scan globally, reinvent locally: innovating financial markets joseph e. stiglitz columbia university...
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SCAN GLOBALLY, REINVENT LOCALLY:INNOVATING FINANCIAL MARKETS
Joseph E. StiglitzColumbia University
New York
Global Leadership ForumKuala Lumpur
September 6, 2005
INNOVATION AND FINANCE: KEYS TO SUCCESS IN A DYNAMIC MARKET
ECONOMY
Need to scan globally– To look for best practices– To look for failures– To see the circumstances in which different
policies, institutions have worked well or failed– To assess what has best prospects of working
Reinvent locally– After determining the strengths and problems,
challenges and opportunities of the local economy
– “One size fits all” policies have failed
ROLE OF FINANCE AND FINANCIAL MARKETS
Allocates scarce capital- Brain of economy- Without access to capital, new enterprises
cannot be created and old enterprises cannot grow
Monitors that it is used well Redistributes risk
- All investment is risky, and- Firms, individuals risk averse- Risk discourages investment- Innovative mechanisms for risk sharing can help
promote investment, development and growth by lowering risk premium
FINANCIAL DYSFUNCTION AND RISKS OF LIBERALIZATION
Poorly designed, managed financial systems can impede growth
– Macro instability– Lack of access to capital– Access only at high cost
While liberalization and innovation are intended to improve the functioning of capital markets
– Overall risk is increased– Capital is less well allocated– Certain groups no longer have access to capital– Cost of capital actually increases
EXAMPLE: RISKS OF FINANCIAL INNOVATION
Some of innovations in financial markets, including those for divesting risk also increase opportunity for risk taking– Derivatives
Have been abused, especially in under-regulated markets– To avoid taxes– Led to conflicts of interest
• Evident in the U.S. during the “Roaring 90s” Leading to
– Misallocated and over investment– More macro instability, huge underperformance of
economy– Lower growth
IMPLICATIONS
Signifies the importance of good financial market regulations
Cannot separate out “micro-” and “macro-” regulations– Prudential regulations have important
macroeconomic effects
EXAMPLE: CAPITAL MARKET LIBERALIZATION
Was supposed to increase growth and stability- Actually led to more instability - And not to increased growth- Consistent with economic theory based on
imperfect (asymmetric) information- Even IMF now recognizes this - IMF models assumed perfect information
• Failed to understand modern advances in economic theory
• Their models were internally incoherent— they talked about problems of lack of transparency and bankruptcy, but their models did not incorporate these phenomena
EXAMPLE: PROBLEMS WITH ACCESS TO FINANCE
Long history of concern that unrestricted markets may lead some groups in the society to be underserved
– Predicted consequence of the theories of financial markets based on asymmetric information
– Explains the historical U.S. policy of limiting inter-state banking
– Lending (CRA) and branch requirements in the U.S, India have proven to be effective
SOUTH EAST ASIA IN THE GLOBAL CONTEXT
Peculiarities of global financial market– Risk of exchange rate and interest rate fluctuations born
by developing countries• Though “theory” predicts it should be borne by those more
able to bear risk– The richest country in the world borrowing huge
amounts from poorer countries• Though “theory” predicts flows of capital should move in
the opposite direction– Asia, especially South East Asia, is the major source of
global savings• And yet the dollar continues to be viewed as the reserve
currency• And much of Asian savings is “mediated” by Western
capital markets
PUZZLES AND PARADOXES: THE GLOBAL ECONOMY
Risk premia very low– Yet high levels of risk, uncertainty—exchange
rate volatility, oil prices, global imbalances
Low ‘risk premia’ sometimes attributed to global savings “glut”– Yet huge U.S. deficits, which look like they will
be getting larger
Soaring oil prices– Yet investments in alternative energies,
conservation have not increased much
PUZZLES AND PARADOXES: THE U.S. ECONOMY
Short term interest rates have continually increased in the last two years– Yet long term interest rates have fallen
Interest rate decreases have failed to stimulate business investment– Though it did lead to real estate boom (bubble)
U.S. Consumption level remains strong– Yet real wages stagnate
Huge turnaround in the U.S. fiscal position - from 2% surplus to 4% deficit– Less stimulation to U.S. economy than one would have
expected
CHANGES ARE IN THE WIND: END OF DOLLAR AS A RESERVE CURRENCY
Dollar losing the status of reserve currency Already evident in changes in private holdings and some
Central Bank portfolios Exchange rate instability means that dollar is no longer
good store of value – what matters to countries is a ‘reserve of wealth’
• Instability likely to continue• As U.S. fiscal and trade deficits continue to increase• U.S. fiscal deficits may further increase with
– Permanent tax cuts– Social security reforms (probably dead)– Other tax reforms– Costs of war in Iraq– Borrowing not being used to finance investment
What countries need to do is to manage their wealth• Which entails risk diversification
INNOVATIVE RESPONSES
Reforms in the global reserve system– Problems are inherent in current system– But reforms will be difficult given the resistance from U.S.,
even though it would be in best interests of U.S. – Current system not only leads to instability– But there is a huge opportunity cost in holding dollar reserves
Exchange rate and interest rate volatility is likely to remain large– Need to recognize huge costs associated with freely flexible
exchange rates• Though as Argentine experience showed, there can be huge costs
associated with excessively rigid exchange rates as well Need to have regulatory frameworks that recognize this,
mitigate consequences• Need to find innovative ways of transferring, absorbing risk
better within Asia, managing Asian financial markets• Asian Monetary Fund• Chang Mai Initiative
MANAGINGS THE RISKS OF HIGH ENERGY PRICES
Why have high energy prices so far failed to elicit supply response?
– Long lags– Uncertainty about whether prices will remain high: low
costs of production in Saudi Arabia What is needed is more conservation
– But, unfortunately, largest energy consumer (US) just passed energy bill which did little for conservation
– ‘Drain America First’ policy leaves the U.S. more vulnerable to supply disruptions
And free market economics has left Europe more vulnerable to gas interruptions from Russia While financial markets themselves provide only limited “insurance” against these risks
MANAGING THE RISKS OF HIGH ENERGY PRICES
The ‘best’ way of managing risk is to own energy-based assets
– Global market place makes this possible– Even countries with high energy dependence
can thus mitigate risk– But this means a different approach to
managing nation’s “reserves”, national asset management
– Has consequences both for distribution of income within and among countries and for macro-stability
MANAGING ONE’S OWN WEALTH
Lessons of the “Class of ’97”
Control does matter– Decisions about moving money into and out of
country can have huge consequences for entire country, not just capital markets
Asia, especially South East Asia, pays huge costs for “cycling” money through the U.S.– Differences between rate paid by US (e.g.
Treasury Bill) and rate paid to US (lending rate)– Huge costs of reserves– Lack of control
MANAGING ONE’S OWN WEALTH
Strengthening Asian financial markets would thus increase income, growth and stability
May require development of new financial instruments– Paying in a new unit of account– Based on a weighted average of currencies– Backed by governments– Perhaps through creation of new Asian
Monetary Fund
SOUTH EAST ASIA: BETWEEN TWO GIANTS
Fast changing global economy– With correspondingly fast changes in comparative
advantages• Dynamic and static comparative advantage
Even with globalization, borders do matter– One of the reasons why investors are attracted to China
But lying between two giants – China and India - gives South East Asia some distinct advantages– “Cross Roads”– And entrepreneurial intermediary– Knowledge of both economies– Access to both economies– Dual role, both competitor and complement
SOUTHEAST ASIA: BETWEEN TWO GIANTS
This will require countries of South East Asia to reassess their dynamic comparative advantages
– Niche markets– High innovation– Enhancing intermediary roles
Innovative financial markets will play a key role in redeployment of resources And will enable South East Asian countries to sustain the remarkable growth rates of the last three decades