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