to spur its flagging economy and shake up its debt-strapped banks, thereby denying East Asia a vibrant importer and source of capital. Tokyo's political gridlock is seen as the biggest unresolved issue threatening investor confidence.

But Tokyo is not the only government fiddling while markets burn. Congress has failed to approve $18 billion in IMF funding, thereby undermining the Clinton administration's calls to foreigners for potent, market-calming initiatives.

France and Germany have resisted pressure to lower interest rates and keep strong the economic engine of Europe. They fear a rate cut would imperil a smooth launch of the region's common currency - the euro - on Jan. 1.

Weak credibility among the leadership in the United States, Japan, and Germany has also spurred an aversion to risk among investors. President Clinton faces the prospect of an impeachment investigation. And Japan's ruling party has sought several times to revive the economy with initiatives deemed "too little, too late."

Finally, Chancellor-Elect Gerhard Schrder has yet to clarify how reliance on a politically diverse coalition will color his economic policies.

Leaders of international financial organizations also give investors ample cause for doubt. The IMF has poured more than $100 billion in aid into besieged economies since July 1997. Yet lightning strikes of panic or speculative selling continue to devastate weak emerging markets.

The force and breadth of the market tumult has left international officials aghast. "What we have not seen well is what I would call the virulence of the contagion," says IMF managing director Michel Camdessus.

In the weeks ahead, leaders of the major economies might try to revive investor confidence by staging coordinated interest rate cuts.

Although much of Europe is now cool toward such a concerted step, "the stage is being set for aggressive action in the days ahead," says Stephen Roach, chief economist at Morgan Stanley in New York. He sees a 60 percent chance of a "market-friendly policy breakthrough" on interest rates.

Countries in Recession

(Projected change in gross domestic product in 1998)

Hong Kong: down 5 percent. Real estate bubble, banking system burdened with bad loans.

Indonesia: down 15 percent. Considered in depression. Poor banking system, crony capitalism, low oil prices.

Japan: down 2.5 percent. Deepest recession since World War II. Heavily indebted banking system. Government raised taxes last year and cut spending, putting a brake on economic growth.

Malaysia: down 6.4 percent. Troubled banking sector. Falling currency, stock market.

New Zealand: down 0.5 percent. Slumping exports to Asia, drought.

Philippines: down 0.6 percent. Falling currency, weak banking system.

Russia: down 6 percent. Collapsing banking system, weak currency, poor tax collection system, falling oil prices.

Romania: down 4 percent. Poor economic policy, legacy of Soviet era.

South Korea: down 7 percent. Crony capitalism, weak banking system.

Thailand: down 8 percent. Weak banking system, crony capitalism, overvalued currency.

Ukraine: down 0.1 percent. Spillover from neighboring Russia's problems.

Venezuela: down 2.5 percent. Low oil prices.

Countries Vulnerable to recession

Brazil: up 1.5 percent. Falling currency, stock market. Big budget deficit.

Colombia: up 2.7 percent. Large budget, trade deficits.

Iran: 0 percent. Low oil prices.

Kuwait: up 1.3 percent. Low oil prices.

Nigeria: up 2 percent. Low oil prices.

Peru: up 3 percent. Low metals prices. El Nio-caused drop in fish catch.

Saudi Arabia: up 0.4 percent. Low oil prices.

South Africa: up 0.8 percent.Low commodity prices.

Turkey: up 3.7 percent. Falling stock prices. High inflation. Close trading partner of Russia.

Source: IMF, Associated Press