Culprit Is Unregulated Capital

The world’s great financial powers and institutions continue to scramble in an effort to contain the Asian financial crisis. But the one-size-fits-all austerity packages that the International Monetary Fund is shipping to East Asia target the domestic symptoms, not the international causes, of the crisis there. They will not solve the underlying economic problem.

High economic growth in Asia has smothered political conflict there; austerity can only ignite it, contributing to additional financial and economic distress.

Are the East Asian economies today so different than they were just a few short years ago, when the World Bank trumpeted that the “Asian miracle” was due largely to sound macroeconomic management? No. What we are currently witnessing is the consequence of a fundamental flaw in the international financial system, not of individual countries’ domestic economic policies. This flaw can be classified as a “market failure,” which is of profound significance.

The magic of the market system is that the effort of each actor in pursuit of his or her particular (selfish) interest generally results in the outcome that is optimal for society as a whole. Adam Smith’s “invisible hand” assures this outcome, not government policy. However, Smith and the classical economists recognized that there are some instances when the sum of individual actions does not produce socially optimal results. These are cases of market failure, and as such provide justification for government intervention to correct the imbalance.

The classic example of market failure is pollution. When a factory produces cars, it may also create air and water pollution in the process. This represents a cost to society, but it will not be factored into the cost calculation of the manufacturer. Thus there will be more pollution than is socially optimal.

It is crucial to recognize that pollution itself is not the market failure but rather the fact that too much pollution gets produced because its cost to society is not taken into account. However, government can restore the harmony between particular and social interests by taxing pollution.

The unregulated flow of financial capital is a form of economic pollution that is soiling economies around the world. Why? Because the pursuit of self-interest by the owners of financial assets does not lead to the social optimum for three reasons.

First, economies need some basic price stability to function. But today’s technology means that investors can move huge amounts of money almost instantaneously, at very little cost. Thus the value of assets, including national currencies, can change significantly, literally overnight. This is costly for any society: Imagine living in a world where your income, rent and the price of lunch fluctuated dramatically each day.

Second, to an important extent, financial assets are worth what people think that they are worth. Thus fears regarding what other people are thinking can cause herding behavior, unleashing financial stampedes with economic consequences that veer far from the path suggested by any reading of the economic “fundamentals.”

Third, it is a fallacy to think that every country should pursue the same macroeconomic policies. Countries face diverse economic conditions and needs to tailor their economic policies accordingly. But investors, scanning the globe for the best rates of return, create pressures for conformity across countries’ macro policies. Nations that deviate from the international norm, even when pursuing policies appropriate for local needs, are “punished” by capital flight.

Unregulated capital is thus a case of market failure. But as with other forms of “pollution,” the problem is not mobile financial capital itself, which is one of the engines of global economic growth. Rather, the problem is the unregulated nature, or “cost-lessness” of contemporary capital movements, which results in greater financial mobility than is optimal from a global societal perspective, because its negative effects are not part of the calculations of its producers.

The best way to correct this problem is the traditional solution to market failure: Tax the pollution in order to force producers to consider the full range of its costs so that pursuit of narrow self-interests and the social optimum again converge.

Such a tax was proposed 20 years ago by Nobel Laureate James Tobin. The “Tobin Tax” would not eliminate all instability in the international financial system. But it would go a long way toward correcting a serious and consequential market failure without sacrificing any of the benefits that capital mobility provides. A tax of, say, 0.2% would discriminate between “good” and “bad” financial flows, deterring quick round trips (because 0.2% would then translate into a high effective annual rate) while having only a trivial effect on long-term flows. It would also give countries greater macroeconomic policy autonomy but would still leave them accountable: Inappropriate policies would remain subject to the discipline of capital flight.

East Asia’s economic problems are principally international in origin. The national solutions that are being proposed--and imposed--are misguided and politically dangerous. Failure to recognize this will serve solely to contribute to greater upheavals in the future.