Ebook The Globalization of International Financial Markets: What Can History Teach Us?
Globalization has become the buzz word of the new millennium. It is viewed as the cause of many of the world’s problems as well as a panacea. The debate over globalization is manifest both in public demonstrations against the WTO in Seattle in the Fall of 1999 and the IMF and World Bank earlier. It also has led to a spate of scholarly and not so scholarly books on the subject.
Until three years ago the consensus view among economists on the issue of the international integration of financial markets was very positive. The benefits of open capital markets stressed include: optimal international resource allocation; intertemporal optimization; international portfolio diversification and discipline on policy makers. However, the recent spate of crises in Latin America and Asia has led some to argue that the costs of complete liberalization of financial markets for emerging countries may outweigh the benefits.
The paper focuses on the globalization of financial markets from the historical perspective of the past 120 years. In Section 2, I summarize the empirical evidence on the international integration of financial markets from 1880 to the present primarily based on my research with Barry Eichengreen and that of Maurice Obstfeld and Alan Taylor. This research shows that globalization has followed a U-shaped pattern for both stocks and net flows of foreign investment relative to GDP over the period 1880 to 1998. The ratios of both the stocks and net flows of foreign investment relative to GDP in the period before World War I was comparable to or even higher than today, collapsing to almost negligible magnitudes in the interwar and post World War II periods, until a recovery from the early 1970’s to the high levels observed today.
In Section 3, I consider the issue whether indeed the globalization of financial markets is much more pervasive today than pre 1914 – that although net flows relative to GDP may be less today than pre 1914 – the markets are broader and deeper. The greater extent of globalized capital markets today largely reflects institutional innovations overcoming the barriers of asymmetric information.
The flip side of open capital markets for emerging economies is the problem of financial crises – the pattern of lending booms and busts, massive capital inflows and equally massive reversals. This was a problem in the earlier golden age of liberal capital markets and is once again today. In Section 4, I examine the evidence on the incidence and severity of financial crises (currency crises, banking crises and twin crises) before 1914 and since 1973. The record suggests that crises are slightly worse on average for today’s emergers than those of the past, although there were several famous episodes where the collapse in output greatly exceeds the recent experience of the Asian tigers. Explanations for this pattern include the international monetary regime followed (the classical gold standard) and institutional differences (the advent of lenders of last resort and the International Financial Institutions).
Crises in both golden ages led to international rescues. In the earlier period they were arranged between advanced country central banks by private investment bankers whereas today by international financial institutions. In addition to a change in the character of the lenders, as I discuss in Section 5, the nature of the loans has changed from relatively small amounts to cover temporary current account shortfalls to today’s much larger packages to cover massive capital outflows.
An offshoot of the recent crisis problem is a backlash in favor of shutting off or slowing down the process of capital market liberalization. This is discussed in Section 6. Many have argued for the reimposition of capital controls (some on inflows, others on outflows) while others favor the sequencing of liberalization for those countries which are still not completely open. The evidence, both contemporary and historical on the effects of capital market liberalization/controls on growth and welfare is mixed.
The debate over capital controls is part of the more general debate on globalization. O’Rourke and Williamson (1999) provide comprehensive and convincing evidence that the integration of capital, labor and goods markets in the 1870-1913 period, led to factor price equalization and the convergence of real wages and real per capita incomes in the Atlantic economy. This process led to a political backlash in the early decades of the twentieth century in Europe and the Americas in the form of tariff protection, restrictions on migration and growing nationalism. A backlash against capital movements followed in the 1930’s in an attempt to protect monetary sovereignty. The question arises whether similar forces are at work today.
The paper concludes with some policy lessons from the historical record. The benefits of financial market integration are long run while the costs of financial crises are short-run phenomena. The role for policy is to provide an environment for markets to work efficiently and to allow private capital flows to seek their best use in an unfettered manner. Such an environment can mitigate the incidence of crises but not prevent them entirely. In that eventuality there may be a role for the emergency provision of liquidity on classical Bagehotian lines.
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