THE ANNALS OF THE AMERICAN ACADEMY RISK WITHOUT REWARD Capital Market Liberalization and Exchange Rate Regimes: Risk without Reward

This paper examines the consequences of capital market liberalization, with special reference to its effects under different exchange rate regimes. Capital market liberalization has not lead to faster growth in developing countries, but has led to greater risks. It describes how International Monetary Fund policies have exacerbated the risks, as a result of the macro-economic response to crises, with bail-out packages that have intensified moral hazard problems. The paper provides a critique of the arguments for capital market liberalization. It argues that capital flows give rise to large externalities, which affect others than the borrower and lender, and whenever there are large externalities, there is potential scope for government interventions, some of which are welfare increasing. 219 ANNALS, AAPSS, 579, January 2002 Joseph E. Stiglitz holds joint professorships at Columbia University’s Economics Department, School of International and Public Affairs, and Business School. From 1997 to 2000 he was the World Bank’s Senior Vice President for Development Economics and Chief Economist. From 1995 to 1997, he served as Chairman of the U.S. Council of Economic Advisers and a member of President Bill Clinton’s cabinet. He was previously a professor of economics at Stanford, Princeton, Yale, and All Souls College, Oxford. He was awarded the Nobel Prize in Economics in 2001 for his analysis of markets with asymmetric information. F OR almost half a decade, capital market liberalization raged as the prime battleground between those who were pushing for and against globalization, and for good reason: By the mid-1990s, the notion that free trade or at least freer trade brought benefits both to the developed and the less developed countries seemed well accepted. President Clinton could claim passage of NAFTA and the Uruguay Round, with the establishment of the World Trade Organization, among the major achievements of his first four years. APEC and the Americas had both committed themselves to creating a free-trade area. Not only had the intellectual battle been won— only special interests resisted trade liberalization—but so seemingly had the political battle. On other fronts, the broader liberalization/freemarket agenda was winning victory after victory: the Uruguay round had extended the scope of traditional trade liberalization to include liberalization in financial services, the protection of intellectual property rights, and even investment. Although the Multilateral Investment Agreement was having trouble, investment protections in NAFTA were cited as a basis on which further agreements could be reached. Even “liberal” governments—the democratic administration in the United States, the labor government in Britain—embraced privatization and deregulation, with the United States going so far as to push through the privatization of the corporation making enriched uranium, the core ingredient in making nuclear weapons (as well as fuel for nuclear reactors). Only capital market liberalization— eliminating the restrictions on the free flow of short-term capital—remained as a point of contention. At its annual meetings in Hong Kong, the International Monetary Fund (IMF) sought to settle this issue too: it asked for a change in its charter, to give it a mandate to push for capital market liberalization, just as it had a mandate, in its founding, for the elimination of capital controls that interfered with trade. The timing could not have been worse: the East Asia crisis was brewing. Thailand had already succumbed, with a crisis that began on 2 July. The delegates to the Hong Kong meeting had hardly unpacked their bags on returning home when the crisis struck in Indonesia. Within a little more than a year, it had become a global economic crisis, touching virtually every corner of the globe, with bailouts billed at more than 150 billion dollars occurring not only in Thailand and Indonesia, but Korea, Brazil, and Russia. And it was clear that hot, speculative money— short-term capital flows—was at the heart of the crisis: if they had not caused it, they at least played a central role in its propagation. The only two large emerging markets to be spared the ravages of the global financial crisis were India and China, both of which had imposed capital controls. (Even as the global economy faced a major slowdown, China managed to grow by more than 7 percent, India by more than 5 percent). Malaysia had imposed capital controls to help it manage its way 220 THE ANNALS OF THE AMERICAN ACADEMY