Robert C. Shelburne⁽¹⁾

Abstract

The poor economic performance of the global economy over the last several years is due significantly to shortcomings in the current design of the international monetary system (IMS). The economic crisis of the Asian emerging markets has been the most visible and obvious manifestation of the design defects, but the problems are much more systemic in nature. The current system 1) fails to adequately distribute global saving in a globally efficient manner, 2) is prone to "irrational" speculative attacks which wrecks fundamentally sound economies, and 3) has, at a global level, a deflationary bias which keeps global growth below its optimal. These design defects have been central factors in a significant number of global economic problems since the breakdown of the international gold standard during the First World War; these include the Great Depression, the breakdown of the inter-war gold standard as well as the Bretton Woods fixed exchange rate system, the inflation of the 1970s, the high unemployment rates throughout Europe in the 1990s, and now the current emerging market economic crises, and the recession in Japan. Global economic integration will ultimately require a global central bank. However, the public's desire for national autonomy will now only allow for marginal reforms in current institutions. Section I begins with a discussion of the "Japanese problem" which has as its source the international financial system's inability to adequately distribute world savings; the resulting Asian currency crises which have been created by "irrational" speculation are discussed in Section II. Section III proposes that the current system has a deflationary bias once disequilibriums occur. Section IV provides a summary.

I. Japan: (The IMS's Inability to Transfer Saving)

Both the crises in Japan and the Asian emerging markets are the result of financial problems stemming from complications in transferring savings (or real resources) from one nation to another. Although it is sometimes assumed by international macroeconomists that the world financial system can be characterized by perfect capital mobility, a number of empirical tests beginning with the results of Feldstein and Horioka have found domestic capital markets to be surprisingly segmented with domestic investment highly correlated with domestic savings. This outcome, which is inefficient from a global perspective, is the consequence of the current design of the international monetary system. The decade long macroeconomic crisis in Japan also has as it's roots this inability of the IMS to transfer savings from one nation to another. Since 1992 the Japanese economy has turned from being the world's greatest economic success story into an economy of relatively mediocre performance on the brink of economic catastrophe. It is somewhat surprising that the problems facing the Japanese economy have received so little attention by the economics profession since Japan is the world's second largest economy and the crisis there has been so persistent.

What is Japan's problem? Simply put, it is that Japan saves too much; Japan's gross savings as a percentage of GDP are nearly twice that of the United States. Japanese savings are so high due to it's demographics, culture, and highly regulated oligopolistic domestic markets. Japan's aging population has the highest life expectancy in the OECD⁽²⁾ and Japan is projected by 2025 to have a ratio of retires to working age population twice that of the United States⁽³⁾. These demographics combined with a Confucian ethic of self reliance and the lack of a pay-as-you-go social security system results in a high personal savings rate. A decade of economic malaise which has made the Japanese very cautious has further increased the savings rate. However, it is the high level of business profits and the high percentage of these that are kept as retained earnings that is responsible for the truly high rate of business savings which provides the bulk of private savings. The high profit rate is the result of the highly regulated and oligopolistic structure of Japanese domestic industry.

During the early post-World War II period, this high savings rate allowed a high investment rate which was a major, if not the major, component of Japan's remarkable high growth rate during it's catch-up phase. However, now that Japan has caught up technologically with the leading industrial nations, has achieved a relatively high capital-worker ratio, and is facing reduced economic growth due to it's demographics, the investment opportunities are fewer. The surplus of desired savings due to this long-run reduction in investment needs and the long-run increase in savings has been further enlarged by the economic stagnation of the current decade. The result of all this excessive savings (relative to investment) is that there is a persistent shortage of aggregate demand which produces a typical Keynesian type recession; that the situation has now deteriorated into something much more sinister like a liquidity trap is a real possibility.

There is the possibility that much of the investment shortfall is due to the recession itself and if the economy can simply get out of its stagnation, due perhaps to a large monetary or fiscal injection, that there will be no long-run problem. The situation is reminiscent of the debates in the 1930s as to whether the U.S. was entering a period of permanent demand deficiency; in retrospect the answer was probably no although the U.S. did adopt a number of policy changes after the war that redistributed income to households likely to spend -- perhaps Japan will be so lucky. As long as the savings are not so excess relative to desired investment, a low interest rate could clear the market without creating any significant macroeconomic problem for Japan. However, even in this case where Japanese real interest rates are significantly below world levels, the outcome is less than satisfactory from the global level since capital is not being optimally distributed.

However, the problem now is possibly much worse and it's not just a misallocation of capital from high return to low return projects; the failure to invest all of the savings has created a major decades long recession costing Japan over a trillion dollars in lost output. It is potentially possible, of course, to solve the macroeconomic problem by creating inflation so that real interest rates could be negative to the degree necessary to get investment sufficient to use up the available savings. This is the Band-Aid solution proposed by Krugman, however, besides questions about feasibility⁽⁴⁾ there remains the problem of the global misallocation of investment. There is also the fiscal expansion solution to the macroeconomic problem but that solution, like the monetary solution, results in an inferior time profile of consumption and a misallocation of global capital and, in addition, creates a undesirable future distribution problem (i.e., taxpayers to bondholders).

Figure 1 illustrates the limitations of the monetary or fiscal solutions to Japans problem. The full employment level of production is labeled P while the desired level of consumption is labeled C. The optimal solution is for Japan to achieve the desired level of consumption, and produce at full employment with the accumulation of foreign assets from t₁ to t₂ and the deaccumulation from t₂ to t₃. The current predicament is that Japan is producing and consuming along the C line (or even below it), and therefore will be constrained to consume (and produce) along the P line in the future (t₂ to t₃). The fiscal or monetary solution results in consumption throughout along the P line. The point being, that a domestic solution to Japan's problem is sub-optimal.

Thus the fundamental problem is that the international monetary system is incapable of transferring saving from one country to another. This is similar to the Keynes-Ohlin transfer problem regarding German reparations in that the financial system somehow keeps a real transfer from occurring, but is quite different in form since in the original transfer problem the financial transfer occurs (although the real transfer does not) while now the financial transfer can not be accomplished.

Why is a financial transfer not possible? If all the world used one currency, there would appear to be no problem with making either the financial or real transfer⁽⁵⁾. The problem results from having a multiple currency world where exchange rates are allowed to fluctuate; with this type of monetary system there is a constraint on the amount which can be profitably exported. As capital is exported it depreciates the currency, and when it is repatriated it appreciates the currency.⁽⁶⁾ Thus today's capital exports from Japan are likely to turn into capital imports into Japan over the next ten to twenty years. The result is that a Japanese investor suffers a capital loss due to the future yen appreciation. Thus, the capital loss sets a limit to how far the currency can depreciate which then limits the capital outflow to the current account surplus at that exchange rate. Thus the current exchange rate system limits to a sub-optimal degree the distribution of surplus Japanese savings to investment deficient areas in the rest of the world.

The problem is the reverse for the capital importing nations, but these nations have had to deal with another more immediate defect of the current system --it's vulnerability to "irrational" speculative attacks which have imposed hash constraints on their ability to maintain internal balance.

II. The Asian Crisis: (The IMS's Inadequacy in Dealing With Speculation)

There were a number of factors which resulted in the collapse of investor confidence in the Asian emerging markets including the Japanese quagmire, the Chinese depreciation and the weak regulatory practices in their financial sectors, but the implications of these developments were compounded by the design defects of the IMS. What happened in Asia was not fundamentally differ from what happened in Mexico several years before. The failure of policy makers to correctly understand what happened in Mexico and institute changes to deal with similar future events is one of the great tragedies of the current crisis. In both cases the macroeconomic policies in the afflicted economies were reasonably sound.⁽⁷⁾ Investors have come to understand that regardless of the fundamentals, a significant capital outflow can easily result in a depreciation of a currency since central banks do not have the reserves and the IMF is unwilling to provide reserves sufficient to maintain an exchange rate under pressure from capital outflows. In addition, it is not sensible for investors to simply "wait out" the crisis under the assumption that prices will return to their "fundamental" value since downward rigidity in prices and wages means that the depreciation will lead to economic changes that will validate the depreciation. Even real assets which would be immune to depreciation's inflationary effects are likely to fall in value due to the recessionary after-shocks.

In the case of Mexico, the large provision of foreign exchange by the IMF and the U.S. Government was sufficient to restore investor confidence. However, when a similar attack began in Thailand this support was not there. The issue at that time was one of liquidity not solvency, and had the needed reserves been provided the Asian crisis could have been contained. Why were reserves not made available? The IMF had the wrong mind set and the U.S. did not have a sufficient economic interest. The IMF and its programs are ill suited for the type of speculative crisis which affected the Asian nations. The IMF programs were designed to deal with nations whose irresponsible policies had produced fundamental current account crises; IMF programs and resource levels were not designed to deal with capital crises resulting from speculative attacks. The IMF was unable to shift gears when a new type of crisis arose (even though they had three years to prepare since Mexico); the new disease required a new medicine. Instead of providing reserves to soothe the speculative fever, the IMF imposed contractionary policies which magnified the financial problems by creating credit crunches, bankruptcies and ultimately recessions.

Although Mexico was also forced to impose contractionary policies, the emphasis in that crisis, due to U.S. involvement, was more on providing additional reserves. The U.S. did not have the incentive to help the Asian nations that it had had with Mexico. An economic crisis in Mexico has more direct implications for the United States in terms of reduced exports, increased immigration, and investor and commercial bank losses than similar crises in Southeast Asia. Officials within the U.S. Government also needed to save face for their own policies since the NAFTA had just been created.

Once it was clear that the needed support for these Asian nations would not be forthcoming, and depreciation and depression were likely, it become clear to all that any investment in an emerging market was subject to significant capital loss once the slightest exit of capital began regardless of the economic fundamentals. The result are irrational and speculative markets where self-fulling expectations dominant although each investor can be said to act rationally. Ragnar Nurkse carefully documented that global capital markets had this characteristic during the world's previous period of global financial freedom in the 1920s and 1930s. Thus this lesson had been learned before but the free market gurus which have come to dominate the global institutions and central banks throughout the world came to believe that things were somehow different now.

These currency crises have now moved through Russia and on to Latin America. The line has now been drawn in the sand at the shores of Brazil. The fundamentals are not, as is often stated, better for Brazil --- they are not. The reason for this final stand is that it is now realized that a severe blunder was made in not providing more liquidity for Southeast Asia, and Brazil is a last ditch effort to contain the crisis before it truly engulfs the rest of the world. It is unfortunate that Brazil has been chosen as the site for this battle since it's fundamentals are so poor.

What is the optimal policy response for a nation experiencing these capital outflows? As is apparent from the prescribed IMF response as well as alternative suggestions by other government and academic economists, there really is no "desirable" policy response; all of the alternatives have some really undesirable consequences for the affected nation. Although this question must still be addressed since there are a number of countries in this predicament, it is natural to ask another question as to whether it is possible to avoid the whole situation altogether with a different set of policies in the years prior to a crisis.

Is it possible to avoid a speculative crisis in the first place? What is remarkable about the analysis of the current crises is how the arguments concerning banking solvency, transparency and crony capitalism have dominated the debate, when in fact, these are at most side issues or consequences instead of causes. If these nations had dollar based economies, it is unlikely that there would be any crisis at all other a few foreign investors losing some money. What has turned some insolvent companies into a full fledged global economic crisis is the foreign currency aspect of the crisis. The fundamental problem is that the assets and liabilities are denominated in different currencies. Thus the cause of the crisis is in the design of the international monetary system which allows liberal capital flows but does not provide a lender of last resort for foreign exchange; the fundamental problem is not, as is often stated, in the lending and investment practices of these nations' banks and nonfinancial firms.

These currency crises are like a run on a bank. In the banking analogy, the term structure of the assets and liabilities are significantly different, making a run possible which can bring down even a sound bank; in the emerging markets, the currency of the assets and liabilities (as well as the term structure) are different. The result is that sound economies can be brought down. Just as bank should not allow its term structure of assets and liabilities to vary if there is no lender of last resort, no country should allow it's assets and liabilities to be in different currencies if there is no foreign currency lender of last resort. To avoid future crises, the sensitivity of capital towards speculative outflows needs to be reduced, banks and firms should be restricted from taking on foreign currency debt, and there needs to be some mechanism to provide more foreign currency in times of an outflow.

Although all capital is potentially capable of participating in a capital outflow, some is much more likely to do so than others. The retired school teacher can transfer her life savings from domestic to foreign accounts in order to avoid a currency depreciation, but that is far less likely than foreign investors deciding to repatriate their investments. Therefore those forms of capital that are most subject to rapid outflow should be restricted or at least subject to outflow constraints. Chile's restrictions on short-run capital inflows appear to be a sensible policy for other nations to consider. At the global level, a Tobin tax on foreign currency transactions may also prove beneficial in reducing volatility. In regard to restricting foreign currency debt, the critical issue is the need to limit debt which would be significantly increased by a currency depreciation and which could thereby threaten the solvency of domestic firms. Thus portfolio investment, although subject to the same "irrational" speculative flows may not have the same devastating consequences as direct bank or firm borrowing. Therefore restrictions should be concentrated on direct borrowing in foreign currency; it will take time to determine if an outright ban is required or if disincentives such as eliminating the interest deductibility of foreign currency loans will be sufficient to keep them to manageable levels.⁽⁸⁾ In regard to providing a foreign currency lender of last resort, there are two possibilities, each of which has its own problems. The required foreign currency can come from either the domestic central bank out of its international reserves or it can be borrowed from external sources such as the IMF or other arrangements with foreign governments. To have the domestic central bank accumulate international reserves during the inflow period (i.e., prior to the crisis) does not appear to be an economically sound policy. If the central bank intervenes on the foreign exchange market in response to the inflows, the monetary expansion will have to be sterilized; the higher interest rates will counteract much of the postulated benefit of the increased foreign investment. In addition, the central bank which accumulates foreign reserves will invest these in low yield (U.S. or other reserve country) government securities. Thus from the developing nation's overall perspective, it is borrowing at commercial rates and reinvesting at U.S. government rates; this hardly seems like a sensible policy. In addition, it is not sound government finance since the government has to issue it's own bonds (when it sterilizes) paying high interest rates and then reinvest the money in foreign bonds paying low interest.⁽⁹⁾ In order for some external source to provide the needed international reserves, the external provider is likely to require that it be given some supervisory control in order to avoid irresponsible borrowing (the loss of national autonomy in making economic decisions); the unlimited provision of funds also results in a moral hazard encouraging the borrowing government to act irresponsibly. Charging market interest rates for loans could help reduce the moral hazard problem. Of course, simply having access to an international lender of last resort is likely to significantly reduce the need for one. The enlargement of IMF resources which was approved by Congress in the fall of 1998 was a step in the right direction but more will be needed. Current IMF resources were designed to deal with current account problems, reserve levels needed to address capital account disturbances will have to be much larger. A solution will probably require reforms on all three fronts: restrictions on foreign currency loans, larger central banks reserves, and larger and more automatic reserves from the IMF.

However, over the last decade, policy has been moving in the opposite direction. Countries have been loosening their restrictions on capital inflows, central banks have not intervened in the exchange markets but have allowed the capital inflows to appreciate (at least in real terms) their currencies (which created large current account deficits), and IMF resources have been allowed to shrink dramatically in terms of their percentage of foreign exchange activity. Thus emerging markets now find themselves in a situation with significant foreign currency debt, minimal international reserves, and an IMF unable and unwilling to lend sufficient amounts to reassure investors. Once a significant currency outflow begins there are basically four options: 1) stop the currency outflows with exchange controls, 2) raise domestic interest rates to a level high enough to compensate investors for any depreciation risks, 3) allow the exchange rate to drop to whatever rate is needed to re-establish "equilibrium," or 4) obtain more reserves from the "outside world." The ability to carry out option 4 is not a viable option for most countries (Mexico was a special case). Thus they are left with the first three and there are major costs to each of these options: for option (1) transaction and administrative costs and microeconomic inefficiency, and the possibility that controls may limit future capital inflows needed for development, for option (2) recession and unemployment, and insolvency for heavily indebted firms, and for option (3) insolvency for firms with debt denominated in foreign currency, large changes in competitiveness requiring costly reallocation of capital amongst sectors, and cost-push inflation which could start a vicious cycle of depreciation and inflation. As can be seen, there is no cost-free or obvious alternative; clearly these emerging market nations have boxed themselves into a corner and there is no way out that doesn't entail significant costs. The question is which policy, or which combinations of policies has the minimum of undesirable effects. In the current situation a combination of policies is usually advanced but the emphasis differs: Krugman appears sympathetic to the first, the IMF the second, Sachs the third, while it is argued here that the fourth option (although not available to an individual country) needs to be given more consideration.

III. Global Deflation (The IMS's Bias Towards Deflation)

The current design of the IMS biases the world economy towards deflation. This design flaw was a major contributing cause of the Great Depression, the breakdown of the inter-war gold standard as well as the Bretton Woods fixed exchange rate system, the inflation of the 1970s, the high unemployment rates throughout Europe in the 1990s, and now the current emerging market crises. This underlying problem was first identified by John M. Keynes in his assessment of the inter-war monetary system and although he attempted to correct this defect in his proposed design of the post-World War II Bretton Woods system, his views on this matter were largely vetoed by the U.S. Treasury. This defect currently persist in the post-Bretton Woods flexible exchange non-system. This design flaw can be stated several ways. Most simply, global liquidity needs to be determined by some form of centralized mechanism that determines liquidity based upon the needs of the global economy; however in the current system global liquidity is determined by default and in most disequilibrium situations, is below the optimal level.

More specifically, the design flaw is that when a disequilibrium develops in the global economy due to a change in either real conditions or investor sentiment, the region from which capital is flowing out of is required to adjust by contracting while the regions to which this capital is flowing into have the luxury of pursuing their own self interest by neutralizing these inflows to maintain their desired domestic conditions. The result is a deflationary bias to the world economy. This results from the fact that foreign exchange reserves have asymmetric bounds, they have a minimum of zero but an unbounded maximum. Of course, the current monetary system has attempted to lower the minimum bound below zero with borrowing from private commercial sources, IMF lending, and government swap agreements, and the IMF briefly created a meager amount of Special Drawing Rights. However, the situation remains asymmetric in that losses of foreign exchange are fundamentally different from gains. The result of a disequilibrium is that deficit nations are required to restrict demand which results in recessions and deflation while surplus nations need not increase demand since they can neutralize these capital inflows. Once deflation takes hold in the deficit nations, however, history shows that the economic turmoil in the deficit nations ultimately spreads in a perverse matter through financial contagion and trade flows and ultimately brings crisis even to the fortunate nations spared from the original pain. As the surplus nations' exports fall, and as their investors lose confidence due to accumulating losses on foreign loans, demand falls. The fall in demand and the appreciating currency results in deflationary pressures even in the surplus nations. The surplus nations' central banks generally do too little, too late.

In the current global financial crisis the emerging markets have had to initiate draconian deflationary policies in order to keep capital from fleeing. Meanwhile the capital inflow nations (mainly the U.S. and Europe) continue to conduct monetary policy towards domestic considerations. If there is no global mechanism (e.g., central bank) to provide liquidity, then a hegemonic national central bank must do so. As is usual, unlike the Europeans, the United States has at least given minor consideration to its global responsibilities by lowering interest rates; however, the Fed was primarily motivated out of concern about a domestic slowdown due to falling exports and errant financial markets. The Bundesbank's (and now ECB's) continued monetary tightness despite Europe's high unemployment rates is especially fragrant. Thus the U.S. and Europe have largely neutralized the capital inflows and maintained stable conditions in their regions; globally, however, the overall effect has been the destruction of liquidity which has biased the world towards deflation. It is somewhat cynical for the U.S. to be preaching to Japan about it's global responsibilities in regard to macroeconomic policy while the U.S. maintains it's own self-centered macroeconomic policy.

This pattern has been repeated numerous times this century. The Great Depression was largely the result of surplus nations sucking liquidity out of the global economy. As Kindleberger has argued, the U.K. was unable and the U.S. was unwilling to accept the role of global central bank. During the late 1920s, first it was France that drained gold from the rest of the world by running surpluses due to an undervalued currency; they further reduced reserves by demanding gold instead of holding British pounds. These actions compounded an already low level of world reserves which existed due to the attempt by many nations to return to pre-war parities after the inflation of the First World War. These developments prompted monetary tightness in the deficit nations including the United States during 1928 and 1929; France failed to provide an equivalent stimulus and the result was a recession in the U.S. in the summer of 1929. After the U.S. recession began, the United States also became a surplus nation and also began draining gold reserves from much of the rest of the world. Once again, the surplus nations including the U.S. failed to provide any counteracting stimulus and as a result the depression ultimately became global.

An even more recent parallel, abet on a smaller scale, that is instructive has been the high unemployment rates in Europe experienced throughout the 1990s. After the fall of the Berlin Wall, the German government, in order to revitalize the East, went from a budget surplus in 1989 to fiscal deficits of around 3 percent of GDP for the next 7 years.⁽¹⁰⁾ The result was higher interest rates which had the effect of sucking capital out of the rest of the EU. Those nations that attempted to maintain their exchange rates with the mark were forced to raise their interest rates to keep capital at home. The result was low growth and, due to particularly inflexible labor markets, increases in unemployment in all the periphery EU countries. The Bundesbank, however, did not allow the fiscal stimulus to inflate the German economy, monetary policy was kept sufficiently tight in order to counter the fiscal stimulus. Thus once again, the same pattern emerges, the capital outflow nations experience recession while the inflow nation has the luxury of selfishly maintaining stability. The overall result is a deflationary bias. And once again, the same long-run pattern emerges, the deflationary effects ultimately find their way to the capital importer as unemployment in Germany (the western Landers) increased slowly from 5 percent in 1991 to almost 10 percent by 1997. Throughout Europe the cyclically unemployed have now become structurally unemployed through the process called hysteresis whereby human capital is depreciated by periods of unemployment.

The EU members of this currency arrangement clearly realized that it was undesirable to be part of a monetary system where the central bank (the Bundesbank was in effect the central bank of Europe) made decisions not on the economic conditions of the entire region but only on the economic conditions in a sub-part of the region, e.g., Germany. It would be equivalent to the U.S. Federal Reserve making monetary policy based on conditions only in New York state instead of the entire country. Thus the Europeans decided to replace this arrangement with the Euro controlled by a European Central Bank which would base monetary decisions on EU-wide economic conditions and not just conditions in Germany. The Europeans have clearly recognized the basic problem -- economic stability requires that monetary policy be determined by a centralized authority which determines liquidity based on the economic conditions of the entire region.

Paradoxically, even the inflationary episode experienced by the world during the latter part of the 1970s resulted from the same defect. Firstly, although there is a deflationary bias in the design of the monetary system, the deficit nation generally experiences inflation in domestic currency; thus, for example, although deflation is said to exist throughout Asia now, there has actually been significant inflation in these Asian nations in terms of their domestic currency. In the 1970s, the deficit nations (oil importers) turned out to be the industrialized nations; thus inflation in dollar or mark terms is consistent with the pattern. Also, the surplus nations chose not to neutralize their surpluses (which is the usual pattern) but instead to recycle them. This was possible because the deficit countries were, in this unique instance, the creators of the international reserves, and therefore unlike the usual case were reserves are limited, had basically unlimited reserves since they were able to simply print them. Thus although the inflation of the 1970s would at first appear to be an exception to a world biased towards deflation, properly interpreted it was a result of the same design flaw. Instead of the deficit nations having to deflate to conserve reserves, the deficit nations were able to print the needed reserves which ultimately produced global inflation in terms of those currencies. The United States has been the great defender of the current architecture because it has this luxury of being able to print international reserves and is therefore free from ever having to be the economy required to deflate.

Conclusion

The current international monetary system is deficient in a number of ways. Three areas are readily apparent from the global economy's current situation. The current system is unable to transfer savings from nations that "over" save to those in need of the savings. The current system is susceptible to "irrational" hot money movements that are wrecking havoc on basically sound economies, and the current design is such that these capital flows do not just redistribute demand from one area to another but actually result is an overall decrease in global demand which imparts a deflationary bias on the global economy. The economic recession in Japan, the Asian currency crises, and the spreading global recession are all significantly connected to these design defects. The problem is that economies that are highly integrated need a central bank to facilitate the transfer of resources, act as a lender of last resort, and control the level of liquidity. Keynes recognized this a half century ago; however, because of the public's desire for national autonomy, a patchwork of institutions and programs have had to oversee the operation of international monetary affairs. The shortcomings of the current approach will continue to become more apparent as economic integration proceeds. The history of the economic integration of the United States and Europe clearly bear this out. Currently Tony Blair and Bill Clinton are talking about a new Bretton Woods conference to provide bold initiatives to prepare the world economy for the 21st century. However, it is extremely unlikely that anything bold will be proposed, instead the proposals will likely be small and make very marginal changes in the current design of the international monetary system. Certainly the real issue of a global central bank will not be seriously discussed. The sacrifices of national autonomy to a global institution is well beyond serious consideration at this time. However, what can be hoped for are marginal changes in the design of the international monetary system that can partially alleviate some of the shortcomings. What is likely are increased funding for the IMF, with perhaps addition emergency funds from various sources such as the regional banks or more swap agreements. Increased financial regulation and oversight of banking and commercial lending are likely. Capital controls of some form may be adopted. The need for monetary policy in the reserve currency nations to be more oriented towards global conditions must be accepted. This Band-Aid patchwork, which is better than nothing, may keep the system going another decade or two. At some point, however, the basic design flaws pointed out by Keynes fifty years ago will have to be squarely addressed.

The basic problem with the international monetary system is similar to the basic problem confronting the international trading system and the WTO. Despite all the desirable properties of a capitalist market economy, for optimal performance, an economy requires centralized control. As global economic integration proceeds, the patchwork of agreements amongst sovereign states become less effective. In the trading regime the issues are the use of common property resources, labor standards, transboundry pollution and other externalities, environmental dumping, intellectual property rights, and the provision of global public goods. The states of the United States and now the nations of the European Union have recognized that these trade issues as well as the monetary issues discussed here require centralized decision making; at some future date, an integrated global economy will realize that as well.

References

Feldstein, Martin and Charles Horioka, "Domestic Saving and International Capital Flows," The Economic Journal, Vol. 90, 1980, pp. 314-329.

Krugman, Paul, "It's Back! Japan's Slump and the Return of the Liquidity Trap," mimeo, 1998.

Nurkse, Ragnar, International Currency Experience, League of Nations, 1944.

Organization of Economic Cooperation and Development, various country reports for Japan, 1997 and Germany, 1998.

Rodrick, Dani, "Who Needs Capital-Account Convertibility?," Princeton Essay in International Finance, forthcoming.

Salvatore, Dominick, "Capital Flows, Current Account Deficits, and Financial Crises in Emerging Market Economies, The International Trade Journal, Vol. 12, No. 1, Spring 1998, pp. 5-22.

1. The views expressed here are those of the author and do not represent the official positions of the Department of Labor or the U.S. Government.

2. (OECD-Japan-1997-p.112)

3. (OECD-Japan -1997-p.140)

4. How does central bank create inflation if it can't increase aggregate demand?

5. Theoretically there could still be a real problem but the required elasticities for such an outcome are unlikely.

6. The expected reversal (due to demographics) is a critical component of the problem, some transfers such as the German reparations would not have that characteristic.

7. For example both Stiglitz and Salvatore conclude that even with the benefits of hindsight, it is difficult to predict which countries would be subject to capital outflows.

8. The degree to which restrictions on foreign investment may negatively impact growth will have to be compared to the growth debilitating effects of macroeconomic crises. However even at a general level, Rodrick finds no evidence that liberalized capital accounts have been associated with higher economic growth.

9. Many commentators seem to imply that countries which have run significant current account deficits have acted irresponsibly, but they usually don't articulate exactly what should have been done otherwise. The only alternatives are capital controls and sterilized intervention.