Introduction: international financial crisis: what role for government?

• Author: Dorn, James A.

If investment flows are to continue to emerging economics, a new means must be found to bring predictability to the resolution of unsustainable sovereign debt. But will this be imposed by flat or evolve though market forces? Will the IMF return to its original mandate or extend its command and control over developing nations and markets? ... The outcome will determine the wealth and well-being of the globe's developing countries.

--Adam Lerrick and Allan H. Meltzer (2002: 1)

The Credibility Problem

The impoverishment caused by broken promises on the part of governments that fail to protect private property rights, enforce contracts, and limit taxing and spending to prudent levels is evident in the increased frequency of financial crises in emerging market economics. Argentina's stunning default in December 2001 and the Brazilian crisis in 2002 are only the latest examples of how bad government policies undermine confidence and destroy wealth.

After the Argentine government defaulted on its debt, reneged on its promise to convert pesos into dollars on demand, devalued its currency, denied free access to bank deposits, and, most recently, imposed capital controls, what investor could possibly have confidence in the future of that country--or in Brazil--without fundamental political and economic reform?

The International Monetary Fund's refusal to bail out Argentina was an admission that a new course was needed to deal with sovereign debt crises, which are closely linked with currency and banking crises. To contain and prevent such crises requires that governments pursue transparent pro-market policies that cannot easily be reversed. There must be a long-term commitment to free trade, the rule of law, and sound money; otherwise global investors will take their capital elsewhere. By failing to honor its debts and to maintain the value of its currency, the Argentine government destroyed the confidence it had established and increased the costs of attracting future investment funds.

Although the IMF has poured billions of dollars into emerging market countries since the 1994-95 Mexican peso crisis, the credibility problem remains--namely, how to create an institutional framework in which governments "do no harm," so that markets can increase economic growth and stability. That issue and the question of whether IMF intervention can improve on potential market solutions to sovereign debt crises were the focus of the Cato Institute's 20th Annual Monetary Conference--"International Financial Crises: What Role for Government?"--cosponsored with The Economist, October 17, 2002, in cooperation with the Donald and Paula Smith Family Foundation.

The articles in this issue of the Cato Journal were all first presented at the 2002 monetary conference. Those that relate directly to sovereign debt, especially the question of alternative approaches to restructuring unsustainable debt of emerging market countries, are summarized in this introduction.

Promoting Financial Resilience

To avoid the debt, currency, and banking crises that have plagued emerging markets, governments should work with, not against, market forces. That is the best way to promote financial resilience, according to William McDonough, former president of the New York Federal Reserve Bank. Strengthening market institutions is essential for averting financial crises and efficiently allocating capital around the world. Both the new Basel Capital Accord and any future changes to the framework for resolving sovereign debt crises must start from market principles.

The Basel Capital Accord

The 1988 Basel Accord, which established capital adequacy standards, became outmoded as global capital markets, innovation, and advanced information technology outpaced regulators. Existing regulations are burdensome and need to be revamped. McDonough, as former chairman of the Basel Committee on Banking Supervision, favors improving the allocation of credit by increasing capital requirements for high-risk banks and lowering requirements for low-risk banks. He also would allow greater flexibility in measuring operational risk.

The more fundamental question, however, is whether a new accord, which would presumably continue to harmonize capital standards, is superior to competition among standards. That issue is central to the problem of promoting financial stability and resiliency. As Jacobo Rodriguez, a financial analyst at the Cato Institute, notes in his article, "Greater emphasis on...